The Portuguese pension sector is undergoing changes. Since taking office in 2005, Prime Minister Jose Socrates’ government has tried to reduce one of Europe’s largest budget deficits by reducing pensions, raising the retirement age and withdrawing civil service benefits.

And in legislative changes to implement the EU pensions directive, which came into effect in late June this year, quantitative restrictions on pension fund investments were relaxed.

However, the two developments were not linked. “The replacement rate will fall with the reforms,” says Maria João Louro at Mercers in Lisbon. “The main variable will be an individual’s average career salary, so somebody with a high-flier career will get one result and somebody with an ordinary career will get another. These changes would lead to potential retirement pension reductions of at least 10%, so a significant reduction.”

But the government has failed to take steps to encourage the development of private pension provision to fill the gap between what people expect and what they will actually get.

“The general trend is towards an opening of the economy to private solutions, there are privatisations and private initiative is being given the possibility to be involved and is working in many sectors of the economy, but this is not happening in the social security area,” says Frederico Jorge at Watson Wyatt in Lisbon. “The government appears to only be able to think of government-owned alternatives to the current system.”

This attitude compounds an existing problem. Of the 200,000 or so companies registered in Portugal, only 1,000-2,000 have an occupational pension plan. Pension schemes have total assets in the region of €18bn, or 10-12% of GDP, but only 40% of this is in second pillar funds. The rest belongs to the pension funds of banks, which have their own pensions structure. So small Portuguese companies tend not to have pension funds and only about 15-20% of the large and medium companies do.

And overall the investment outlook tends to be conservative. “There are two main reasons for this,” says Pedro Costa, member of the board at Espirito Santo Activos Financeiros (ESAF), the asset management unit of Banco Espirito Santo that manages 35, mostly closed, pension funds.

“First is the regulatory situation. Until 28 June this year pension funds were not allowed to invest more than 55% of their portfolio in equities. And I’d say that no more than half-a-dozen Portuguese funds were close to this amount. The second reason is historical. Last year our funds had 25-30% in equities and that was pretty close to the average of the Portuguese pension market. But that was nevertheless an increase on the levels of close to 20% seen five years or so ago.”

ESAF services a variety of pension funds ranging from those for the Banco Espirito Santo, the Portuguese operation of BP and local utility EDP to smaller open-ended pension funds.

“Their performance has been quite good,” says Costa. “In 2006 the main positive driver for the performance of our funds was our equity allocation. Our average return for last year was 6-7%. And since the beginning of the year one of the more aggressive funds achieved a return of almost 20% while the others are close to 4-5%.”

“Last year we continued to be overweight in equities and underweight in bonds, the situation in bonds did not improve lat year compared with 2005,” says José Veiga Sarmento head of the pensions business at BPI Pensões, the pension fund manager of the BPI banking group and of 94 other companies at the end of 2006.

“We were more pro-European in 2006 than in 2005 when our position in US equities did not do so well. We ran an equity selection screen of thousands of funds and those that we chose posted very good results.”

BPI Pensões also runs both closed end and open end funds. “We have four open end funds that go from the most conservative class to the most aggressive in terms of equities,” says Sarmento. “The pension fund of the BPI group had an overall return of 14.36% and for the other clients it depended on the type of mandate, so we have different figures, ranging from more than 10% to the most conservative at 3-4%.”

But independent pensions manager SGF took a different approach. “Our best performance last year was in European real estate funds,” says SGF head José Santos Teixeira. “We are the only independent SGFP, all the others are 100% owned by banking groups.

“We are now exiting European real estate funds and changing to Asian property funds because the prices are too high in Europe. Similarly, we are looking for specialised Asian infrastructural funds. We have found some funds from Invesco in this area and we are also investing in Brazil.

“This year we are coming back to the US. We had been out of the US for the last four years - we underperformed there before the dollar fell and our return was zero both in bonds and equities. But we started again last year with some equities, which we have reinforced this year because we think the US economy is very strong and the dollar is now low. Our fixed income strategy is to try to avoid the effects of higher interest rates through short - three- to five-year - duration bonds and sterling treasury bills.”

“We think that the trend to a more diversified asset allocation will be important over the coming few years, and this will come with the change in the regulations,” says Costa.

“Clients will be increasingly concerned not to be so close to the benchmark and the law now gives more opportunities to cover a portfolio in more volatile markets. And I think that clients will be more demanding regarding the idea of absolute return.”

“The change at the end of June means there is no longer a threshold for pension fund investment in equities, they can go up to 100% if they want,” notes Sarmento. “And the limits for investing in hedge funds doubled to 10% from 5%. But we must still discuss with clients to check how much they want to change their investment policies, so for the moment we are not looking to make any dramatic moves in the coming period. But we can make the decision for BPI and we are now increasing our equity stakes to 60% of the portfolio.”

“We have been investing in alternatives since 2001,” says Costa. “We started with funds of hedge funds and two years ago we started to invest in commodities for both diversification and returns. And we are starting to invest in some currency overlay. As with commodities, the idea is to move to areas that we think could earn some money through a real diversification effect. In addition, we have increased our allocation to emerging markets, which was also a driver of our performance these last few years. We are doing this both directly in bonds and in equities, and we have some positions through funds.”