Brexit Threat to Pensions as Investors Seek Sanctuary in Bonds

Uncertainty in financial markets in the immediate aftermath of the UK’s vote to Brexit the EU saw investors dump equities and riskier assets and seek the relative sanctuary of government bonds and gold which is putting further strain on companies’ ability to meet their pension obligations.

Pension Funds have traditionally been the largest buyers of government bonds – ‘Gilts’ – as they are high quality investments delivering certain returns over a long time frame; this allows the funds to match contributions they receive from those paying into a pension with future liabilities as pensioners are paid out.

There is an inverse correlation between bond prices and yields; when bond prices rise because of increased demand, the effective yield is reduced because coupons are paid at a fixed rate relative to the issue price – colloquially ‘par’.

When a bond trades above par its coupon is thereby diluted as a percentage of the purchase price.

However, as yields fall it becomes increasingly difficult to match income with outgoings; pension funds typically target a return of 5% to 10% a year on their assets but with most government bonds now yielding less than 2%, there is a very real and mounting problem facing the industry.

Defined benefit or ‘final salary’ schemes are considered the most vulnerable; it is common for these funds to run with a funding gap, but that gap has been widening of late and it is now estimated that UK pension deficits are at a record £935bn.

More than 11m people are reliant on defined benefit pension schemes in the UK and the challenge of closing a funding gap of almost £1trillion cannot be exaggerated.

‘the challenge of closing a funding gap of almost £1trillion cannot be exaggerated’

BT’s pension deficit is now £10.6bn – an increase of more than 50% in 18 months, and equivalent to more than four times the company’s annual pre-tax profit of £2.6bn; analysts estimate that BT will have to pay in an additional £1bn per annum through to 2030 to fill the pension black hole.

As deficits at some companies eclipse profits there is a very real danger chance that some won’t be able to meet these obligations; meanwhile the UK’s Pension Protection Fund, a government-sponsored safety-net for collapsed pension schemes, has a funding surplus of just £4.8bn – 0.51% of the total value of estimated pension deficits.

The figures are frightening and only getting worse, and it seems inevitable that there will be some catastrophic failures of schemes in the future.

An answer for the confident DIY investor may be to take your pension away from the professionals and seek to construct a pension portfolio of high yielding investments that deliver sustainable growth and reliable income.

That could be achieved by buying high-quality blue chip companies with international operations and a demonstrable track record of out-performance; however, that will almost inevitably mean buying individual equities which may not suit everybody’s risk tolerance.

We are still a very long way from knowing precisely what effect Brexit will have on financial markets and what the UK’s relationship with the remaining EU nations, and indeed the rest of the world will look like; markets have seemingly recovered from the shock they woke up to on June 24th but all the time there is uncertainty there will be nervousness concerning the future of pensions.