pensionsinvest: investor agenda -...

Contents

Day to day investment decisions by trustees

Fiduciary Management: what should trustees be thinking about?

Advocate Generals opinion in ATP Case – money purchase investment services exempt from VAT?

HMRC responds to Ruling in PPG Holdings BV Case

EMIR: Risk mitigation techniques should be in place by 30 April 2014

SPRING | 2014

Welcome to our Spring 2014 edition of Investor agenda

This edition, in addition to our usual update articles, we have a couple of more in-depth items. In one we discuss an issue which comes up regularly for many pension schemes: what decisions can trustees take about investments without needing Financial Conduct Authority authorisation? In the second, we look at the concept of fiduciary management and the issues trustees need to think about if considering adopting this structure.

As usual, we welcome your feedback on Investor Agenda and whether it continues to suit your needs.

Rosalind KnowlesPartner

PensionsInvest: Investor Agenda

Day to day investment decisions by trustees

We are often asked by trustees to look at whether a particular investment decision is a “day to day” decision. Trustees are asking about this because, generally speaking, they rely on an exemption from the requirement to be authorised under the Financial Services and Markets Act 2000 (“FSMA”) in managing the assets of their pension scheme that prevents them from making “day to day” decisions about the management of pension scheme assets. It is important for trustees to understand this exemption because managing assets when not authorised to (or exempt under FSMA) is a criminal offence.

Trustees are managing investments: unless they are not taking day to day decisionsFSMA requires all persons who carry out specified regulated activities to be authorised to do so (unless an exemption applies). The regulated activities are set out in the FSMA Regulated Activities Order 2001. One of the regulated activities, and the one that all trustees would do but for the exemption, is managing investments. Article 37 of the Regulated Activities Order provides that “managing assets belonging to another person, in circumstances involving the exercise of a discretion, is a specified kind of activity if…the assets consist of or include any investment which is a security or a contractually based investment…”. Clearly, trustees of occupational pension schemes would be managing investments under this definition.

However, Article 66(3) of the Regulated Activities Order provides an exemption commonly relied upon by trustees of occupational pension schemes. Broadly, the exemption provides that a trustee will not be managing investments unless (a) it holds itself out as providing a service comprising the management of investments or (b) the assets are held for the purposes of an occupational pension scheme and the trustee is treated as carrying on that activity “by way of business” by virtue of the Article 4 of the FSMA (Carrying on Regulated Activities By Way of Business) Order 2001. The By Way of Business Order also provides that the trustee carrying on the activity should not be remunerated separately for what it does in addition to any remuneration it receives as trustee. A question we are commonly asked is, when is a trustee of an occupational pension scheme carrying on its activities “by way of business”?

Generally applying Article 4(1) of the By Way of Business Order means that a trustee of an occupational pension scheme will be managing investments by way of a business unless it “takes no day to day decisions relating to the management of any relevant assets” or “all day to day decisions in the carrying on of that activity … so far as relating to relevant assets, are taken on his behalf by an authorised person [who has permission to manage investments or someone who doesn’t need to be authorised under FSMA].” Therefore, all “day to day” decisions in the management of a pension schemes’ assets must be carried out by an appropriately authorised person. There are some exceptions set out in Article 4(6) of the Order which allow occupational pension scheme trustees to decide to buy, sell or subscribe for:

> units in a collective investment scheme;

> shares or debentures (or warrants relating to such shares or debentures) issued by a body corporate having as its purpose the investment of its funds with the aim of spreading investment risk and giving its members the benefit of the results of the management of those funds by or on behalf of that body; or

> rights under (or rights to or interests in) any contract of insurance.

after having received and considered advice from someone who is authorised under FSMA to advise on investments (or someone who doesn’t need to be authorised).

…managing assets when not authorised to (or exempt under FSMA) is a criminal offence.

when is a trustee of an occupational pension scheme carrying on its activities “by way of business”?


The exceptions all relate to investments in pooled investment type arrangements and this makes sense since these types of investments are “managed” by the issuer. As noted above, however, in order to rely on this exception, the trustees must have taken appropriate advice. In addition, trustees can take decisions in relation to investments which do not fall within the scope of Article 37 of the Regulated Activities Order (such as cash or real property).

Therefore, occupational pension scheme trustees cannot make “day to day” investment decisions in relation to securities or contractually based investments (other than in relation to specified decisions in relation to specified kinds of pooled investment vehicles after acting on advice). This raises the question of when a decision is a “day to day” decision.

What is a day to day decision? The Financial Conduct Authority (“FCA”) has provided its views on this through its Perimeter Guidance in the Financial Services Handbook (known as “PERG”). In PERG 10.3, the FCA distinguishes between decisions which are “day to day” which cannot be taken by occupational pension scheme trustees without being authorised and decisions which are strategic which can be taken by occupational pension scheme trustees without authorisation. Strategic decisions include decisions:

> about the adoption or revision of a statement of investment principles as required by relevant pensions legislation;

> about the formulation of a general asset allocation policy;

> about prescribing the method and frequency for rebalancing asset classes, and the permitted ranges of divergence, following the setting of the general asset allocation policy;

> about the proportion of the assets that should constitute investments of particular kinds;

> affecting the balance between income and growth;

> about the appointment of fund managers; or

> as to which pooled investment products to make available for members to choose from under a money purchase scheme.

The list is not intended to be exhaustive and merely provides a guide as to the kind of decisions which the FCA considers would be strategic rather than day to day. What is clear from the FCA’s list is that they are all high level decisions, none of which are as “day to day” as the acquisition or sale of a particular investment.

This is reinforced by another category of decisions which the FCA states could be made by occupational pension scheme trustees, which are decisions that can be made in exceptional circumstances such as:

> in a take-over situation; or

> where the person managing the scheme’s assets has a conflict of interest;

> where the decision is sensitive (such as one relating to investments in the same market sector as the employer or in the employer’s own securities);

> where the decision raises sensitive policy considerations (such as investments in certain territories or markets or in ethical or green areas);

> where the trustees are required to make decisions:

- about investments acquired purely as a result of a demutualisation by an insurer or building society in which the scheme holds investments or deposits; or

- following a change in fund managers which results in the scheme holding investments which the new fund manager is unable or unwilling to take on.

This second list of decisions give an indication of the kinds of the decisions which the FCA considers would be “day to day” decisions if they were not being made in a (presumably) one off exceptional circumstance by a trustee.

PERG also provides a third list of decisions which, generally speaking, are decisions that occupational pension scheme trustees cannot make and indicate what the FCA’s view is on a “day to day” decision. These include:

> decisions to buy, sell or hold particular securities or contractually based investments such as a fund manager would be expected to make in the everyday management of a trustee’s portfolio (other than day to day decisions about investment in pooled investment vehicles taken after obtaining relevant advice (as mentioned above));

Decisions which are strategic… can be taken by occupational pension scheme trustees without authorisation.


> decisions made as a result of regular or frequent interventions outside scheduled review meetings in the decision-making of external fund managers; or

> recommendations made to fund managers, on a regular basis, with a force amounting to direction relating to individual securities or contractually based investments.

The need for cautionUltimately, trustees should consider on a case by case basis whether decisions are strategic decisions or “day to day” decisions, given that PERG does not provide a determinative or exhaustive list on what are “day to day” decisions and what are “strategic decisions”. Trustees should always exercise caution in this area and ensure that their practices (documented through relevant statements of investment principles, governance and investment committee papers) are strategic in nature. Failure to do so could potentially mean that the trustees are engaging in a regulated activity for which they would need to be authorised under FSMA, where acting without such authorisation is, as mentioned above, a criminal offence.


Fiduciary Management: what should trustees be thinking about?

An increasingly popular way to manage pension scheme investments is fiduciary management. It’s something that we get asked to advise on frequently. However, it is not always clear what is meant by the term fiduciary management (sometimes also called delegated consulting, outsourced investment, and other variations). We have seen arrangements which look like fiduciary management, but which are not described that way; and some which call themselves a fiduciary management arrangement but look very much like normal discretionary investment management over a part only of the scheme’s assets.

So what is fiduciary management and what should trustees think about when considering adopting a fiduciary management arrangement? Perhaps the starting point is to define fiduciary management by reference to what it is not: standard discretionary investment management. Under a standard discretionary investment management mandate, the manager undertakes to manage, on a discretionary basis, a portfolio of the pension scheme’s assets in accordance with a mandate agreed between the manager and the trustees (acting on the advice of their investment consultant). Within the confines of the mandate, the manager is free to manage the portfolio how it sees fit. Most large pension schemes have a number of such mandates in effect, in relation to various asset classes and investment strategies, with managers managing specific parts of the overall assets of the scheme. However, the strategic decisions about the overall investment of the scheme sit with the trustees on advice from their investment consultant; and the overall investment strategy will likely involve the use of other types of investment such as pooled investment funds and investment linked life policies, as well as separate derivatives overlays to hedge risks.

Fiduciary management distinguishes itself by being a more integrated solution to the overall management of the scheme’s assets. Fiduciary managers will look to take responsibility for a pension scheme’s overall investment performance (rather than the performance of a particular part of a portfolio) and also to give strategic input on the scheme’s investments. In general, they may look to take over the advisory, tactical, and implementation sides of the trustees’ investment functions, and some of the strategic functions. There are, however, varying models in the market, with some managers looking to do more or less - there is no one style of “fiduciary management”.

So can trustees delegate their investment discretion to this extent? Section 34(2) of the Pensions Act 1995 allows discretion of the trustees to make any decision about investments to be delegated to “a fund manager”. The drafting of the Pensions Act 1995 almost presupposes that the majority of schemes would have a single fund manager for all of their assets, even though this has generally not been the case for larger schemes.

Trustees would also need to check whether their trust deed and rules permitted the delegation, but if not, we would normally expect the amendment needed to allow this would be uncontroversial.

However, in spite of the apparent breadth of the delegation power in the Pensions Act 1995, there are legal views to the effect that trustees have an “irreducible core” of trustee functions. Certainly trustees remain responsible for ensuring that a Statement of Investment Principles (“SIP”) is prepared which must set out “their policies” in relation to (amongst other things) the

It is not always clear what is meant by the term fiduciary management.

Fiduciary management distinguishes itself by being a more integrated solution…

There is no one style of “fiduciary management”.


kinds of investments to be held; the balance between different kinds of investments; and risks, including the ways in which risks are to be measured and managed. Although there is some legal uncertainty, therefore, over quite how much of their investment function trustees can delegate, one might expect that strategic matters of sufficient importance to be covered in the SIP would likely remain decisions on which the trustees would continue to set overall policy.

The more difficult question for trustees is whether they should delegate to the extent envisaged by most “fiduciary management” mandates, and if so on what terms? The first consideration is what level of legal risk is there for the trustees in delegating to this extent. Under the Pensions Act 1995, where trustees delegate their investment discretions, section 34(4) protects trustees from liability in respect of the acts of the manager to whom they have delegated. The protection applies where the trustees have taken all such steps as are “reasonable to satisfy themselves … that the fund manager has the appropriate knowledge and experience for managing the investments of the scheme, and that he is carrying out his work competently and complying with section 36”. In addition, the trust deed and rules of their scheme is likely to exonerate the trustees from all but wilful wrongdoing. So, provided that trustees comply with these requirements, they should not be exposed to liability as a result of the manager’s decisions.

Due diligence: Being satisfied with the appropriateness of the manager is really a question of due diligence. Trustees should ensure they carry out appropriate due diligence before appointing a fiduciary manager. If they feel they are not otherwise equipped with the expertise or resource to form an opinion on the proposed manager’s expertise and suitability, they might consider arranging for input on the due diligence process from an independent expert in the field.

Monitoring: In order to satisfy themselves the manager is carrying out its work competently, trustees should establish a process for monitoring the performance of the assets of the scheme and the performance of the fiduciary manager. The performance of the assets of the scheme can be measured by setting out clear benchmarks and ensuring reporting against them. However, monitoring the performance of the manager is perhaps the most difficult area for the trustees since they are relying on the fiduciary manager for the monitoring and performance of the scheme’s assets, but the fiduciary manager will not be in a position to assess its own performance as a fiduciary manager. It may be that the trustees need to agree with the fiduciary manager that their performance will be monitored by a third party

The second, more difficult consideration for trustees is around the safeguards that should be put in place before implementing fiduciary management. In its purest form, fiduciary management is delegation of close to all of the investment functions of the trustees to a third party. However, the trustees retain the obligation to monitor the fiduciary manager and most probably to direct the fiduciary manager as to high level investment strategy. The trustees would need to ensure that the agreement:

> clearly sets out the risk parameters within which the fiduciary manager will operate. This may be particularly important where a fiduciary manager receives a performance fee for outperformance over an agreed benchmark level – this encourages risk-taking and it may be beyond the risk appetite which the trustees (or indeed the employer sponsor) is comfortable taking (and beyond what the employer covenant might be thought reasonably to support - a matter which could be of interest to the Pensions Regulator);

> provides for clear objectives and sets out the manager’s mandate and discretions clearly. As noted above, there are various “flavours” of fiduciary management and it may be that the trustees wish to retain more (or less) control over aspects of their investment discretion, so the agreement needs to be specific;

> clearly establishes notification procedures for risk events that the trustees consider material, such as breach of risk parameters, agreed asset allocation, market risks etc. The trustees must remain in a position to be able to ensure the manager is carrying out their work competently and in accordance with section 36 in order to retain their protection under section 34(4) of the Pensions Act 1995;

> contains provisions dealing with the management of conflicts. If the fiduciary manager is providing both the selection and implementation of investments, trustees should ensure that there are clear provisions dealing with conflicts that the manager may face – eg selecting “in-house” funds or providers for the trustees’ investments; or how the manager assesses and selects competitor products for the scheme’s portfolio;

> contains clear provisions on the extent to which the fiduciary manager can contract on behalf of and give representations, warranties and indemnities to third parties on behalf of the trustees. In particular, the trustees should ensure that the fiduciary manager is taking

Section 34(4) protects trustees from liability in respect of the acts of the manager to whom they have delegated.

The second, more difficult consideration for trustees is around the safeguards that should be put in place before implementing fiduciary management.


reasonable steps to ensure the correctness of the representations and warranties it gives, and that the contractual commitments and indemnities it agrees to are in line with market norms; and

> contains provisions dealing with the liability of the fiduciary manager in respect of both its advice / strategic functions and its investment implementation functions. This would also require careful consideration as the standard market positions for liability for investment consultancy work are different from those for investment management and implementation. In addition, as the fiduciary manager could effectively be responsible for all of the scheme’s assets, the trustees may look for a liability position and level of insurance cover which is commensurate with the risk in delegating that level of discretion to the manager.

The list above is not exhaustive and there are other considerations for the trustees before going down the fiduciary management route. For example, the trustees will still need to be able to satisfy their trustee knowledge and understanding obligations and ensure they are aware of the scheme’s assets and their performance. This too will require regular monitoring by the trustees (or their appointed investment committee).

Trustees should also think about how the need for diversification of risks fits within the fiduciary management model. Should they be putting all their strategic investment risk in one basket, is this risk adequately spread by the use of multiple assets / managers by the fiduciary manager (and is this different from their current model)? Should the trustees retain the use of a third party investment consultant to advise them on the performance of the fiduciary manager and strategy-setting where the fiduciary manager may have a conflict (eg if it receives performance fees)?

It is impossible to capture all the issues in one place since fiduciary management means different things to different people. What one set of trustees may be considering could be subtly different from what is being presented to another set of trustees. The key thing that trustees should be aware of is that fiduciary management, whatever its form, requires detailed consideration from both a strategic and legal perspective.

…requires detailed consideration from both a strategic and legal perspective.


Advocate Generals opinion in ATP Case – money purchase investment services exempt from VAT?

In our Summer 2013 edition of InvestorAgenda, we looked at the European Court of Justice (“ECJ”) judgement in Wheels Common Investment Fund Trustees Ltd and Others v HMRC. In that case, the ECJ ruled that there is no VAT exemption for defined benefit occupational pension schemes, nor for the collective investment schemes in which they pool their resources. They came to this view on the basis that a defined benefit scheme was not a “special investment fund” for the purposes of the EU directive on the harmonisation of taxes.

In a surprising development, the Advocate General has released his opinion in the case of ATP Pension Service which concerns whether or not VAT should be payable on services provided to a defined contribution scheme in Denmark by a third party provider, and concluded that a defined contribution scheme is a “special investment fund”. The Advocate General’s conclusion is:

… the term ‘special investment funds as defined by Member States’ has to include occupational pension funds where such funds pool the assets of several beneficiaries, and allow the spreading of the risk over a range of securities. This is only the case where the beneficiaries bear the risk of the investment. The fact that the contributions are made by their employers for their benefit under a collective agreement between organisations representing employees and employers and that payments out of the fund are only made upon retirement is irrelevant, as long as the beneficiary has a secure legal position with respect to her or his assets. Whether a fund fulfils these requirements is for the national courts to decide.

Broadly, the Advocate General concludes that because a in defined contribution scheme, the members bear the investment risk of investment, the principle of fiscal neutrality means it should be treated in the same way as other retail investment funds where investors bear the risk (eg UCITS). The consequence is that the exemption for “special investment funds” should apply to these types of funds and they should be exempt from VAT. In this way, the Advocate General distinguishes the conclusion in Wheels as that case concerned a defined benefit arrangement where members do not bear the investment risk.

It remains to be seen whether the ECJ will accept that Advocate General’s opinion when it rules on the case. However, traditionally, the results have been in line with the Advocate General’s opinion.

The consequence is that the exemption for “special investment funds” should apply to these types of funds and they should be exempt from VAT.


HMRC responds to Ruling in PPG Holdings BV Case

In our Autumn 2013 edition of InvestorAgenda we looked that the ruling by the Court of Justice for the European Union (“CJEU”) in the PPF Holdings BV case. In that case it was found that VAT incurred on third party services relating to both the administration of the pension scheme and the investment management of its assets could, in principle, be deductible for the employer company in so far as they formed part of the employer company’s general overheads and as such a component of the price of goods or services it provided.

On 3 February 2014, HMRC issued a response by way of a Revenue and Customs Briefing (No 06/14). Until then, HMRC had taken the view that the costs of the investment management of the assets of a pension scheme relate solely to the activities of the pension scheme and do not give rise to a right of deduction for the employing company. In that Briefing, HMRC have said it is changing its policy on the recovery of input tax in relation to the management of pension funds so that there are now circumstances where employers may be able to claim input tax in relation to pension funds where they have not been able to do so in the past.

Broadly, HMRC accepts that in order to deduct the VAT incurred on a cost, a business must establish a direct and immediate link between the supply received and the taxable supplies of that the business makes. As such, where a supply relating to investments is received by the employer (and it goes further than the management of investments), HMRC accepts that the VAT incurred will potentially be deductible by the employer.

However, HMRC states that it will not accept that VAT incurred in relation to the fund is deductible by the employer where the:

> supplies were not made to the employer; or

> supplies are limited to investment management services only (ie it is not a combined investment management and administration service).

Employers may now wish to consider putting in claims for unclaimed input VAT. However, HMRC notes that claims for repayment will not be considered for periods ending more than four years before the date on which the claim is made.

Finally, employers should also be aware that HMRC has flagged that if the decision in the ATP Pension Service case (discussed in this InvestorAgenda) means that defined contribution schemes are exempt from VAT, HMRC will take steps to protect its position and could issue assessments to recover any VAT that was deducted by employers which was incorrectly charged.

…claims for repayment will not be considered for periods ending more than four years before the date on which the claim is made.


EMIR: Risk mitigation techniques should be in place by 30 April 2014

As previously mentioned in our Summer and Autumn 2013 editions of Investor Agenda, the EU regulation on OTC derivatives, known as EMIR, came into force on 16 August 2012 and is taking effect in phases. The first risk mitigation techniques requirements took effect in March 2013 and required trustees to ensure that they had in place:

> processes to mark-to-market the value of their outstanding non-cleared OTC derivatives on a daily basis, or mark-to-model where market conditions prevent marking to market, eg when the market is inactive. The trustee board (or delegated committee) must understand and approve models on at least an annual basis; and

> processes for the timely confirmation of any non-cleared OTC derivatives.

The second phase of risk mitigation techniques took effect on 15 September 2013 and these requirements are broadly:

> putting dispute resolution processes in place. This means that before entering into a non-cleared OTC derivative, trustees will need to have agreed procedures to identify disputes relating to the valuation of the contract or collateral, record such disputes, monitor them and resolve them in a timely manner; and

> engaging in portfolio reconciliation and portfolio compression. This means that trustees will be subject to a new portfolio reconciliation requirement. Before entering into a non-cleared OTC derivative, the trustees (or their providers) will need to agree arrangements with their counterparties to reconcile the key terms of their portfolios in order to identify any discrepancy. The frequency of such portfolio reconciliations ranges from once a year to every business day, depending on the number of contracts outstanding between the parties.

The FCA has published bulletins on its supervisory priorities in relation to EMIR and had stated that it expected firms to have in place robust and specific plans to ensure compliance with the requirements as they came into force. However, the FCA stated that if there is a reason why full compliance cannot be achieved in specific circumstances, a firm should prioritise having a detailed and realistic plan to achieve compliance within the shortest timeframe possible.

On 21 February 2014, the FCA updated its bulletin and has reiterated that it expects firms which were unable to comply with risk mitigation requirements for non-cleared trades relating to portfolio reconciliation, dispute resolution and compression to have a detailed and realistic plan to achieve compliance within the shortest time-frame possible. The FCA has now confirmed that it expects that such plans will be completed and implemented by 30 April 2014 and that firms will be able to demonstrate compliance after 30 April 2014.

We are aware that trustees have been working with their investment managers and counterparties to ensure that these risk mitigation techniques are in place in respect of their non-cleared OTC derivatives. However, to the extent any of the techniques have not been implemented with your managers and counterparties, we recommend you speak to your managers and counterparties immediately to ensure they are in place by 30 April.

For more information on your obligations in respect of EMIR generally, please see here: http://www.linklaters.com/pdfs/mkt/london/NL_EMIR_Sept2013.pdf


http://www.linklaters.com/pdfs/mkt/london/NL_EMIR_Sept2013.pdf

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Please get in touch with your usual pensions contact to find out how PensionsInvest can work for you.

Rosalind KnowlesPartnerTel: (+44) 20 7456 3710rosalind.knowles @linklaters.com

Mark LatimourManaging AssociateTel: (+44) 20 7456 4639mark.latimour @linklaters.com

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