ON 4 AUGUST the governor of the Bank of England, Mark Carney, cut the Bank of England’s base rate to 0.25% and launched a massive stimulus package to counter what he said were clear signs that the Brexit vote was already having a negative impact on the UK economy. Irrespective of how one feels about the respective merits of being in or out of the European Union, Brexit looks, over both the short and the medium term to be bad news for UK defined benefit pension schemes.
For a start, there are two obvious negatives that are likely to increase DB scheme deficits for the next year or two at least. First, as the Bank of England demonstrated in spades with its rate cut, the low interest rate environment looks set to persist for a long while yet. Second, markets hate uncertainty and the one sure and certain fact about Brexit is that it is going to take at least two years and possibly longer for the terms of the exit to become clear. So we are in for a protracted period of low base rates and heightened uncertainty and market volatility.
What should trustees and scheme sponsors do in response to Brexit?
The question then is what should trustees and scheme sponsors do in response to Brexit? Mark Jones, a director in Deloitte’s pensions advisory services practice says that the best advice for both is to work together to plan a middle road between the two extremes of doing nothing and leaping into a hugely defensive investment strategy.
“What is needed is a measured action plan,” he says. However, it will be a “measured action plan” set against an unfavourable economic backdrop. There is no doubt that depressed gilt yields – a natural result of the low base rate regime around the world – magnify deficits by reducing the discount rate on scheme liabilities. At the same time substantial uncertainty in the markets is likely to depress asset values (though at the time of writing markets were at or near all time highs).
As a result, schemes could be looking at a double whammy of elevated liabilities and depressed asset values. This is not a happy position for scheme sponsors, some of whom could soon be facing calls for additional chunks of funding to help shore up their DB schemes.
Post-Brexit investment strategy
Jones argues that it is important for trustees and finance directors to look beyond the scary headlines. They need to look specifically at how their particular scheme is being impacted. “Schemes that have been quite heavily de-risked already have probably not seen a significant decrease in their deficit since Brexit,” he notes.
Raj Mody, partner and head of pensions at PwC agrees. “The fundamental point here is that despite all the headlines, Brexit has not yet happened and it has not yet been defined. So you need to take stock and not over-react,” he cautions. Interestingly, Mody argues that the furore around Brexit provides yet another reason for trustees and sponsors to move away from the practice of valuing their scheme liabilities by reference to gilt yields.
“If you are planning to have all your scheme assets in gilts as your end game for the scheme, or if you are planning a buyout, then sure, the discount rate is relevant. But if you are planning to run off your scheme off your own books, then I would really question its relevance. You need to work out what measure is right for your scheme,” he says.
The key point here is that IAS 19 prescribes the discount rate that schemes need to use, but the cash financing deficit that finance directors need to agree with their scheme trustees is not prescribed. This should be the measure of the deficit that is strategically right for that particular scheme’s overall investment strategy.
In those circumstances, Brexit notwithstanding, it could make more sense to construct a liability-matched portfolio of assets that may well have a cash flow basis, with the cash coming from a variety of asset classes.
What is certain is that both sides, trustees and finance directors, need to sit down with their advisors and work out a carefully thought through strategy to deal with the new dynamic imposed by Brexit.