Waiting for a window of opportunity to open
Promoters and providers of defined contribution (DC) plans in Portugal have to face the uncomfortable fact that currently they can compete for no more than a third of the total corporate pensions market. The remaining two thirds is effectively barred to them.
This is because the bulk of the country’s corporate pension funds are schemes set up by the banks and former state-owned entities. For historical reasons, the act as surrogate social security systems. Francisco Cordeiro, secretary general of the Associação das Empresas Gestoras de Fundos de Pensões (AEGFP) explains: “When the companies set up the plans more than 10 years ago their workers were not entitled to a pension through the general social security system, and the companies paid their pension benefit through their own pension schemes. So these pension funds really work as first pillar pensions because they provide a substitute for the social security system. That is why they can never change to DC.”
The assets of these ‘first pillar’ pension funds dwarf the those of the rest of the corporate pensions market and in particular the assets of DC plans. Figures from the Instituto Seguros de Portugal (ISP), which supervises Portugal’s pension funds, show that in 2000 DC schemes represented only 0.22% of total pension fund assets. The extent to which the assets of the banks’ pension plans distort this picture is demonstrated by the fact that DC pension plans account for 6% of the market in terms of the number of participants and 21% in terms of the number of funds.
In general, corporate pensions plans, both DB and DC, still play a relatively small part in Portugal’s pension provision. Watson Wyatt Worldwide in Lisbon estimates only 1% of the country’s 200,000 registered companies have any pension arrangement.
Bernie Thomas, practice manager at Watson Wyatt, says: “These companies are the larger companies. Small and medium sized Portuguese companies are more likely to rely on social security to provide old age benefits. As for the types of plan, the larger domestic companies would tend to have DB plans as a result of labour collective agreements. So, for the DC market, we’re pretty much looking at the multinational organisations.
“We’ve seen, over the last three to four years, a considerable trend in multinational companies moving away from DB plans into DC plans. And I would say every single new plan that has come out of the market has been a DC plan.”
Pension fund consultants have encouraged this development. “If a company wants to establish a pension fund, unless its people are very young, we would advise them to go for a defined contribution,” says Thomas. “But most of the funds are already established and it’s very difficult to get them to change from DB to DC. People generally prefer defined benefit because they know what they are going to receive.”
People also may not have much disposable income left for DC contributions after they have paid social security contributions and income tax. Companies that offer DC plans will typcally have a target of between 10% and 20% of final pay. To achieve this they will contribute between 2% to 3% while employees will contribute between 1% and 2%.
“If you’re already paying 11% to social security and 20% taxes and you have to pay a mortgage, buy a car and feed the family there isn’t an awful lot of money left over for long term savings,” says Thomas.
There have been some surprises, however. Two or three domestic DC pension schemes for blue collar workers have been set up. However, these are the exception.
For employees, the attraction of DC plans is their portability. A large proportion, perhaps 90%, of DB pension plans in Portugal do not offer employees vested rights. This is because employers have used pension plans as ‘golden handcuffs’ to bind the employee to the company. Employees in collective agreement schemes lose all their accrued pension rights if they leave before retirement age.
“Vested rights in Portugal are in a fact in a very close relationship with defined contribution plans,” says AEGFP’s Cordeiro. “Once you consider a pension plan as a kind of income for workers then you are talking about a defined contribution arrangement because the employer wants to contribute within the whole package of the worker’s remuneration.”
For employers, the attraction of DC plans is the transfer of risk from the balance sheet to the employee. “The move towards DC has been influenced by the companies’ desire to limit their risk,” says Cordeiro. “By changing to DC they have in a certain way immunised themselves from this risk.”
However, he suggests this poses problems of investment choice for employees. “If the risk is transferred to the employee it seems acceptable that that the employee has more power of decision over its investment. What is difficult to accept is a defined contribution plan in which the company itself decides in what kinds of asset to invest.”
A single company DC fund offers a single mix of assets. Typically the fund is divided into three sub-funds – equities, bonds and balanced. The fund member can choose how much to contribute to each sub-fund, with a maximum of 50% in equities.
Third pillar individual pension plans (PPRs) offer considerably more investment choice, although the investment limits are stricter – investors must hold a minimum of 50% in Portuguese government bonds, for example. However, most investment managers offer different levels of risk from 100% in bonds to 25% in equities.
Cordeiro suggests that once employers offer DC schemes which contain real investment choice, they are offering something that resembles a PPR. “When a worker does have total power of investment choice within a DC scheme it is very close to a third pillar plan. You can call a DC plan the pension fund of the company, but inside that pension fund you cannot have only one mix of assets. You must offer the workers a variety and if you offer a great variety, it’s like a personal pension plan.”
This partly explains why personal pension plans or PPRs have been so successful in Portugal. Employees – and sometime employers – may contribute to these schemes as an alternative to or an addition to corporate DC plans.
José Mendinhos, general manager at Futuro, one of the big five pension fund management companies, says that PPRs offer the best market prospects currently. “What is undoubtedly moving in the market at the moment are the retirement individual accounts. They are tax-driven – that’s a fact – but they have been a real success. Our clients are moving to that sort of savings plan and I can only suppose the trend will increase.”
Some observers even see the beginnings of an equity culture. Leonardo Mathias, general manager of Schroder Investment Management in Lisbon, says: “There is going to be and there has been incredible growth in these personal pension plans, although they are starting from a very low base.”
He senses a change in the attitude of Portuguese savers. “One sees more and more of an equity culture and a culture of having your own savings plan and your own educational plan for your kids.”
However, he concedes that the task for DC plan providers is an uphill one. “A senior manager of an English multinational in Portugal told me that although new managers are offered a range of alternatives for private pensions what they really care about is whether they will get a BMW.”
For the moment, the DC market has paused for breath. It grew rapidly in the 1996 and 1997, when double digit returns made investment choice an attractive option. However last year Portugal’s pension funds reported an average return of minus 2%.
On top of that, members of DC pension plans face falling annuity rates. Thomas suggests that, in future, annuity rates could become as important as equity returns. “Most of the people with PPR and DC plans haven’t yet retired. Most are still in the accumulation of wealth stage. But I’m sure that as people start to retire and they go to their insurance company to buy their annuity they are going to be unpleasantly surprised how small their pensions are because of what is happening in the annuities markets. And I think that’s going to become a big issue in the next five to 10 years in Portugal.”
The hope is that, by the time the DC market is mature enough for people to worry about annuities, it will be strong enough to cope with these concerns.