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Scotland the brave?

17 September 2014

What will a Yes vote mean for UK pensions? Will the "sensible and practical transitional arrangements" the Scottish Government is confident it can provide come to fruition?

Broadly, from the pensions and financial service perspective, Scottish independence is likely to result in extra operating costs that will be passed on to customers and pension schemes, and will have an impact on UK plc's prosperity. Scotland would be likely, in due course, to have to set up its own Financial Conduct Authority, Prudential Regulation Authority, Financial Services Compensation Scheme and Pension Protection Fund paid for by levies from the industry to provide regulation, security and compensation for "Scottish" benefits.

It seems unlikely this can all be achieved by March 2016. In the interim, it's unclear what guarantee arrangements there would be for pensions and deposits with Scottish institutions. Companies will have to manage customers in two separate jurisdictions, with different tax regimes and so different tax efficient investment products.  Even the new Scottish currency is uncertain.

So while the Scottish Government's approach to the resolution of these questions is admirable, there would be just so many questions to be resolved. While we know many will be subject to the outcome of on-going negotiations between Scotland, the rest of the United Kingdom and the EU, there are some matters the pensions industry will have to address in earnest, should Scotland vote for independence on 18 September 2014.

EU membership - whether Scotland will be part of the EU is a key unresolved question and is important from a pensions' perspective. Although there may be a gap in Scotland's membership, we anticipate that Scotland will aim to continue to comply with all EU law during such a gap.

Funding of defined benefit schemes, cross-border issues and the IORP Directive - if Scotland becomes an EU member state, any underfunded DB pension schemes, operating in both Scotland and the rest of the UK, will have to plug their funding deficits, potentially immediately. Even if a two year transition period is permitted, this is substantially shorter than most DB pension schemes' recovery plans. Unless trustees and sponsoring employers take the necessary steps of separating and/or ring fencing the Scottish elements of their pension schemes, which in itself will not be an easy task, money which could be used by the sponsoring employers to grow their businesses will instead have to be used to plug the large funding deficits. This is because the IORP Directive imposes a more onerous funding requirement on EU cross-border schemes, than for non cross-border schemes, with cross- border schemes having to be fully funded on scheme specific funding basis.

Compensation for members of defined benefit schemes - whatever arrangements are set up post- independence, trustees will have to consider the level of security a Scottish compensation scheme could provide. This will be a greater concern if trustees are being asked to agree to the separation/ring-fencing of "Scottish" benefits.

Special vehicle, asset backed funding arrangements, through Scottish limited partnerships, for defined benefit schemes - independence will mean existing special purpose asset-backed funding arrangements will have to be unravelled - at substantial cost - because the current legal loophole which allows trustees to invest in Scottish limited partnerships will effectively be closed. The reason for this is that a Scottish limited partnership will no longer be an unincorporated body constituted in the territory of the UK. The consequence is that sponsoring employers and trustees will have to revisit their scheme funding arrangements and most probably have to  put in place potentially less tax efficient, and so more costly, security arrangements.

Regulatory divergence - post independence, in the short-term, the legislative, regulatory and taxation regimes will probably not change more than they have to. However, over time there will probably be a divergence in the approach of the administrations north and south of the border. Those who intend to continue to provide pensions on both sides of the border will have to be ready to deal with two separate regulatory environments and two separate tax regimes. Even if there is a "No" vote, the Scotland Act 2012 will introduce a new Scottish rate of income tax in due course, and devo-max may allow for further divergence still.

Investment selection - The markets have already reacted with jitters to the very real possibility that the Scots may opt for independence. Scotland's exit procedures would be complex and even fundamental issues like what currency should be used in Scotland are not yet resolved. So trustees will need to review their investment strategies and decide what exposure they want to both UK and Scottish equities markets and what currency hedging may be available to reduce risk.

Personal pension providers - Scotland's insurance and financial services industry are dominant in the UK's pension sector. Depending on the regulatory environment following independence, employers in the rest of the UK may wish to review who they use to provide their employees' pensions to ensure employees have maximum regulatory protection at an acceptable cost. We also know key providers are looking very carefully at where they want operate.

Two sets of state pensions?- there will be many changes to state pensions if Scotland has its own state pension system. This includes deciding what state pension ages it wants and how the state pension should be increased. Will it put in place its own national insurance system to fund it? There will be haggling over what legacy state pension costs Scotland is responsible for, perhaps as part of negotiations on how to share the national debt. Pension costs are high and difficult to evaluate: Scotland has an older population than the rest of the UK. Changes to the state pension system by Scotland will have an impact on UK workers who work, or have worked, in Scotland.

Final thoughts

Even with a "No" vote, unless there is a decisive endorsement of the union, which seems very unlikely, the Scottish question could easily reignite, with Scotland following Quebec's example of "neverendum" and the same question could be asked again a few years later.

With these types of considerations, we think, whatever the result of the referendum, the referendum itself means Cameron and Scotland will have had their "Birnam Wood coming to Dunsinane" moment.

For more information, please contact Michael Jones on +44 (0)20 7203 8917 or michael.jones@crsblaw.com