While it may already feel like the distant past, the United Kingdom voted to exit the European Union after 43 years of membership just over three months ago. Also known as the British exit, or “Brexit,” this unprecedented decision has wide ranging consequences with varying degrees of severity. In one of Prime Minister Teresa May’s first acts in office after David Cameron’s resignation, she assured Britain and the rest of the world that there was no turning back on Brexit and “there will be no attempts to remain inside the EU.” With Brexit inevitable, it is time to consider the impact it will have on Plan Sponsors and Participants.
Brexit will affect several key issues in Britain such as immigration control, annual budgeting, trade agreements and adherence to EU regulations. However, the mechanism for an exit from the EU allows for a two-year negotiation window to determine the terms of the withdrawal. To date, the start time for that two-year window is yet to be determined, making the near-term picture unclear and the long-term outcome even more uncertain. To attempt to make a market call for what transpires over the next several years of negotiations would be ill-advised.
In general, 401(k) plan participants were not so rational in processing this information. The historic vote resulted in consecutive days of above normal trading activity and a large swing in the equity market, even before Ms. May reinforced Brexit’s certainty with her comments. The MSCI EAFE Index, which tracks the performance of large and mid-cap securities across 21 developed and primarily European international markets, fell nearly 10% in the two days following the Brexit decision. A prominent 401(k) index showed inflows of $138 million to GIC/stable value funds, $118 million into bond funds and $51 million into money market funds. Conversely, outflows from company stock funds, target date funds and U.S. equity funds were comparable1.
There are a few ways in which these reactions can be rationalized. To start, it may seems reasonable to think that the UK will struggle to negotiate favorable exit terms since there’s concern of a Brexit contagion whereby other nations would be compelled to follow suit and pursue an exit. What’s more likely is that the vote simply caught investors by surprise. As polls closed, some bookmakers in London had the odds of Brexit passing at less than 10%. If betting odds reasonably reflect the sentiment of the general population, it’s safe to say that most investors were blindsided by Brexit and appear to have responded with a flight to perceived safety.
Shock and uncertainty are recurrent themes when it comes to negative volatility in the market. However, the average retirement plan participant will struggle attempting to make market calls, particularly when the global picture is unclear. Even worse, once a selloff reaches a tipping point, many participants will join in on the flight to safety simply because they see investments declining. Defined contribution plan participants must stay focused on the long-term and understand that markets will consistently experience ups and down. Plan Sponsors can mitigate participant skittishness through education efforts and by offering multi-asset portfolios, such as target date funds.
Multi-asset portfolios are well-diversified and help dampen the impact of selloffs in pockets of the market. As previously mentioned, the MSCI EAFE had a precipitous drop following the Brexit development. That same index was the only one of the 19 asset class-specific indexes DiMeo Schneider tracks that was negative in the second quarter. Therefore, participants with a diversified multi-asset portfolio such as target date funds or risk-based models would have likely still achieved positive returns in the second quarter.
Communication can also play a key role. Brexit highlights the fact that retail investors and 401(k) participants in particular often behave irrationally and emotionally. Strong communication and proactive education efforts can positively influence participant behavior and diminish knee jerk reactions. Investment election re-enrollment, which resets participant investment elections, is a viable option for Plans exhibiting weak asset allocation decisions by participants.
Please contact any of the professionals at DiMeo Schneider & Associates, L.L.C. for assistance in reviewing your Plan’s participant activity, education and communication efforts, multi-asset portfolio offerings or any other area of fiduciary oversight.
