Brexit – the implications for UK Pension Schemes
Pensions are long-term savings vehicles and can have a major financial impact on employers who provide them. They have a large volume of specific legislation but they are also affected by a host of other areas of law, including employment, financial services and data protection. Defined Benefit schemes also have a special long-term relationship with the business of the sponsoring employer and, if available, financial support from any parent group.
Our short-term advice on Brexit to pension scheme trustees remains the same as it was on Friday 24th June, you should ask the employer (and any parent) to update you on their contingency planning for their business(es) but beyond that most of your actions will be in the medium- and long-term.
In the medium-term trustees will need take advice on investment strategy, consider market developments and possible new hedging products and review their internal controls process and risk register.
In the long-term any action required will depend on what deal is done between the UK and the EU (or, indeed, any parts of the UK which leave the EU). You will need to consider whether this causes legal changes to available investment products and legal developments in important areas such as data protection, equality legislation and VAT. Although there are EU-wide laws for pensions, most matched pre-existing UK law and little impact is likely.
This note looks at some of these issues in more detail based on what we know as of June 2016.
The employer covenant is an important concept in schemes which provide benefits on a Defined Benefit basis, often using a multiple of final salary in the calculation of pensions. The employer covenant is the ability and willingness of the sponsoring employer group to support the scheme now and in the future. Assessing the covenant involves looking at the legal relationship between each employer entity and its parent company structure as well as looking at the financial strength of each entity and its future business outlook. Where reliance is placed on a parent company (or other member of the group that does not have a direct sponsoring relationship with the trustees of the scheme) the future outlook includes an analysis of the future legal relationship between the direct sponsor and indirect supporter.
Employer covenant is scheme specific and the effect of Brexit will be different from scheme to scheme. Some employers have made it clear that they do not envisage significant changes to their business and some of the businesses supporting the "Leave" campaign did so because they thought it would be better for their business.
For others a negative impact is feared. This may be a direct impact on the employers' business if it relies on the European market for significant elements of its turnover and profits. For others, the impact may be seen in the structure of the corporate group with the possibility of a UK entity becoming more economically and legally remote from European based associated companies or parent shareholder entities.
Where a scheme specifically has cross-border support through a guarantee or similar structure and that non-UK supporter is an EU entity, it is likely that the trustees have placed great comfort on the enforceability of the arrangements through the EU legal system.
If there are proposals that the UK breaks up into separate territories with different relationships with the EU – for instance, Scotland breaking from England and Wales and remaining an EU member – similar issues arise with employer groups which cross whichever boundaries become relevant.
At this stage there has been no negotiation started to determine the extent and nature of the relationship between the UK and the EU following any exit. Early statements from relevant leading politicians suggest that even the most prominent "Leave" campaigners want and expect there to be close trading links between the UK and the EU. Trustees will need to monitor the situation and, where more concrete developments become known, assess the impact on their covenant structure. The level and importance of the monitoring and the areas to be monitored will need to be decided by the trustees taking into account their employer structure and the importance of the competing issues to their scheme and its members. Where relevant it may be in the best interests of members of the scheme for trustees to respond to any consultations on proposed legislation or proposed terms of any agreement.
Pension Scheme Investments and Funding
The trustees of each occupational pension scheme are legally responsible for the investment of the scheme's assets. In Defined Benefit schemes the risk of under performance against liabilities generally lies with the sponsoring employers as they usually meet the balance of costs; in a Money Purchase scheme it is members that carry the benefit or burden of investment risk.
In taking investment decisions pension scheme trustees must follow any statement of investment principles (SIP) they have, consider their Trust Deed and Rules and before investing in any manner they must obtain and consider proper advice on whether the investment is satisfactory having regard to established legal principles. In deciding to retain any investment they must determine at what intervals the circumstances and the nature of the investment make it desirable to obtain proper advice on retention and they must of course consider that advice accordingly.
Nothing in this note should be taken as being investment advice and trustees must take that from a properly appointed investment advisor who should consider the overall circumstances of the scheme and not just the particular investment in isolation. Where the SIP needs to be amended, consultation with the employer will be required and we would expect most schemes to review their SIPs by the end of 2016.
Fundamentally pension schemes are long-term investment vehicles and their investment strategy and investment principles should already be designed to cope with short-term fluctuations and volatility in investment markets. So the immediate market impacts of the referendum results would not normally be a trigger to trade for pension schemes.
But looking to the medium term if trustees receive advice that they are facing several years of more extreme volatility or fluctuations then they need to consider the effect of market developments. On the investment side strategic options may become available to them which would allow them to capture some opportunities or protect themselves from increased risks. The development of new Brexit-hedging funds or products is possible. On the valuation side, the impact of economic changes may affect scheme funding and actuarial valuation assumptions such as discount rates and inflation.
For Money Purchase schemes that allow members to switch their investments, there is a risk that members may be tempted to "play the markets" in times of high volatility. Trustees should consider if it may be helpful to explain to members or remind them of the impacts of making switches. There may be costs involved and time delays between investment decisions and the implementation of them. If members have unrealistic expectations as to how quickly transactions are being processed and are making significant financial decisions based on those unrealistic expectations it will protect the trustees from future criticism if they explain the system more explicitly to the members. Remember trustees should not be giving financial advice to members.
Internal Controls and Risk Register
Trustees of all occupational pension schemes must establish and operate a system of internal controls which are adequate for securing compliance with all laws. Adequate internal controls are, in the words of the Pensions Regulator "a key characteristic of a well-run scheme and a key component of the trustee's role in securing members benefits".
The Regulator strongly recommends the use of risk management as a tool to identify risk and develop internal controls and, in practice, most schemes address this by drafting, reviewing and updating a Risk Register. While the exact contents can vary, the principle constituents of a Risk Register are:
- identify the risk;
- identify the potential impact if the risk materialises;
- identify steps that can be taken to mitigate the risk to stop it from arising or mitigate the damaging effect if it does arise;
- allocate responsibility for management of the risk and, if mitigation steps are needed, for reporting when those steps are taken; and
- review following specific events and pre-agreed time periods (usually between 1 and 3 years depending on scheme size and complexity).
More specific contents of Risk Registers will depend on the nature of the scheme, the nature of the employers' business and the availability of internal resources within the employer to support the process.
It is clear that the potential exit of the UK from the EU requires trustees to address their Risk Register, to review it and probably to amend it. As of June 2016 there is far too much political uncertainty to make any meaningful progress in a review of a Risk Register. If a review has to be undertaken now the output would be that the Brexit risk is noted and that a group of trustees or a nominated person is given responsibility for monitoring developments and updating the board and/or the Risk Register when those developments become more certain.
In our view it would be more useful for scheme members if trustees were, at their next regular meeting, to note the significant impact that Brexit will have on their Risk Register and set a time-scale for reviewing it by reference to political developments which have become known by the time of that meeting. If political developments are slow it would still be advisable to review the Risk Register by end of 2016 at the latest.
We heard a lot in the referendum campaigning about how much legislation in the UK starts at the EU. Some legislation is passed at a European level and is directly in force but most "European" legislation is implemented in the UK by UK-specific legislation passed by the Westminster Parliament on a basis that has been pre-agreed at a European level so that all members of the EU have consistent legal principles.
The areas of EU law in this wider sense that are most likely to affect pension schemes are employment law and workers' rights, data protection and information security, financial services and tax.
As the referendum was a single issue vote neither side was required to set out a detailed manifesto with policy proposals on a wide range of issues. As a result we have no clear information as to which laws will stay, go or be amended. Laws might stay the same either because Britain agrees a deal with the EU that is close to EU membership and therefore requires Britain to keep the rules or because Britain makes it own sovereign independent decision that it wishes to retain the same legislation. Only once these political decisions are made will trustees and employers be able to manage the impact of them. For certain legislative changes it may be sufficiently important for trustees and/or employers to involve themselves in consultations before the post-Brexit rules are finalised.
As the approach to certain legislation becomes clearer this will need to feed into the trustees' Risk Register with specific responses then to be considered. A few examples of potential changes and their impact on pension schemes are:
- If the UK's Data Protection laws deviate from EU standards then trustees are likely to need to take additional steps before using an administrator with an EU-based processing centre and the contract will need additional terms, including in relation to any exports of data from the EU back to the UK. This potential for change may impact on the terms of scheme administration contracts in the interim.
- If the UK is not part of the EU "passporting" system for financial services providers then a UK occupational pension scheme may not be a permitted investor for funds based in Dublin or Luxembourg which are commonly used by UK pension schemes. This will involve either the provider replicating the investment product on a London-based basis or requiring the UK pension scheme investor to sell its interest and invest elsewhere. The timescale for planning the exit will depend on the liquidity of the particular product, and whether transitional rules are agreed.
- VAT on administration and investment charges – currently UK occupational pension schemes operate with VAT treatment of investment management and adviser fees as a result of European Court of Justice case-law. Once Britain leaves the EU, HMRC would no longer be bound by this (subject to the final terms of any deal) and would be free to write their own rules going forward on the VAT treatment of such fees. In future any potential challenge could only be made on the grounds of the UK legislation to the UK legal system.
EU law on pensions is currently not a significant issue. Most provisions of the IORP Directive (IORP means Institutions for Occupational Retirement Provision and covers UK pension schemes) were similar to existing UK legal principles for pension schemes and they have now been in force for over 10 years. It is unlikely that the UK would amend these significantly even if not obliged to have the rules by EU membership.
EU pensions law does have severe funding obligations for cross-border schemes but the practical result of that was that most schemes added a rule that terminates membership for anyone who would make it a cross-border scheme. A difficult challenge will arise with the cross-border funding rules if Scotland or Northern Ireland leaves the UK to join the EU without England and Wales and schemes then become at risk of being cross-border. It is not clear that they will become cross-border as it is only where members are in two EU countries that it applies, but it may nevertheless mandate splitting pension schemes for employers who are in more than one separate former-UK countries.
These are uncertain times for all of us: trustees, employers and advisers. For pensions schemes we need to keep a calm head, review developments and implement sensible changes. Work will be required to implement changes once the detailed reality of those changes becomes clear. Rest assured that we are here to help you manage those changes effectively, appropriately and efficiently.