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Annual and Lifetime AllowancesChanges to the annual and lifetime allowances mean that many more employees now face the prospect of paying tax on their pension savings. However, through careful planning, trustees and employers can help members to manage their position and thus maximise the tax-efficiency of the employer’s pension spend.

The amount of pension savings an individual can make while benefiting from tax relief is limited by two allowances. The ‘annual allowance’ limits tax-free pension savings over a year, while the ‘lifetime allowance’ limits the total value of benefits when they are drawn.

Over successive budgets since 2010, the government has reduced these allowances, with the annual allowance being cut from £255,000 to £40,000 and the lifetime allowance from £1.8m to £1.25m (see chart). These changes have enlarged the group facing possible tax charges from the most senior staff in the biggest organisations to a much wider variety of employees.

Until 2010, both allowances were increased each year, keeping the pool of those affected relatively stable. However, in these more straitened

times, pension savings have become a soft target for politicians looking to raise badly needed revenue. There is a real possibility that in the years to come the allowances could be reduced still further. Indeed, the Liberal Democrats at their Autumn Conference have just voted for that, calling for a further cut in the lifetime allowance from £1.25m to £1m.

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Tax on pension savings can present a real challenge for employers, trustees and affected individuals. However, by identifying those affected early, there is scope to tailor solutions that can maximise the value delivered to employees. In managing these issues, forewarned is forearmed.

Inside: October 2013Annual & lifetime allowances Page 1

Communications update Page 5

Directors’ remuneration Page 6

Pensions and same sex marriages Page 7

Pension Protection Fund Page 8

Investment viewpoint Page 10

Pension schemes and VAT Page 13

International Accounting Standard Page 14

Auto-enrolment seminar Page 16

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ANNUAL AND LIFETIME ALLOWANCES

How the allowances work – a reminderAnnual allowanceAnnual allowance calculations are based around ‘pension input periods’ (PIPs). A PIP will generally be a year, although the start and end point will vary by scheme and for some money purchase arrangements by individual. Annual allowance calculations for a given tax year are based on the savings during the PIP ending in that tax year.

The savings figure that is compared to the annual allowance is called the ‘pension input amount’. For individuals who have more than one active pension arrangement, the calculations for a given tax year are based on the total of the pension input amounts from all PIPs ending in that tax year.

Example annual allowance calculationAt the start of the pension input period, a member has an accrued pension of £25,000. Following a promotion, the member’s accrued pension rises to £30,750 at the end of the PIP. With inflation of (say) 3%, the pension input amount would be calculated as:

Starting pension increased with inflation: £ 25,000 x 1.03 = £25,750

Increase in pension after inflation: £ 30,750 - £25,750 = £ 5,000

Pension input amount 16 x £5,000 = £80,000

Money purchase schemes - the pension input amount for money purchase benefits is simply the total contributions (both employer and employee) made to a member’s fund over the year.

Defined benefit schemes – the pension input amount for a defined benefit scheme is calculated as 16 times the increase in the accrued pension, after allowing for inflation. This means that, in broad terms, the annual allowance of £40,000 for 2014/15 translates to an increase in pension over a year of £2,500, after inflation.

To help alleviate the effects of spikes in pension savings, an individual can ‘carry forward’ any unused allowance from the previous three years to

offset against his or her pension input amount. However, individuals with large spikes in their pension savings may not have sufficient carry-forward to entirely avoid an income tax charge.

Although the annual allowance system was designed to be relatively straightforward, in practice there are a number of subtle factors that increase the complexity of the calculations. For members who are close to the limits, trustees and employers will need the support of their advisers when it comes to detailed calculations.

Lifetime allowanceBenefits are tested against the Lifetime Allowance whenever an individual ‘crystallises’ their benefits, usually by drawing them. Individuals whose total crystallised benefits from all schemes exceed the allowance are subject to tax at 55% on benefits taken as a lump sum or 25% on benefits taken as income (in addition to standard income tax).

Money purchase schemes – pension savings are simply the members’ total fund when they retire, made up of employer contributions, employee contributions and accumulated investment returns.

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ANNUAL AND LIFETIME ALLOWANCES

Defined benefit schemes – pension savings are calculated as 20 times the member’s pension at the date of retirement, plus the value of any cash sum taken. For, a member retiring with a £40,000 pension and £200,000 in cash, the value of the crystallised benefits is deemed to be £40,000 x 20 + £200,000 = £1,000,000.

Double taxation – the fact that some of the member’s savings have already been subject to an annual allowance tax charge does not automatically reduce the lifetime allowance tax charge. In other words the member may be taxed twice on the same ‘excess savings’. But if ‘scheme pays’ is used the extra tax payable will be reduced.

Informing membersTrustees are required to check the annual allowance position for active members each tax year and send a pension savings statement to any members who have breached the limit. The statement indicates the member’s pension input amountunder the scheme for the tax year and the three previous tax years, and has to be provided by 6 Octoberfollowing the end of the tax year.

Although statements are only required for members who have breached the limit, trustees may wish to send statements to a wider population. This can be of particular use to members who are contributing to a second pension arrangement, such as a personal pension. Members not automatically sent a statement can request one at any time.

There is no similar regulatory requirement to keep members informed of their lifetime allowance position. In many ways it is easier for individuals to keep track of and manage their own lifetime allowance position than their annual allowance position. However, reductions in the lifetime allowance will draw people into the net who have not previously

considered the issue and some employees may need help.

Managing the annual allowanceOne of the key steps in addressing the annual allowance is to identify in advance those individuals who might breach the limit. Once individuals are identified, their position can often be managed to improve the tax efficiency of their overall benefits package. At the very least, identifying affected members can help with future retirement planning, particularly for those members looking to pay AVCs.

For defined benefit schemes managing the issues is likely to require careful planning. For some high earners, the annual allowance may be breached simply as a result of the accrual of additional service. These individuals can usually be identified fairly easily and monitored on an ongoing basis.

However, more moderate earners can also be affected, particularly if they have long service. Sudden increases in accruing pensions, due to promotion or the payment of a pensionable bonus, can cause these individuals to go over the limit. Those involved in setting general and promotional salary increases need to be alive to the possibility of such issues and know when to seek further help.

Scheme pays If the annual allowance is breached, the individual member faces the prospect of funding an additional and potentially significant income tax charge. For most people, meeting such a charge directly will be difficult. However, the tax framework provides for an alternative approach known as ‘scheme pays’. As the name suggests, this involves a pension scheme paying the annual allowance charge on the member’s behalf. In return, the pension scheme must cut back the member’s benefits by an amount of equivalent value.

While a reduction of pension is not a welcome prospect, for most people it is more palatable than meeting the tax charge directly themselves, and for that reason ‘scheme pays’ is proving to be the most popular means of dealing with annual allowance charges. A member who has breached the annual allowance within a scheme and who faces a tax charge of more than £2,000 can require his pension scheme to operate scheme pays on his behalf.

The operation of scheme pays requires some additional administration. Members applying for scheme pays in respect of the 2011/12 tax year are required to do so in writing by 31 December 2013. Trustees will need to decide how members’ benefits are to be reduced.

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ANNUAL AND LIFETIME ALLOWANCES

Actions and timeframeA number of deadlines are now approaching to help manage tax on members’ pension savings (see diagram). For trustees and employers it is thus ever more pressing to understand how the reduced annual and lifetime allowances will affect members of their schemes and take action where necessary.

This article is based on our current understanding of the law and is intended as a general explanation of a complex subject. It cannot cover the wide variety of individual situations that arise; employers and trustees are strongly recommended to seek advice specific to the circumstances of their pension scheme and its members. Please contact your usual Xafinity consultant or call Chris Fletcher on 0113 284 8066. n

Managing the lifetime allowance‘Protections’There are many people who already have savings above the new £1.25m limit that will apply from the 2014/15 tax year. In order to protect such individuals from an unexpectedlifetime allowance charge, the government has introduced new ‘protections’. Like similar protections introduced in the past they allow the individual to retain a higher lifetime annual allowance, subject to some restrictions. The two new protections are:

Fixed Protection 2014 (FP14) FP14 mirrors the similar protection introduced in 2012 (when the lifetime allowance was reduced from £1.8m to the present £1.5m) and is designed to help those who already have pension savings above £1.25m or who expect investment growth on existing money purchase benefits to take them over the £1.25m limit.

Individual Protection 2014 (IP14)IP14 protection gives an individualised lifetime allowance equal to the member’s pension savings as at 5 April 2014, provided these are at least £1.25m,

but limited to a maximum of £1.5m. An individual can apply for both Fixed Protection 2014 and Individual Protection 2014, in which case FP14 would take priority.

Pragmatic managementThere are a number of actions that individuals can take to manage their position and maximise the tax efficiency of their benefits. This will also be of interest to sponsoring employers, who will want to ensure that their spend on benefits ends up with the members concerned and not with the tax authorities.

Fixed Protection 2014 Individual Protection 2014*What do you get? A lifetime allowance

fixed at £1.5mAn individualised lifetime allowance equal to current savings (up to £1.5m)

What are the restrictions on further savings?

No further money purchase contributions, and limited defined benefit accrual

No restrictions

* We are still awaiting final details of IP14 from HMRC, so this information may be subject to change.

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COMMUNICATIONS UPDATE

Member communications – an updateSome changes to the Disclosure of Information legislation are to come in from next April, following DWP consultation earlier this year. The Government had intended the changes to apply from this October, but has accepted that schemes will need time to comply, even though many of the changes are optional.

At the time of writing the finalised new regulations are still awaited, but the key elements are known. The current detailed requirements will generally remain, without being made more prescriptive. So many schemes will not require any significant changes in practice. The main new areas are as follows.

Electronic communicationsThe ability for schemes to use email or a website to provide information to members will be extended; for instance, transfer value quotations could be sent electronically rather than schemes having to use post. This is to be welcomed and should result in some cost savings. The existing safeguards will remain, in that a member will still be able to opt out of electronic communications.

Statutory Money Purchase Illustrations (SMPIs)At present, SMPIs have to assume that the annuity at retirement will increase in payment in line with inflation and will have an attaching 50% continuation to a surviving spouse. In future, schemes will have flexibility over the ‘shape’ of the annuity (which could even be member-specific!) when producing SMPIs. This recognises that in practice many – if not most – individuals with money purchase benefits opt at retirement for a non-increasing single-life annuity.

In addition, it is envisaged that SMPIs could include allowance for retirement lump sums, again reflecting what typically happens in practice.

There will also be some extra optional flexibility around the timing of the first SMPI issued to a member, as a result of the automatic enrolment (AE) legislation, although the details are still under discussion. Currently, occupational pension schemes have to provide SMPIs no later than 12 months after the end of each scheme year. So, for example, there could be some instances where the deadline date falls between a member being enrolled and contributions being paid, meaning that a ‘nil’ contribution initial statement would at present need to be issued. This is likely to be exacerbated by the extended deadline for employers paying over contributions deducted during the AE joining and opt out window. The DWP has commented that it cannot see the benefit of requiring schemes to automatically issue pension statements for new members where no pension contributions have yet been credited, or where a member is in their opt-out period when their first statement is due.

LifestylingOnce the new legislation is in force, all DC schemes adopting a ‘lifestyling’ investment strategy will have to inform all affected members (and prospective members) of this as part of the ‘basic scheme information’. Based on draft regulations, we expect this to include the age when a member’s funds would start to be moved into ‘less risky’ investments, as well as a summary of the advantages and disadvantages of lifestyling. This may necessitate a revision of (or in the short term, an insert to) the current scheme booklet.

A subsequent reminder will also have to be provided to individual affected members at a time falling between five and fifteen years before the member’s retirement date. The idea here is that schemes will do this shortly before the intended move into less risky investments, in order to give the member the opportunity to choose a different investment strategy for his or her fund.

Scheme trustees will need to consider how they will accommodate the new requirements and options. Xafinity will be happy to assist. n

All DC schemes adopting a ‘lifestyling’ investment strategy will have to inform all affected members (and prospective members) of this as part of the ‘basic scheme information’.

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DIRECTORS’ REMUNERATION

Directors’ remuneration: New reporting requirements from OctoberIn our September 2012 issue [ http://www.xafinity.com/Uploads/Files/290_intouch_sept_web.pdf ] we explained the Government’s proposals for improving the reporting of directors’ pay. This was part of the Government’s plans “to curb excessive executive pay”. Those proposals have now been finalised in regulations and will apply to large and medium-sized (as defined) quoted companies in respect of financial years ending on or after 1 October 2013.

The Directors’ Remuneration Report will have to be split into two parts:

n A report setting out the company’s forward looking policy on all elements of their directors’ remuneration, how these support the short and long-term company objectives and the key factors that were taken into account in setting that policy. (This part can, however, be omitted if the company does not intend seeking approval of the policy at the forthcoming shareholders’ meeting. In that case, the policy must still be accessible to shareholders.)

n A report on how the remuneration policy was implemented in the past financial year, setting out in tabular form the actual payments to directors – including a single total figure for each director – and details of the link between company performance and pay over the year.

Changes to pension calculationsThe 2012 proposals included detailed requirements for calculating the value of defined-benefit pension accrual but these contained some hidden flaws. In particular they did not produce sensible results where the promised pension on retirement at normal retirement date is unrelated to service, for example a fixed 2/3rds pension, but where the ‘true’ accrued pension at any time is service-related.Following representations by actuarial and other bodies, BIS has amended its

proposals to avoid some of these flaws. The calculation steps now run as follows:

1. Calculate the director’s accrued pension as if he/she had left service at the end of the financial year.

2. Calculate the corresponding figure at the end of the previous financial year, increased by any rise in the Consumer Prices Index over the 12 months to the previous September.

3. Subtract (2) from (1) and multiply the answer by 20.

4. Then deduct the director’s own pension contributions, if any, made during the year.

Cash payments in lieu of pension rights are also to be included under the pension heading.

Other pension disclosuresThe new regulations also require:

n For each person who has served as a director of the company at any time during the relevant financial year and has a prospective entitlement to defined-benefit pension rights:- details of those rights as at the year end, including the person’s normal retirement date (i.e. the earliest date at which an unreduced entitlement can be drawn without consent)- a description of any additional benefit that will become receivable in the event that the

director retires early- if the person has rights under more than one type of pension benefit (e.g. DB and DC), separate details relating to each type.

n Details of any payments in the year to any person who was not a director at the time of payment but who had previously been a director. This does not however include any payments by way of regular pension benefits that had commenced in an earlier year.

n A bar chart indicating potential future remuneration for each executive director, in which the value of pension rights is separately identified.

Finally, a reminder that the UK Listing Rules have not yet been brought into line with the new regulations. To avoid unnecessary duplication, the Financial Conduct Authority has proposed removing from the Listing Rules those aspects relating to directors’ remuneration. However, it is planned that this will not come in until 1 January 2014. For financial years ending before that date the current Listing Rules – which require a different method of valuing pensions – will still apply, so affected quoted companies will still need to carry out dual calculations.

If you need assistance with these calculations or with drafting the new-style pension disclosures, please contact your usual Xafinity consultant. n

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PENSIONS AND SAME SEX MARRIAGES

Pensions and Same Sex MarriagesThe Marriage (Same Sex Couples) Act 2013 received Royal Assent on 17 July 2013 and will enable same sex couples to get married in England and Wales. The regulations bringing the Act’s provisions into force have still to be made, but the Government expects the first same sex marriages to take place by next summer.

In this article we look at how this will affect defined benefit occupational pension schemes.

England and WalesWhilst the Act will provide that “in the law of England and Wales, marriage has the same effect in relation to same sex couples as it has in relation to opposite sex couples”, as regards pension schemes it will treat same sex marriages in the same way as civil partnerships.

This means that - at least initially - schemes will only have to extend survivors’ benefits to same sex spouses in respect of pensionable service from 5 December 2005, or from 6 April 1988 as regards minimum contracted-out rights.

From a practical perspective, scheme sponsors will need to decide whether to provide just the statutory minimum survivor benefits to same sex spouses or to treat them in the same way as opposite sex spouses. A similar decision will have been made when civil partnerships were first introduced, so we expect that employers may want to adopt a consistent treatment.

However, employers choosing to restrict same sex survivor benefits to pensionable service from 5 December 2005 (and minimum contracted-out rights from 6 April 1988) need to be aware that this may not be sufficient in future:

n First, the Act commits the Secretary of State to arrange for a review of differences in survivor benefits under occupational pension schemes and of the costs in eliminating such differences, with this being completed and published by 1 July 2014. If, after considering the review, the Secretary of State thinks that the differences should be reduced or eliminated then further legislation will be brought in.

n Secondly, as noted in our March 2013 issue [ http://www.xafinity. com/Uploads/Files/028XC_ Intouch_Final_Web_version.pdf ] a recent employment tribunal (Walker v Innospec) held that the employer directly discriminated against Mr Walker on sexual orientation grounds in refusing to allow him a survivor’s pension in respect of his civil partner’s pensionable service prior to 5 December 2005. This decision is not binding on other occupational pension schemes, and is being appealed. The outcome of the appeal should give more clarity on whether excluding pre 5 December 2005 pensionable service for civil partners – and by extension, same sex spouses – is discriminatory.

The requirement to pay contracted-out death benefits to a same sex marriage survivor will require explicit changes to scheme rules. The remain-ing statutory minimum requirements are overriding; any intended changes that go further, though, would need to be reflected within scheme rules.

Northern IrelandThe Act does not extend same sex marriages to Northern Ireland.A same sex marriage taking place in England or Wales will, nevertheless, be treated in Northern Ireland as if a civil partnership.

ScotlandThe Scottish Parliament is currently considering whether same sex couples should be allowed to marry in Scotland. However, whilst this remains illegal under Scottish law, the Act gives the Secretary of State power, with the consent of the Scottish Ministers, to provide that the marriage of a same sex couple under English and Welsh law is to be treated in Scotland as a civil partnership.

The Government’s review of the differences in survivor benefits, and the possibility of further legislative changes, also extends to Scotland.

Employers with defined benefit schemes will need to consider the implications of the Act and any actions needed for their scheme. In any event, we would recommend that scheme rules are amended so that the benefits payable are clear. Trustees will also need to tell members about the changes. n

A same sex marriage taking place in England or Wales will, nevertheless, be treated in Northern Ireland as if a civil partnership.

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PENSION PROTECTION FUND DEVELOPMENTS

Pension Protection Fund developmentsIn this article we cover a number of recent developments - including the case of Olympic Airlines which will be of particular concern to trustees with overseas sponsoring employers.

Insolvency Risk ProviderAt the end of July the PPF Board announced that it will be switching its provider of insolvency risk ratings for levy calculation purposes from Dun and Bradstreet (D&B) to Experian. This will first affect the levy for 2015/16 (i.e. that due to be paid in the autumn of 2015).

We understand that Experian are in the process of developing a bespoke failure score model, aimed at providing a more informed picture of the risk of insolvency faced by sponsoring employers in the UK’s economic environment.

We have had initial discussions with Experian and aim to work closely with them to fully understand their model and how it will affect credit ratings for our clients.

Inevitably there will be winners and losers from the change in provider. However, depending on Experian’s

model there may be some simple changes an employer can make to improve its score.

PPF Compensation CapWhen a scheme enters the PPF, the amount of PPF compensation paid to a member who had already reached the scheme’s normal pension age (or had retired early due to ill-health) is initially set at the level of the member’s accrued pension, with no limit.

For all other members, the PPF compensation is 90% of the accrued pension, subject to a monetary limit: the PPF compensation cap. At present, for compensation commencing at age 65, the cap amount is £34,867.04 per year (which means a maximum annual compensation of £31,380.34 when the 90% factor is applied).

To date, the same compensation cap has applied irrespective of the length of a member’s pensionable service.However, on 25 June the Pensions

Minister announced that the Government accepted that the PPF compensation cap, as it currently operates, has a disproportionately adverse effect on long service members. Accordingly, it proposed increasing the cap by 3% for every full year of pensionable service in excess of twenty years (with an overall maximum of double the standard cap). This has now been included within the Pensions Bill work-ing its way through Parliament. The Bill is anticipated to get Royal Assent in April or May next year ; the actual date the relevant clause comes into effect will be set out in secondary legislation.

When the change is introduced, anyone already receiving capped compensation will see an increase in their compensation if they have enough pensionable service, but it will not be backdated.

As regards the knock-on effect for PPF levies, we understand that the earliest affected year will be the levy for 2015/16. The impact for any particular scheme’s levy will depend on its membership profile, in particular the proportion of relatively well-paid longer-service members.

“I thought the PPF was akin to an insurance scheme?”So did the members of the Olympic Airlines scheme. After all, the scheme had been paying PPF levies. Yet despite the liquidation in Greece in October 2009 of the scheme’s sponsor, Olympic Airways SA, the scheme has been denied access to the PPF.

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PENSION PROTECTION FUND DEVELOPMENTS

So why has this happened? In isolation, foreign liquidation proceedings do not count as “qualifying insolvency events” triggering a PPF assessment period. So, in July 2010 the scheme trustees presented a petition to the High Court seeking to commence a secondary winding up of Olympic Airlines SA in the UK on the basis of its inability to pay the section 75 debt, estimated to be in excess of £15 million.

The High Court concluded that it did have jurisdiction in the UK to wind up the employer and this would have enabled the scheme to enter the PPF. However, this was overturned by the Court of Appeal in a decision handed down on 6 June this year.

Under European insolvency regulations, a company incorporated in an EU member state has to be subject to main insolvency proceedings in the jurisdiction where it has its centre of main interests. Secondary proceedings, running in parallel, may be opened in another member state where the debtor has an ‘establishment’, but only for the purpose of dealing with assets located in that member state. For this purpose, an establishment is described as “any place of operations where the debtor carries out a non-transitory economic activity with human means and goods”.

At the time of the petition to theUK High Court, Olympic Airlines SA had for several months ceased commercial operations and had dismissed its remaining staff the previous week. However, it remained in possession of its London office and had retained the services of two former employees on short term ad hoc contracts to support the winding-up in Greece. The Court of Appeal disagreed with the High Court that this was sufficient to meet the ‘establishment’ criterion, as there was no business operation in the UK at the time of the petition to justify secondary proceedings of winding-up.

It is clearly unfair that members of UK pension schemes are denied access to PPF compensation due to what appears to be a technical loophole.

Will the PPF entry requirements be changed?It is clearly unfair that members of UK pension schemes are denied access to PPF compensation due to what appears to be a technical loophole in the PPF entry legislation, particularly where the scheme has been paying (risk-based) PPF levies. Indeed, it could be argued that the Government is failing to comply with EU legislation requiring member states to provide protection for pension scheme

members’ benefits in the event of employer insolvency. We are aware that Steve Webb, the Pensions Minister, has been lobbied to amend the legislation, and we await developments.

In the meantime, DB schemes with non-UK sponsoring employers should consider whether they ought to seek additional funding and/or contingent assets, given the possible lack of the PPF safety net on employer insolvency. n

PPF Levy for 2014/15Just before we went to press the PPF published its consultation document on the 2014/15 levy. It estimates the total levy to be £695 million, a 10% increase on the previous year.

However, at the individual scheme level the average increase is expected to be higher than 10%. Moreover increases will vary considerably from one scheme to another as shown in the chart below:

Source: Pension Protection Fund. “Including CAs” means that contingent assets have been taken into account.

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INVESTMENT VIEWPOINT

Best of both worlds?As employers seek good investment returns, but with lower volatility, do trustees have a solution to hand?

We expect several such opportunities to provide protection against movements in liabilities but on considerably more attractive terms than those currently available from the risk-free gilt markets.

Trustees, mindful of the need to be “prudent” in their funding requirements, will often wish at the same time to maintain a sufficient investment return to assist the sponsor in making up any funding deficit over the period of the Recovery Plan.

Investment solutions offering the following features are therefore of considerable interest:

n return generating capability - with the potential for equity-like returns, but with lower volatility than equities, andn liability matching characteristics - both fixed and (especially) inflation related.

Such investment characteristics are attractive to both employers and trustees as they enable strong returns to be targeted but with a reduced prospect of a worsening deficit.

In particular, we expect several such opportunities to provide protection against movements in liabilities but on considerably more attractive terms than those currently available from the risk-free UK Government fixed inter-est and index linked gilt markets.

n the Pension Protection Fund - levy calculations now incorporate an element of scheme specific asset allocation, and diversified liability- aware strategies are able to generate considerable annual levy savings in most cases.

Market conditions:n the 2008 credit crisis resulted in governmental bailouts for financial institutions and a sustained period of austerity; n equity markets falling and experiencing subsequent volatility;n ultra low bond yields as a consequence of Quantitative Easing putting a large strain on liability valuations; and n Western economies struggling to regain previously accepted norms of medium term economic growth rates.

And if that was not enough, recognition of ongoing increases in longevity, whilst a boon to all of us at the individual level, has put a materially increased strain on defined benefit (DB) pension scheme funding levels.

There has been a transformation in the world of UK defined benefit pension fund investing, with a number of factors combining to produce a sea change in how pension fund trustees approach their investment related responsibilities:

Regulation:n the Pensions Regulator’s input into sponsor funding - bringing the actuarial valuation assumptions and the investment strategy into greater focus with each other;

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INVESTMENT VIEWPOINT

DiversificationThe investment management community has responded to the first of these demands through the development of products such as Diversified Growth Funds. Generally having a “cash plus” performance objective, these funds are designed to capture the majority of equity returns, whilst at the same time having either implicit or explicit downside risk controls to mitigate against market falls, especially within equity markets. Such funds also provide potential for the manager to add value through

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active decision taking, often through opinionated asset allocation positioning and also, in some cases, security selection. In addition, economies of scale often enable these funds to take positions in asset classes which are not otherwise easily accessed by small or medium sized pension funds.

The success of these funds is illustrated by the above chart showing the performance of our recommended range of providers against that of the equity market over recent years.

Protection against market fallsIn the chart below, we illustrate the performance of the funds relative to global equity markets in months in which equities have risen and when they have fallen.

A figure of 50% in the left hand chart shows that the particular fund has (on average) captured 50% of any month’s rise in global equity markets. Whereas the corresponding 7% figure in the right hand side chart would mean that the fund had suffered on average only 7% of any month’s fall in equity markets.

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INVESTMENT VIEWPOINT

A high left hand side percentage and a low right hand side percentage would therefore mean that a fund had performed very well in rising markets but had also protected capital to a good degree when markets went down.

Direct, rather than pooled, investmentWhilst a number of our clients have chosen to allocate scheme assets to such ‘pooled diversifier’ funds, this is not the only option for reducing risk while preserving the potential for returns. We have other clients who have made direct allocations to specific classes in order to obtain exposure to investments with suitable characteristics.

These are not always the traditional routes that investors have followed in the past. Historically, many investors have sought growth asset diversification and inflation-related income through investment in very illiquid markets with strong and direct inflation related characteristics. Common examples include private equity, private debt, real estate and infrastructure markets. It can however be less than straightforward for schemes to access such classes, for instance due to factors such as:

n prohibitive access costs for relatively modest sizes of allocation;n shortage of supply;n factors relating to the niche market of the underlying asset; and n liquidity constraints both on acquisition and realisation.

Modern investment methods are able to avoid many of the obstacles to investment of the classes mentioned above, thus enabling trustees to gain exposure to higher expected levels of return than those available in mainstream bond markets as well as the attraction of inflation-related cash flows. We have identified a number of new opportunities which could enhance liability matching in this way, including:

n Corporate index linked bondsn Long lease propertyn Ground rentsn Infrastructure bondsn Social housing debt.

Some clients have already made allocations to these classes, often because of an expectation that they will fit well with de-risking techniques as well as being consistent with flight-paths towards a fully funded position.

Trustees should consider the merits of such allocations and we should be pleased to discuss this matter with clients over coming months as appropriate, highlighting funding opportunities when they arise.

It is helpful for trustees to engage in discussions at an early stage as this allows steps to be taken more quickly later on, avoiding delays when suitably attractive periods of market timing are identified. n

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PENSION SCHEMES AND VAT

HMRC’s stance in the UK has always been that a VAT-registered employer who has set up a trust-based pension scheme may recover the VAT incurred both in setting up the scheme and on its day-to-day management. This is provided the employer is not reimbursed by the trustees for the costs incurred.

However, this has not extended to tax incurred on a scheme’s investment activities, even if the employer pays those expenses on behalf of the trustees. This could, though, change following a recent CJEU ruling relating to a Dutch employer and its defined benefit scheme.

The Dutch CaseThe employer had set up funded defined benefit pension schemes for the employees of its undertakings. (The fact that the schemes were created in order to satisfy a Dutch statutory obligation does not appear to have been relevant.) The schemes were separate from the employer from a legal and taxation point of view. A subsidiary of the employer had entered into contracts with suppliers of administration services and investment management; the costs of these

Pension Schemes and VATIn the light of a ruling of the Court of Justice of the European Union (CJEU), employers may be able to reclaim VAT on a pension scheme’s investment management fees.

services were met by the subsidiary and not passed on to the pension schemes. The employer had deducted the amounts of VAT relating to those costs as input tax. The employer subsequently received an additional tax assessment from the Dutch tax authorities, which the employer challenged and led ultimately to a referral to the European Court.

The Dutch tax authorities’ argument was that the employer was not entitled to deduct VAT invoiced to it where the employer was not itself the recipient of the services provided: these had been provided to the pension schemes.

The Court disagreed.

It ruled that “... a taxable person who has set up a pension fund in the form of a legally and fiscally separate entity...in order to safeguard the pension rights of his employees and former employees, is entitled to deduct the value added tax he has paid on services relating to the management and operation of that fund, provided that the existence of a direct and immediate link is apparent from all the circumstances of the transactions in question”.

The crucial phrase here is a direct and immediate link. The Court interpreted this quite loosely, noting that whether there is a direct and immediate link will depend on whether the cost of the input services is incorporated either in the cost of particular output transactions or in the cost of the goods or services supplied by the taxable person as part of his economic activities.

Impact on the UK?In many cases the fund manager makes a single charge which (in HMRC’s eyes) covers both ‘manage-ment services’ and ‘investment services’. The VAT on the management element is deductible whereas the VAT on investment services is not. As a pragmatic simplification, HMRC are prepared to deem 30% of the overall charges to be for ‘management services’ and hence 70% of the total VAT will at present be irrecoverable.

We are waiting to hear HMRC’s views on the impact as regards UK pension schemes of the European Court’s ruling and it is possible that HMRC might argue that there are sufficient differences to justify maintaining its current stance.

We suggest that employers in a similar position to the Dutch sponsor should discuss this issue with their tax advisers and consider making protective claims to HMRC, to maximise the amount of VAT reclaims that might become available in due course.

More generally, all sponsoring employers should from time to time review their VAT processes with their tax advisers – especially the interaction between trustees and employer. n

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INTERNATIONAL ACCOUNTING STANDARD

International Accounting Standard, IAS 19: plan ahead!Our September 2012 Intouch [ http://www.xafinity.com/Uploads/Files/290_intouch_sept_web.pdf ] explained that the revised version of the international pensions accounting standard IAS 19 was coming into effect for accounting periods beginning on and after 1 January 2013. The changes will affect the next set of accounts for most quoted companies, so this article should prove a timely reminder. For many the changes are significant and planning ahead will be vital.

Recap – the changesn Actuarial gains and losses will be recognised immediately on the Balance Sheet through Comprehensive Income.– This will result in a much more volatile Balance Sheet progression for those companies currently using the “corridor” method to smooth those gains and losses.

n Any unrecognised gains or losses at the start of the prior year (1 January 2012 for many) will result in a shareholders’ equity adjustment. This is to enable the Balance Sheet asset or liability to reflect the funded status of the pension scheme at that date.– This will have a significant effect on entities currently carrying a large volume of unrecognised gains or losses.

n Companies will no longer be able to take advance credit for anticipated investment outperformance above that expected from AA-rated corporate bonds. – Most companies will see an increase in reported P&L expense.– Key performance indicators (eg EPS, EBITDA) are likely to be affected.

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INTERNATIONAL ACCOUNTING STANDARD

As always, your Xafinity consultant will be happy to provide guidance and should be contacted if you have any queries. Alternatively, for more information please contact Ted Belmont on 0113 284 8025 or ted.belmont@xafinityconsulting.com. The information contained in this Intouch should not be relied upon for detailed advice or taken as an authoritative statement of the law. Any decisions should be taken on the advice of an appropriately qualified professional adviser.

– The change may impact banking covenants, bonus or incentive arrangements and distributable reserves.– Investment strategy changes will no longer immediately affect the sponsor’s P&L account.

n Investment-related expenses will be deducted in determining the return on plan assets and so will effectively pass through Comprehensive Income, whereas administration expenses will be recognised in Operating Expense as and when they are incurred.– The split between investment and administration expenses may not always be clear and so may present an opportunity for companies to influence their Operating Expense.

n More extensive disclosures will be required. These are designed to extract information about the risks the pension scheme poses to the sponsor. Most of the new disclosures require new narratives rather than new calculations, but the value of the assets and the liabilities will need to be broken down in more detail than was previously required.– It may take some time to agree the new disclosure wording with your advisers and auditors, so starting early should ease some of the pressure. Who will be affected the most?n All quoted companies with final salary pension schemes will be affected by the new disclosure requirements.

n Companies using the corridor approach (which are mainly those with a European parent) may see significant changes to their Balance Sheets.

n Sponsors of pension schemes with significant equity investment will see increased P&L costs.

The good news – what’s not includedn The proposal for a gilt based discount rate was dropped. This would have added billions of pounds to the liabilities of UK companies.

n Future non investment-related expenses do not need to be reserved for as a Balance Sheet liability.

What should companies do now?To avoid a year-end surprise, companies should consider the impact of the changes on:

n Their Balance Sheet and shareholders’ equity.

n The P&L account.

n Key performance indicators, debt covenants, distributable reserves, bonus and incentive arrangements.

n The pension disclosure wording and in particular the new risk-related wording.

Companies should also revisit their views on the Trustees’ investment strategy as any restructuring will no longer have an immediate effect on the P&L charge. Some may wish to accelerate any plans to de-risk from equities into bonds or to increase the allocation to corporate bonds to reduce Balance Sheet volatility.

Above all, companies should plan ahead – the new standard may take longer to implement than you anticipate. n

Companies should also revisit their views on the Trustees’ investment strategy as any restructuring will no longer have an immediate effect on the P&L charge. Some may wish to accelerate any plans to de-risk.

Xafinity Consulting Limited. Registered Office: Xafinity House,42/62 Greyfriars Rd, Reading, RG1 1NN.Registered in England and Wales under Company No. 2459442. Xafinity Consulting Limited is authorised and regulatedby the Financial Conduct Authority for its investment consulting activities. A member of SPC. Part of the Xafinity Group of companies

Xafinity is one of the UK’s leading specialists in pensions and employee benefits. Our expertise addresses the needs of both trustees and companies in pensions and actuarial services, flexible benefits, healthcare and training. We are committed to providing a professional and proportionate service, tailored to our clients’ needs and delivered cost effectively.

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Auto-enrolment:The final call

An invitation to our complimentary auto-enrolment seminar

Are you prepared for auto-enrolment and your staging date? Our expert speakers will share the lessons learnt by employers so far, to help you plan with confidence and ensure your ‘solution’ really works.

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15 October – London

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