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What are the political and covenant risks of Brexit?

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In the first of three articles looking at the impact of Brexit on defined benefit pension schemes, this blog shines a light on the political and covenant perspective.

Brexit has been going round in circles for many months, with little sign of the merry-go-round ever stopping. However, we are fast approaching 31 October, the current deadline when the UK is due to leave the EU. This is not the place to rehearse the politics of Brexit in detail, but we do want to make two points that are relevant to DB scheme covenants.

The first and broader point is that the British constitution is creaking under the strain of Brexit. We have a minority government, 43 votes short of a majority, trapped in this position by the Fixed Term Parliaments Act. Fractures in the two main parties have led to an unprecedented number of independent MPs. The government was taken to court over its unusually long suspension of parliament, including by MPs and a former Prime Minister. When the Supreme Court ruled that the suspension of parliament was unlawful, MPs quickly went back to work. And we have had MPs seizing control of the House of Commons order paper and passing laws to tell the government how to deal with the EU, of which more in a moment.

It is very hard indeed to predict how this will play out in the medium to long term. But a creaking constitution creates huge political risk. And political risk leads to long term economic risk for business.

The more urgent political point is that the law that MPs passed to take no deal off the table—the so-called Benn Act—doesn’t actually do so. All it does is mandate the government to seek an extension if certain conditions are not met. There are various possible routes and loopholes that could easily lead to a no deal exit on 31 October, whether by accident or design. While the government has assured the courts that it will comply with the new law, the Prime Minister continues to assert in public that the UK will leave on 31 October, deal or no deal. If the government refuses to comply with the law, then all bets are off.

What does all this mean for covenant? Well, first there is that residual risk of a no deal Brexit next month. The risk has reduced, but it hasn’t gone away.

Over the last year or so we at Buck have worked with many sponsors on their contingency plans. We have heard of wholesalers taking on extra warehouse space, and importers and exporters increasing their currency hedging. Companies supplying services into the EU have contracted with agents to allow them to carry on doing what they do.

So businesses can and have planned for their ‘known unknowns.’  But really big problems — what you might call ‘unknown unknowns’ or ‘black swans’— arise when complex systems interact in unpredictable ways. Let me give you a recent example.

On the afternoon of Friday 9 August, lightning hit power lines in or around Hertfordshire. This caused supply to fail at two power stations, one in Bedfordshire and a wind farm off the Yorkshire coast. The frequency of the current thus fell below the normal 50 Hz across the national grid.

A software feature on certain train models means that when the frequency falls in overhead power lines, the engines stop. Dozens of Thameslink trains stopped running. The disruption caused delays and cancellations across the network throughout that evening and the weekend.

Now lightning hits power lines all the time, and the National Grid has contingency plans to keep the grid working.  But in August something weird happened, and lightning hitting a pylon in Hertfordshire caused power cuts nationwide and two days of transport disruption north of London.

What does any of this have to do with Brexit? Well, a no deal Brexit would lead to many such metaphorical lightning strikes. We can’t say where or when or what they would hit, but you can be sure that they would happen. The complex systems and supply chains that our country run on mean that the results could be very unpredictable and would test the resilience of businesses and their management.

Looking further ahead, however the current stage of the crisis resolves—whether that’s a no deal exit on 31 October, or a re-heated Withdrawal Agreement—there will still be a very long way to go. To paraphrase Churchill, Exit Day would not be the end, or even the beginning of the end – it would just be the end of the beginning.

Negotiating the withdrawal was supposed to be the easy bit. We haven’t even got to the start of the hard part – that of negotiating the long-term trading relationship with the EU. Sir Ivan Rogers, the UK’s former Permanent Representative to the EU, warned Theresa May’s government in 2016 that it could take up to ten years to negotiate the future trading relationship. Nothing that has happened so far suggests that he was being unduly pessimistic.

UK plc is in for a prolonged period of political, legal and economic uncertainty.  As in any economic environment, some businesses will do well and others will do badly.

What is certain is that many schemes face increased long-term covenant risk that they need to understand and address. You may have a covenant assessment telling you that you have a strong covenant, but almost by definition a covenant assessment will look as far as the planning horizon of the business, usually somewhere between one and five years.

At this point it is hard to look beyond 31 October – let alone one year, let alone five years. Whether you are a trustee or a sponsor, you need to be mindful of the increased risk that covenant could deteriorate in the medium to long term if Brexit proves to be bad for business.

So what should trustees and sponsors be doing at this point?

The Pensions Regulator expects trustees and sponsors to have open and collaborative discussions about the possible effects of Brexit on your businesses, and to examine the interaction of covenant risk with funding and investment risk.

As the Regulator wrote in its Annual Funding Statement last year, trustees should discuss the outlook for the economy as a whole and for the particular sector in which the business operates. Sponsors should share thoughts on how the business may be affected, both operationally and financially.

Brexit is a special case that nevertheless serves to bring what trustees and sponsors should be doing anyway – in thinking about integrated risk management – into sharp focus.

The effects of Brexit will be wide-ranging. Whether you think Britain would be better off inside or outside the EU, few will expect it to make no difference either way. It is therefore vital that trustees and sponsors have a shared understanding of the risks that Brexit poses to your businesses and their ability to support your schemes.

Changes to customs and regulation will affect trade with customers and suppliers in the EU. Even if the business does not directly trade with the EU, suppliers might. Your biggest problem might well be outside the business, wherever the weakest point in the supply chain is.

Changes to immigration rules will affect workforce recruitment and retention. Changes to the law will affect contracts. And all will have financial impacts on the profitability, cash flow and balance sheet of the business.

It has been well said that Brexit is a process, not an event. Unless we as a country call the whole thing off, Brexit will dominate the political, economic and regulatory environment for many years to come. Even an extension to achieve a re-heated withdrawal agreement would just push the potential cliff edge back to December 2020 or perhaps further.

Similarly, covenant assessment is a process, not an event. Covenant cannot be a box to be ticked every three years. Instead trustees and sponsors need to engage in regular dialogue about the changing risks that your businesses face and how these are being addressed. You should agree and document covenant monitoring frameworks and contingency plans, including triggers and actions for both parties.

The triggers will be very dependent on the nature and circumstances of the business in question. They might include a fall in turnover of X%; or a loss of a particular contract; or a fall in headroom on banking covenants. The point is to identify some relevant indicators that would give early warning of downside covenant risk.

When a trigger is breached, the immediate action will in most cases be for trustees to ask questions of the sponsor, either in writing or, if urgent, in a meeting. The important thing is that you will have agreed in advance a process that you can follow if and when the covenant monitoring flags up a potential problem.

Business in the UK is facing a period of what the Bank of England has termed “entrenched uncertainty”. Trustees and sponsors must assess and monitor covenant, funding and investment risks holistically across the pension scheme and company. In the next two posts in this series, we will tell you how you can manage the scheme funding risks that Brexit brings, as well as looking at the impact and actions from an investment perspective.

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