DB asset allocation and pensions risk management models will be tested by uncertainty caused by the Brexit referendum, with gilt yields, interest rates, equity values, volatility, default risk of corporate bonds and FX all likely to impact both the pension scheme and the sponsoring companies says Lincoln Pensions.
Lincoln says consultants and schemes should be reviewing their hedging strategies, and argues high volatility raises the question of whether asset and liability allocation models used by consultants are still fit for purpose since they are based on historic factors which have never experienced a Brexit scenario.
Lincoln Pensions actuary and senior advisor Francis Fernandes says: “In the run up to the Brexit vote, there may well be sharp spikes in volatilities across many asset classes typically held by pension fund trustees. Whilst many trustees will be happy to sit tight, knowing the employer standing behind the DB promise is strong enough to absorb any short-term shocks, for others with weaker employers behind them, these spikes may present a window to take short-term action, albeit for different reasons: some to try and take advantage of any favourable short-term impact on from weakening sterling in relation to overseas investments; others by purchasing short-term insurance to protect against adverse outcomes like assets falling sharply in the run up to 23 June.
“It seems prudent for the Brexit issue in a wider sense to be an item on all trustee agendas but especially for those schemes with weaker employer covenants, not only to decide if any short-term action is required but also to assess the long-term impact taken together with the impact of other global factors which appear to be creating more uncertainties for the years ahead. Combined, these may mean that we could be heading for a step change up to higher levels of volatility and risk in the next few years. If that is the case, the assumptions for future asset returns, volatilities and correlation assumptions which help to drive asset allocation will need a rethink by placing less reliance on assumptions derived from the past and more on where pension funds are about to find themselves in the new world.
“Where you have macroeconomic changes, FX tends to react first, which is what happened following the revelation of Boris’ position. What we haven’t seen is a significant sell-off of UK equities related to the Brexit – the current volatility probably relates more to the continued nervousness around China. There tends to be a lag between significant FX movements and equity sell offs of this nature.
“I think that we’re not going to see mean reversion of long term rates for some time now. We’re in a different place from the US and Carney’s essentially said that he doesn’t see a rate increase in the near term. That was on the assumption that the position remained as is – i.e. within the EU. If we depart post-referendum, then, you’re more likely to see the BoE being cautious until they’ve got a handle on how fragile that may make the UK economy – so, whether we’re in or out, I don’t think rates are likely to go up in the near future – which clearly has an impact on scheme liabilities.
“Spreads are widening. They may have an adverse impact on the balance sheet strength of insurers who have tended to focus on credit-based portfolios and also persuade their schemes to do the same thing.
“Insurers will have modelled for potential Brexit in the internal stress tests – so it will be interesting to see how their models will play out relative any real position. They also tend to be the biggest buyers of gilts and corporate credit, so if they and utilities are concerned, the increased demand will continue to have a negative (i.e. downward) effect on long term gilt yields because of the inverse relationship between the gilt prices and yields.”