brexit – taking stock for pension schemes€¦ · covenant better able to underwrite current risk...

H E A L T H W E A L T H C A R E E R

B R E X I T – T A K I N G S T O C K F O RP E N S I O N S C H E M E S

1 9 J U L Y 2 0 1 6

M E R C E R W E B C A S T

ALAN BAKERUK DB Risk Leader

LE ROY VAN ZYLFinancial StrategyGroup Consultant

DARREN MASTERSHead of Covenant

Consulting

WAYNE DAVIDSONSenior Investment

Consultant

DEBORAH COOPERUK Policy

& Research Leader

RACHEL CROFTUK Governance

Leader - Retirement

ANDY PARKERDC & Financial

Wellness Consultant

© MERCER 2016 1

A G E N D A

COVENANT CONSIDERATIONS2

IMPACT ON RISK MANAGEMENT STRATEGY3

Working inpartnershipwith you

IMPLICATIONS FOR INVESTMENT STRATEGY4

SUMMARY AND QUESTIONS


MACRO-ECONOMIC CLIMATE1


CONCERNS FOR DC MEMBERS5

© MERCER 2016 2

Q U E S T I O N F O R Y O U

Following Brexit, what is your key concern??a. Strength of

employer covenantPoll results: 16%

b. Contribution levelsPoll results: 13%

c. Investmentoutcomes

Poll results: 65%

d. Member concernsPoll results: 6%

© MERCER 2016 3(C) MERCER 2016 3

MACRO-ECONOMIC CLIMATE– CHANGES SO FAR

© MERCER 2016 4

K N O W N U N K N O W N S

• Short-term impact on UKeconomy expected to benegative

• Medium to longer-termeffects much harder topredict.

• General election / anotherreferendum?

• UK ‘s negotiating stance?

• Scottish referendum?

• Irish referendum?

• EU negotiating stance?

• Calls for referenda in othercountries?

• Elections in Germany,France and Netherlands in2017 and a constitutionalreferendum in Italy(October 2016)

• Markets remain fragile dueto heightened uncertaintyand reduced liquidity

• Policy-maker response willalso be important (i.e.monetary and fiscal policy)

DOMESTICPOLITICS

EUROPEANPOLITICS

ECONOMICEFFECTS

MARKETEFFECTS

Brexit is not taking place within a vacuum – it is just one part of a complex macro-economicpicture containing many sources of uncertainty (e.g. China and the US)

© MERCER 2016 5

T H E M A R K E T S

-0.5

0.0

0.5

1.0

1.5

2.0

2.5

3.0

Jan 2016 Feb 2016 Mar 2016 Apr 2016 May 2016 Jun 2016 Jul 2016

%

Global bond yieldsUS 10 y UK 10 y Japan 10 y Germany 10 y

Source: Thomson Reuters Datastream

70

80

90

100

110

120

Dec 2015 Jan 2016 Feb 2016 Mar 2016 Apr 2016 May 2016 Jun 2016 Jul 2016

Global Stock Market Performancelocal currency, indexed to 100 at 1 January 2016

FTSE All-Share MSCI EM MSCI USA MSCI Europe ex UK MSCI Japan


1%

1.5%

2%

4%

5%

6%

7%

8%

9%


Opt

ion

Adju

sted

Spre

ad

Opt

ion

Adju

sted

Spre

ad

Credit SpreadsBarclays Capital Global High Yield BofA Merrill Lynch Sterling Non Gilts


1.1

1.2

1.3

1.4

1.5

1.6

1.1

1.2

1.3

1.4

1.5

1.6


Inde

x

Sterling exchange rates

GBPEUR GBPUSD

Source: BoE, Thomson Reuters Datastream

© MERCER 2016 6

G I L T S A N D S T E R L I N G• UK gilt yields at all time lows:

– 10 year gilt yield c.1% lower than at thestart of 2016

– 30 year nominal gilt yield c.1.7% at 15 July

• Mark Carney has suggested that the BoE islikely to ease policy over the summer– This could include rate cuts and

quantitative easing– Markets are now expecting no rate hikes

until after 2020– The March 2018 gilt dipped below a zero

yield (the first negative-yielding nominal UKgilt)

• Sterling has reached its lowest level againstthe US dollar since 1985

• S&P downgraded the UK from AAA to AA– Fitch downgraded the UK from AA+ to AA

and Moody’s placed the UK on a “negativewatch”

NOMINAL G ILT Y IELDS

1.0

1.5

2.0

2.5

3.0

1972 1976 1980 1984 1988 1992 1996 2000 2004 2008 2012 2016

Inde

x

GBPUSD since 1972

GBPUSD


0.0%

0.5%

1.0%

1.5%

2.0%

2.5%

3.0%

1 6 11 16 21 26 31 36 41 46

Yiel

d(%

p.a.

)

Duration

31-Dec-1519-Feb-1622-Jun-1624-Jun-1615-Jul-16

50

© MERCER 2016 7

B R E X I T S C E N A R I O S

Quick resolution - Hard Brexit

• UK leaves EU, reverts to WTO rules, has conclusive trade negotiations with EU.• Brexit creates winners and losers on industry sector level.• Economic activity recovers by 2018 causing short term inflation.• GBP recovers modestly by the end of the period.

Quick resolution - Soft Brexit

• Sharp slowdown in economic activity in 2016 HY2, GBP weakens.• Political resolution in mid-2017 (EEA type arrangement, or even a vote reversal).• Political clarity returns the markets to the pre-referendum levels.• No ‘EU exit’ referenda in pan-Europe and market-friendly parties win elections.

Protracted uncertainty - Inflationary

• UK fails to negotiate access to the single market on good terms.• UK economy slows down sharply, in a recession through 2018.• Monetary and/or fiscal stimulus and falling GBP impose inflationary pressures.• Anti-EU parties lose popularity in Europe after ‘Brexit’ sets an example.

Protracted uncertainty – Disinflationary

• No fruitful negotiations with EU by 2019, UK remains in the single market.• Economic growth is close to 0% in 2018, BoE cuts rates to 0%.• Continued uncertainty keeps global bond yields low and dampens equity markets.• GBP falls slightly.

Global contagion

• Negotiations between UK & EU are acrimonious, extreme political instability.• Anti-EU parties popular in EU, sovereign debt problems re-emerge in Eurozone.• UK moves into a recession and global growth slows, no GBP impact.• Yields continue to fall and inflation remains subdued.

Loss of confidence in UK

• Negotiations between UK & EU are acrimonious, extreme political instability• Anti-EU parties popular in EU, sovereign debt problems re-emerge in Eurozone.• Global growth slows while UK falls into a deep recession.• Further cuts in UK credit rating, GBP declines which is inflationary.

© MERCER 2016 8(C) MERCER 2016 8

C O V E N AN TCONSIDE RATIONS

© MERCER 2016 9

B R E X I T – C O V E N A N T I M P A C T S

• Brexit has created economic uncertaintyfor the foreseeable future

• Some companies and sectors of theeconomy will be much more severelyaffected than others, with marketsindicating strongly the key sectors ofconcern and anticipated winners fromBrexit

• Profit warnings have begun to emerge insectors likely to be impacted

• In an environment of significantuncertainty and limited opportunities,trustees and sponsors should not beafraid to consider material changes tofunding and investment strategy alignedwith any concerns regarding the futurestrength of the employer covenant

© MERCER 2016 10

KEY COVENANT QUESTIONS:

• Who provides my covenant support?

• How has Brexit impacted on the covenant:– Short term?– Medium term under different economic scenarios

and EU exit models?

• What alternatives are there to simply paying morecontributions?– Wait and see?– Contingent assets?– Alternative financing /SPV?

• What mechanisms are in place to monitor thecovenant and more importantly to respond tochanges?

B R E X I T C O N S I D E R A T I O N S S T A R T W I T HC O V E N A N T

Now more than ever a clear understanding is needed of the covenant support available,scenarios as to how that may change, and to link potential current and future covenantchanges to scheme actions

© MERCER 2016 11(C) MERCER 2016 11

I M PAC T O N R I S KM AN AG E M E N T S T R AT E G Y

© MERCER 2016 12

Funding level uncertaintyfrom investment andlongevity outcomes

Covenant strength isincreasingly uncertainover time

Time Time

+

Likelihood of memberslosing some of theirbenefits

Time

=

Given the prime importance of paying members their full benefit, the combined uncertainty must bemanaged robustly now and over time.

T H E B R E X I T I M P A C T O N R I S K M A N A G E M E N T

© MERCER 2016 13

Liability(self-

sufficiency)

Assets Risk Covenant(minimum)

Secure

Primary objective toreduce this exposureover time

Increase securedcovenant

Reduce risk2

5

Reduce liabilitiesvia memberoptions

1

Obtaincontributions

3

Earn investmentreturn

4

• How is Brexit changing the pressure points?• How should the solutions be restructured?

T A K I N G A H O L I S T I C V I E WT H E I N T E G R A T E D P E N S I O N B A L A N C E S H E E T

© MERCER 2016 14

W O R K I N G T H R O U G H T H E F O G

Expected outcome

…

…

….

…

…

…

Schemeoutcome

overnext

period

Covenant

…

Worst case event – mustmitigate this risk

Same/ Weaker

Actions Rationale

Solid paths more likely than dotted paths

© MERCER 2016 15

W O R K E D E X A M P L E

Expected outcome

*“Outcome” refers to a move in funding position, e.g “Downside” refers to a higher deficit.Dashed lines are less likely.

Reduce risk – Originalrecovery period for fullfunding maintained

Maintain risk – Aim toreach full funding earlier

Covenant better able tounderwrite current risk

Maintain risk – Seekadditional contributions

Actions very dependent onthe specific circumstances

Maintain risk – Originalrecovery period for fullfunding maintained

Lock in gains

Good outcome eventhough funding asexpected

Schemeoutcome

overnext

period

Covenant

Possibly reduce risk,depending on the nature ofany covenant weakness

Risk reduced if theCompany too weak to payadditional contributions –extend Recovery period

Continue to pursueefficiency gains

Worst case event – mustmitigate this risk

Depends on valuationcycle – preferablyautomatic contributiontrigger

Same/ Weaker

Stronger

Actions

Risk reduced if additionalcontributions unaffordable

Rationale

© MERCER 2016 16

H A V E / R E V I E W T H E R I S K M A N A G E M E N T P L A NKEY QUESTIONS INCLUDE:

• How much risk can we afford?

• How does this risk budget need tochange over time?

• What is an appropriate mediumterm milestone to focus near termactivity?

• How much can contributionsreasonably contribute to thejourney?

• What alternatives are there to theCompany simply paying morecontributions?– SPV / contingent assets?– Parent guarantees?

• What impact can member optionshave, on both existing TPs andlong term target?

• What does the low risk “residual”state look like?

REQUIREMENTS OF THE DE-RISKING JOURNEY PLAN:

• What?

• When? (e.g. trigger conditions and priorities)

• By how much?

• How? (e.g. monitoring and making sure “plumbing” in place)

Current position

Contingent contributions

Equity market risk

Longevity swap

Liability management

Interest & Inflation hedge

Benefit design

Residual

Buyout

End position

Value at Risk

Derisking Journey

Brexit couldmean re-

ordering and/orphasing

© MERCER 2016 17

A B E T T E R S E C U R I T Y A P P R O A C H ?

• External security creates the bridge between member security and flexible contribution policy• Brexit uncertainty can make this approach the best way forward

The contribution and risk package mostly wrong!

Scenarios: better than planned

poor

“according to plan”

Contributions Risk

Were too much Could have had less

Well judged Well judged

Were too little Should have had less

© MERCER 2016 18(C) MERCER 2016 18

IMPLICATIONS FORINVESTMENT STRATEGY

© MERCER 2016 19

I M M E D I A T E I N V E S T M E N T I S S U E S

Interest Rates Currency impact Liquidity

Have hedging portfoliosacted in the wayexpected?

Liquidity arrangements forcurrency hedgingpositions

Reduced liquidity in creditmarkets

Impact of lower yields:• reduced leverage in

LDI mandates/funds• Rebalancing

Currency hedging inoverseas equity positions

Freeze on trading inproperty funds

© MERCER 2016 20

K E Y I N V E S T M E N T T H E M E S

Take advantage of marketopportunities

Have you got the right governancestructure in place?

Does your investment strategy remainfit for purpose?

© MERCER 2016 22

PENSIONDELIVERY

ATRETIREMENT

WIDERSAVINGS

INRETIREMENT

GUIDANCE ANDADVICE

It’s all about the members!

Strategic planning

DEFAULTINVESTMENT

OPTIONTrustees

PlanSponsors

Both

C O N C E R N S F O R D C M E M B E R S

© MERCER 2016 24

S U M M A R Y

EXPLORE THE IMPACT OF DIFFERENT SCENARIOS TO TEST YOURPLANS

MONITOR DEVELOPMENTS AND BE READY TO REACT


MAKE SURE YOU HAVE A CLEAR RISK MANAGEMENT PLAN(COVERING FUNDING, COVENANT AND INVESTMENTS)

© MERCER 2016 25

Q U E S T I O N F O R Y O U

What are you planning to do next, as the firststep??

a. Review covenantPoll results: 9%

b. Discuss fundingwith sponsor / trustee

Poll results: 18%

c. Review riskmanagement

framework (IRM)Poll results: 28%

d. Review investmentstrategy

Poll results: 37%

e. Communicate withmembers

Poll results: 8%

© MERCER 2016 26

A N Y Q U E S T I O N S ?

Q U E S T I O N S

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© MERCER 2016 27

T O D AY ’ S S P E A K E R S

27

ALAN BAKERUK DB Risk Leader

[email protected]+44 20 7178 5531@notjustpensions

LE ROY VAN ZYLFinancial Strategy Group Consultant

[email protected]+44 20 7178 7057

@leroyvanzyl

DARREN MASTERSHead of Covenant Consulting


WAYNE DAVIDSONSenior Investment [email protected]

+44 20 7178 3259

DEBORAH COOPERUK Policy & Research [email protected]

+44 20 7178 7184

RACHEL CROFTUK Governance Leader - Retirement


@RachelCroft1

ANDY PARKERDC & Financial Wellness Consultant


© MERCER 2016 28

I M P O R T A N T N O T I C E S

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brexit – taking stock for pension schemes€¦ · covenant better able to underwrite current risk...

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