Diving much deeper
Pooling has occupied increasing column inches of the trade press over the past year, as Irish and Luxembourg service providers have sought to promote their respective solutions.
Pooling occurs when the assets of one or more pension schemes are aggregated in an underlying pool in order to realise economies of scale. Those economies of scale arise from a number of sources, including: custody (larger pools are able to negotiate lower custody fees); brokerage (larger transactions lead to lower unit cost); netting transactions (with more sources coming into the pool the ability to net flows and reduce transaction costs increases); and administration costs (which are have lower bps if when assets are pooled).
Pooling can take two different forms: ‘entity pooling’ or ‘virtual pooling’. Entity pooling utilises a collective investment undertaking (CIU) to pool the assets of one or more pension schemes, such as an Irish common contractual fund, Luxembourg fonds commun de placement or a UK pension fund pooling vehicle. Units in the CIU are valued in proportion to the net asset value of its underlying portfolio of shares and securities. The purpose of this valuation is to ensure that the pension schemes enjoy the same economic risks and benefits as if they had invested directly in that underlying portfolio of securities. It is essential that entity pooling utilise CIUs which are ‘transparent’ for tax purposes.
Virtual pooling utilises information technology to enable the assets of pension schemes to be co-managed as if there were an underlying pool, but without actually constituting the pool as a legal entity, such as a CIU. The administrator of the virtual pooling arrangement supplies the technology to enable ownership records to be maintained at all times, to effect transactions and resulting changes in respective ownership, and to ensure that the transactions generated by the pooling arrangement are executed according to the contract and in a manner which preserves at all times the equity between participating pension schemes. Crucially, virtual pooling enables pension schemes to retain direct legal and beneficial ownership of their underlying assets at all times (unlike entity pooling which requires them to exchange their ownership of the underlying assets for economically equivalent ownership of units in a CIU). Consequently, virtual pooling is less problematic for taxation purposes because pension funds remain in exactly the same position ex ante in relation to the pooled assets.
A key question that a corporate sponsor/scheme trustee should ask themselves when considering pooling, is ‘what form should it take – entity pooling or virtual pooling?’ This impacts on investment and borrowing regulations and accounting. Pension schemes are subject to investment and borrowing regulations which place restrictions on the investment of assets. In the US pension there is the Employee Retirement Income Security Act (ERISA), and in the European the Occupational Pensions Directive.
Investment and borrowing regulations should not act as a restriction to virtual pooling. The point being, as described above, that virtual pooling enables pension schemes to retain direct legal and beneficial ownership of their underlying assets at all times, and so they should be able to meet investment and borrowing regulations in exactly the same way ex ante. For example, the Occupational Pensions Directive requires pension schemes to be “…predominantly invested on regulated markets” (Article 18(1)(c)), and entering into a virtual pooling arrangement should in no way alter a scheme’s ability to meet that requirement.
With entity pooling, the analysis is a little more complex. Entity pooling works by exchanging direct ownership of a portfolio for a unit in a CIU. Although the pension scheme has the same economic exposure as it had ex ante, it is clearly in a different legal position since it now owns a unit in a CIU with indirect exposure to the underlying shares and securities. As it happens, the legal engineering that makes Irish common contractual funds and Luxembourg fonds commun de placement transparent for tax purposes might also have some application here – just as the CIUs should be looked-through for tax purposes, so it might be possible to look through them for the purposes of determining whether the pension scheme is compliant with relevant investment and borrowing regulations. For example, to the extent that the CIU invests in shares and securities which are eligible under the pension schemes investment and borrowing regulations, so the pension scheme itself may be deemed to be so invested.
Article 18(1)(c) requires assets to be invested predominantly on regulated markets. Indirect investment via collective investment vehicles where underlying assets are traded in regulated markets should be treated as being equivalent to direct investment on regulated markets, based on a “look through” principle. This “look through” principle equally applies to asset diversification rules.
This principle has been carried over into the recently published UK regulations which implement the Directive (ie, regulation 4(9)(a) explicitly requires look through). Insofar as European pension schemes engage in an entity pooling solution, they should be able to look-through any intermediate CIU for the purposes of determining compliance with relevant investment and borrowing regulations. Corporate sponsors and trustees should ensure that other participating pension funds in an entity pooling solution can similarly look-through their investment in the CIU.
Pension schemes must account for their assets in accordance with the generally accepted accounting principles (GAAP) of the country in which they are domiciled. Although over time various local GAAPs are likely to converge on IFRS, in the meantime different pension schemes (and sponsors) remain subject to different accounting rules. These differences pose challenges of their own - corporate sponsors may be subject to IFRS which require them to calculate their scheme deficit/surplus on a bid-price basis, while the scheme may be subject to GAAP which requires it to value scheme assets on a mid-price basis.
In the case of virtual pooling, corporate sponsors/trustees must ensure that the technology underpinning the pooling arrangement is capable of maintaining ownership records in the relevant GAAP of participating pension schemes. This is no mean feat - particularly if schemes subject to different GAAPs are to be accommodated in the same pool - and should be thoroughly investigated.
In the case of entity pooling, the situation more compicated. On the one hand, since a pooled pension scheme will be the legal and beneficial owner of a unit in a CIU, it should be relatively simple to account for that asset under local GAAP. On the other hand, if the scheme (or sponsor) is subject to IFRS, then International Accounting Standard 27 (which deals with consolidated and separate financial statements) appears to require companies to consolidate their holdings in CIUs where the holding exceeds 50% of fund units or where control is exercised in some other way. This may require the accounts of the CIU to be reconciled to the GAAP of the pooled pension fund, which may be a complex and costly exercise.
Although tax poses a significant barrier to pooling, it would be a mistake to lose sight of the other challenges, including investment and borrowing regulations and accounting. IMA’s list of the issues that need to be considered when pooling pension asset might act as a useful checklist.1
The good news is that the potential market for pooling is so large that major services providers have already deemed it worth while to invest significant resources into developing solutions.