UK defined benefit (DB) pension plans are missing out on hundreds of millions of pounds in additional income each year because they are not taking advantage of certain tax efficiencies available to them, according to a study from Northern Trust and institutional asset management marketplace The Asset Management Exchange.
The study found that UK defined benefit pensions invested £56 billion ($70.24 billion) in less tax-efficient funds in 2019, leading to lost income of up to £256 million last year alone, which extrapolates to nearly £2.5 billion over the next decade. However, the study found that the loss could be mitigated if the pooled equity investments were optimized for tax efficiency through use of a tax transparent fund.
“Asset managers that operate or are planning to launch equity-based European funds would do well to consider how the use of a tax transparent fund may benefit their investors,” Clive Bellows, Northern Trust’s head of global fund services for Europe, Middle East, and Africa, said in a statement. “It is now potentially more cost-effective than ever for them to derive the advantages of tax transparency while optimizing efficiencies across their fund ranges.”
The firms hired Broadridge Financial Solutions to survey 120 UK defined benefit pension plans and found that 72% of them are using fund structures that are tax inefficient, including unit trusts, investment trusts, and open-ended investment companies. Additionally, 69% of plans that are using less-tax-efficient funds said they were unaware of the investment income benefits that tax transparent funds have compared with other fund structures, and 82% said that tax efficient fund structures for equity investments were not included in their risk register.
“Tax efficiency has become an important factor for fund performance in recent years—particularly for pension funds that suffer too much withholding tax (WHT) on the dividends of their pooled equity investments,” according to the study. “This is because UK pension schemes, as tax-exempt investors, are entitled to reduced WHT on dividends from global equities under double taxation agreements.”
However, it said that unless the plans invest in tax-transparent funds or insurance policies for their pooled fund investments, they will not be entitled to apply for reclaims or reduced WHT to foreign governments’ tax authorities on their foreign equity holdings. As a result, many UK plans are potentially suffering more WHT than may be necessary, the study said, which may reduce their income and ultimately have a negative effect on the plan sponsors’ ability to meet member payments.
The study recommended using a tax-transparent fund (TTF) structure for tax-exempt institutional investors to benefit most effectively from the use of pooling. Switching to a TTF does not require changes to the plan’s asset allocation policy or to its selected managers. Use of a TTF may offer “superior investment returns” for investors through the potential reduction in withholding tax drag, according to the study. It added that the elimination of tax drag facilitates improvements in investment performance and can make a significant difference to investment returns over time.
“These findings carry particular urgency against the backdrop of economic conditions caused by the impact of the global COVID-19 pandemic,” the study reported. “Many schemes collectively face the prospect of widening funding gaps, with some scheme sponsors in potential financial difficulty.”