Back to the drawing board?
The plan to co-opt the TFR to boost contributions into anaemic pension funds has failed to meet its target. George Coats examines why, and assesses what comes next
By the end of June last year Italian employees had to decide whether or not to allow their Trattamento di Fine Rapporto (TFR) to be paid into a pension fund on their behalf. The TFR is a portion of a salary that all Italian companies have traditionally kept on their books to give to their workers when they retire or leave for another job.
The initiative represented a rare example of consensus between the right and left wings of Italy's political spectrum to address the need to boost the country's fledgling second pillar. It came after several attempts since the early 1990s to bolster the sustainability of the pension system through a series of parametric reforms that have reduced the level of future state pensions.
However, the liberality of the state pension, even after the parametric reforms, has left it one of the major contributors to Italy's chronic debt problem.
Consequently, the idea of co-opting the TFR to provide a new stream of income to the second pillar was irresistible. The mathematics were compelling: the total assets under management in all forms of pension funds was around €50bn, or just 3% of GDP, while the annual new flow of the TFR was estimated by the Treasury at some €19bn.
And the mechanics of the plan to channel the TFR into pension funds were designed to exploit the inertia of employees through an auto-enrolment provision known as ‘silenzio assenso' or ‘silent consent', so that if in the six months to the end of June 2007 an employee had not refused, their TFR would be transferred to a pension fund.
The proposal was the brainchild of a centre-right government led by Silvio Berlusconi. It was coupled with an extension of the retirement age from 57 to 60 in one step with effect from the beginning of this year. The Berlusconi government then lost office but its Romano Prodi-led successor adopted the pension reform. However, it amended the timings, bringing the TFR measure forward a year from the Berlusconi team's intended start date of end-June 2008 and postponing the delay in the retirement age until 2011.
But they were good ideas so what could go wrong? Well, as markets and governments should always bear in mind, nemesis so often follows sharply on the heels of hubris.
In the event, only 23% of employees allowed their TFR to be transferred to a pension fund, meaning that 77% confounded the expectations placed in the silenzio assenso and actively said no to the pension funds.
"The authorities' declared goal was to get more or less 40% of the working population into pension funds," says Michael Atzwanger, managing director at Pens-Plan, a pension services provider in Italy's Trentino-Alto Adige region. "There was a substantial increase - the percentage more than doubled to 25% of the workforce, but the target was not reached."
"Of the more than 12m people who had the right to subscribe their TFR to a pension fund only 1m did, and this raised the membership of occupational pension funds to 2m," says Stefano Pighini, formerly head of pensions funds at energy giant Enel and now managing director of start-up consultancy Shap Corp. "So although the increase was significant the expectation was much, much higher."
Well what did go wrong?
"Bringing the implementation forward by a year meant it was done in a rush and not enough time was allowed to set up a proper communication campaign," notes Livio Mocenigo, (pictured left) managing consultant at Watson Wyatt in Milan. "This was important because the level of understanding of the pension system in Italy is generally very low. Then the details were not released in good time. The budget law with the framework was passed in late December, the six-month enrolment period started at the beginning of January but the final rules were only communicated in February."
"The fact that during this last year there has been a decrease in coverage provided by the state at retirement is not clear to most people," says Claudio Pinna, managing director of Hewitt in Italy. "They have the idea that if they work for 40 years, participating in all the national collective agreement programmes they are enrolled in, they will not need any additional supplementary coverage. But this is not true, and especially not true for categories that have been particularly affected by the parametric reforms - young people, middle management and executives."
"There is a significant number of very small companies in Italy," says Pighini. "A breakdown of the data shows that the larger funds reached around 80% of their target membership - Fopen reached about 85%, Fonchim reached 82% - while the percentage is much lower among those working in small companies, with commercial sector fund Fondati reaching 8.6%."
"The more successful funds had teams going around Italy talking to people in each company," says Andrea Canavesio, partner at Rome-based consultancy MangustaRisk. "A big fund can do it this but the smaller funds don't have the resources. But generally many more could have done a lot better in the field."
"People were contacted by their trade union," explains Guido Blasco, a veteran observer of the Italian pension scene. "But the commerce sector, where it was a flop, consists of small and medium-sized companies that are not unionised, so there was no marketing for the reforms."
"If it had not been brought forward, they could have used the period to the beginning of 2008 to really promote awareness, inform people with examples, explain why some people have a bigger problem than some others," adds Mocenigo. "For example, there was a huge problem with the atipici - those who work on a project basis, on short-term contracts with no guarantee of renewals or have different types of contractual agreements. Then there are those who have little money or have no pension environment because their employer is not sponsoring anything."
However, Canavesio is sceptical: "You know very well that in Italy all the work is always done in the last six months. And it is right to do so. It's useless to do the communication a year and a half in advance because people will forget. Honestly, I don't think that there would have been a very different result."
Nevertheless, if the timing might have been unfortunate what about the message? Well, there appear to have been problems here too. The Prodi government, a coalition spanning a broad spectrum from the centre to the radical left, sent mixed messages. "One of the incentives to pay the TFR to a pension fund is the interesting fiscal treatment of the benefits to be paid by a pension fund at retirement," says Pinna. "The minimum income tax rate is 23%, and for a manager it could be 43%, but the tax rate on benefits from pension funds is 15% in the first15 years of participation, after which it falls by 0.3% a year to 9% after 35 years. But in the middle of the period to decide whether to put the TFR into a pension, the then-social solidarity minister Paolo Ferrero, one of the leaders of the Communist Refoundation Party, declared that probably the fiscal treatment was too generous, especially for managers, and he demanded a review."
"I would say that politicians did not really understand what the changes were and how they had to communicate them," says Mocenigo. "The social security pension has been cut for those people who started working in 1996 but not a lot of people know how the pension will be calculated - it's a nightmare if you try to understand it and how much pension income it will deliver at retirement. And that's why people were scared to make a decision to commit what, at about 7% of a salary per year accrual, is an important part of their income."
"When I held seminars on the new legislation the usual question was ‘at the moment I pay less than €1,000 to the pension fund, so what will be the benefits?'," says Pinna. "You cannot answer that, you can just give some projections of a lump sum. But then they ask what will an annuity give. They know exactly what the TFR would give - the annual accrual and the revaluation, 75% of inflation plus 1.5%, and they can take the benefit as a lump sum without a problem."
"The network of financial planners, who want to sell alternative products, urged people not to go into a fund because they are mismanaged," says Mocenigo. "They noted that by law the trade unions must be represented on a fund's board but that they are not investment experts. There were divergent messages and a lot of scary things were said."
Indeed, for some the role of the trade unions in the pension funds was an issue.
"When the first reform was enacted it was decided to involve the trade unions in defining the new system," says Oreste Gallo, head of southern Europe for Barclays Global Investors. "It was basically the trade unions that negotiated the pension plan for the workers in the different sectors and as a consequence the system was very fragmented from its birth. This is very important from the end-user point of view because it increases the costs and reduces efficiency and the chances to access the most innovative solutions available in the market place."
But the employers are also represented on the boards and so have a share in running the pension funds? Well, not really. "The employers are not very involved," says Mocenigo. "These are DC schemes so employers don't carry any risk, it's not like in a DB situation where they would have financial and longevity risks so need to care abut how to invest the money. This it is a voluntary system, and when the employee chooses to join the employer has to match the contribution, but after that doesn't care about it. And employers do not want to have another point of argument with the unions. So the unions are very happy to run the show."
And there are hints of darker problems. Financial planners claimed that the unions just want to get hold of the money and that the members will never see it. And independent observers suggest that a key motivation for trade union support for the industry-wide pension funds is indeed a desire to exercise control over the assets rather than pursue the best returns for the members. They allege conflicts of interest, questionable investment decisions and a general lack of governance.
Industry players highlight another design fault. "When the TFR was with the employer there was the possibility to take 70% of the amount after eight years," says Mocenigo. "So the government agreed to give the same possibility to those who joined a pension fund. It had to do that to be able to demonstrate that whether you left the money with the employer or put it into the pension fund you would have the same access otherwise nobody would have accepted to move."
Pighini highlights another potential problem: "The pension reform gave people the right after eight years in a fund to take out 70% of their pension contributions accumulated to that point to buy a first house for themselves or their children, or for medical expenses and they can take out up to 30% for any reason at all. This is not just TFR money, it's any money they put in the pension funds. And since many of the funds started around the year 2000, they are seeing increasing demand. This will be the nightmare for the funds for the next six months.
"Another problem is that, when you transfer your TFR, you put it into an account that somehow has a guarantee. But the cost of the guarantee means you can never reach the same theoretical calculation of inflation used for the TFR. So today most of the funds give a yield that is lower than that which the TFR would have given, which was 75% of official inflation plus 1.5%, which these days means 3.5% a year. And the real cost of the money for small companies is double, so this is why the owner of a company tries to keep the money in the company for auto financing."
"In the mind of employees the return obtained by the pension funds will be compared with that given by the TFR and so although the benchmark given by the pension fund will be completely different, it is a still sort of benchmark for the money managers," says Pinna. But he doubts that people will respond to the current market downturn by withdrawing their money from pension funds. "Perhaps it's a reflection of the level of financial education but the approach of Italian employees does not depend on the financial aspects of the situation, it more on their specific personal situation. So as with the TFR, people ask for an advance because they need the money to buy something. They are more likely to respond to market conditions by switching to another line of investment within their fund, so from a more aggressive to a move conservative line."
But following the return of Berlusconi to office in this year's general election and his appointment of Maurizio Sacconi, a member of the team that drafted the last reform, as welfare minister, will the new administration pick up where it left off two years ago and attempt to revitalise the reform?
Last month Sacconi denounced the Prodi government's delay in extending the retirement age as "an onerous mistake" but signalled it would not be reversed. However, he has signalled that he would begin employing new coefficients or ratios through which pensions will be calculated as a function of contributions, from as early as this autumn, rather than 2010 as foreseen by Prodi's government.
But for Atzwanger the key question is how to get more members into pension funds. "Now government action is absolutely required to go on with efforts to boost pension fund membership," he says. "The problem is you can't just go back to the people who showed themselves to be strongly against the pension funds with the same marketing and communication strategy."
"I don't see anything happening any time soon," says Canavesio. "I recently attended a conference with pension funds, academics, trade unions and our regulator, Covip, where it was suggested that the legislation has changed too much over the last 15 years, it has changed every two years or so. Let's take it as it is, it could be better but it's not bad so let's make the most of it. Now is a period for analysing what happened. Some of our second pillar pension fund clients are assessing the motivations behind why people signed up to them. They are not looking at the TFR anymore, they are looking for other ways to convince people that second pillar pensions schemes are important."
But Covip is not giving up that easily. In an article in Italian financial newspaper Il Sole 24 Ore in May, Covip president Luigi Scimia, claimed that the 2007 result was satisfactory but that in 2008 the situation was worsening, with a reduced flow of new members because of the perception of the condition in the markets. He proposed a number of measures. He highlighted a need to further expand supplementary pensions within small and medium enterprises and to review the ETT taxation system applied to pension funds. And he mentioned that that people were not ready to opt to put their TFR into a pension fund because the choice is irreversible. His suggestion was that the possibility of somehow making it reversible should be explored.
"I don't believe this is the right way to go," says Mocenigo. "People tend to think short term. In the last couple of years the financial market went very bad, so if people had had the possibility to stop the TFR contribution they would have done so. They would have been scared to put more money in, which in fact they should be doing because, with the prospects that the market will pick up, this is a buying opportunity. What Covip said is debatable; I don't think there will be many advantages to changing the rules."
So what should the government do? "One of the options the government is considering is making the payment of the TFR compulsory," says Pinna. "Another necessary change is to eliminate the 11% tax on pension fund investment returns which is driving several companies, especially multinationals, to consider enrolling their employees in a pension fund domiciled in another European country.
"The problem will come in 10 years' time when the baby boomers are retired on pensions that are dropping quite significantly," says Pighini. "So the next two governments will not have to face this but it will happen after that. The initial reform, the Amato reform of 1993, foresaw the 17% of GDP weight of pensions spending and a strong reform then could have defused this problem. But instead it took 15 years."
"Politicians are underestimating the impact of this cost, because it is costing an arm and a leg," says Mocenigo. "Going forward I don't see any light at the end of the tunnel for the pension system."