Silence is golden
The Italian pension scene is in a state of flux. According to the Pension Funds Supervisory Authority (COVIP), the the newly established defined contribution (DC) second pillar pension funds that came into being after the 1993 reforms were finally applied in 1998 still only had a fifth of the assets, or around E6bn, of the older defined benefit schemes at the end of last year.
The new legislation was good news for pension funds because following a period of high inflation between 1986 and 1993 it became much more costly to provide defined benefit schemes.
But the new DC schemes have got off to a slow start both in terms of assets and membership. Measures will be introduced shortly to stimulate growth. Silence please.
Prior to the 1993 law there were three kinds of pension scheme, which together were known as the ‘fondi preesistenti’ or ‘pre-existing’ funds. The banks had their own pension fund; there were also funds for professional groups such as doctors and engineers who were not included in the social security system. A third category was the corporate pension schemes which companies set up for their management as a supplement for their social security provision.
For the majority of the population prior to 1993 the generosity of the state social security system meant that additional pension provision was unnecessary. Piero Marchettini, managing partner of Adelaide Consulting explains that today this luxury only applies to those above the age of 50. “It is much less generous for people between 40 and 50 and even less for people under 40.”
Cue the new funds which the 1993 legislation brought into being: the ‘contrattuali’ literally contractual, also known as closed funds, which were introduced for all employees, usually on a sector basis; and the ‘aperti’, or open funds which were introduced for the self employed and for those who didn’t have an industry fund to join.
As well their limited coverage, the funds that were set up prior to the 1993 reforms had a reputation for something rather sinister. Think of a crate of parmesan in a damp cellar; the air was foul indeed. Theme: real estate.
The funds that substituted state social security provision were required by the ministry of labour to invest at least 40% of the available resources in real estate. Of this amount, half had to be invested in low-rent real estate for social reasons. “At the beginning of the 1990s these funds had a huge amount invested in real estate,” says Marchettini. “In the doctors’ fund for example it represented 90% of the assets.” The obligation to invest in real estate ended at the beginning of the 1990s.
Nothing wrong with that on the face of it, until we draw a connection with the financing of political parties. “The real estate developers were close to the political parties,” says Marchettini. “They also built very poor buildings. Furthermore, the boards of these funds were mostly made up of political appointees who approved the purchase of these buildings for a very high price. The real estate developer then gave money back to the political parties.”
Such practices were brought to an end at the beginning of the 1990s as a result of a nationwide police investigation into political corruption.
It is for this reason that the new funds are not allowed to invest in real estate. The preesistenti on the other hand still have around 22% invested in real estate, with bonds the largest single asset with 42%, according to COVIP data. The 1993 legislation obliged them to progressively sell their investments in real estate and move to more liquid investments.
As well as their penchant for real estate the preesistenti also invested a significant proportion of the funds in bonds; faut de choix, it seems. “Italian financial markets were underdeveloped 15 years ago, so it was quite natural for Italian institutional investors to orient themselves towards the instruments that existed – bonds,” notes Bruno Mangiatordi, commissioner of COVIP. “And they were very profitable because the level of interest paid by the state on its debt was very high until a few years ago.” The yield on treasury bonds in Italy was five to six points above inflation until the mid-1990s.
The other factor that deterred funds from investing in equities at that time was a discussion as to whether equities should be considered speculative investments and as such subject to capital gains tax.
Once the decrees were enacted in 1998 the first new funds started to operate. The contrattuali took a prudent line. “They were much more focused on trying to get members rather than on investments so they invested in bonds and other liquid investments so that they didn’t lose money,” notes Marchettini. A lack of experience of investing was another factor.
The new law encouraged funds to offer a variety of investment options, an arrangement known as ‘multicomparto’, as opposed to the single line or ‘monocomparto’.
In most cases the contrattuali have maintained a single portfolio since they were first set up, with an allocation of just over 70% in bonds, 25% in equities and the rest in cash, according to data provided by COVIP. Meanwhile the aperti offered a number of investment options. It is for this reason that the aperti and contrattuali differ significantly in terms of their asset allocation. Today bonds account for 30.1% of the assets of the aperti compared with 71.8% of the contrattuali.
“If the contrattuali retain a single portfolio I think they will maintain a prudent approach,” notes Luigi Ballanti, director of the Association for the Development of the Italian Pension Funds Market (MEFOP). “If they go for multicomparto we will see an increase in equity weight because the younger worker could decide that in the longer run more risk means more yield.”
As in other countries the interest in the international equity markets has increased and today international equities represent around 90% of the equity portfolios of the new funds.
On the fixed income side meanwhile, the Parmalat scandal seems to have dampened the appetite for corporate bonds. However, Mangiatordi notes that “Italian pension funds had a very low exposure to Parmalat securities.” In general, pension funds choose investment grade bonds with a minimum rating of triple-B.
So what of alternative investments? It seems that the industry is still too young to contemplate this. Livio Mocenigo is partner at the benefits practice of Watson Wyatt’s office in Milan. “It is something for the future,” he says. “There is not enough sophistication and also not enough assets to diversify. The problem is that some people at board level do not understand even the basics of the risk management and governance process, and who they should be talking to in the different areas of investment. Sophisticated investment philosophies and decisions do not belong to them.”
He adds: “with limited exceptions the so-called trustees do not have enough financial knowledge. And generally they don’t use a consultant because they think they are too expensive; they don’t understand the value of a consultant.”
It is not surprising that current legislation stipulates that all management should be outsourced.
So without knowledge and consultants to help, where do pension funds turn?
Good question? The answer is even better. Mocenigo notes that when funds move from the single line of investment to offering several lines, the asset manager is sometimes asked to do the investment consulting. “If I am an asset manager I would advise the fund to choose the line of investment where I am strong. So there is a conflict of interest.”
And the conflicts of interest don’t end there. “The unions have their preferred providers. They bring asset managers on board because they have some connections with them.”
Mocenigo stresses the need for a transparent manager selection process. He does not have confidence in the quality of corporate governance at Italian pension funds. “Some funds are taking initiative because of the push coming from the Anglo Saxon world but they are still very inward-looking and conservative.”
The new legislation contains a set of rules governing conflicts of interest and will require their full disclosure by the new pension funds. It is expected that the rules will be extended to the preesistenti.
The lack of expertise among pension fund boards doesn’t help their members who in this young industry are at the bottom of the knowledge ladder. So doesn’t this make a nonsense of the multicomparto system where members have to choose among a number of investment lines the option that suits their specific needs?
“It is a waste of time if you don’t have the capacity of informing people adequately,” says Mangiatordi of COVIP. “That is one of the more delicate issues that we will have to deal with in the near future. We are not satisfied with the level of awareness that pension and members have about risk profile. And this is particularly necessary because we have a defined contribution (DC) system.”
Mangiatordi considers that without adequate information the choice of investment lines in a DC system “could be an invitation to disaster”.
He adds: “All workers should be presented with a decision tree with other information including a combined forecast of his pension fund revenue and the first pillar coverage so they can understand exactly what is their interest.”
Mocenigo notes: “The choice that is made by members of some funds does not make any sense according to their risk profile, and the reason for this is that they are not informed. They are told: ‘pick one of these three or four and sign here’, and that’s it.”
The good news is that the new legislation has the matter in hand, insofar as it contains a statement that members must be informed in terms of investment choice and the consequences of that choice.
But for the meantime the lack of knowledge and information explains why funds that have offered additional investment options have seen so little movement away from the original line of investment.
As mentioned at the beginning of this article the level of assets under management is not spectacular. COVIP data shows that while there were 121 new funds at the end of 1999 this figure had grown to only 138 at the end of last year.
This was not the start that the authorities had hoped for, which is why the new legislation contains measures intended to stimulate the new funds. One involves increasing the amount of the TFR, a deferred compensation item retained in the employer’s books, that is diverted to pension provision. The sum, equivalent to 7% of salary, earns 75% of the rate of inflation plus 1.5% annually, and at the end of the employee’s contract of employment the employer releases the sum. The regulations regarding its use are currently set out according to the following categories of employee.
q Those who had a pension fund established prior to the pension fund legislation in 1993 don’t have any obligation to pay the amount to a pension fund and can put it to whichever use they please;
q Those who started to work prior to the legislation but didn’t have a pension fund: If they want to join a pension fund, Italian tax law says if an employer contributes to a pension fund then a portion of the TFR equivalent to 50% of that must be added to ensure tax deductibility;
q Those that started to work for the first time from 1 January 1996 have to pay all the money to the pension; they have no choice.
The legislation proposes replacing these three categories with a system of ‘silenzio assenso’, or silent assent, whereby if an employee does not state that the TFR should be paid out as a cash sum on termination of the contract of employment, it will automatically be paid into a pension fund.
In view of the pressing need to
stimulate the new funds it might seem odd that the payment of the TFR into a pension fund is not going to be made compulsory. The reason is that the TFR has a guaranteed yield while
the vast majority of pension investments and investment options do
not have this cast iron backing. As
Ballanti of MEFOP notes: “if we say that it is compulsory to move from a guaranteed investment to the risk of the market we would create a legal problem.”
Indeed the legislation requires that pension funds will have to offer a guaranteed option which mirrors the guaranteed return of the TFR.
Estimates of the effect the measure will have on total pension assets vary. Some suggest that 50% of the total annual value of the TFR of E14bn will be diverted to pension provision. Mocenigo is more conservative and predicts a figure of between 30% and 40%, citing the likely reluctance of young people to make long-term commitments.
Marchettini: “it is not unrealistic to say that over next 20 years assets of Italian pension funds will be multiplied by ten.”
In terms of stimulating second pillar provision is there anything else that could be done? The legislation speaks generally about raising the level of tax deductibility. Since the 2001 fiscal reform it has been the lower of 12% of salary and E5,164. “This is peanuts for someone earning E100,000,” says Mocenigo.
He explains that there is a provision to increase the present tax threshold. “Doubling the tax deductibility would be a good incentive. Or they could scrap the E5,000 fixed limits so if I earn E100,000 I will accrue E12,000.” He also approves of the proposal to abolish the 11% tax which is currently paid by the pension funds on their investment returns.
What might hinder the development of the second pillar schemes is the threat posed by third pillar schemes. “Now you can’t differentiate now between the fondi aperti and individual contracts from a fiscal point of view,” says Mocenigo. “The real differentiation is in the hidden costs and front-end charges of the third pillar schemes. The association of insurers has lobbied heavily in parliament to include the third pillar product within the new pension fund legislation.”
He is concerned about the vested interest of third pillar advisers. “This is a big problem because they will earn more commission if they suggest a product with high fees. It is driven by the product construction rather than good financial planning and analysis. So we could even arrive at the mis-selling scandals that happened in the UK.”
So is this siphoning off money from the second pillar? “In my view yes unless it is properly handled.”
The decree is expected to come into force around the end of this year, and not a moment too soon. Effective communication will be key if the legislators are to achieve the boost to pension assets that they are hoping for.