The Pension Pros (and Cons) of Brexit | Chief Investment Officer

UK pension funds could benefit from a vote to exit the European Union (EU) next month—but only in the short term, according to a report from a leading industry body.

“The assumption that a ‘stay’ vote would entirely remove uncertainty about Britain’s continuing membership of the EU is open to question.”The country’s combined corporate pension deficit—estimated to be £270 billion ($391 billion) at the end of April—could fall significantly in the immediate aftermath of the June 23 referendum, reported the Society of Pension Professionals (SPP). It estimated that a rise of 0.3% would cut £70 billion from defined benefit (DB) pensions’ combined liabilities.

A vote in favor of ‘Brexit’ would “provide a slight boost to pension finances in the short term, although the longer-term impact is harder to gauge,” the group said.

While markets are expected to react negatively to the uncertainty ensuing from a Brexit vote, the SPP said subsequent higher yields on index-linked bonds would “benefit most pension schemes, as they have not completely hedged their liabilities.”

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Similarly, a weakened sterling would also benefit pension funds that have not hedged out overseas exposure, according to the SPP.

But the society warned that longer-term risks were far less certain, as there was no plan yet agreed on for how the UK’s relationship with Europe would evolve following an exit.

“In all likelihood, a vote to leave would change nothing material in the short term,” the SPP said. “The resulting period of uncertainty would likely have a detrimental impact on financial markets—and therefore pension funds. On the other hand, the assumption that a ‘stay’ vote would entirely remove uncertainty about Britain’s continuing membership of the EU is open to question.”

Away from investment issues, the report highlighted potential savings from the ability to opt out of European legislation. It cited research from the Department for Work and Pensions, suggesting that “freedom from EU regulation could result in the UK pensions industry avoiding potentially crippling future measured deficits of at least £450 billion.”

UK pensions could also avoid solvency rules if the country exits Europe, the report said. The European Insurance and Occupational Pensions Authority (EIOPA) last month introduced watered-down reporting system for the funding levels of defined benefit plans.

EIOPA has said UK pensions would be liable for the bulk of €300 million ($339 million) in implementation costs, as the country’s regime is decidedly different from most other EU member states.

“The chances of a solvency regime for the UK is pretty much zero should Brexit occur,” said Robin Penfold, chair of the SPP’s investment committee. “That chance is much higher if we’re in the EU.”

The SPP’s membership includes pension managers, actuaries, consultants, and asset managers.

The relevant question for plan sponsors isn’t whether to transfer liabilities, but rather when to do it, according to Russell Investments’ research chief.

All frozen defined benefit (DB) plans will be terminated eventually, Bob Collie pointed out. At some point, handing off lingering payout responsibilities to an insurer or some other third party just makes business sense.

“If you’re frozen, at some point you will be doing a risk transfer,” he said in an interview with CIO.

Collie said interest in annuity buyouts has “really ramped up” over the last five years, with six deals in excess of $1 billion occurring in the US since 2012. Upwards of $260 billion in pension liabilities have transferred since 2007, according to Prudential, including $67 billion in US PRT deals.

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prudential prt Source: Prudential’s “Closing the Gap in DB Plans”When asked, 38% of corporate plan sponsors told Prudential they see PRT as a way to focus on the company’s core business, rather than pension risk management. An additional 35% said they viewed liability-driven investing as a path toward a full liability transfer.

But just because a risk transfer is the next logical step for frozen plans, Collie cautioned, doesn’t mean it ought be the next immediate step.

“When the possibility of risk transfer is being discussed, it’s often, ‘Are we going to do this or not?’” Collie said. “The assumption being that we’re going to do this right now.”

Collie said pension plans can usually benefit from a hibernation phase—that is, continuing to manage assets and pay out liabilities after the plan has been frozen. Hibernation, he explained, allows time for the plan’s liabilities to “run down” as active employees leave the company or retire and participants and their beneficiaries die. The plan as a whole becomes less risky and the costs of offloading liabilities less expensive.

“The longer you wait, the more those liabilities get closer to being paid, and the better place that liability profile is in.” he said.

In addition to the plan’s liability profile, other factors sponsors should take into consideration when deciding when to conduct a risk transfer include how big the plan is, how much it costs to operate, and whether it is potentially destabilizing for the company, Collie said.

“There are both risk and cost elements of it,” he concluded. “It’s important to make sure you’re looking at it from every angle.”