Strong equity markets gave Italy’s pension funds a shot in the arm last year but mounting concerns of a potential and sustained downturn in stocks, the prospect of further monetary tightening from the European Central Bank and recent pension reform will present the industry with numerous challenges in the months ahead.
Against such a backdrop, some market participants see value in shifting from a passive to a more aggressive investment stance - with alternative investments set to become the asset class of choice.
Although it is quite optimistic on the prospects for equities, particularly against bonds, the main focus of the pension fund of Deutsche Bank in the months to come in Italy is a planned shift into alternatives, explains Ferruccio Serale, one of the fund’s directors.
He explains that Deutsche will be much more focused on achieving returns that far outstrip the market: “We are looking to move from a beta model to alpha generation. And we will focus a little more on increasing exposure to alternative investments as a result.”
The Deutsche pension fund currently has around €250m in assets under management, and 22% of that is invested in hedge funds. Around half of the total assets under management are currently invested in money market instruments - interest rate securities of less than one year in maturity - and 4.5% is in bonds.
The balance is held largely in equities, some of which are in emerging markets. The fund’s targeted return for this year is Euribor plus 100 bps. The fund returned around 5% in the last financial year and is on track to deliver “around the same levels of return” this year, Serale says.
Alternative investments also loom large at Inarcassa, a first pillar pension fund for self-employed engineers and architects. The fund’s net return of 6% last year was largely thanks to a strong performance of alternatives - hedge funds, private equity, infrastructure and commodities. “Last year was a good year for alternatives and this year we will be investing more in high yield, emerging markets, and alternatives,” says Inarcassa finance director Antonio Falcone.
Fondo Enel meanwhile sees equity markets providing the foundations for good growth over the medium to longer term. Stefano Pighini, who is responsible for co-ordinating investment policy at the pension fund manager, says that, while equity markets had rallied to the pre-market crash levels of 2000, there is still room for growth.
“It is clear that it was at a high level in 1999/2000 but seven years have passed since then and the real economy shows a normal growth of 2-3% a year, so there is still come catching up to do,” he says.
Compared with other asset classes, equities are the only consistent performers over the longer term, he adds. “We give our members a choice between five different lines of investment: a monetary line, which is invested in the JP Morgan six month cash index so there is no risk to the capital; a balanced line with only 10% in shares, which is also very low risk; our main line, which is 30% equity and 70% bonds; a full balanced 50:50; and an equity line with more than 70% equity,” says Pighini. Last year the equity line generated returns of around 10%, balanced line returned 6.7-6.8% while its monetary line returned 2.8%, he adds.
Unicredit, another of Italy’s top 10 private pension fund managers, posted a return of around 7%, according to investment officer Cristina Clementelli.
The €1bn fund is primarily invested in real estate, which makes up 50% of its entire portfolio. Of the remainder, 30% is held in fixed income, 15% in equities and 5% in hedge funds. The fund is on track to repeat its 2006 performance in the current financial year Clementelli says, adding: “We don’t see a major strategy shift next year.”
Strong equity markets were the main driver for returns in 2006 at Fondenergia, the pension fund for the oil, energy, gas and water industries. Rallying stocks helped lift returns in the fund’s dynamic line to 7.06% and its balanced line to 4.65%. Its monetary line saw returns of 2.5%.
“Our results were mainly due to the equity side because in bonds we are invested more or less in all durations and our average portfolio duration is just over five years so we had a more or less zero result,” explains Fondenergia managing director Alessandro Stori.”And then we suffered a little from our exposure to non-euro currencies, especially the dollar, and that affected the dynamic investment line because it has 60% in equity, with a little less for the balanced investment line.”
Looking ahead, Stori sees the fund’s bond holdings providing a solid base for growth, with fixed income getting a boost from what he expects will be a fall in borrowing costs. Stocks meanwhile should see something of a correction, he maintains.
“For the future we hope that the cycle of higher investment rates will come to an end, let’s say somewhere around the end of this year and the beginning of next and to use the biggest part of our portfolio, which is invested in bonds, to provide us with a solid base of return given that the equity markets may not perform so well in the future.
“We see equity markets as being more of less valued correctly, historically speaking,” Stori adds.
As for strategic shifts, Fondenergia seems unlikely to make any major changes to the asset allocation within its three main investment lines. However, it will seek to place a greater emphasis on giving specialist mandates over balanced mandates, and look to “pick up more alpha” from its investment managers, Stori says.
But the financial markets will not be the only focus for Italy’s pension funds over the medium term as pension reform is set to remain a major blip on their radar screens.
Italy spends around 15% of its GDP on public retirement benefits, far above the EU average, with state pensions still far more generous than those in the rest of Europe. So as reforms go, recent changes to the pension system are not the radical shake-up that organisations like the OECD have been calling for. But they could prove to be a turning point for the country’s private pension industry.
The changes concern the workings of the TFR, a severance pay system for private sector workers whose origins date back to the 1930s. Private sector workers pay about 8% of their gross salaries into a severance fund held by their employer. The cash plus interest accrued would then be paid back in a lump sum when the employee left the firm.
However, under reforms passed by the previous centre-right government but implemented this year by the current centre-left administration, employees now have the option of transferring their TFR contributions into a privately managed pension fund. Tax incentives for both employer and employee are part of the package.
After a shaky start, the scheme slowly started to gain traction among both employers and employees. Unofficial estimates currently show that some two in five of all private sector workers - over 700,000 employees - have so far taken up options to move their severance fund into a pension, which potentially equates to around €7-8bn in additional annual inflows into Italy’s private pension sector - a significant amount in an industry whose total funds under management are equal to approximately 3% of the country’s GDP.
“The TFR reform is an important step in the development of private pension provision in Italy,” explains Marcello Marchese, a consultant with Watson Wyatt, Milan. “At the end of last year, less than 15% of private sector employees had private pensions but by the end of this year, taking the TFR transfers into account, that could rise to 30-40%.
“That could provide an additional€7bn of fresh money into the private pension sector.”
The key beneficiaries as far as the pension fund industry is concern will be sector-wide funds but open-ended funds and private funds will benefit too, he says. According to the government’s own estimates, just over a third of the €18.9bn paid into TFR accounts per year will flow through into employer-sponsored or private pension funds.
To be able to receive TFR contributions, Italian pension funds have had to put in place a new structure of investment options to offer prospective clients a choice between conservative, balanced or aggressive investment strategies.
At the same time, pension providers have also been required to create a default option that would match the returns generated by TFR funds - in effect a product that offers a capital and minimum yield guarantee.
The new business likely to result from the TFR reform should lead to greater product innovation and more specialised mandates within the defined contribution pension sector, according to Serale.
For his part, Serale will waste little time in taking advantage of the business boost the TFR reform could bring. He says the pension fund already has everything in place to set up new business lines designed specifically to take advantage of TFR inflows. “We are looking to open four new lines as quickly as possible following the release of the official data on the TFR take-up rate, which will be published in September,” he says.
“The four lines will range from cautious to growth-focused. One, for example, might be 70% bonds, 30% equity and another 30% equity and 70% bonds. Money market funds will also likely form part of the firm’s TFR-related product line.”
Pighini is also optimistic on the prospects for TFR-related business. He expects bumper growth in assets under management next year. Fondo Enel currently has around €500m in assets under management, but Pighini expects to grow that by up to €130m next year.
But while the TFR reform brings obvious opportunities, it also presents a number of tough challenges for Italy’s private pension industry, experts say. As an increasing number of Italians dip their toes into private pensions, it is inevitable that the sector’s participants will come under an unprecedented level of scrutiny.
Calls for radical change are sure to follow as the spotlight falls on practices - hitherto tolerated - that have no place in a highly developed private pension system.
In a white paper published earlier this year, Watson Wyatt warned that regulation of Italy’s private pension industry needed to be loosened and that “greater competition and transparency is needed” across the entire sector.