EU referendum Going, going, gone

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1 Perspectives EU referendum Going, going, gone 23 June The day that the people of the UK voted to leave the European Union (EU). The decision is likely to have implications for many facets of life in the UK from climate change and environmental agreements through to migration policy and the consequences for public services. But what will be the effects on UK pension schemes?

2 EU referendum Going, going, gone This document sets out what we consider to be the areas that could be affected, recognising that much depends on what happens next, particularly in terms of trade agreements reached with our former partners in Europe and the rest of the world. What next? The process The UK Government will need to give notice to the European Council the European institution representing each of the governments of the member states. It is not clear when this will be, but it is unlikely that it will be immediately, and almost certainly will be given by David Cameron s successor. The various heads of the European institutions the Parliament, the Commission and the Council of the EU have jointly stated that they expect the UK to start this process as soon as possible. 1 Once notice is given, the Treaty on European Union provides for a two-year window for negotiating the terms of exit; this period can be extended, but only with the unanimous agreement of all 27 remaining member states. By contrast, the terms of the withdrawal agreement can be settled by a majority of the Council in this case what is called a super qualified majority, which means that it has to be agreed by at least 72% of the countries (in other words, 20 of the 27) and represent at least 65% of the population of the remaining states. Much was made in the period before the referendum of three potential benefits arising from a vote to leave: A revised trade agreement with the EU. The ability to restrict migration. Redeploying the savings from the UK s contribution to the EU. These issues are inextricably linked. In order to agree a special trade deal with the UK rather than reverting to a World Trade Organization standard the EU will impose conditions. As the joint statement from the heads of the EU institutions made clear: Any agreement, which will be concluded with the United Kingdom as a third country, will have to reflect the interests of both sides and be balanced in terms of rights and obligations. 1 Access to the internal market comes with strings, as experienced by those countries such as the members of the European Economic Area (Norway, for example) and the European Free Trade Association (such as Switzerland). The key requirements will be: 1. Acceptance of the free movement of goods, persons and capital particularly if, as seems likely, the UK wants the free movement of services too. 2. Payment for club membership for example, Norway pays approximately 115 pa per capita and, in 2009, Switzerland paid around 53 pa per capita. These figures compare with the UK cost of 152 pa per capita. So, in brief, any special agreement struck with the EU will be critical in determining how pre-vote claims of securing borders and saving monies to support public services will be realised. 1. Joint statement from Martin Schulz, Donald Tusk, Mark Rutte and Jean-Claude Juncker 2 willistowerswatson.com

3 What next? The potential impact on pensions We discuss two elements here. First, the legislation that can be considered to emanate from Brussels, and second, the wider effects on investment and markets. Pensions Comparatively little of the legislation that pension schemes have to contend with stems from Brussels. For example, the complex and ever-ballooning rules surrounding the tax treatment of pensions is largely homegrown. This is not surprising as competence over tax matters rests with the member states rather than the EU. This is not the case in relation to VAT, which is under the EU s remit, and following the decision to leave the UK Government might decide to reform it. Where the EU does hold sway is in legislation to support the operation of the internal market, including related social protection measures. Pension Directive The Pensions (or IORP 2 ) Directive led to the introduction of the scheme specific funding requirement. There were other minor amendments in relation to Statements of Investment Principles, but the main aspects mirrored existing UK provisions anyway. This was indicative of the UK influence in framing the Directive in the first place. Ironically, measures to facilitate cross-border provision saw the demise of many UK/Irish reciprocal arrangements and, therefore, a fall in cross-border schemes. Another victim was death benefit only occupational schemes. Having left the EU, it may be possible to revisit these matters. So we might see a resurgence of UK/Irish schemes and the birth of UK/Scotland schemes. Protection on insolvency In the face of the Robins case, which found the UK had not appropriately provided for protection for supplementary pension rights in the event of sponsor insolvency, the UK set up the Pension Protection Fund (PPF). The 1980 Insolvency Directive had required member states to provide such protection. In theory, the Government could reform or abolish the PPF however, it seems extremely unlikely that it would do so in the near future unless the lifeboat fund became overwhelmed with new claims. Social protection There is much more in the area of member protection legislation that can be directly attributed to the EU. This includes: Anti-discrimination provisions (on sex, age, sexual orientation and disability). Provisions for agency, part-time and temporary workers as well as parental leave. Protection of employment rights on business transfers (TUPE). Depending on your viewpoint, these can be considered to restrict the flexibility that could otherwise be possible in the UK employment market or to provide valuable protections against unscrupulous, exploitative employers. Although it is entirely possible that these provisions could be removed from the UK statute book, or at least modified, this seems unlikely in the near future. What is clear is that the UK might not be subject to future developments in EU social protection measures. That depends on whether our renegotiated relationship binds us to accept such changes. One issue that has been hanging over schemes for more than a quarter of a century is the requirement to equalise for the effect of Guaranteed Minimum Pensions. The Government has made it clear that its view that equalisation is necessary stems from its interpretation of EU law. It seems likely that the Government will now need to establish whether this requirement persists as an acquired right from our membership of the EU. Legal challenges in Europe The level of compensation provided by the PPF has already been questioned through the Court of Justice of the European Union (CJEU). The vote to leave might well remove the threat of any further challenges in this regard. Similarly, it was the CJEU, via the Test-Achats case, that forced adoption of unisex annuity (and insurance) rates. Potentially, there is scope to reverse this requirement. Likewise, the CJEU s decision to include commission in holiday pay in Lock v British Gas Trading Ltd could be reversed. As with the other areas of law emanating from the EU, whether the UK removes or modifies provisions incorporated into UK legislation depends on two things: the domestic political will to do so and the new deal agreed with the EU. If we want access to the internal market, we may still have to accept the supremacy of the CJEU in matters relating to its operation. 2. Institutions for Occupational Retirement Provision 3 EU referendum Going, going, gone

4 Data protection From 25 May 2018, the new General Data Protection Regulation, (GDPR) will apply in the UK. Being a Regulation, it is directly effective in UK law. This contrasts with a Directive, which has to be transposed into UK law. Given the two-year negotiating window, it seems likely that trustees and sponsors will be subject to the GDPR at least for a while. So, the decision to leave the EU does not mean that they can ignore it. Moreover, if there is to be an exchange of data between the UK and the EU post-brexit, we are likely to have to agree equivalence provisions in any event. IORP II and capital requirements We expect the text of the recast Pensions Directive to be released very soon and its text to be published to the official journal later this year, with a two-year window for implementation. As with the GDPR, trustees and sponsors may still need to plan for the possibility of having to comply with its requirements for additional governance measures and changes to disclosure requirements. There is also a general belief that calls for capital requirements similar to those under Solvency II for insurers have only been muffled and not silenced for good. Now that we are to leave the EU, the UK at least should be able to deal with scheme funding as we see fit, rather than being potentially constrained by EU institutions. However, as with many other issues, this very much depends on what strings we agree to in any renegotiated relationship with the EU. Investment and markets Headlines: This was an immediate shock to the global financial system, not just to the UK and Europe. From a medium- to long-term global perspective, the key uncertainty is the extent to which this decision undermines wider European stability, growth and sentiment. From a UK perspective, the impact on the UK economy revolves around the terms of our exit, how long it will take and the impact of the uncertainty in the interim. Sterling (versus the US dollar) and European equity markets have sold off around 7% to 8% but have recovered somewhat in recent days (this varies widely by market). More importantly from a UK DB perspective, gilt yields are sharply lower (30 bps lower at the long end in nominal space at the time of writing), which will be painful for funding levels. For now, we are not recommending any dynamic changes. This will depend upon our medium-term economic view and, critically, on the policy response. This is an evolving picture but we would note the need to adopt two-sided approaches to risk; whilst the inclination may be to take risk off the table given the uncertainty, if risky asset prices keep falling there may be an opportunity to re-risk. Economy and policy The UK economy is likely to be negatively impacted by the uncertainty created in the medium term. The channels for this are numerous but, ultimately, already slowing aggregate demand will be further undermined by uncertainty around regulatory regimes, migration rules, London s position as the premier European financial centre, and trade terms with the EU and the rest of the world post-brexit. The long-term economic outlook depends on the trade agreements that Britain has with the rest of the world the diagram below gives a crude indication of the possibilities. Policy-wise, the Bank of England is immediately providing liquidity to stabilise the financial system. Ultimately, some combination of emergency liquidity provision, quantitative and credit easing, and interest rate cuts is likely. 4 willistowerswatson.com

5 Figure 1. Possible trade relationships?? Standard World Trade Organization terms European Union Customs Union European Free Trade Association European Economic Area European Union Euro area Austria Latvia Bulgaria Iceland Switzerland Andorra Belgium Lithuania Croatia Liechtenstein Guernsey Cyprus Luxembourg Czech Republic Norway Isle of Man Estonia Malta Denmark Jersey Finland Netherlands Hungary Monaco France Portugal Poland San Marino Germany Slovakia Romania Turkey Greece Slovenia Sweden Ireland Spain Italy Source: LGIM, Willis Towers Watson 5 EU referendum Going, going, gone

6 Markets Given the surprise result, there was a sharp market reaction to the Brexit news as market prices adjusted to discount the new reality. Foreign exchange Given the size of the UK s current account deficit, sterling has weak fundamentals, even ignoring the risk of Brexit. Now that risk has crystallised, sterling is the key channel through which the markets assessment of Brexit s implications is focused. So far, sterling has fallen significantly against the US dollar (although this is highly volatile) over the coming weeks it will be no surprise if sterling were to fall further. Against the euro, sterling is down moderately less, while the euro has also weakened against the US dollar. Short and long rates gilts: We believe that the Bank of England will ease financial conditions as much as it can to support any weakening in domestic conditions. As a result, the declines in short-term and long-term government bond yields are warranted. So far, Governor Carney has announced an additional 250 billion of funding through normal channels. However, this comes on the back of significant yield declines in recent weeks, particularly at the long end. There is a limit to which continued yield declines are justified. On Monday 27 June, S&P downgraded the UK from AAA to AA, although the impact this has on gilt purchases is moot. Credit and equity: Global credit and equity prices initially fell on the back of higher risk premia required by investors. Longer term, the degree to which these price declines stick will depend upon: The market s judgement over the extent to which cash flow generation of assets is undermined. This is linked to the emerging assessment of how much global economic growth is undermined. The extent to which central banks ease financial conditions and reduce risky asset discount rates (and hence bid up prices). As we have discussed over recent years, the high starting point for asset prices and already very accommodative nature of monetary policy may make this difficult. As a general point, we note that indiscriminate falls in asset prices (and rising risk premia) suggest there may be investment opportunities to capture either through asset allocation changes or through active managers. The comments above relate to the first-order impacts on liquid markets. Of equal concern will be the second-order impacts on illiquid assets and the positioning of active managers around what is a surprise outcome. Investor implications This environment (falling risky asset prices and falling yields) will be challenging for UK schemes funding levels. In practical terms: The market action on 24 June and the following days comes on top of some already material declines in yields so far this year. This is an important catalyst to take another hard look at strategy, and in particular to consider adopting a set of risk-return assumptions that project asset returns to stay lower for longer. UK schemes will see big short-term currency hedging outflows that will have to be met from liquid assets. Depending on the future reaction of long-dated gilt and swap markets, this may also be true of leveraged Liability Driven Investment (LDI) portfolios if yields increase (as above, this is not our expectation). Nevertheless, a close eye on schemes, leverage, liquidity and currency hedging positions is warranted. 6 willistowerswatson.com

7 What next? Other implications It is not just the effects on EU-sourced pensions legislation or the consequences for markets that affect UK trustees and sponsors. What prospects for growth for sponsoring employers? There will be direct consequences for the economic outlook for many businesses. For some there will be little discernible change. Others may currently be heavily reliant on the EU market, and yet others will gain if not subject to constraints arising from EU membership. What is clear is that trustees will need to consider the implications for the sponsor covenant, and possibly consider bringing forward funding negotiations if appropriate. Schemes with sponsors or guarantors based in EU member states will also need to consider any implications affecting PPF insolvency scores, eligibility and guarantees. Similarly, guarantees backing a withdrawal arrangement under employer debt legislation will need reviewing. Prospects for change in insolvency legislation and potential divergence between UK and EU rules will also factor. What prospects for liability settlement? In time, Solvency II may no longer apply to UK insurers, which might impact pricing. However, as the UK s Individual Capital Assessment regime for annuities was not dissimilar to the Solvency II approach, we consider this unlikely. Perhaps what is more likely is that the UK could tweak the requirements, particularly in relation to the risk margin and its sensitivity to interest rates. In the short term, the cost of bulk annuities is expected to go down (relative to gilts) as bond spreads have (as had been expected in the wake of a vote to leave) widened. What prospects for political upheaval? In the final weeks of the Leave and Remain campaigns, the intensity of the rhetoric increased. The divisions within the Conservative Party became ever more apparent. It was clear that Figure 2. Timetable of significant political events whichever way the vote went, there would be political fallout. With David Cameron having invested so much political capital in a remain outcome, it was not surprising that he was unable to stay in number 10. However, the turmoil has not been limited to the Conservatives, with upheaval in the Shadow Cabinet too. These changes may also spark a no-confidence vote and another general election. Even if it does not, we could well experience an emergency budget from an incoming Chancellor. Whilst pensions may not be the top priority, the budget will introduce yet more uncertainty. Beyond British shores, the key risk is the extent to which this result stimulates other European countries to review the terms or existence of their membership of the EU and/or the eurozone. A series of presidential elections both in Eurozone and the US cast further uncertainties on the global political landscape and must raise questions about the chances of further political contagion, both regionally and worldwide. Region Event type Description UK Government New leadership of the Conservative Party, new Prime Minister and probably Chancellor, Cabinet reshuffle Country New Scottish independence vote highly likely Eurozone: Spain Election General election on 26 June 2016 Country Possible Catalonia independence vote Italy Reform Referendum on Renzi s constitutional reforms in October 2016 France Election Presidential election in April and May 2017 Germany Election Federal election in September and October 2017 US Election Presidential election in November EU referendum Going, going, gone

8 What prospects for the Union? Voters in Scotland and Northern Ireland were more favourably disposed to the EU than voters in England and Wales. In part this may have resulted from the fact that Scotland and Northern Ireland have been net beneficiaries of the UK s contribution and reciprocal regional investment relationship with the EU. In the wake of the vote, the Scottish Cabinet has agreed to prepare for another independence vote and simultaneously seek to negotiate for an independent Scotland to remain part of the EU. What next? Actions to take A key aspect will be, as mentioned at several points above, what new deal is cut with the EU. This will determine to what degree legislation from Brussels will still affect UK pension schemes. Inevitably, in these areas there is a wait and see approach. However, the decision to leave will have implications Further information for scheme sponsors growth prospects, and trustees should be considering these sooner rather than later. Similarly, many businesses and schemes will be affected if Scotland leaves the UK, so this is one more thing for trustees and sponsors to think about. On one thing we think we can all agree: the vote heralds an interesting age. Scottish independence raises prospects for change for any business with employees, customers or suppliers on both sides of the border. For further information, please contact your Willis Towers Watson consultant or Mark Dowsey +44 (0) mark.dowsey@willistowerswatson.com David Hoile +44 (0) david.hoile@willistowerswatson.com About Willis Towers Watson Willis Towers Watson (NASDAQ: WLTW) is a leading global advisory, broking and solutions company that helps clients around the world turn risk into a path for growth. With roots dating to 1828, Willis Towers Watson has 39,000 employees in more than 120 countries. We design and deliver solutions that manage risk, optimise benefits, cultivate talent, and expand the power of capital to protect and strengthen institutions and individuals. Our unique perspective allows us to see the critical intersections between talent, assets and ideas the dynamic formula that drives business performance. Together, we unlock potential. Learn more at willistowerswatson.com. Willis Towers Watson 71 High Holborn London WC1V 6TP Towers Watson is represented in the UK by Towers Watson Limited. The information in this publication is of general interest and guidance. Action should not be taken on the basis of any article without seeking specific advice. To unsubscribe, eu.unsubscribe@willistowerswatson.com with the publication name as the subject and include your name, title and company address. Copyright 2016 Willis Towers Watson. All rights reserved. WTW-EU-16-PUB-3659 willistowerswatson.com