One year out, Brexit is still a major pensions risk

With one year to go until the official transition period should begin, many questions remain unresolved, and both defined benefit and defined contribution scheme sponsors and trustees will have to assess, and continue to review, the broad ranging implications for their members.

The first question hovers over the likely performance of asset classes during this period of uncertainty and how to mitigate this risk.

Beyond market volatility, Brexit will have significant impact on the regulatory structure of the pensions industry

How will markets react?

With the possibility of heightened volatility in the financial markets, trustees and sponsors will have to consider carefully the impact Brexit will have on their portfolios and what effect any economic changes might have on a scheme’s ability to provide adequate retirement income to its members.

Not only might there be implications for long-term risk-free yields and spreads, but the uncertainty borne out of Brexit has also given rise to anxiety over weakness in sterling relative to the euro and the downgrading of estimated profitability for certain companies or sectors in the UK.

Of course, for some sectors, where overseas earnings make up a material proportion of earnings, the results in (devalued) sterling might give rise to increased profitability.

Sponsor covenants could weaken

For DB pension schemes, any negative impact on asset and liability values will require further action to be taken to repair these deficits.

Some schemes may choose to increase payments by sponsoring employers into the pension scheme or implement a reduction in benefits.

For DC assets, poor performance will feed directly through to the scheme members, with adverse impacts either leading to potentially lower living standards in retirement or the need for increased contributions in the future.

Regulatory divergence is an unknown

Beyond market volatility, Brexit will have a significant impact on the regulatory structure of the pensions industry.

Regulatory change will particularly impact pensions contracts issued by insurers; post-Brexit, UK-domiciled insurers will no longer legally be in the EU and, depending on the terms of any future UK/EU agreement, could be governed by independent capital and risk regulations.

However, any legislative change would take time and for the moment, the UK regulator has made it clear it intends to remain closely aligned to Solvency II.

Operational cost could be huge

Other changes are more time sensitive, and the operational effects of Brexit are already being borne out.

Insurance companies that have historically conducted business in Europe through a branch structure are working hard to find viable solutions that will allow them to continue to serve their customers and satisfy regulators with the minimum disruption post-Brexit.

According to the latest EY Financial Services Brexit Tracker, 13 insurers and insurance brokers have publicly confirmed at least one location in Europe to where they are moving or considering moving some staff and/or operations.

While there are numerous business and financial impacts for insurers to contend with post-Brexit, there should be little disruption from a consumer perspective as long as they are retiring in the UK.

Consumers face headaches

However, if a UK member chooses to retire to one of the EU27 countries, there may be complications.

Certain European regulators have already set out a definition for ‘conducting insurance operations’ and, as a result, for some UK insurers, this may make it illegal to pay pensions to ex-UK annuitants now residing in certain countries.

The UK government is aware of this issue and the concept of ‘contract continuity’ is on the agenda as part of the myriad considerations impacting the financial services industry.

Although fears of a ‘cliff edge’ in March 2019 have been reduced by the political agreement on a transition agreement, the ratification of that deal is still some months off.

Pension scheme trustees and sponsors will be closely monitoring the resilience of the market, while insurers’ contingency plans will continue to be implemented until the long-term future is fully clarified.

Gordon Wood is associate partner at professional services firm EY