The EU addresses Supplementary Pensions

The EU addresses Supplementary Pensions

Tom Collinge, Pensions lawyer, Pensions Unit, Hammond Suddards

Current Moves

The European Union has achieved a great deal in its pursuit of a true single market, but inevitably there are some areas that have progressed more slowly. Occupational or Supplementary Pensions are one of the largest sectors of European commerce to remain largely outside the framework of European law. While they have not been untouched by developments at the Court of Justice or by Council Directives, the harmonising of European pensions is still not certain.

Nevertheless, the prospects for positive developments are better now than for many years. Following the generally favourable reception of his Green Paper, Professor Mario Monti as Commissioner for the Internal Market and Financial Services has now indicated that the Commission will shortly issue a Communication on Supplementary Pensions - the next step in introducing new European legislation on this subject.

The Commission has taken on board responses from a very wide range of interested parties and it will be fascinating to see how the next stages develop. Many observers have concluded that the crux of the debates to come will be about the achievement of cross border membership of pension funds and the enhancement to the much trumpeted freedom of movement that this would bring.

However, while developments in this field will be enthusiastically welcomed, there is a much more important debate at the heart of any change of European policy on pensions. This is the question of investment.

Pension Promises and Cost

Europe has a problem. Approaching 90% of the pensions paid in Europe are paid from State schemes and the great majority of these pensions are unfunded pay-as-you-go systems. The costs are high already and an ageing and increasingly long-lived population means that these costs are set to rise yet further. From a Dutch, Irish or British perspective, the worst effects of this situation have largely been avoided by the sensible use of liberal private tax regimes that have allowed pre-funded occupational pension schemes to prosper. This is not the case in most other EU Member States.

Apart from the obvious lack of incentive to develop funded pensions in countries where the State arrangements are currently generous, there are a number of worrying factors that need to be addressed at a European level. Principal among these are the restrictions on investment freedom for pension fund managers.

Restrictions can take several forms and are often found in combination. One form is to restrict the proportion of any fund that can be invested in equities and to require a high level of investment in bonds. A further variant is to require the majority of a fund to be invested in securities that match the currency of the jurisdiction in which the fund operates. While this second restriction has been partially neutralised by the advent of the Euro, for eleven of the EU Member States the results of both sets of quantitative controls tend to restrict the growth potential of funds. When this happens the cost of funding pensions increases with the effect that costs of labour for employers rise and opportunities to boost job creation fall.

In the Netherlands, Ireland or the United Kingdom the only quantitative restrictions on pension funds are the 5% self-investment rules. Control over where managers invest is achieved by more subtle means. The concept of the "prudent man" prevails, and the use of actuarial techniques such as asset/liability modelling helps shape portfolios with appropriate degrees of diversity. Risk is reduced by such techniques without denying funds the chance to seek optimum results.

On the face of it, the way forward seems clear. The progressive replacement of an increasingly costly set of State schemes with funded schemes may be a step too far for Europe. Even though the US Administration may be prepared to contemplate using the stockmarkets to help manage the cost of first pillar pensions, European governments would have even more reservations than Alan Greenspan about that strategy. Nevertheless, funded schemes must play a larger role in meeting the overall costs of providing decent standards of living in retirement for more of Europe's citizens. To do this without bankrupting employers and employees who will have to pay a larger amount towards their own future provision as well as continuing to meet the cost of pension promises made to those already in or reaching retirement, pension funds must be free to optimise returns from their portfolios.

Practical Responses

How might this be achieved? There are signs that some European regimes are willing to take a progressive view of the implications of the ECJ decision in the Safir case. This ruling pointed out that the Treaty freedom to establish and to provide services precluded tax discrimination that constituted a barrier to a Swedish national availing herself of the products of a British assurance company. This has led to plans in Luxembourg to introduce two new pension investment vehicles. These are intended to be sufficiently flexible to satisfy any national prudential rules but their principal attraction will be that they offer access to investment in a very low tax environment. The Luxembourg bankers' association are confident that the ECJ has opened the door to a flow of cross border investment that Member States will be unable to inhibit.

Earlier attempts to provide such cross border vehicles have had mixed fortunes at best. The UK attempt to promote Pension Fund Pooling Vehicles has had only limited success. This is principally because the number of countries recognising PFPVs has been small and restricted largely to nations with access to a rich source of domestic funds. In states where the culture of investment is not equity-driven, PFPVs have not made headway.

There is, perhaps, more evidence of progress in the development of Open-ended Investment Companies (Oeics). As the Euro has brought low interest rates and bond returns to the Euroland eleven and is exerting downward pressure on rates in outside countries like the UK, the arguments in favour of utilising Oeics seem to be attracting new listeners across Europe. Their relatively simple structure and pricing has greater appeal than traditional Unit Trusts. Their ability to offer sub-funds that can be designed to match national investment regulations makes them a useful asset in promoting diversification.

It should also be remembered that the model of funding pensions with higher equity exposure is not only "Anglo-Saxon". There is a long tradition of pension fund investment with many similarities in the Netherlands. It may be that the Dutch can exploit the legal architecture of their Stichtingen to greater advantage than their Pensioenfondsen as a package for cross-border pension investment with similarities to the Oeic and its sub-fund structure.

Piecemeal or Planned Progress?

The picture that is emerging appears to show the arrival of cross border pensions in a piecemeal fashion. Given the size of the pensions problem across Europe, this is unhelpful. There is little real evidence of true inroads being made into underlying cultural inhibitions about the cost benefits of adopting a more pro-equity or, at least, a more diversified stance in funding for pensions.

These inhibitions will persist as long as there is no certain framework for funded pensions in European law. The great benefit of a new Directive would be to deliver that certainty along with the mutual recognition of regulatory regimes that can bring confidence and security to the single pensions market.

While we still await the Commission's Communication, it is to be hoped that Mario Monti has not been minded to water down the extent of the legislation he is expected to propose. There has been some pressure from governments of Member States, in their responses to the Green Paper, to limit the scope of a new draft Directive. This would be regrettable, especially if it becomes caught up in the debate on harmonisation (or co-ordination) of direct taxes that has become so heated recently.

Although the absence of signs of momentum towards a convergence upon a common structure for the incidence of taxation is a problem, in the long run this may be less damaging to Europe and its citizens than a failure to liberalise the investment environment. While recognition of a tax-neutral "exempt-exempt-taxed" (EET) regime across the Union would make life much easier for mobile workers, international employers and their advisers, the best way to reduce the frightening cost projections for European pensions is to address their funding.

There are many indications that the question of European taxation will be sorted out over time. This has become a political issue rather than a legal or technical matter. More pertinent to the development of proper funded pension schemes across Europe is the progressive removal of domestic tax restrictions such as bedevil the German market and lead to increased costs.

The question of Union-wide tax harmony clouds the issue. Europe must shift some of the responsibility for pensions towards funded pensions that enjoy liberal investment and domestic taxation regimes or pay the consequences. Those consequences could include increased relative poverty among a politically more significant retired population, swingeing taxes on the reduced proportion of the population still in work and increased unemployment as employers attempt to avoid the huge on costs of social security levies. Either that or State retirement ages will have to rise much further than the levels set at the last round of amendments across Europe.

Accepting investment freedoms and equity cultures will be hard for many of our European partners. The difficulty is that the alternatives may be even more unpalatable.

For further information please contact Tom Collinge, e-mail: Click Contact Link , 7 Devonshire Square, Cutlers Gardens, London EC2M 4YH, UK, Tel: + 44 171 655 1000

This article was first published in the February issue of Pensions International, e-mail Click Contact Link

The information and opinions contained in this article are provided by Hammond Suddards. They should not be applied to any particular set of facts without appropriate legal or other professional advice.