New regulation may go some way towards widening the investment possibilities for Spain’s pension funds, Iain Morse finds

After several delays, liberalisation of the investment restrictions on Spanish pension funds is promised in January 2008.

“The new regime, already applied to insurance companies, permits up to 30% investment in unlisted investments,” confirms Angel Martinez-Aldama, director general at the Spanish Association of Investment and Pension Funds (Inverco). Subject to meeting at any funding requirements, this means that a pension management company could invest 70% in listed equities and 30% in alternative investments such as private equity. “The new regulations will open opportunities for the alternative investment industry,” says Alberto Ruiz, principal at Madrid based Omega Capital. “The large pension funds are very interested in alternatives.”

This is big change for a country which 10 years ago had little or no pensions industry. “Change has been rapid,” adds Martinez-Aldama, who has just been appointed as chairman of the European Federation for Retirement Provision (EFRP). “But there is retrograde movement,” he adds. Spain retains a very generous system of state pensions. The current left-of-centre government has done nothing to dismantle this system, while reducing tax allowances on second and third pillar pensions. “Right now the state system is in surplus, but we know this cannot last,” says Martinez-Aldama. “History teaches us that only a funding crisis brings change.”

The state pension is the only source of retirement income for around half of Spain’s 8m retirees, and its preservation has become a major political issue. State pensions are generous, worth up to €32,000 per annum, and are funded on a pay-as-you-go basis. The state pension reserve fund, which opened in the early 1990s, is designed to pre-fund part of the cost of the system, and has current assets worth around €45bn. For the past couple of years there has been public debate about whether 10-15% of this should be invested in equities rather than in cash and bonds.

But with a parliamentary election due next March, no decision has been taken in the face of strong opposition from the right-of-centre People’s Party, which has condemned these plans as too risky. Meanwhile, the OECD has warned that Spain must develop “a more farsighted strategy” to deal with the consequences of an ageing population. Public spending will cost an estimated 7% of Spanish GDP by 2050. The response from the government has been to guarantee state pensions until 2036. In late 2006 labour minister Jesús Caldera told employers that current surpluses would last 10 years, after which the cost of maintaining the system would equal 0.5% of GDP. The current government has also been generous in raising the state pension in line with inflation. For 2006, this cost an additional €429m. Spanish law guarantees that state pensions increase in line with inflation.

Second and third pillar provision is often described in Spain as complementary to the state pension. “It is strongly conditioned by the state social security system,” says Jon Aldecoa, technical secretary of the Basque federation of provident mutual societies (EPSV). A process of reform and innovation started in the 1980s with the introduction of a legal framework for employer-sponsored and voluntary pension schemes. Prior to this, a handful of employers ran pre-funded, DB schemes while a larger number used book reserve funded pensions for employees. When book reserves were externalised in the late 1990s and early 2000s they were nearly always converted into DC plans. Employers with large pension schemes were typically banks, insurance companies or newly privatised utilities. “Almost all new pension plans since the 1990s are now drawn up on a DC basis,” adds Aldecoa.

There are about 8m DC members with some accrued contributions and 6m of them are making current contributions. Only about 1m employees are members of occupational schemes. Those accruing defined benefits are in a small minority. According to Inverco, they account for 3% of all active pensioners. “This is more surprising in a country with 14m salaried employees,” says Aldecoa. For those in employment, access to second and third pillar pension provision is either though a pension scheme or mutual provident society. Around 80% of second and third pillar contributors are in pension schemes. The employer usually finances occupational schemes, although members may be allowed to top-up the payments.

But these are not directly comparable to pension schemes run by boards of fiduciaries in the US, UK or Ireland. Instead, contributions are paid to an external pension management company with a separate custodian, under the overall control of a supervisory commission composed equally from the sponsor and relevant employee representatives. Off-the-record briefings from consultants and asset managers suggest that politics plays a strong part in influencing the trade unions. The pension management companies (PMCs) are run by Spanish regulated banks or insurance companies. One PMC can service the requirements of multiple employers or run an industry-wide scheme and a PMC is under no obligation to offer more than one fund to members. Investment returns are published net of expenses and performance benchmarking is not consistent, although the consultants collate peer group performance data.

According to Mercer’s investment consulting business, there has been rapid change in the average asset allocation of Spanish pension funds over the last 10 years. At the end of 1996 this was 92% in fixed income and cash, 7% in equities and 1% in other assets. By the end of 2006, fixed income and cash had declined to 58%, equity had risen to 37% and other assets to 2%. The new investment regulations will permit a far wider range of investments including credit, non-financial derivatives and non-harmonised collective investments. Not only will the regulations on investment into private equity be eased, but also those into exchange traded funds and structured investment products.

“This means that in theory a pension fund can be better diversified than in the past,” says Martinez-Aldama. Some of the larger funds already hedge portfolio and currency risks. A new law passed in 2006 permitted the establishment of hedge funds in Spain and some types of hedge fund are expected to be permitted to pension funds under the new regulations.

There are also over 400 pension schemes in Spain varying in size from less than 100 members to many thousands. Only six schemes have assets in excess of €1bn. The largest, Telefonica de España which run by Fonditel, has assets worth €€4.4bn, followed by the Caixa de Pensions Fond de Empleo, with assets of €3.7bn and Caja de Madrid with assets of €3.46bn.

After this the banking group BBVA has assets of €2.59bn, Caser Gestora de Fondos de Pensiones has€2.37bn and Endesa €2.29bn. Behind these sit a relatively small number of Spanish banks and insurance companies with an extraordinarily dominant position in the market.

The Spanish asset management industry as a whole has assets under management of approximately €262bn. The market is highly concentrated: of 95 asset management companies, five - Santander Gestion Activos, BBVA Gestion, Invercaixa Gestion and AhorroCorp Gestion - run 51% of the assets.

The sale of pension products, particularly individual plans, is commission-based and there are no independent financial advisers, only tied agents of one kind or another. Indeed, with the exception of the high-net-worth market, distribution of nearly all retail financial and pension products is through high street branches and tied agents. “I estimate that the banks have 95% of the market,” says David Burns, head of Schroders in Spain. This virtually obliges foreign asset managers to form a partnership with a bank that will distribute their products.

Spain is seen as a difficult market for non-domestic managers but this is less true now than in the past. Domestic banks and insurance companies may have control of distribution but some are the subsidiaries of foreign groups.

For instance, Aviva Spain has a pensions subsidiary, Aviva Vida y Pensiones, with its own chain of tied agents and brokers. However, Aviva also has joint ventures with five Spanish savings banks, Bancaja, Caixa Galicia, Caja Expanan, Caja Granada and Unicaja. Each of these joint ventures is a jointly owned subsidiary of Aviva and the relevant bank.

These banks are all ‘cajas’, effectively local mutual savings banks owned by members and communities and run on a non-profit basis. Schroder has similar agreements with local distributors. It currently has over 8,000 points of sale in Spain, most through high street branches of banks.

Many more foreign asset managers now have their SICAVs or other funds distributed via the domestic banks and insurers. Inverco does not have concrete data on the total market share for non-domestic managers although it estimates their market share to be up to 20% of the total. The reason for the uncertainty is that distributors are required to account for funds managed by third party asset managers and sold by their agents on a stand-alone basis but not if these same funds are sold through wrapped products such as pension plans or fund of funds. What is fairly certain is that foreign managers have a substantially larger market share than has been commonly believed.

Inverco wants to see the rules changed so that data on individual fund sales in wrapped products is separated out. When this happens it may cause an outcry among politicians and lobbyists intent on defending the domestic financial services industry. Understanding why a Spanish bank might distribute other managers’ funds depends on studying the bank’s core competence.

“They are very strong in Spanish equities and fixed interest, very strong in Latin America, but less so in other emerging markets, or the US and UK,” says Burns. Some of the very largest banks like BBVA and Santander offer their customers selective open architecture.

Core funds, both active and passive, will be managed by the bank’s own asset management division. Third party asset managers are invited to distribute funds in non-core areas like China, Asia-Pacific, Australasia, the UK and North America. Mid-sized savings banks, the cajas, some of which have no asset management capability, offer more genuinely open architecture and a far wider range of funds from third party managers.

The Personal Income Tax Act, which came into effect from the beginning of this year, reduced the tax contribution limits for companies sponsoring pension schemes and for members of these schemes.

Under the new system, total maximum annual contributions from both employer and member cannot exceed €10,000 or an amount equal to 30% of taxable income, whichever is lower, for employees aged 50 or less.

For older employees the maximum contribution is €12,500 or 50% of earnings. In addition, the law will revoke corporate tax rebates for employer contributions from 2011. Also, lump-sum withdrawals from DC pension plans are subject to a 40% tax, although this will only be charged on contributions made after 2007. This is intended to encourage use of annuities but in fact it may be seen as a disincentive to increased pension saving.

Neither is there going to be any relaxation of the current restrictions on the establishment of pension management companies. “The regime for UCITS III mutual funds is now quite open,” says Ingasi Puigdollers, head of investment consulting at Mercer. “But PMCs still require authorisation from the Spanish domestic regulator.”

Among the conditions to be met for PMC authorisation are capital adequacy requirements several times higher than those applying to a UCITS management company. Given the modest size of the Spanish market, meeting this condition remains a substantial barrier to entry.