Firms face difficult choices
By now, probably all the finance and human resources directors of multinationals established in Spain know that, if their company has employee pension commitments financed through an internal fund, they must in the near future externalise the reserve, either through a qualified company pension plan (QCPP) or a group insurance (GI) policy.
This is one of the provisions of the Private Insurance Law (Ley de Ordenación y Supervisión de los Seguros Privados - LOSSP), promulgated in November 1995. It aims to ensure that employees receive benefits even when a company becomes insolvent or bankrupt (in accordance with European Union Directive 80/987/CEE). The period for formalising the external fund, either via a QCPP or a GI, or for transferring past service commitments from the internal to the external fund, was originally due to end in May 1999. However, it is almost certain that this deadline will be extended to January 1, 2001.
But before they can start this process, companies must wait until the government publishes the regulations governing the LOSSP, which will detail the terms, conditions and requirements to be met with respect to the transfer of past service commitments. Companies are in the paradoxical situation of having to meet legal requirements, but being unable to do so, since the government has not yet published the requirements they have to meet. This situation is further complicated by the fact that a new Personal Income Tax Law (IRPF), that could change the tax treatment of QCPPs and life insurance policies, is being debated by parliament.
QCPPs and GIs have very different characteristics. I will also consider a third option, a cash compensation system (CCS), which involves substituting the pension commitment (usually defined contribution) with additional salary payments that the employee must channel to an individual savings vehicle.
The main characteristics of a QCPP are:
q contributions are tax-deductible, for both company and employee;
q there is an annual contribution limit of Pts1.1m ($7,200) per person (1998);
q collective bargaining with employees is required prior to implementation;
q a control commission, including company, beneficiary and employee representatives (who are in the absolute majority), manages the plan;
q it must be open to all employees (no discrimination), although a maximum waiting period of two years may be established, and
q the employee is 100% vested immediately.
As can be seen, the important tax advantages available are counterbalanced by a series of restrictions that can make it difficult, or even impossible, for a company to choose this as its funding vehicle. For example, companies often have pension commitments with only a select group of employees, such as management. Such a company would be unable to formalise a QCPP since it would not comply with the 'no discrimination' condition. In other cases, a company may have a defined benefit plan and be reluctant to leave certain decisions in the hands of the control commission. This problem can be mitigated, but not totally solved, by establishing qualified majorities within the control commission, thus permitting an effective veto of certain decisions by company representatives.
A GI is a much more flexible funding vehicle, since it is not necessary to comply with any of the requirements for a QCPP. Of course, there is a corresponding disadvantage in that no immediate tax deduction is available to companies for the contributions made. Furthermore, contributions only become tax-deductible when the benefits become payable, with the corresponding financial impact deriving from the deferral of the deduction. (In fact, the only way a company can deduct contributions for tax immediately is to impute them to the employee for tax purposes. This means that the employee would be liable for tax on the contributions, since they are not tax-deductible. In my opinion, this option would be very difficult to put into practice, so this approach does not really merit further analysis.
The third option, the CCS, could be valid for many companies, since it avoids all the disadvantages of the QCPP (except for 100% immediate vesting) while offering all the advantages. Briefly, a CSS usually involves the company making additional salary payments (calculated using a contribution formula, as for any defined contribution plan) which are paid to an individual funding vehicle. If this is a qualified individual pension plan, employees may take a tax deduction for the contributions and receive a tax deduction when they file their tax returns the following year. CCS contributions may also be paid to a mutual fund or an individual insurance policy, but these vehicles do not offer the same tax advantages as qualified individual pension plans.
Another matter of critical importance for companies adapting to the new legislation (and for those with external funds) is the current framework regarding the investments made by QCPPs, GIs and CCSs.
A QCPP must be implemented via a pension fund, which can include one or more plans. Pension fund investments are very flexible, since there are no restrictions on the proportions that must be invested in fixed income, equities, etc. The only requirement is for investments to be made in assets negotiated on officially recognised capital markets. There are also certain additional restrictions to avoid excessive emphasis on the shares of a single entity. In contrast to the apparent flexibility of pension funds, QCPPs have one major limitation that can have disastrous consequences for participants in defined contribution plans: the QCPP must invest all its assets in the same pension fund. This means that all participating employees must have the same asset mix, regardless of their personal characteristics (age, preferences, etc). It is not difficult to imagine that a younger employee would be prepared to accept more risk with their pension investment (more equity) than someone nearer retirement age, who would probably prefer to safeguard the assets they have built up (more fixed income), so as not to risk reducing them in the final stage of their working life. Such differentiation is not possible with a QCPP, so this is one issue that will soon have to be resolved.
Once again, GIs are much more flexible with respect to investments than QCPPs. Insurance companies are able to offer different types of policies depending on the structure of the investments. Three options are available:
q Integration of the individual policy assets into the overall investments of the insurance company. In these cases, a guaranteed interest rate is offered (maximum 4% pa) and, in addition, profit sharing calculated on the real financial return obtained. The investment policy is usually conservative.
q Individual policy assets are invested separately from the overall assets of the insurance company. This means that the company can impose its investment criteria on the insurer. A minimum volume of assets is usually required and no interest rate guaranteed.
q Employees choose their asset mix. The insurance company offers different portfolio combinations, so that employees can choose the option they prefer and even change the mix from one year to the next. Only a few companies offer this type of product, due to certain gaps in tax legislation. As the tax situation becomes clearer, this type of product will become more popular.
The CCS is probably the instrument that offers the greatest range of investment choices. If, for example, the funding vehicle chosen is a qualified individual pension plan, each employee can choose his or her preferred asset mix.
From all the above it is clear that there are a series of factors - human resources, financial, tax, among others - that companies need to review in detail.
Jaime Albo Gonzalez is a consultant with Towers Perrin in Madrid