Investment Beyond The Limit
By: Terri M. Troy
With pension plan sponsors looking for ways to increase the foreign content of their investments, multi-level master trusts offer one solution, says Terri M. Troy, of RBC Financial Group.
Increasing foreign exposure has always been a challenge for Canadian plan sponsors. Even though the federal government has raised the Foreign Property Rule limit for investors from 20 per cent to 30 per cent, pension funds are still looking for higher levels of foreign content. And that means considering a wider range of investment opportunities. Unfortunately, not all of the available options are low risk, or cost-effective.
One solution is multi-level master trusts. The master trust approach can raise the foreign content of a pension to up to 50 per cent foreign exposure – much higher than the 30 per cent foreign content limit – and it is done completely within legal boundaries. At the same time, it can allow sponsors to harmonize investments and help to reduce costs. It can also lead to a new and more efficient way of monitoring compliance in funds.
What Is A Multi-level Master Trust
The structure isn’t as complicated as it might sound at first. Since the 1960s the term ‘master trust’ has been used to describe a unitized trust that consolidates the assets of two or more pension trust funds under the management of a single or multiple investment managers. This is allowed under the Income Tax Act in Canada, which permits the creation of a pooled fund or mutual trust for the collective investment of taxexempt groups such as pension funds, the unitholders. This type of arrangement is usually referred to as a master trust.
Master trusts typically bring economies of scale to the running of different plans under one umbrella – and that reduces the costs of investment management, custody, and monitoring. It also ensures that each participating trust holds a proportionate share in the consolidated assets of the overall portfolio.
But perhaps one of the most exciting features of a master trust is how it can help increase the amount of foreign content in a plan. Here’s how it works.
Master trusts can be established on a multi-level basis by implementing two concurrent trusts: a domestic master trust (DMT) and a foreign master trust (FMT).
Through the multi-level trust structure, a sponsor can derive indirect foreign exposure through units of the domestic master trust and direct foreign content from units of the foreign master trust. For example, a fund could end up with 40 per cent foreign exposure by having 18 per cent exposure through its DMT and 22 per cent foreign content in its FMT. This is because the units of the DMT are considered non-foreign property as long as the DMT’s foreign property remains below 30 per cent of the DMT’s book value throughout the prior year.
It is important to note that the structure must adhere to the Income Tax Act Regulation 5000 (1) and (7) pooled fund trust rules at all times.
Of course, this structure won’t suit everybody. At a minimum, a plan sponsor needs to have two Canadian pension plans in order to participate. And plan sponsors need to look at all of the choices out there before deciding which one makes them the most comfortable in terms of cost and monitoring.
The Bottom Line
The biggest advantage of a multi-level master trust can be seen on the bottom line – in other words, cost savings. By harmonizing investment managers and mandates under just two master trusts, the costs of running a plan can be significantly reduced.
Simplification is another major advantage. A multi-level master trust structure has proven to be an excellent way to streamline investment and administrative processes.
It also takes very little time to set up. And, when it comes to the day-to-day administration of the plan, the structure significantly reduces the amount of monitoring time required. When multiple plans are consolidated under one umbrella, the process becomes more standardized and a lot less complicated.
However, the biggest advantages and cost-savings are in the way the plan’s assets are invested. By putting different DB options into a multi-level master trust, returns are harmonized. This is a major benefit, especially from the plan member’s point of view.
Overall, this type of structure is a great way to increase diversification and decrease costs. Instead of working with a group of smaller, separate portfolios, the plan sponsor lowers investment management fees and custody costs by focusing on one large investment fund.
Playing By The Rules
Multi-level master trusts aren’t for everyone and plan sponsors need to take a close look at the list of disadvantages before taking on this kind of arrangement.
Although the structure reduces costs in the long run, it can be expensive to set up. The process involves legal fees, time, and resources. Plus, all contracts with existing investment managers need to be renegotiated and not all managers are willing to participate in a master trust structure if they feel the rules are too stringent. In some cases, new managers need to be hired.
A combination of domestic and foreign master trusts also adds another layer of monitoring, which leads us to the biggest risk involved in this structure – off-side risk. Under Regulation 5000 (1) and (7), the DMT must adhere to six specific conditions for foreign property exemption and any deviation can mean big fines. In general, those six rules dictate that:
- The trustee has to be a Canadian trust company.
- The cost or book value of foreign assets in the trust can’t exceed 30 per cent of the total cost of all its assets in either the previous or current tax year.
- A minimum of 80 per cent of the total book value of the trust must be held in shares, bonds, mortgages, marketable securities, and cash. And investments in non-marketable securities (securities that aren’t traded on an exchange such as pooled funds) are restricted to a maximum of 20 per cent of the total book value of the master trust.
- No more than 10 per cent of the total book value of the trust can be invested in any one issuer other than debt obligations of, or guaranteed by, federal, provincial, or municipal governments.
- A maximum of 10 per cent of the book value of the master trust can be invested in any one parcel of land.
- At least 95 per cent of the annual income of the trust must be derived from eligible investments.
If any of the six conditions specified under Regulation 5000 (1) and (7) are not met on a real-time basis, the units of the DMT could be deemed foreign content to the pension plan unitholders. And that could result in major tax penalties. In addition, Regulation 5000 Pooled Fund Trust rules require that foreign content be on side at all times – not just at month end.
All this means that monitoring is a major part of running a plan with a multilevel master trust. The good news is that this can be automated.
Getting To Sleep At Night
While setting up a multi-level master trust structure can be time-consuming, ongoing monitoring and compliance is the key to making it work. This means plan sponsors must ensure that a potential provider can give them the information they need as often as they need it.
Compliance and monitoring can involve daily analysis of the portfolio using an automated system. The process involves going into the system every day and checking all the security-level detail of all the plan assets. Adaily series of tests may need to run to determine foreign content in both the domestic and the foreign master trusts. Book value and income generated from non-marketable securities should be closely monitored. For the 10 per cent rule, regular real-time tests – something that’s required within any pension plan structure, master trust or not – must be in place.
While these tests are very important and need to be performed regularly, they are certainly manageable. For example, if plan sponsors do not invest in real estate, resource properties, or non-marketable securities, they only have to monitor foreign content and the 10 per cent rule. On the other hand, plan sponsors should already be used to monitoring these factors on a daily basis, no matter what structure they’re using.
A solid buffer for foreign content is a good way to ensure that your plan doesn’t surpass the limit without giving you plenty of time to catch the error. If your multilevel master trust structure can give you up to 50 per cent foreign exposure over both trusts, use only 40 per cent of it to provide a healthy buffer zone of 10 per cent.
Another source of risk protection can be written into contracts negotiated with your investment manager.
Plan sponsors must ensure that any manager who takes the DMT over the foreign content limit by deviating from its prescribed mandate is fully responsible for the penalty incurred. That means they are liable not just for their own portion of the DMT assets, but for 100 per cent of the DMT assets. Plan sponsors must also make sure their investment managers are fully insured – something they should be insisting on anyway.
The Right Fit?
In our experience, the advantages of a multi-level master trust structure have far outweighed the disadvantages. Monitoring is key, but working with the right provider makes all the difference. In the end, the right provider will be flexible and responsive to the unique needs of each plan and will add value by ensuring that the new structure will run efficiently and effectively.
The foreign property rule will no doubt continue to present plan sponsors with an investment conundrum for years to come. Fortunately, solutions such as multi-level master trusts can help ease the pain.
Terri M. Troy is director pension and strategic investments at RBC Financial Group.
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