The means of funding retirement that is organised at a state level by means of redistribution is nowadays faced with a major problem. This problem is arithmetical in nature: a falling birth rate coupled with longer life expectancy.
In Europe, it is estimated that the population aged over 65, and thus of pensionable age, represents 22% of the total population and is set to rise to 30% in 2020 and 40% in 2050. Consequently, the ratio between the working age population and the number of pensioners will inexorably fall over coming years.
It will therefore be increasingly difficult in future for states to maintain levels of pension payments that are comparable to present levels. Although it is true that this issue affects all employees, it is of special concern to executives, since, given the cap generally set by governments on their pension payments, retirement is often synonymous with a significant drop in their purchasing power.
Businesses are conscious of these concerns and are increasingly setting up occupational retirement schemes for their executives. In this regard, it is crucial to emphasise that setting up a supplementary pension scheme need not necessarily have the sole aim of providing its members with additional pension on retirement.
In addition, the reason for this is that companies will have to take advantage of tax reductions surrounding the creation of a supplementary pension scheme in order to generate tax breaks for the members. Moreover, companies can structure the benefits flowing from their retirement schemes by defining entry conditions (seniority, grade, etc.) and/or defining a level of coverage linked to the executive’s individual performance. This creates a powerful tool for managing the expectations of key executives and their retention. For company shareholders, having an effective tool used for retaining executives will thus immediately create added value to the business and its prospects.
Thus, it is clear that a supplementary pension scheme is at the same time a compensation policy instrument that can be used to foster firm loyalty for high calibre members, a tax optimisation tool for the members and provides a flexible alternative to meet their retirement pension needs. The success of a supplementary retirement scheme within a business or a group of businesses will inevitably also depend on an efficient conceptualisation of the pension plan rules and a policy of providing the members with complete information so they clearly identify the benefits and advantages offered by the scheme and to some extent enable them to manage their benefits.
A business that wishes to set up a supplementary retirement scheme has to choose from a number of possible funding alternatives. A distinction is drawn here between internal and external ‘vehicles’.
The internal system, allowed in a few countries only, constitutes an unfunded reserve, characterised by the fact that the company makes no actual cash payment before the benefits are due. This is advantageous for the company due to cash flow, but provides a lesser guarantee for the beneficiary.
External vehicles require full funding. It means that the funds necessary to finance the supplementary pension scheme - which will need to be expensed by the company - will leave the business. The funds will be paid by the company to a vehicle that will undertake responsibility for paying the benefits.
External vehicles include group insurance solutions, pension funds and collective retirement funds.
Why an executive pension fund?
The advantages linked to setting up a pension fund are multiple.
The first is financial in nature, since utilising a pension fund means that no charges are due on the contributions paid into or capitalised by the scheme. In the latter case, paying charges based on capitalised contributions into the scheme generates a growing cost for the company as total capitalised contributions under the scheme increases with time.
Use of a pension fund also allows greater freedom in choosing the investment policies that can be conducted under the scheme, since the executives are not subjected to restrictions of an external insurer.
International groups will appreciate having a pension fund as a tool for centralising the financial management of the supplementary retirement scheme and allows for self-tailoring of the scheme.
In addition, executives who consequently work in various countries welcome the possibility of increased and continuous assurance of their retirement pensions. Due to their mobility, these executives will not always have a right to a retirement pension in each of the various countries where they have worked, or alternatively their retirement benefit will be unequal especially in relation to the executive’s performance in that country. In addition, in the absence of centralisation in the supplementary retirement scheme, every time they are transferred to another subsidiary, these executives may integrate into the local pension scheme implemented by that subsidiary (if there is one). Bearing in mind the disparities that could exist amongst the various local schemes, it will be very difficult for the beneficiaries to clearly identify the total supplementary benefit they will be entitled to from the various countries schemes. This concern will be dispelled where the executive is a member of a group pension fund, since the benefits under the scheme will remain unchanged regardless of the state where he is working or enables top-up of benefits throughout the group for international executives.
A new alternative
By creating a legal framework allowing for the creation of international pension funds, Luxembourg is again maintaining its resolutely international ambition. Its long-standing experience and its know-how in the administration of funds, its stability, both political and legislative, will be important factors that will have to be taken into consideration when choosing where to locate a pension fund.
By enacting special pension funds legislation, Luxembourg has created a tool that is sufficiently flexible to tailor the scheme for the different characteristics required for executives. Even though vehicles impose a minimum amount of restrictions that does not jeopardise the security of its participants, the legislation does allow the addition of specific conditions that may be imposed by foreign legislation or required by the sponsor. In addition, Asseps and Sepcavs are designed not to suffer a punitive tax regime.
The lack of harmonisation on pension funds laws within the European Union is felt as putting a brake on the development of such tools at an international level. For the time being, it has to be recognised that regulatory and fiscal barriers continue to exist at a European level. However, it has to be underlined that the European Commission has reiterated its objective of eliminating obstacles to the free circulation of pension beneficiaries in its ‘green paper’. Furthermore, a new European draft directive on pensions proposes a common legal framework covering pension schemes within the European Community.
It is clear that the European harmonisation on pension funds is on the move and Luxembourg is one of its first architects. This changing environment, although far from optimal, still provides opportunities today for optimising executive benefits, incentives and company retention policy.
Michiel Roumieux and Manuel Quintana Iglesias are respectively Director and Manager in the Global Human Resource Solutions of PricewaterhouseCoopers in Luxembourg