The United Kingdom’s June 25 vote to exit the European Union triggered a wave of market volatility that caused a number of anxious investors—including those in employer-sponsored retirement plans—to sell off large portions of their equity assets and shift to safer investments.
Aon Hewitt reports that Brexit news bumped up participant trading to safety in a significant way, with 18 out of 22 days during the month favoring inflows to fixed-income instruments over equities. GIC/Stable Value funds saw $138 million in inflows and company stock funds led outflows with $117 million. While global market volatility surged, so did the price of deferred annuity income. According to BlackRock, the days following the Brexit vote saw the estimated up-front costs of purchasing annuity income spike 10% or more.
As with many major geopolitical events that raise more questions than answers, the markets saw a decent rebound soon after the surprising Brexit vote came down. “In about two months, the market readjusted quickly and those people who reduced or removed equity exposure are probably wishing they hadn’t done that,” says John Brown, head of global client development at INTECH, a provider of managed volatility products.
Of course, full Brexit has yet to actually occur, and so some uncertainty naturally remains. The country’s formal exit from the EU will be a long and complicated task carried out through closed door negotiations between the British government and European ministers. In fact, Britain has yet to officially begin exit negotiations with the EU by issuing a notification under Article 50 of the Treaty on European Union (TEU). Following this milestone, Britain would have two years to strike a trade deal with the EU and officially exit the organization.
Speaking at a symposium in the U.S. about Brexit’s impact on the financial services industry, Antonia Romeo, Britain’s Consul General in New York, echoed British Prime Minister Theresa May’s stance that trade negotiations will most certainly not conclude before the end of the year, and the government will offer no “running commentary” on the explicit details of these ongoing negotiations.
“You can’t negotiate something as complicated as this in two years,” says Jacob Funk Kirkegaard, a senior fellow with SIFMA, who also spoke at the symposium. He explained that no major country has ever formally left the EU, offering no playbook by which onlookers can gauge the outcomes, and potentially pushing global markets further into uncertainty as negotiations press forward and rumors circulate about when Prime Minister May will enact Article 50. Last week, Britain’s Foreign Secretary Boris Johnson told reporters he expects that to happen early in 2017.
It’s an environment that leaves many investors scratching their heads and reassessing portfolio exposures, but Brown has one clear and ready piece of advice: Don’t try and time the markets, and don’t let participants put their money in funds that are overly complicated and tactical for the user.
“Regardless of how long the process takes, it’s important to note that timing the markets in light of macroeconomic, geopolitical events is rarely a component of a good investment strategy,” Brown says. “I urge most participants and companies to not do any market timing, because it’s extremely risky and studies have shown it doesn’t work effectively.”
NEXT: Staying informed about portfolio risk
Plan sponsors and plan advisers can benefit from urging participants to not engage in knee-jerk reactions during the Brexit milestones that will arise, and to remain knowledgable of their long-term savings goals, time horizons, and risk tolerance.
“We tell people to maintain their equity exposure because they’re going to need that for the long term, but it’s imperative to understand how volatility could impact your portfolio so there are no unsettling surprises along the way,” Brown says.
At INTECH, Brown deals with beta-focused portfolios often called volatility-management portfolios. He stresses that those in the retirement benefits industry can help plan participants by educating them on how to manage drawdowns in the equity markets before and during retirement. Stock markets felt the immediate effect of the Brexit vote as a stand-alone event, and the lack of clarity behind ongoing negotiations and the major milestones ahead will likely affect the markets significantly, as well.
“We are talking to a lot of people in defined contribution (DC) and defined benefit (DB) about managing volatility, and recognizing that while you have 30% or 40% of equity in your retirement portfolio, it’s imperative that you understand the risk of drawdowns. Putting constraints that capture, say, only 80% of the upside but 60% of the downside could on average extend a retirement portfolio, we believe,” Brown says.
Given all this, Brown says it remains critical to remind investors that market volatility can make it dangerous to bet on any particular asset class, sector or region. Sometimes, it may even be better for some more-jumpy clients to ignore the immediate market volatility that emerges from major geopolitical shifts like Brexit—to help resist the emotional reaction to try to time the market. If the last century of market history is any guide, these events tend to have little effect on a properly diversified portfolios in the long term.
“You will never be able to predict how these events may unfold, but you do have the ability to structure portfolios in a way that dampens the drawdown,” Brown says. “Probably even more important is making sure that the plan and the participants have the appropriate amount of information so they’re not going somewhere else in the market where the opportunity to rebound is removed or mitigated.”
NEXT: What’s on the table for Britain?
Several potential trade deals are on the table for Britain and each could have a major effect on global markets as well as the legal and regulatory playing field that the financial sector will have to adapt to. Couple that with speculation about Britain setting off a domino effect across Europe, and it becomes extremely difficult and even ill-advised for long-term investors to try to time the markets.
One option the UK may take is joining the European Free Trade Association (EFTA), a regional trade organization comprising Iceland, Liechtenstein, Norway and Switzerland; or by joining the European Economic Area (EEA). Both would provide UK-based financial services firms with some degree of single-market access to the EU. However, experts note the EEA option may be politically unlikely due to its provision of free movement of workers and mandatory monetary contributions.
The UK can also enact is own bilateral trade agreements with the EU similarly to Switzerland, which has enacted more than 120 such contracts. However, global law firm DLA Piper notes that none of these agreements grant “full access to the EU internal market for financial services.” While some analysts have mentioned a customs union approach similar to that of Turkey, DLA Piper points out that this particular agreement applies to goods and does not extend to financial services in Turkey’s case. It’s also seen as a precursor to EU membership rather than an exit strategy.
So far, the UK government has generally been weary to express preference of one deal over another. “There is no consensus about what deal the UK should seek, none in her [Prime Minister May’s] party or parliament or society,” Kirkegaard said. “Uncertainty behind Brexit extends back to before the referendum, when there still was no clear realization of what Brexit actually entailed ... This is by far the most daunting bureaucratic and political task faced by any country in Europe short of those that severed completely such as Czechoslovakia in the early 1990s.”
“Plan participants need to understand that volatility is part of the market," Brown concludes. “There is not much we can do to eliminate that, and the worst thing we can do is leave people to act out of fear.”