AMX, in association with Northern Trust and Broadridge Financial Solutions, recently conducted a survey of 120 UK defined benefit (DB) pension schemes. This revealed the startling costs of failing to invest in tax efficient fund structures.
Overall, the researchers estimated that UK DB pension schemes paid around £256m of unnecessary Withholding Taxes in 2019 because they had invested in tax opaque funds, with potential tax drag costing investors around £2.4bn over the next 10 years. Furthermore, it turned out that 72% of the private UK DBs interviewed were using funds with inefficient tax structures but that 69% were unaware of how tax efficient structures could help them increase returns. Just as importantly, but perhaps not surprisingly, 82% said the issue was not included in their scheme’s risk register.
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AMX colleagues Aaron Overy and Nick Horsfall looked at this issue in our recent online panel discussion for institutional investors, chaired by Jignasa Patel.
As Aaron explained, Withholding Tax (WHT) is an important issue for pension funds. UK schemes tend to benefit from numerous reciprocal double-taxation treaties when investing directly in overseas assets. Those treaties normally allow recognised direct investors to reclaim WHT on dividends.
However, a pension scheme that invests through a pooled fund risks losing its right to reclaim WHT. That means the beneficial investors stand to lose benefits that are rightfully theirs. It also means sponsors of DB schemes with sizeable deficits are potentially ‘leaving funds on the table’ that they could use to reduce those deficits and so protect the pension beneficiaries.
… a pension scheme that invests through a pooled fund risks losing its right to reclaim WHT.
Unfortunately, not enough people in the pension industry appear to be aware of this downside to investing in certain pooled funds. As such, they don’t seem to realise that this is an avoidable cost. Simply by choosing tax transparent funds, UK pension schemes can save money on investing in overseas assets.
How do tax efficient funds work?
Essentially, the difference between tax opaque and tax transparent funds is whether taxation happens at the fund level or the investor level. Tax opaque funds pay WHT on all dividends, from equities listed in the same country, at the same rate. The WHT applies to the tax status of the fund, regardless of investor type.
That means a traditional pooled fund (such as a SICAV or ICAV) investing in US stocks, would pay WHT of 30% on dividends. A pension scheme using such a fund would not be able to claim this back. However, a pension fund that invested directly in the same asset would be able to reclaim the full WHT.
With tax transparent funds, taxation happens at the investor level. The structure enables the administrator to identify the beneficial owners and apply the appropriate WHT, as if they were direct investors in the asset. This ensures fair treatment for investors from different jurisdictions and with different tax profiles.
These tax transparent funds exist in various jurisdictions, most notably in Ireland where Common Contractual Funds (CCF) have now been available for 17 years. In that time, they have attracted $100bn of AuM from asset managers across Europe. Switching to a CCF makes it easy for managers or administrators to claim back WHT on their investors’ behalf, while retaining the functional benefits of other pooled fund.
With tax transparent funds, taxation happens at the investor level. The structure enables the administrator to identify the beneficial owners and apply the appropriate WHT, as if they were direct investors in the asset.
This is not aggressive tax planning; it simply delivers exactly what the double-taxation treaties set out to deliver – fair treatment of investors. Even where the savings are only in the region of 3-5 bps, removing this tax drag delivers real value for tax-exempt investors.
How much can schemes gain from using tax efficient funds?
As Nick Horsfall went on to explain, the Pension Protection Fund’s ‘Purple Book’ (which looks at around 5400 UK pension funds) reveals that a typical scheme has around a quarter of its assets in equities. Improved tax efficiency could be ‘worth’ about 0.1% a year, which in terms of scheme valuations, could change liabilities by around 2%. That equates to £100-200k a year in contributions for a typical £100m fund, which many sponsors who have been paying deficit repairs would appreciate.
The CCF structure offers investment managers an additional benefit over the traditional life insurance wrapped funds, which some pension schemes used to protect their WHT reclaims. That is, the managers can sell their CCF to investors across the EU, not just in the UK. This offers them a much greater market for their product and gives their funds increased economies of scale.
Switching from a UK OEIC to an Irish CCF is relatively straightforward. HMRC has confirmed that the CCF structure is tax efficient and, as such, there is no stamp duty to pay on conversion. There are some small administrative costs (and these are falling as the market develops) but these are outweighed by the potential gains. In short, you are investing in well-regulated pooled funds that enhance returns through greater tax efficiency.
To see how much your pension scheme could save by using tax transparent funds use our calculator.