How to avoid the tax pitfalls of collective investing

Whether this involves reaping the benefits of economies of scale to lower costs, gaining exposure to index strategies or increasing the diversification of portfolios, pooled investments have a role to play in most UK pension schemes.

They make up almost half (44 per cent) of corporate pension assets and 43 per cent of local authority pension assets, according to the Investment Management Association’s annual UK asset management survey in 2013-2014.

There are several types of pooled vehicles available to UK pension schemes. When making a choice, schemes need to go beyond ensuring they receive the benefits of collective investing and the right fit with their overall investment strategy.

They need to think about two additional factors: tax efficiency and asset security.

Reducing tax drag

Tax efficiency is an important consideration given the tax-advantaged status of UK pension schemes.

Due to the double taxation treaties the UK has with other countries, pension schemes may be exempt from withholding tax or eligible for a reduced rate.

This is a tax on dividends from overseas equities. To receive the beneficial rates, schemes need to invest in a collective vehicle that is tax transparent.

A tax-transparent fund allows authorities to see through the fund structure and respect the tax status of the underlying investor, in the same way an investor’s segregated portfolio would be treated.

The tax position of some fund structures may be less advantageous than the scheme’s. For example, investing in a UK Ucits open-ended investment company would reduce the impact of withholding tax on US equities, but the fund would still have to pay 15 per cent.

The pension would then receive only 85 per cent of dividend income.

Life funds and common contractual funds are tax-transparent collective vehicles. Investing through one of these means UK pension schemes would receive the full dividend in the case of a US equity investment. 

But the US is only one example. Tax rates vary from country to country and over time. If you took an investment in a developed-world mandate, which invests in 26 different countries, an OEIC could suffer between three and four times as much tax drag as a common contractual fund.

This drag on fund returns could be many times more than the cost of the investment management fees.

Asset security

Life funds have been the dominant product structure for pension schemes’ overseas equity portfolios.

They reduce the tax drag on dividends when their units are wholly owned by UK pensions. But they are at a distinct disadvantage compared with CCFs and OEICs.  

In the case of CCFs and OEICs, the unit holders and not the investment manager own the underlying assets in the fund.

Should the life company run into financial difficulty or become bankrupt, the life fund’s underlying assets remain the property of the insurer.

While this is a low-probability event, if it does occur the cost to a pension scheme is likely to be high.

This cost would be borne as much in terms of time and resources as it would be financially.

Even if there are sufficient assets to cover all claims, the recovery process is likely to be lengthy, which could impair a scheme’s ability to meet its liabilities.

Pension managers and trustees need to be aware of the different characteristics on offer from the various types of collective investment vehicles.

Exploring options that combine the tax efficiency of direct equity investing and the scale and cost advantages associated with mutual funds could lead to significant savings for schemes.

Steven Charlton is DC proposition manager, Europe, at Vanguard