A new paradigm for Europe
Multinational corporations have sought to co-ordinate the activities of their pension funds across multiple countries and most recently the Institutions for Occupational Retirement Provision (IORP) has been introduced through a European Commission directive. The industry must find a way to integrate these different pension offerings so the well meaning aspiration of creating choice for pension members is not compromised by administration and investment management costs.
Multinationals are increasingly concerned about the large number of pension funds in which their employees participate. These multinationals are seeking to achieve consistent best practice for their pension funds around the world – particularly in the fields of fund manager selection, custody and administration. Asset pooling is one solution to meeting these aspirations of the multinational corporate.
Ireland, Luxembourg and the Netherlands have emerged as candidate locations for tax transparent pooling entities. Pooling of assets through these vehicles is known as ‘entity’ or ‘substantive’ pooling.
Tax transparency of the pooling entity is the key characteristic for successful asset pooling of pensions. Very significant legal and tax work has been undertaken by participants in the industry to verify that tax treaties between a country of domicile of a pension fund (say the UK) and the country of investment (say the US) is exercisable when assets are held by through a pooling entity. Some service providers have built sophisticated reporting and accounting systems to support the allocation of income to the underlying pension funds in the pool.
Parallels exist between the pensions industry and the mutual fund industry. Despite the existence of the UCITS directive, many fund managers have international fund ranges to complement domestic fund ranges in their primary distribution markets. Fund managers are faced with replicating product in multiple locations to meet local marketing, tax or regulatory requirements. So the same issues of product proliferation, small asset size and costly administration are characteristic of the challenges facing the mutual fund industry as well as the pensions industry.
Mutual funds have been successful in implementing asset pooling. This has been conducted through the use of ‘virtual’ or ‘notional’ pools, which in contrast with the substantive pools used by pension funds have no legal form. Notional pooling enables the economic activity of buying and selling investments to be divorced from the regulatory, accounting and tax interpretation of that economic activity.
The IORP directive came into effect from September 2005. It opens up the opportunity for a company to create a single pan-European pension scheme that is accessible to all its employees in the EU while preserving the domestic tax regime for pensions in their country of residence (host country) and respecting the social and labour laws of that country. The IORP will have a home country domicile, and many of its characteristics (such as funding and solvency rules) will be derived from that home country. However, IORP will have ‘country sections’ in which the particular fiscal and legislative requirement of different ‘host’ countries will be maintained.
Much work has to be done to understand precisely what each host country will require in terms of country sections in an IORP domiciled elsewhere. Governments will work to align domestic requirements where possible and therefore reduce the breadth of requirements that will be required in the country sections.
There has been little debate on the subject of withholding tax to which income arising in an IORP will be subject, the single greatest obstacle to achieving asset pooling for pension funds mentioned above. The solution to this issue will be the development of new pension structures to meet the international dimension of the membership of IORPs. This could result in pension funds that meet current national requirements but are also tax transparent, just like the substantive pooling vehicles already mentioned. In this way pension members from one country will not be disadvantaged by investing in an IORP domiciled in another.
Concern has been raised about the viability of the IORP as a long term solution to European’s proliferation of pension funds and the attendant issues of scale and cost. While the IORP will not be an immediate panacea, it does pave the way for a long-term solution. The transition from DB to DC is directly comparable to the transition yet to be seen from traditional domestic pension schemes to IORPs.
The prospect of wholescale conversion of existing pension funds into IOPRs is slim. Bringing together existing DB pensions from multiple countries into a single uniform package seems unachievable. But there is no reason to believe that new employees across the whole of Europe would become members of a single new company IORP from 1 January 2008. Existing plans would be closed to new members and over time the IORP will dominate the landscape in terms of active members.
In all this, a concern arises about the very issues that we are seeking to address – pension fund scale and cost. By introducing IORPs to co-exist with the existing DB schemes and DC schemes, it appears that we fuel the problem and not resolve it. To address this apparent contradiction, we can look to integrating substantive and notional pooling.
Substantive pooling will be used to aggregate the assets of smaller legacy funds within a group company. The larger legacy funds will be closed to new members and will continue to exist in their current form without participating the the pension pooling arrangement. A tax transparent IORP will meet the needs of future pension members for the whole of Europe. Country sections will deal with the fiscal and legislative needs of each country from which members originate.
With advanced accounting, custody and reporting systems it is possible to contemplate that service providers to the pensions industry will consolidate the assets of substantive pools, tax transparent IORPs and large legacy pension funds into a single asset pool using virtual pooling. The legal integrity and reporting of each participant in the virtual pool will remain constant. All participating entities will gain from the benefits of scale. The proportionate ownership of the pool assets will shift from the legacy pension structure to the new IORP structure as active IORP members grow.
So, the industry has the opportunity to address the concerns of pension fund proliferation, scale, asset allocation and high administration by adopting the new possibilities offered by substantive pension pooling (CCF, FCP and FGR), tax transparent IORPS (yet to be developed!) and virtual pooling.