Money for nothing: why pension funds are paying too much tax
June 13, 2016
Too few pension funds are giving sufficient priority to operational tax risk management, new research from PwC reveals. As a result, many are missing out on enhanced investment returns
In theory, the majority of pension funds do not pay tax; in practice, many funds’ investment returns may be being impacted by the taxes they are incurring. And while it has never been more important for pension funds to manage operational tax risk, with more and more countries introducing new portfolio taxes, PwC’s latest research suggests there is a need to increase focus on this issue.
It is time for these funds to catch-up. Four years ago, when PwC first surveyed global asset managers in order to assess the effectiveness of their operational tax risk management, we found there was a great deal of work to do; but while our latest survey suggests many managers have made significant progress since then, pension funds are being left behind.
Overall, PwC’s work suggests almost a third (30%) of asset managers have invested heavily in their operational tax functions in the past three years; of those, more than half (53%) have increased their operational tax resources. Yet not a single pension fund interviewed for this research was part of this trend: none have increased investment or added to dedicated resources.
By contrast, only a minority of pension funds have a dedicated tax function. Instead, tax risk management is typically overseen by more general financial functions with broader (and often expanding) tax responsibilities.
There may be good explanations for this. Not least, the long term nature of pension funds’ assets and liabilities allows them greater freedom to assess their tax obligations. Also, a large number of pension funds continue to rely on third parties such as custodians for many services: in an outsourced business model, it may be far from clear where responsibility for operational tax risk management lies.
However, pension funds are at risk of increasing tax leakage, as well as a lost opportunity to add value for sponsoring employers and other stakeholders by making greater returns on investments through tax savings (known in the industry as generating ‘tax alpha’). PwC’s belief is that the impact of tax on long-term investment returns is at least as significant as manager fees – perhaps as much as 3-4%. These issues and opportunities must therefore be addressed: pension funds are going to have to reconsider the level of resource dedicated to operational tax and think again about how they manage their outsourcing arrangements.
At the very least, pension funds will need to ensure that they hold their custodians to account, which is where tax resourcing may first be directed. PwC’s research with asset managers reveals this has become a priority for many firms: that 51% have renegotiated service level agreements over the past three years suggests asset managers are seeking to define the roles and responsibilities of their custodians much more clearly and sovereign wealth funds are following suit. Pension funds should aim to do the same.
Part of that work will be to monitor and measure what better portfolio tax risk management is actually delivering, whether via a process outsourced to a third party custodian, or by a dedicate function in-house. Pension funds have traditionally focused on the absolute performance generated by their particular asset allocation model, yet while a more strategic approach to tax could enhance returns, few are even attempting to measure the tax alpha they are generating.
Moreover, if we accept that better tax risk management will deliver measurable performance gains, it makes sense to factor this in to the net long-term return assumptions that pension schemes – and sponsoring employers – are making about their funds. And just as other investment professionals are set performance targets, and remunerated on the basis of these, so the most forward-thinking asset managers are introducing Key Performance Indicators for portfolio taxes to help them generate tax alpha.
Pension funds must now learn these lessons too – and should expect to be judged on their ability to do so. As sponsoring employees confront scheme deficits and the need for larger contributions, they will rightly become ever-more demanding of every aspect of fund performance. Similarly, as pension fund managers embrace alternative investment strategies with more demanding tax profiles, they too will look for tax alpha. And in jurisdictions where pension funds face greater competition from other tax-efficient products, such as the new Lifetime ISAs in the UK, net fund performance will become even more important.
Finally, it’s important to establish that the danger for pension funds that do not give sufficient priority to tax risk is not just an opportunity foregone, but also a potentially damaging impact from some form of failure. In this context, our survey includes another important warning signal: while 42% of asset managers said they had robust internal control frameworks in place, 33% could not document any broader strategic policy or operational management objectives.
Like other asset managers, pension funds need clear due diligence processes in place. They must also seize the broader opportunity to deliver enhanced performance through operational tax risk management.
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