Assessing the key factors
Michael Atzwanger explains the current issues affecting the Italian pension fund industry
In recent months the Italian finance ministry has been leading a discussion within the country on how to change and relax the investment limits for pension funds. Such a move would not only have an impact on the asset management of pension funds but also on supervisors, who have to be prepared to advise pension funds that would be adopting more sophisticated investment strategies.
Whatever the outcome it is at least encouraging that the investment guidelines issue is being addressed and that the industry is aware of the fact that Italian pension funds have to be allowed to participate in the evolution of the global financial markets, as pension funds based in other European countries do.
But for now Italian pension funds, at least those created after the pension fund law of 1993 which allowed the establishment of pension funds for the entire Italian workforce, are not at all diversified among different asset classes. In fact the average asset allocation of closed pension funds run by the social partners is 4.7% in cash, 68.6% in bonds and 20.4% in equities, while for open pension funds created by banks and insurance companies is 7% in cash, 43.9% in bonds and 25.5% in equities.
This lack of diversification is exacerbated by the existence of investment guidelines adopted in 1996 that limit the investment opportunities mainly to equities and bonds. Alternative asset classes, like closed Italian private equity funds and closed real estate funds, are not used by pension funds because of unresolved accounting issues (notably that for prudential reasons pension funds are obliged to value these investments in their balance sheets and performance reports at significant discounts because of their illiquidity) and risk control concerns. Italian pension funds are banned from investing in hedge funds.
This means that Italian pension funds are fully exposed to the positive or negative performance of equity and bond markets without having the possibility to diversify substantially into non or less-correlated assets. The recent market turbulence has given rise to concern among workers regarding the performance of the pension funds. They are aware that last year, the standard return from the TFR, which by law has to be 75% of inflation plus 150 bps, was better than that achieved by pension funds.
And in a period of discussions about cross-border activities by pension funds due to the implementation of the IORP directive, Italian pension funds are expected to come under increasing performance pressure from members who can compare their performance with that of their European pension fund ‘competitors'. The miserable performance of the mutual funds sold to Italian retail customers in recent years (due to very high distribution costs) is recognised as being one of the main reasons for the collapse of the Italian mutual fund market. Consequently, the threat for pension funds in today's globalised world would appear to be real.
As well as the low diversification of pension fund assets there is also the problem of the low volume of assets under management.
The average of assets under management in Italian pensions funds is still far below the average of pension funds in most OECD countries. Last year's so-called TFR reform, which required employees to decide whether or not to transfer an annually accrued deferred salary that was formerly held on an employer's books to a pension fund, convinced approximately 1.5m Italian workers to do so, meaning that only a quarter of Italy's employees are members of pension funds. Consequently, the increase in assets under management of these pension funds is still not sufficient.
Without further government action - for example, offering even more incentives for pension fund membership and adopting a widespread communication strategy - it is unlikely that the membership of Italian pension funds, and therefore their assets, can be further increased. As the new government has not yet revealed its strategies to promote second pillar pension funds, an alternative open to pension funds is the promotion of asset pooling. Only by pooling will Italian pension funds be able to achieve economies of scale and the possibility to really diversify their assets.
Without the possibility to establish suitable pooling vehicles in Italy, pension funds are looking outside Italy's borders. Just as almost the entire Italian mutual fund industry moved from an operational point of view to markets like Ireland and Luxemburg, establishing UCITS III vehicles for distribution to Italian retail clients, so many Italian institutional investors and pension funds have already moved or are considering doing so. A first pension fund, an ‘old category' fund belonging to a major Italian banking group, has already established its own pooling vehicle in Luxemburg and so has Fondazione Cariplo, one of the most important Italian bank foundations. Others will follow. The government and the industry regulator Covip are therefore being forced to create a suitable environment to permit and promote such a development; otherwise Italian pension funds will remain excluded from developments in the global asset management industry.
Asset pooling may have other beneficial results for the Italian pension fund industry:A higher quality of custodian/settlement/back-office services offered to pension funds and therefore the possibility to engage in sophisticated, alternative asset management strategies, state-of-the art hedging techniques and derivative investments; and The introduction of suitable risk procedures and controls, introducing European best practice to Italy.
Another Italian concern is the lack of a clear governance of the investment process within pension funds. For example, it is not clear who is responsible for performance, whether it is the board of trustees of a pension fund that selects the asset managers or the selected asset managers. In addition, although in recent years the global asset management industry has become significantly more sophisticated, custodian and settlement service providers are delaying these changes and do not offer suitable technical assistance to pension funds. This exposes trustees to administrative risks, for example difficulties in accounting and settlement of derivatives or sophisticated financial instruments; almost no Italian pension fund is engaged in securities lending or commission recapture; no fund is adopting currency overlay strategies.
So given that the achievement of a better diversification of pension fund assets would deliver higher and more stable returns and that good pension fund returns will be key in promoting second pillar pension schemes across Italy, it could be fiduciary management that will play an important role for Italian pension funds. Within reasonable time frames, and just before other European pension fund may discover cross border appetite, Italian pension funds could enter from the front door into European and global developments in strategic asset allocation, efficient portfolio construction, asset diversification, professional investment performance and risk monitoring, even though the level of assets under management remain far below OECD averages.
Michael Atzwanger is the managing director of PensPlan, which is based in Bolzano, Italy