First-pillar reforms and proposals to change investment rules for second-pillar funds represent a step change for Italian companies and pension funds. But they have not been matched by a commitment to support supplementary pensions as a whole, finds Nina Röhrbein

When Italy's new government under prime minister Mario Monti took over from the Berlusconi administration in 2011, a wind of change started to blow.

Having to make deep budget cuts in areas of government expenditure, the country's social security system, famous for its generous provision, underwent a radical transformation.

The state pension system moved to a notional defined contribution (NDC) system, similar to that of Sweden. Any state benefits paid out to citizens are now based on the contributions they put into the system.

The NDC system was introduced in 1995 for new employees and those with less than 18 years of contributions. But the new reform has extended the system to all workers.
Besides the faster transition to the NDC system, the main elements of the reform, which came into force in January 2012, are the alignment of the retirement age of women to that of men, which stands at 66 for both from 1 January 2012 and the automatic indexation of the retirement age in line with improvements in life expectancy starting with three months from 2013.

Depending on data to be published by the Italian statistical agency, a further increase of at least three months will be added in 2016. From 2019, the adjustment will be made every two years. Seniority pensions, which are based on the number of years of contributions, will be limited and their contribution period indexed to life expectancy. Pension contributions for the self-employed will increase from 20% to 24%, while the price indexation for current pensions of more than three times the minimum pension is temporarily suspended.

"It is a new world for employees and companies," says Claudio Pinna, managing director at Aon Hewitt in Rome. "Employees will need to learn how to make appropriate savings and monitor their pension coverage. Companies will have to introduce specific instruments in order to manage an older workforce in the future."

In addition, the ministry of labour is reviewing the financial stability of independent first pillar funds, the casse di previdenza, which provide pensions to specific professions such as doctors, lawyers and accountants and have around €60bn in assets under management.

"If they do not demonstrate sufficient long-term financial stability they may be forced to shift to DC schemes," says Michele Boccia, head of institutional clients at Eurizon Capital.

"But as almost all of these funds have a more favourable formula than the one applied in the social security they will try to retain their autonomy," says Piero Marchettini, managing partner of Adelaide Consulting. "To do that, it is crucial they manage their assets properly. They can start this by reducing their real estate holdings because for many years their assets were mismanaged with plenty of conflicts of interest occurring, sometimes even involving bribes paid to or by their advisers, mainly in their real estate but also in their other financial investments."

Results of the review are expected by the end of September.

COVIP, the regulator, introduced further regulations in March. The most important one, according to Luigi Ballanti, director at the Company for the Development of the Italian Pension Fund Market (MEFOP), is the provision of a financial office to support the board of the pension fund in the different phases of the investment process such as strategic asset allocation, selection of asset managers and risk management. Furthermore, a statement of investment principles is required of all pension funds with more than 1,000 members by the end of 2012, while for those with fewer members the requirement has been postponed until the end of 2013.

Severance pay, the trattamento di fine raporto (TFR), has also been discussed.
The last pension reform in 2005 introduced the ‘silent agreement' principle for the TFR, meaning if employees not actively choose to leave the TFR with their employer, it was moved to a pension fund. However, nobody foresaw that employees would promptly elect to leave the TFR with their employers, which had an impact on the amount of TFR expected to be transferred to pension funds.

The main reason why Italian employees have been reluctant to transfer the TFR into second pillar pension funds, according to Marchettini, is that pension funds have so far failed to produce better returns than the TFR with its formula of 75% of inflation plus 1.5% fixed interest. "With a 2% inflation, this gives a 3% net annual return over 10 years," he says. "Few second pillar pension funds have a 10-year history and the ones that do have not been able to guarantee a better return than the TFR over that period taking costs and fees into accounts."

All employees can receive some of their benefits in advance to cover house purchases or medical bills. Initially this only applied to the TFR before it widened to general pension benefits.

"Requests for this type of advance have become more frequently since the economic crisis," says Pinna. "This has had a direct impact on the asset allocation of pension funds who have had to invest more short-term to cover such potential outflows. But advance payouts have now come under fire. People will have to realise they will have to use pension funds as a source of funding their post-retirement income."

The ministry of economy has also produced a new draft regulation of the investment rules, the old 703/96 decree, which was under consultation until 29 June 2012. It provides new and less restrictive rules on eligible assets.

Its few remaining limits concern direct fund investments, commodities and investments in non-euro currencies.

"The draft entails a move from a quantitative approach with plenty of investment restrictions to a prudent person principle," says Andrea Scaffidi, retirement senior consultant at Towers Watson in Italy. "This law would finally allow the new pension funds introduced after the 1993 reform to invest in alternatives such as private equity, hedge funds, commodities and real estate. But for investments in such asset classes, the governance would also have to be reinforced because mandates would become more complex."

Under current legislation, occupational pension funds and open pension funds could within certain limits already invest in real estate or private equity. "But nobody took advantage of that except for the pre-existing pension funds," says Ballanti.

"In several cases the pre-existing pension funds are trying to reduce their investment in real estate and possibly convert it from direct investments to investments through collective instruments," adds Ambrogio Rinaldi, general director at Italy's pension supervisor COVIP. "The situation is different for the new pension funds, which currently have zero investment in real estate."

"The new 703/96 law is opening up opportunities," says Francesca Ciceri, head of wholesale and institutional distribution at Pioneer Investments Italy. "Since 1996, we have been operating in a restrictive asset allocation universe and not been able to exploit new opportunities. Now this universe has opened up we can look for new alpha sources."

Through the Association of Italian asset managers, Assogestioni, Pioneer Investments is working together with the legislator to further clarify the new decree - for example emerging markets and leverage are not mentioned in the new law - as well as pension fund governance. The pension fund industry has 18 months to adjust after the law comes into force. In that time, Pioneer Investments aims to work with other fund managers, boards of directors and consultants on new investments and benchmarks.

"If we wanted to apply the new rules today, we would not be able to because we manage money under clear benchmark limits that exclude, for example, emerging markets and commodities," says Ciceri. "In short, before the investment phase can start, the industry will need to adjust to it."

As of now, sovereign bonds remain the most important asset class for Italian pension funds, accounting for 62% of all occupational pension funds assets in 2011. But due to the Italian downgrade, the average exposure to domestic sovereigns by new pension funds fell from 36.2% to 28.9% between 2010 to 2011, while investments in other euro-zone bonds rose from 32.1% to 41.7%, according to Ballanti.

The large exposure to Italian treasury bonds in combination with mark-to-market valuation has resulted in low or negative returns over the past year, according to Marchettini. "This is why they have to address diversification," he says. "But while they face significant risk from keeping a large share of their investment in Italian government bonds, there is political pressure on them to keep that exposure despite the greater freedom of investment."

While new investment rules could indeed spur the move away from fixed income to other asset classes, in the end, the asset allocation remains in the hands of the employee who is able to select his preferred, generally conservative, investment line, or is defaulted into guaranteed lines. And, more broadly, the lack of measures to support the second pillar is also a concern.