Investor Agenda. PensionsInvest: Welcome to our Winter edition of. Contents. Winter DC scheme governance and charges

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1 PensionsInvest: Investor Agenda Winter 2014 Contents DC scheme governance and charges Welcome to our Winter edition of Investor Agenda VAT round-up including impact of ATP PensionService on defined contribution schemes Trustee considerations in relation to a buy-in proposal Looking ahead to 2015 As appropriate for the time of year, we are doing some looking back over the past year and some looking forward into the New Year in this edition. We look back at various recent decisions of the CJEU on VAT, and discuss the recent brief from HMRC that will re-shape pension schemes ability to recover VAT on investment management fees in the future. We also draw on our experiences during 2014 for an article concerning the key issues for trustees contemplating a buy-in proposal, and finally look forward to the introduction of the charge cap and new governance requirements from April 2016, and some of the steps trustees should be taking in the interim to ensure they are ready for the introduction of this legislation. As always, we hope you will find Investor Agenda informative and useful, and we welcome your feedback on what you would like to see in it. If you want to discuss further anything raised, please do give us a call. Rosalind Knowles Partner

2 DC scheme governance and charges The Government has issued a command paper and draft Regulations with: Trustees will have new duties to ensure that their SIP explains how default arrangements have been designed in members interests > > its response to its March consultation about minimum governance standards for defined contribution (DC) schemes; and > > a further short consultation on DC charging structures (which ended on 14 November). The Government intends for the final regulations to take effect from April New statutory minimum governance standards The Regulations will introduce statutory minimum governance standards for occupational pension schemes providing DC benefits. The standards will focus on the scheme s DC default arrangements, charges and administration processes. In particular, trustees will have new duties to ensure that their SIP explains how default arrangements have been designed in members interests, and to keep those arrangements under regular review; that core scheme financial transactions are processed promptly and accurately and that they assess and report on the value of transaction costs and other charges borne by scheme members. There is very little detail on how the governance standards will work alongside the new DC flexibilities announced in the 2014 Budget. Trustees will need to review the appropriateness of their default funds and understand scheme members actual and anticipated behaviour. This is likely to be difficult to do in practice but the command paper does not provide any substantive guidance on how trustees should approach this - there is simply an acknowledgement that challenges exist. Which schemes/benefits does this apply to? The requirements do not apply where the only DC benefits in a scheme are AVCs. The position for money purchase AVCs in hybrid schemes (i.e. a single scheme with separate sections providing DC and DB benefits) remains unclear. Currently, the Regulations are drafted in a way which means that money purchase AVCs in a hybrid scheme are caught by the governance requirements whereas money purchase AVCs in an otherwise pure DB scheme are not. Bonus sacrifices used to provide DC benefits are caught, even though they might be thought to be analogous to AVCs; and so are DC benefits provided on transfers-in. 0.75% of the member s fund will be used to set the charge cap s headline rate. Overriding laws to allow choice of providers The rules of occupational pension schemes providing DC benefits will not be able to require trustees to use particular investment, administration or other service providers. Chairs of trustees to have new reporting duties Trustees must appoint a chair who will be responsible for signing off an annual statement on how the scheme has met the minimum governance standards. The statement must also describe how the trustees have the relevant knowledge to run the scheme effectively. Note: This is in addition to the annual governance statement that schemes are expected to publish to show the presence of 31 quality features identified in the Pension Regulator s DC Code of Practice and guidance (some of which are loosely aligned with the DWP s quality standards).

3 10 things to review before April 2015 Trustees should consider reviewing: 1. which arrangements will be affected by the new charge cap; 2. whether the scheme s charge structure will be permitted; 3. whether they will be able to calculate members fund values at three month intervals; 4. whether they have mechanisms in place to calculate whether charges will fall inside the cap and whether the charges represent good value for members; 5. whether systems are in place to maintain necessary records to show and report on compliance with the charge cap; 6. whether they will need to enter into written consent agreements with individual members in respect of any services for which they currently charge (including, possibly, life cover); 7. whether the scheme rules restrict who may be appointed to provide services to the scheme; 8. who could be appointed chair of the trustees; 9. what mechanisms should be put in place to ensure that annual governance statements can be issued and to ensure that and record whether core financial transactions are processed promptly and accurately; and 10. how the SIP should be amended. New requirements for master trusts There will be new independence requirements for master trusts (now defined, broadly, as trustbased DC schemes for employees of non-associated employers). These will be required to have a minimum of three trustees; the majority of the trustees, including the chair, must be independent of the provider ( non-affiliated ); and these independent trustees must be subject to limited terms. The process of appointing these trustees must be open and transparent. Master trusts will also be required to make arrangements to encourage members to make their views on matters relating to the scheme known to the trustees. Master trusts will be required to explain in an annual statement how these requirements have been met. Charge cap for default arrangements A charge cap will apply to the member-borne charges and deductions (excluding transaction costs) under default arrangements in schemes used for automatic enrolment. An arrangement will be caught where members have made no choice to be invested in it; but also where 80% of an employer s active members are contributing into it on 6 April 2015 (or the employer s later staging date). The charge cap s headline rate is to be 0.75% of the member s fund. There are detailed requirements as to how this is assessed, including an effective requirement to value the funds at least quarterly. Different caps apply for schemes where charges are not measured by reference to members fund values (the single charge structure ) but rather, say, by way of a flat fee or percentage of contributions (a combination charge structure ). No charge structure other than a single charge structure or a combination charge structure will be permitted. One particular consequence of the way the regulations are currently drafted is that life insurance premiums, if deducted as a charge on members accounts without the members prior written agreement, could cause the charge cap to be exceeded. This may mean if there is no change in the final regulations - that some schemes will have to reconsider benefit design or seek member consents before April. Further consultation The DWP is consulting further on: > > the detail of member-borne deductions and default arrangements for charge cap purposes; > > an adjustment measure for default arrangements that do not comply with the charge cap (although this will not excuse a failure to comply from April 2015); and > > the content of the Pension Regulator s annual scheme s return, where the proposal is to require schemes to report that they have issued a chair s statement covering the governance standards and that the scheme is compliant with the charge cap. Timing It is quite possible the final regulations will not be passed until close to April 2015 but they will then come into effect immediately; there is very little in the way of transitional provisions in the draft regulations (save that the charge cap won t bite on schemes where employers have not yet passed their staging date for auto-enrolment purposes). Trustees therefore need to use the period before April 2015 to assess their compliance-readiness and ensure in particular that any auto-enrolment default arrangements will meet the charge cap.

4 VAT round-up including impact of ATP PensionService on defined contribution schemes In the Spring and Summer 2014 editions of Investor Agenda we looked at the CJEU s judgment in PPG Holdings BV, a case concerning the ability of employers to recover VAT incurred on services relating to the investment management of a pension fund s assets, and HMRC s response to the decision. We summarise the current state of play regarding this at the end of this article but, first, we will focus on another significant CJEU VAT decision for pension schemes from 2014: ATP PensionService A/S. Defined contribution pension funds may be regarded as special investment funds. ATP PensionService A/S The CJEU published its judgment in ATP PensionService A/S in March The case concerned Danish occupational pension funds, largely analogous to UK defined contribution schemes. ATP can loosely be seen as the defined contribution equivalent of the Wheels Common Investment Fund Trustees Ltd decision concerning defined benefit schemes from 2013 (also recapped below). The case stemmed from proceedings before the Danish courts concerning management, administration and payment services provided to a vehicle which pooled investments from a number of Danish occupational pension funds similar to UK defined contribution occupational pension schemes, including that the return to the employee depended on the yield realised by the pension fund s investments. Under the Sixth VAT Directive and Directive 2006/112, the management of special investment funds as defined by Member States is exempt from VAT. The CJEU was asked to determine whether the term special investment funds is capable of applying to schemes such as those described above. The CJEU drew a distinction with Wheels, and concluded that defined contribution pension funds may be regarded as special investment funds on the basis that they are funded by the persons to whom the retirement benefits are paid, savings are invested using a risk-spreading principle and the pension customers bear the investment risk. The CJEU went on to consider the actual services provided, and concluded that they could fall within the scope of the management exemption. HMRC s position On 25 November 2014, HMRC published a Brief setting out its position following the CJEU decision in ATP. In summary, HMRC now accepts that pension funds that have all of the following characteristics are special investment funds for VAT purposes: > > they are solely funded (whether directly or indirectly) by persons to whom the retirement benefit is to be paid (i.e. the pension customers). It is likely further explanation will be sought from HMRC as to whether employer contributions disqualify a fund from meeting this requirement; > > the pension customers bear the investment risk; > > the fund contains the pooled contributions of several pension customers; and > > the risk borne by the pension customers is spread over a range of securities. HMRC therefore accepts that management and administration services that are integral (i.e. specific and essential ) to the operation of such schemes should be, and always should have been, exempt from VAT.

5 Further, HMRC accepts that vehicles which pool the assets of such schemes (such as the taxpayer in ATP itself) fall within the VAT exemption. More detailed guidance is provided for cases where pension schemes pay members contributions into a number of different funds or where the services are supplied to a number of different funds together. The position is also more complex if individual pension customers give directions as to how their contributions are to be invested that override the investment powers of the trustee or pension provider. Impact in practice UK defined contribution pension schemes which meet the requirements set out above should no longer be charged VAT on fund management and administration services that are integral to their operation. Trustees of UK defined contribution occupational pension schemes that have, to date, been charged VAT on fund management services provided to them may wish to consider making claims for repayment and/or, if they have already made a claim for repayment, should keep those claims open and consider providing further details to HMRC in accordance with the HMRC Brief. Claims for repayment are subject to time limits, which would need to be considered carefully on a case-by-case basis. In addition, because the VAT in question was payable in respect of fund management services provided to the trustees by an investment manager, it will generally have been the investment manager that will have accounted to HMRC for the VAT. As a result, it will be the investment manager that would have the primary right of recourse against HMRC. The trustees would then have to look to the investment manager to account to them for VAT successfully reclaimed (to the extent that the VAT costs were originally passed on to them). Following the UK High Court s decision in the Investment Trust Companies case and Revenue & Customs Brief 15/13, HMRC s view is likely to be that the trustees are only entitled to make a claim directly against HMRC where they can show that the tax was wrongly levied in breach of EU law, the investment manager passed the wrongly charged tax on to them so that they ultimately bore the economic burden of it, and that it is, for reasons unrelated to the merits of the claim, excessively difficult or impossible in practice for them to make a claim against the investment manager. Note, however, that we understand that the Investment Trust Companies case has been appealed to the Court of Appeal, with judgment currently awaited.

6 Recap of PPG Holdings BV case The case concerned an employer s right to deduct VAT paid on services relating to the administration and management of a defined benefit pension scheme. The CJEU ruled that, subject to certain conditions, the employer was entitled to deduct as input tax the VAT it paid on services relating to the administration of its employees pensions and management of the assets of the pension fund set up to safeguard those pensions. HMRC issued a Brief in May 2014 indicating that it was considering revising its policy on this and stating that further guidance was to be expected in the autumn. In the meantime, HMRC extended the transitional period during which pension schemes and employers could continue to agree a 70:30 split between investment management costs on the one hand and general management and administration costs on the other, where both are covered by one invoice. The anticipated further guidance was published on 25 November This makes it clear that HMRC has changed its policy and that the VAT position will be highly fact-sensitive. However, as a general matter, HMRC does now accept that there are no grounds to differentiate between the administration of a pension scheme and the management of its assets: in each case the employer will potentially be able to recover input tax (in accordance with its partial exemption method, if applicable) if it is the recipient of the supply for VAT purposes. In order for the employer to recover the VAT, HMRC will inter alia require contemporaneous evidence that the services are provided to the employer and, in particular, the employer must be a party to the contract for those services and pay for them. A valid VAT invoice will also be required. However, if the employer recharges the services received to the pension scheme, that recharge will be consideration for a VATable supply and VAT must be charged accordingly. The November 2014 guidance also extends the transitional period in which the 70:30 split discussed above can be used until 31 December 2015 in cases where the pension scheme receives the services (after which time this administrative simplification will no longer be available), and sets out the procedure for reclaims in respect of past periods. If they have not done so already, employers may now wish to engage with trustees regarding restructuring the way in which administration and investment management services relating to the scheme are supplied in order to try to maximise VAT recovery. Recap of Wheels Common Investment Fund Trustees Ltd case The case concerned UK defined benefit occupational pension schemes and common investment funds which pool investments for such schemes and whether VAT was payable in respect of fund management services provided to the trustees of the fund/scheme. The CJEU concluded that, where the members of the pension scheme do not bear the risk arising from the management of the fund and the employer s contributions are a means by which it complies with its legal obligations to its employees, an investment fund pooling the assets of a pension scheme is not a special investment fund for these purposes. Accordingly, the management of such a fund is not exempt from VAT. Although the decision is less clear in relation to the position of defined benefit pension schemes themselves, by implication, the same analysis would seem to apply (with PPG arguably confirming this). Defined benefit occupational pension schemes will therefore continue to be liable to pay VAT on investment management fees going forward, and will not be able to recover amounts paid historically.

7 Trustee considerations in relation to a buy-in proposal A scheme s transfer and buy-out provisions may give trustees an explicit authority to secure any or all liabilities of the scheme with an insurance company. Management of pension scheme liabilities continues to be a key concern for employers sponsoring defined benefit pension schemes. Where schemes are appropriately funded, insurance-based solutions such as buy-in, buy-out and longevity swaps remain attractive. What is a buy-in? A buy-in involves trustees changing their investment strategy to reduce the level of risk in their scheme by purchasing an annuity with an insurer to cover all or part of the current liabilities under the scheme. The buy-in policy is an asset of the scheme, held in the name of the trustees. Therefore, members covered by the policy will continue to receive their pensions from the scheme and the existing relationship between members, the trustees and employers remains in place. In practice, trustees will usually continue to administer the scheme and use the payments from the policy to meet some or all of the benefits as they fall due. How does a buy-in differ from a buy-out? A buy-out would usually take place as part of the winding-up of a pension scheme. Trustees would purchase annuities in the name of the relevant members and beneficiaries rather than in their own name as for a buy-in. The insurer would take over responsibility for payment of pensions; and neither the trustees nor the sponsoring employers would have any continuing liability to scheme members. Buy-in contracts usually include an ability to convert to a buy-out policy at the option of the trustees. Why might a buy-in be attractive to trustees? A buy-in protects trustees and the sponsoring employers against the future longevity of scheme members and adverse financial markets. It therefore offers certainty, albeit at a price. In addition, as a long-term insurance contract, a buy-in has the ability to lock-in annuity rates and match liabilities. Do trustees have power to buy-in benefits? The first issue for trustees to check on receipt of a buy-in proposal is whether their trust deed and rules contain powers which are sufficiently wide to enable the purchase of a buy-in contract. These powers can typically be found in a scheme s investment and transfer/buy-out provisions. For instance, an investment power may say that the trustees have the power to enter into any contract or incur any obligation. Wording such as this is sufficiently wide to extend to a buyin contract. Alternatively (or in addition), a scheme s transfer and buy-out provisions may give trustees an explicit authority to secure any or all liabilities of the scheme with an insurance company, either with or without the agreement of the sponsoring employer, and either in their own or the members names. Trustees should seek legal advice on the scope of the powers in their trust deed and rules and consider if rule amendments are required to provide the necessary powers.

8 Key questions for trustees relevant to buy-ins Trustees will need to consider the following questions before going ahead with a buy-in: > > Is a buy-in in the best financial interests of the members? The policy will be linked to certain liabilities, but it would be an investment of the scheme as a whole. Trustees should obtain and consider proper investment advice before deciding to go ahead with a buy-in. > > Does a buy-in provide sufficient financial security to deliver the benefits promised? Trustees will want to ensure that members long-term financial security is protected. If the employer became insolvent, the value of the insurance contract would be assessed as part of the overall value of the assets of the scheme. Therefore, it is important to understand the financial strength of the insurers tendering in the buy-in process. Trustees need to understand how the policy would operate in a number of possible scenarios. Trustees need to understand how the policy would operate in a number of possible scenarios. In the event of winding-up, if the scheme is not sufficiently funded to allow payment of benefits in full, trustees are likely to have to surrender the policy so that the assets can be used for the benefit of all members; the proceeds will not be earmarked by reference to the benefits covered by the buy-in policy. Conversely, if the scheme is funded at a level sufficient to enable members to receive the level of benefits bought out, it should be possible to assign the policy to individual pensioners. Unlike a buy-out where all liability for benefits passes, there is only a partial transfer of risk to the insurer in a buy-in. The scheme retains the primary liability to pay out pensions. The Pension Protection Fund ( PPF ) continues to provide a lifeboat of a minimum level of benefits to all members. This means that if the insurer was unable to pay the benefits, for example on its insolvency, the scheme would still be responsible for paying members benefits and the employer would remain on the hook for funding them. Under current law, trustees should be entitled, as policy holder of the annuity contract, to recovery under the Financial Services Compensation Scheme ( FSCS ) as policy holder. In the event that trustees are able to make a claim under the FSCS, it may be possible for the FSCS to exercise subrogation rights against the employer and ask for the employer to make additional payments to the scheme. This is an untested area but shows that the covenant of the employer will remain of interest to trustees post buy-in. If the employer and the insurer both became insolvent, the PPF would call on the FSCS for the value of the policy and seek to pay a proportion of the benefits under the PPF rules. This again is an untested area of how the competing claims between the PPF and FSCS would be settled, but it is reasonable to expect the PPF to call on the FSCS before resorting to its own funds. This contrasts with a buy-out, where all risk is transferred to an insurer and the members would be covered by the FSCS instead. > > Will there be any impact on funding? Trustees should seek to ensure that the security of members is not immediately prejudiced by the investment in the contract, which it could if the cost of the buy-in contract exceeded the ongoing funding target. In this event trustees may require a cash injection of the amount required to make up a shortfall (if any). Employers may not wish to proceed if a material payment is required. > > What benefits are to be insured? Trustees must be clear on what liabilities are covered by the policy (e.g. will pension increases be covered) and who bears the risk of what issues. Another important area to consider is whether and to what extent discretionary practices should be addressed. Trustees will need to prepare a benefit specification which sets out all the benefits which they expect the insurer to insure under the policy. Any benefits omitted from the specification (e.g. discretionary pension increases) will remain direct liabilities of the scheme (if granted) and must continue to be funded for. > > Contractual terms? Trustees need to understand the contractual terms to be put in place and consider asking insurers to comment on their ability to provide requested contract terms during the tender process. Typical requested contract terms for a buy-in would include: (a) Are there any added extras such as an ability to transfer pensioner administration to the insurer? (b) Can the policy be converted to a buy-out contract? (c) What are the circumstances in which the insurer can revisit pricing/reshape insured benefits/terminate the policy?

9 (d) When does the insurer go on risk? (e) Clarity in relation to the premium payment mechanism. (f) When do force majeure provisions apply? (g) What is the scope of the warranties the insurer will ask trustees to give? Other due diligence considerations for trustees Once trustees are comfortable that they want to proceed with a buy-in, they should consider the following issues when choosing an insurer: > > A detailed analysis of the insurer s financial strength. > > Does the insurer have the capacity to take on the liabilities as well as any other planned growth in this market? Trustees should ensure that the insurer is not overexposed and that its capital, resources and systems will not be overloaded. > > What risks (both financial and administrative) is the insurer willing to take on in respect of issues that emerge after the contract is entered into? > > Quality of administration functions. > > Will the insurer be easy to work with? Trustees will need the insurer s co-operation going forward; for example, its consent will be needed to any rule changes impacting members post buy-in and renegotiation of the contract may be necessary on insolvency or windingup. There will also need to be extensive administrative co-operation, for example the policy payments will need to tie in with the payment of benefits by the scheme. > > Does the insurer s policy offer good value for money? While price is not an overriding consideration for trustees, if there were a number of suitable insurers this may be an area to have regard to in distinguishing them. When comparing quotes, trustees should ensure they have considered what each policy covers so that they can compare like with like. Linklaters (Gareth Craft) acted as legal adviser to the Trustees on the recent 129 million buy-in of the Uniac Pension Fund with Legal & General. The Uniac Pension Fund was established by Unilever under Section 615 of the Income and Corporation Taxes Act 1988 to provide pension benefits to its employees based outside the UK. As a section 615 scheme, the Fund is not a registered scheme under Part 4 of the Finance Act 2004 and is exempt from large parts of the UK legislative regime for occupational pension schemes. The buy-in is unique in being the first one of its kind for a section 615 scheme.

10 Looking ahead to 2015 April 2015 The DWP s changes on scheme governance and charges will come into force. DC scheme governance and charges The DWP s changes on scheme governance and charges (relevant to, amongst other things, DC investments) will come into force in April Clearing Clearing of OTC derivatives will become increasingly important as mandatory clearing under EMIR is rolled out. The exemption for pension schemes is likely to be extended but trustees can expect their managers and advisors to approach them to discuss potential amendments to their IMAs anticipating the need to clear their derivatives transactions. DC default funds Trustees will need to review the appropriateness of their default funds, being mindful of members anticipated and actual behaviour, particularly in light of the new DC flexibilities into force in April Margin Possible amendments to the way in which variation margin of OTC derivatives is calculated/transferred will potentially be introduced from December 2015 onwards. Trustees will need to review the appropriateness of their default funds, being mindful of members anticipated and actual behaviour. AIFMD IORP II In 2015 ESMA may decide to extend pan-european marketing passport to non EU AIFM. This may affect the way in which non EU (e.g. US) fund managers market their products to UK pension funds and could result in an increased cost base to such products, as a result of full AIFMD compliance. The European Commission will continue with its consideration of the so-called IORP II Directive which, as currently drafted, will introduce new governance, compliance, information provision and risk mitigation obligations on trustees. We will be updating you on these in future editions of investor agenda as well as through direct news updates as and when developments arise.

11 Contacts If you would like to discuss anything further, please contact: What is PensionsInvest? PensionsInvest is your one-stop shop for pensions investment-related legal advice. Investment for pension schemes requires more than just pensions advice. Through PensionsInvest, you will have access to experts in all the areas of law relevant to pension scheme investment. Rosalind Knowles Partner Tel: (+44) FUNDS PRACTICE > > Hedge/PE Fund > > Real Estate Funds > > Alternatives Derivatives & structured products practice > > ISDAs > > GMRAs > > SLA INSURANCE PRACTICE > > Buy-ins > > Buy-outs > > Insurance wrappers Philip Goss Managing Associate Tel: (+44) PROJECTS PRACTICE > > Infrastructure Your Pensions Contact CORPORATE PRACTICE > > SPVs FINANCIAL REGULATION PRACTICE > > Regulatory advice You Integrated advice tailored to the needs of your scheme TAX PRACTICE > > Tax structuring > > Reviews >Integrated > advice with your tax adviser Anna Taylor Managing Associate Tel: (+44) For trustees, this means: > > Cost-effective advice leveraging off class-leading experience; > > The most rigorous legal advice to protect you and your members; > > Pragmatic advice that is solution-focused; > > Advice that meets your deadlines; > > Seamless access to the broader firm s expertise through your usual pensions contact. Gareth Craft Associate Tel: (+44) gareth.craft@linklaters.com Please get in touch with your usual pensions contact to find out how PensionsInvest can work for you. Geoff Egerton Associate Tel: (+44) geoff.egerton@linklaters.com Linklaters LLP One Silk Street London EC2Y 8HQ Tel: (+44) Fax: (+44) linklaters.com 7113_F /12.14