Brexit – Short Term Considerations for Long Term Investors
11th April, 2016
The date for the referendum on the European Union membership has been set at 23rd June 2016. The result is not a foregone conclusion and both the “stay” and “leave” camps are going to spend the next 2-3 months on the campaign trail. We don’t know how it is going to go, but that doesn’t mean trustees cannot position themselves to capture potential upside, or to mitigate potential downside risk.
The pension scheme trustee is a long term investor, which means many investment consultants would argue short term investment issues should not be the number one priority. When volatility is unexpected and not driven by an obvious factor, this is probably true. However, when a significant political event is on the horizon that is known, and the volatility can be foreseen, it would be remiss of trustees not to at least consider the impact to the scheme.
Trustees should really look at an Integrated Risk Management (IRM) approach not only at the valuation, but as a long term principle for considering opportunities and risk. The Brexit ramifications could impact all of the pillars of IRM (although not necessarily negatively):
Covenant – How does Brexit impact your employer covenant? Trustees should be positioned to understand the employers view on Brexit and how that might damage or improve their covenant. This is not a question to ask after the event, this is something that can be discussed and debated before hand to predetermine the risks.
Investment – Uncertainty breeds volatility and Brexit provides widespread economic uncertainty which can spread throughout the Eurozone and beyond. Trustees should work with the employer to understand the exposure to key risks such as interest rates and inflation expectations. Trustees can look at their equity holdings, to check they are appropriately weighted in the Eurozone. It would fairly common for UK pension scheme to have a heavy UK equity weighting, this is something that needs to be closely thought about regardless of Brexit potential.
Funding – Investment uncertainty breeds funding fluctuations as the underlying gilt prices move the valuation basis up and down (as well as the assets). Trustees should be looking to consultants and advisers to monitor the movements and to make sure the triennial valuation results are not a surprise and not a shock that leads to difficult funding negotiations. If trustees do not have access to actuarial modelling software through either their actuary or investment consultant then they may be poorly equipped to manage the direction of their scheme.
These are the key considerations. However, the volatility also creates opportunity. For schemes with Liability Driven Investment (LDI) strategies already, there may be fleeting opportunities to extend liability hedging at attractive yields; as positive yield fluctuations could be captured via trigger-based implementation frameworks. These can come at a cost, but with daily yield movements in excess of 10bps, there may be excellent short term opportunities to lock in attractive pricing for liability hedging. What is attractive to one trustee, may be unattractive to you, it really depends on your long term view on interest rates and inflation and how strong the supporting employer covenant happens to be. However, if you have a good feeling as to what you believe represents reasonable or good value, setting yield triggers could be advantageous in a volatile market.
The key point of this blog is for trustees to be prepared. As a trustee you should not be saying “I didn’t expect that result” on the 24th June, you should be sitting in a settled state knowing you have considered the risks, and are positioned to move forward regardless of the result.