Summary
On 23 June the UK people voted to leave the European Union and this has had a significant impact on markets, particularly:
- Gilt yields and the expected path of future interest rates,
- expected inflation,
- the value of Sterling and
- expected economic growth.
Potential implications
Gilt yields have fallen materially since the vote, leading to an increase in the value of most pension schemes’ liabilities. However, to the extent that schemes hold bond investments of appropriate duration, the fall in yields will have led also to an increase in the value of the scheme’s assets. If these lower yields are sustained in the longer term trustees of schemes that have not hedged their interest rate risk should consider the implications for their funding plan.
The main credit rating agencies have downgraded UK Government debt but this appears to have had little effect on investor demand.
It seems likely also that future inflation may be higher than anticipated previously, at least in the short term, because of the weakening of Sterling. This will lead to an increase in the value of schemes’ liabilities, as pension increases and revaluation will be higher than assumed previously. Again, this may have implications for trustees’ funding plans. Again, however, the effect will be less significant for schemes that have hedged part or all of their inflation risk, either through holding index-linked Gilts or through liability-driven investment.
For schemes that hold overseas assets the impact will depend on whether they have hedged their currency exposure. A hedge back to Sterling will have been a drag on performance since the referendum, compared with a similar unhedged fund.
Most commentators expect that the UK’s economic growth will be lower than predicted before the referendum: this may mean that returns on schemes’ UK growth assets will be lower in the future than has been expected. There is an argument that UK companies with significant overseas earnings may outperform but much will depend upon the trade deal achieved with the EU – which will also affect European Growth Further, we might expect to see an increase in default risk for Corporate Bonds issued by UK companies. This may have ramifications for scheme funding if valuations anticipate some or all of that growth, as well as for schemes’ investment strategy.
The shorter term
In the shorter term we expect markets to be volatile – as indeed they have been since the result of the referendum was announced. Therefore we do not recommend any action at this time; we consider that it would be preferable to allow the dust to settle, allowing long-term strategic decisions to be made, rather than short-term tactical calls that may not actually add value. We do, however, recommend that trustees request that their scheme sponsor keep them informed of any changes they are seeing, or are likely to see, in their business as a result of the referendum outcome.