Charlotte Moore looks at some of the issues that could affect UK schemes as we move towards exiting the European Union
- Leaving the EU may prove beneficial for UK schemes if they don’t have to comply with difficult areas of European legislation such as GMP equalisation
- However, economic uncertainty may prove challenging for schemes
- The UK may find it still has to comply with various European laws but have no say in how they are drawn up
At first glance, leaving the European Union could be beneficial to UK pension schemes, as they could avoid taking on some of the more difficult aspects of the latest round of European legislation such as the tricky issue of GMP equalisation.
But any hopes of a life less burdened by European laws are likely to prove short-lived, even if the UK leaves the EU. And over the longer term, life could prove to be much more difficult for pension schemes.
Challenges come from three key areas: additional strain on the funding of defined benefit (DB) pensions, long-term legislative risk and the fragmentation of London's financial services industry making running a pension scheme more complex and expensive.
The BHS and Tata Steel fiascos illustrate that inadequate DB funding was an issue before the UK voted to leave the European Union. Aon Hewitt's EMEA head of investment John Belgrove says: "The regulator might say these are exceptional cases but they are symptomatic of the broader problem of private sector DB underfunding."
The collapse in long-dated gilt yields exacerbated that funding crisis. In July, the Pension Protection Fund reported that private sector pension deficits had reached record levels.
At a micro level, however, the picture is less gloomy. Belgrove says: "Some schemes have taken advantage of market moves to reduce risk at better prices while others have benefitted from the fall in the pound." The schemes which have done well are those which had hedged their interest rate risk at 80% or higher, he adds.
Over the longer term, however, the greater challenge for pension schemes is economic uncertainty. Belgrove says: "This has two impacts on pension schemes: it lowers the returns on investments and it can undermine the strength of the sponsor covenant."
The impact on the sponsor covenant is the most important factor according to Belgrove: "The trustees can make good or bad investment choices but ultimately they are dependent on the covenant to reduce the deficit through sponsor contribution increases."
Companies are already fed up with the pension scheme always asking for more money to reduce the funding gap. "If their trading conditions deteriorate, they might be less able to stump up these payments," says Belgrove.
Rather than simply providing the necessary cash, company executives are more likely to argue against being put under additional financial stress because of a marked-to-market regulatory regime. "It could become a conversation about jobs versus pensions," he adds.
This has the potential to become a serious situation. "Pension schemes could be in a position to reduce employment levels and drive firms to bankruptcy," says Belgrove. This was already an issue before the referendum but will be further exacerbated by economic uncertainty.
This could result in a more serious conversation about the benefits promised to pensioners. Belgrove says: "At the moment, this is sacrosanct but the door was slightly opened with the discussion at Tata about switching to CPI from RPI."
Over the longer term, the consolidation of local authority pension schemes could be applied to private sector pensions. "This happened in the Dutch market," says Belgrove. It's not easy to combine DB pensions but it is a way of reducing costs, he adds.
These economic challenges can then feed into other pressures that schemes will face over the longer term – for example, legislative risk.
What deal will the UK get?
While it is currently impossible to predict exactly what future deal the UK will have with the European Union, once the UK has left, it will no longer be able to participate in the shaping of future legislation.
And while the UK will not have a say in shaping European regulation, there is a broad consensus it will still have to comply with these laws.
Sackers partner Sebastian Reger says: "As part of our trade negotiations we may well have to accept all the regulations, including those governing pension schemes, without having a seat at the table."
Even if the UK were to make a hard exit and have a similar status to other World Trade Organisation (WTO) members, there are no guarantees the UK would still not implement European regulation.
LCP senior partner Bob Scott says: "Even though the UK would not be compelled to follow the rules, the government could decide to implement them anyway."
Under a WTO arrangement, however, complying with regulation would be less of concern.
In a hard exit scenario, it's highly unlikely that the UK could put any meaningful trade deals in place with other partners in the two-year exit period once Article 50 had been triggered. Trade deals typically take between four and ten years to negotiate.
This would have such a destructive impact on the UK economy that most companies and pension schemes would face severe fiscal distress. Being shut out of the legislative process would be a less pressing concern.
However, if the UK were to negotiate a softer exit that enabled it to maintain most of its trading with Europe while complying with European regulation, not having a seat at the table could be particularly difficult for UK pension schemes.
Joe Dabrowski, head of governance & investment at the Pensions and Lifetime Savings Association, says: "This is of particular significance for the pensions industry because there is such tremendous variation in the different systems used around Europe."
Reger agrees: "While our pension schemes are similar to the Dutch, there are still differences. And there are significant differences with other European countries."
CMS Cameron McKenna partner, Emma Frost adds: "We often have to challenge new pension directives to understand how it will impact the UK and how it should be implemented." But without a seat at the table it will be much harder to make these clarifications.
Take the ‘holistic' balance sheet, which was originally proposed to give a harmonised snapshot of the liabilities carried by a pension on a company's balance sheet.
This would have created significant problems for the UK. Private sector pensions are underfunded by around £384bn. Implementation of the ‘holistic' balance sheet would have significantly increased deficits due to the use of a risk-free discount rate to calculate liabilities.
Dabrowski says: "If companies had only a few years to fill such a large financial hole, it would have significant impact on a company's financial viability."
Tightening scheme funding as employers assess the economic aftermath of Brexit would be particularly pernicious, he adds.
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