401(k) Newsletter - Third Quarter
by Vita, on June 30, 2016
BREXIT – Stay Calm and Carry On … Investing
Unless you have been trekking in Patagonia, you have undoubtedly heard that the United Kingdom (“UK”) has voted to leave the European Union (“EU”): also known as “Brexit.” There has been a lot of noise around this development, but not a lot of information. It is impossible for commentators to know what the shape of the UK or the EU economy will be when so many details need to be worked out. Even the successful “exit” campaign still has no discernible plan for what a post-EU UK looks like. The word most commonly used to describe the impact of Brexit is “uncertainty.” In lieu of certainty, let’s focus on perspective.
First of all, this is a big deal, but for a small country. Notwithstanding the “Great” in its name, Great Britain (the popular name for the UK) is a small country. It accounts for less than 4% of global GDP and represent less than 3% of S+P 500 firm revenues. Most commentators expect UK growth to slow toward the end of year, but this should have little or no impact on the US economy. Fears that Brexit will lead to a global recession seem exaggerated.
Second, the UK has never fully committed to the EU. The clearest evidence of this is the fact it retained its own currency, the pound, and its own monetary policy through the Bank of England. This makes the UK’s exit from the EU considerably easier. About 44% of UK exports go to the rest of the EU and about 53% of imports come from the EU. These will surely not drop to zero, and only the exit negotiations (which could take up to two years by EU charter) will determine what sort of non-tariff market access will remain. Negotiations on goods should be relatively straight-forward. It is the trade in services, specifically financial services, which will be the most contentious, as the EU seeks to wrest control of European financial markets away from the City of London.
Lastly, the UK on its own is a very successful economy. When the UK joined the EU in 1973, then called the “European Economic Community”, it was derisively called “the sick man of Europe." The labor, regulatory and financial reforms of the Thatcher government in the early 80’s fundamentally changed the UK economy. Today, the UK stands with Germany as the two most successful economies of Europe. After Europe, the US is the UK’s biggest trading partner, both in terms of goods and capital flows. It is entirely possible that the relationship between the US and the UK will become closer, especially if there is a new free trade agreement between the two.
Brexit has no direct effect on either your 401(k) plan or participants. As with any major political event, short-term volatility will increase as markets adjust to changing economic expectations. In the longer term, Brexit should not have a large negative economic impact on either the US or the rest of the global economy.
Recently we have received a number of questions regarding whether interns can be excluded from 401(k) plans. As with Part Time, Seasonal, and Temporary Employees, Interns may be excluded from 401(k) participation, but with important legal limitations. Breaking down the legal limitations are two provisions of the Internal Revenue Code and Regulations - Sections 410(a) & 410(b).
- Beginning with Section 410(a) Minimum Participation Standards: An exclusion of a class of employees (i.e., Interns) can be considered discriminatory if it is used indirectly as an impermissible service requirement (beyond 1 year of service). The plan may be otherwise fully compliant with the qualified plan rules, but a flawed “write-in” provision excluding a class of employees as described above could result in disqualification of the Plan. For the most recent IRS guidance on the issue of 410(a) violations, please refer to the linked Quality Assurance Bulletin.
- Next is Section 410(b) Coverage Testing: A plan must benefit at least 70% of its Non-Highly Compensated employees if it benefits all of its Highly Compensated Employees. To amplify what the preceding sentence means: A plan must offer the 401(k) plan to 70% of its Non-Highly Compensated [common law] employees, of which Interns, Part Time, Seasonal are included. An uncorrected violation of Section 410(b) results in disqualification of the plan. Fail-safe language is recommended in the definition of the exclusion in order to allow for incremental inclusion of the excluded employees sufficient to achieve a passing coverage test result. Section 410(b) is described in the Relius Technical Update here.
Don’t forget to file your Form 5500! A friendly reminder that for calendar year plans, the Form 5500 and Form 8955-SSA (if applicable) must be filed by July 31, unless an application for extension has already been submitted. In most cases, the extension will be automatically prepared and filed by your retirement plan service provider on your behalf. If you are unsure as to the status of your Plan’s Form 5500 or Form 8955-SSA, you are invited to contact our team for assistance.
View other administrative action items in the Third Quarter Compliance Calendar. Upcoming tasks for this quarter include signing the Form 5500 and distributing the Summary Annual Report
The extreme asset sell-off in the aftermath of the Brexit vote was a result of the markets being wrong-footed by the vote by the UK to leave the EU. This can easily be seen in the lead up to the vote by using the US dollar (USD)–British pound (GBP) exchange rate as proxy for all asset markets.
The market first started to take seriously the possibility of a UK exit from the EU in February 2016. That is when Prime Minister David Cameron announced the details of his attempt to renegotiate the terms of UK’s participation in the EU. USD/GBP fell from 1.44 to 1.38 in the space of a week as it became clear that PM Cameron and his “remain” supporters were not able to win any of the promised concessions from the EU, thereby strengthening the “leave” camp. On Wednesday, June 16, when it was still unclear which way the vote would go, USD/GBP hit a three month low of 1.40. After the murder of pro-remain MP Jo Cox by an apparent follower of “Britain First” right-wing “leave” faction member, most traders thought the UK would vote to remain in the EU. USD/GBP hit a high of 1.50 on the day of the vote until the results of Sunderland came in. Sunderland is a Northern industrial city (coal and ship-building) which was expected to be 50-50 on Brexit. Instead, it voted to leave by a 60-40 margin. That started the selloff of USD/GBP which didn’t stop until it hit 1.31 on June 27, a 30 year low. The point here is that a British vote to leave the EU was always seen by the markets as a negative on the UK economy leading to a weaker pound. But the extreme selloff of USD/GBP was exacerbated by the false market expectation that British voters would reject the leave campaign in the wake of Jo Cox’ death.
In light of the market’s negative view of a UK exit from the EU, the sell-off in equity markets in the UK and Europe from their mistakenly optimistic levels was not that surprising. UK GDP growth is running at 1.6%, year-on-year. Most economists see the vote to leave Europe as taking 1% off British GDP with some saying it could go negative by Q4 2016. Expectations for 2017 are running at 0.6% GDP growth, at best. This is predicated on the expectation that the uncertainty surrounding the UK’s exit from the EU will have a negative impact on corporate and consumer spending and the USD/GBP’s fall will result in a jump in inflation to between 3%-4% (currently at 1%-2%). GDP growth in the EU has been running at 0.6% year-over-year and economists are predicting a more moderate decline to between 0.3%-0.4% by the end of the year.
The selloff of US and other equity markets can largely be put down to panic and the emotions of shock and disappointment. However, US economic figures continue to be steady, if unspectacular, with Q2 GDP growth expected to come in at between 2.0%-2.5%. Both corporate and consumer spending should be strong in Q2, while unemployment remains low at 4.7%. Events in Europe will most likely result in the Fed delaying any further hike in interest rates until the September FOMC meeting at the earliest, which should also be generally supportive of US equities.
With so many details of the UK’s exit from the EU to be worked out, it is reasonable to expect that volatility will remain high until the end of the year. And while this volatility may grab the headlines, the fundamentals in the US, at least, should remain largely unaffected. Both the Bank of England and the European Central Bank are committed to an easy monetary policy to help mitigate the potential slowdown in their economies. The temptation to follow a “risk off” positioning is strong in an environment where the prospects of asset growth are lower. Yet, we still feel that dips in the equity markets continue to provide opportunities to buy well-performing companies at reasonable valuations, both in the US and overseas. Rather than “risk off”, this is exactly the time that a long term investor should be maintaining a diversified portfolio with adequate levels of “risk on” exposure, including quality actively managed equity funds.