The Deafening Silence on FTT | Chief Investment Officer

From aiCIO magazine's April issue: Charlie Thomas on the potential implications of the European Financial Transaction Tax, and why no one is talking about it.

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Why is no one talking about the biggest headache facing asset management? The European Commission’s Financial Transaction Tax (FTT) is due to hit the world January 1, 2014. In case you’ve been vacationing on the moon, here is the lowdown: 11 countries are planning to impose a 0.1% tax of the value of share and bond transactions and 0.01% on derivatives. If a firm involved in the transaction is based in the FTT zone, it will be taxed. A transaction will also be taxed if it involves financial instruments issued in one of the 11 countries: Belgium, Germany, Estonia, Greece, Spain, France, Italy, Austria, Portugal, Slovenia, and Slovakia.

It’s eight months away, but when aiCIO asked asset managers to tell us how they were planning to help their institutional customers lessen the impact of this new tax, very few of them got back to us. Is this because, as one analyst suggested, they are currently in the middle of their own impact assessment reviews? Are they ignoring it because they think it won’t happen (or at least won’t be a big deal for the sector)? Or are they simply behind the curve?

Just two fund managers returned aiCIO‘s call—JP Morgan Asset Management (JPMAM) and Blackrock. Blackrock was only able to provide us with its letter to the UK’s House of Lords. The letter said the FTT would hit their client’s investment performance hard. It warned the FTT would create “unintended investment incentives” and “undermine sound asset management principles such as diversification, proper hedging and efficient execution.” Active portfolios would be forced to take higher levels of risk and/or invest in more derivatives to deliver the same level of returns. It would also reduce market liquidity and increase volatility, further hurting investment performance for pensioners and savers.

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However, JPMAM had a different take, stating that the FTT would not bring about a wholesale change in pension funds’ asset allocation. “The idea that you would avoid an entire market to avoid a transaction levy of 0.1% is a bit extreme,” said John Stainsby, head of UK institutional at JPMAM. “This is just like stamp duty in the UK, which has not historically proved a barrier to investment, despite being a materially higher levy than the proposed financial transaction tax…This is just a change of one of the assumptions going into the investment decisions we make.”

But that view hasn’t satisfied everyone. ATP, one of Europe’s biggest pension funds, said it was considering using more derivatives to keep the fund’s tax bill down, as well as investing in countries unaffected by the FTT.

Kevin Cummings, a tax partner at BDO, reported that some asset managers were considering moving traders and business overseas, most likely to Singapore to avoid the tax. The relocation may have been on the agenda already, but the EC FTT was “another good reason to move,” he said. “If you look at the UK’s stamp duty tax for example, there is a relatively generous exemption for intermediaries-the real surprise was there was no equivalent for the EC FTT…You’ll also get a whole bunch of intermediaries who will only transact as an agent, rather than as a principal, so there’s no cascading impact for them,” Cummings added.

There are considerable behavioral risks from the FTT as well, surrounding just what investors might do to evade the levy. Some schemes may decide to grow their derivatives exposure—but under the EU accounting standards, derivatives have to be held at fair value, leading to an increased volatility on earnings increases and the balance sheet of the business. A scheme’s exposure to losses could also be greater: If you would normally buy exposure to $100 worth of shares, but the equivalent derivative costs $10, you might choose to leverage your exposure—buying $100 of exposure to shares worth $1,000.

But the leverage is risky, because the investor could be called upon to settle the full value of the contract. Are schemes ready for this? And if you decide to invest outside the 11 FTT countries—to Japan for example—that means changing your counterparties, which brings another level of risk. So what are your options if you want to avoid the forthcoming tax?

Lawyers are already warning investors that the European Commission won’t make things easy for tax dodgers. According to Eversheds’ tax expert Ben Jones, the FTT was specifically designed to prevent traders from circumventing it.

There are potential ways in which the FTT could be limited however, centering on ensuring the transaction does not create a taxable “financial instrument.” Entering into fixed-rate loans, for example, rather than floating rate loans with an interest-rate hedge might accomplish this. “Given the general flexibility of financial instruments, opportunities to circumvent the FTT in certain circumstances are inevitable,” Jones said.

Leveraged CDOs part II anyone?

From aiCIO magazine's April issue: Leanna Orr on the nasty surprise waiting for politicians who want to shift public pensions to defined contribution structures.

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Pension risk-transfers to insurance companies are peanuts compared with another brand of transfer still awaiting its big break: the pivot of a major public pension from defined benefit (DB) to defined contribution (DC).

And if the GM/Verizon-Prudential deals are peanuts at this carnival-convenient and delicious to some, absurdly overpriced to others-then the public DB-plan-to-401(k) swap is Whac-A-Mole. Strong unions and mobilized members can beat down most any politician or pension overhaul bill. But as reformers pop their heads in more frequently, isn’t it inevitable that, eventually, they start making it through?

At least one already has: showing remarkable foresight into its economic future, Michigan broke ground in 1997 by closing its state employee DB plan to new members. Revised future liability assumptions immediately boosted funded status from 91.5% to 109%. But the state quit paying its actuarial required contributions in 2002, and funded status now resides at 65.5%. Still, researchers estimate the reform shaved about $2 to $4 billion off the system’s current $5.4 billion shortfall.

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In fact, Michigan legislators passed another potent reform bill last summer-which is apparently no easier the second time around. “We took on a really tough, ugly issue,” said Governor Rick Snyder, speaking at a town hall meeting two weeks after signing the bill into law. “A lot of people got really mad at me.” The legislation included a $150,000 earmark for an independent study of transitioning the state teachers’ hybrid DB/DC plan to pure DC. The estimated price tag: $4.5 billion over the first decade-and that’s assuming state employers paid required contributions in full, every year. New teachers in Michigan can still choose between hybrid and DC, although they won’t retire with guaranteed income streams like educators elsewhere in America-for now.

Pennsylvania, Florida, Washington State, Arizona, Kentucky, and Texas: bills or serious proposals to shut and swap open pension plans for DC schemes have appeared in legislatures in all of these states recently. None of them have come to pass yet, although more will surely pop up in the near future.

“As we’ve seen on the corporate side and now the public side, the transition from DB to DC is happening,” says Fredrik Axsater, State Street’s global head of defined contribution. The public plan segment is also growing at a faster pace than the DC market overall, according to data from financial research firm Cerulli. From 2006 to 2011, the public DC sector had a compound annual growth rate of 3.4%. Firm analysts expect further growth acceleration, hitting 6.7% for the 2012 to 2017 period.

Axsater backs this prediction. “The cost of DB plans is just so high from a plan sponsor standpoint,” he says. “It’s not surprising that last year global DC assets under management topped DB for the first time. The next step in this transition is figuring out how to make DC plans as powerful as possible for participants.”

State Street’s DC team has a three-step approach for the structuring of new and overhauled plans. First comes assessment: “What are the client’s needs? How can we take advantage of in-house expertise?” For answers, the firm might survey participants to better understand their needs and financial literacy. Second, program design: It’s here that clients and their hired guns hammer out the plan’s communication and investment infrastructures. Finally, implementation: communicate the imminent changes, follow-up with participants, and make regular reviews systematic.

Public plan sponsors tend to top their corporate peers at one-on-one interaction with participants, which Axsater says is fundamental to this last stage-and often to positive DC outcomes as a whole. Still, sitting down for a fireside pension chat with a Detroit schoolteacher (or, any Michigan state employee circa 1997) might turn into another Whac-A-Mole situation. But as the earmarked teacher plan study points out, DC and hybridized plans do offer advantages over DB structures: portability is one, as well as the option to have both an income stream and lump sum liquidity at retirement.

Corporate America reached a general consensus over the last couple of decades that DB plans were not broadly feasible in the long term, and has been following the glide path from DB to DC ever since. Public and private employers may well end up with the same retirement benefit target-DC plans with annuity wrappers, say-but the public path includes a nasty set of obstacles.

For some governments, formidable political barriers to reform and weak funded-status requirements have made feeding the DB beast vastly easier than taming it. But festering problems require bigger fixes. And thus, we see the recent spate of bills proposing wholesale shifts of massive retirement systems from DB to DC. But as Michigan’s governor learned, impoverished pensions can price themselves out of that option. A number of courts have ruled that quitting a DB plan does not mean quitting the promises it already made. Sooner or later, obligations must be paid.

Michigan couldn’t do that, and its pure DC plan failed. The mole lost another round, but not because of a mallet blow to its head. It had simply dug its hole so deep it could no longer get out.