Italy's pension market is experiencing a period of significant change in the wake of government reforms enacted at the end of 2011. Armando Piccinno discusses the ramifications
Aimed at reducing the expense of Italian public pensions, Italy's pension reforms include a policy of mandatory defined contribution (DC) for all employees, along with a rapid increase in the retirement age curve. Clearly, there is an urgent need for effective governance models to ensure that these reforms - including regulatory changes for investment restrictions - truly benefit Italy's employees and their families.
A basic overview of Italy's pension landscape reveals a second-pillar pension market worth approximately €94bn, of which €44bn (47%) resides in ‘pre-existing' pension schemes set-up before the pension reforms of 1993; about €27bn (29%) in industry-wide pension schemes - in theory the segment that should offer a valid alternative to public pensions - and €23bn (24%) in schemes sponsored by insurance and financial intermediaries.
This framework is not encouraging, especially when we consider the core component of the second pillar market. Simply described, this segment is not growing as it should; in the past three years, industry schemes suffered a reduction in the number of participants which now represent less than 25% of all potential members. In addition - and ever since its inception - this segment has significantly underperformed the TFR (a severance payment accrued with a fixed formula that takes into account inflation), which, as union representatives frequently point out, is the de facto benchmark for the second pillar market.
Restrictions and governance
It is within this context that Italy's ministry of economy and labour recently opened a public consultation on the new law regarding investment restrictions for pension schemes (which mirrors a proposed law from 2008 that did not withstand the political headwinds of that time). The current law on investment restrictions dates back to 1996 and is thoroughly outmoded, concentrating as it does on a rules-based approach with quantitative limitations on different asset classes. This has prevented schemes from effectively diversifying their asset mixes in recent years - excluding, for example, investments in emerging markets.
The draft of the new law is aligned to the needs of a sophisticated pension investor, and is based on the prudent person principles. As such, it slashes almost all the quantitative limits, allowing pension schemes to broaden their investing universe upon evidence of adequate internal professional skills, mainly in the area of risk management and decision-making processes.
This is a major and beneficial change for the industry. For the first time, the pension regulator (COVIP) has put a clear focus on internal structure and processes, with a strong emphasis on a qualitative approach to investments a best practice across the wider pension market. Indeed, in our opinion there is no effective investment policy without effective governance. But how many pension schemes are already compliant under these new rules? When looking industry-wide, we believe only a few.
That is because adherence to pre-defined investment limits under the old law has prevented many schemes from adopting effective internal structures; the result has been a herd mentality, with almost all schemes relying on the same investment structure. But shifting the focus to internal risk management (instead of simple risk monitoring), effective processes and a qualitative approach will require adequate investments that, in our opinion, may be difficult to put in place in the current climate of falling participation rates. Consider the issue of manager selection. Will a local quantitative approach, utilising local investment consultants, be effective in assessing the idea generation process of an emerging market debt investment team?
Scenarios for scheme effectiveness
In light of all this, what action should be taken by pension schemes? With the top five multi-employer schemes responsible for about 54% of total assets and only six schemes with AUM in excess of €1bn, we do not believe that one size fits all, but that three main scenarios are possible:
• Integration of small schemes, merging in an attempt to optimise economies of scale and gain access to more value-added services. This scenario may be the most suitable for small-scheme members; however, it may prove to be the least attainable due to internal conflicts within the unions that play such an important role in the schemes;
• Large schemes adopt a best practice strategy, effectively diversifying asset allocation and adopting a risk-based qualitative approach, while the rest of the market muddles through, interpreting the principles and complying via a ‘copy-and-paste' approach. Unfortunately, we see this as the most likely scenario and fear it could lead to significantly different pension outcomes fuelled by a divergence of investment returns. Therefore, COVIP will have to be active in its oversight and regulation of pension schemes;
• No integration phase, with smaller schemes adopting different investment approaches to comply with the new law, embracing a delegation model through fiduciary management. We assign this scenario a mid-range-probability.
It is important to note changes to first-pillar schemes for the self-employed - the so-called cassa segment - with AUM in excess of €50bn. It is now under the regulatory purview of COVIP and it is likely that the new law on investment restrictions will soon be applicable to this sector. In addition, governance issues within the cassa segment are more challenging in light of the call for long-term sustainability that the ministry of labour made a few months ago.
The cassa segment, many of whose funds are defined benefit or hybrid schemes, needs to prove its sustainability over the next 50 years through actuarial valuations, otherwise it will have to turn to DC on a pro-rata basis. Despite the relatively short notice period, this will encourage these funds to focus on best practice, with a resulting flight to quality, and international advisers. This is true in areas of investment advice where recent scandals have borne witness to all the limits and pitfalls of local approaches.
Costs, limits, conflicts
Another aspect of Italy's pension reform is related to costs. The draft law declares that, within an effective pension management structure, costs should be carefully managed and aligned with the size and quality of services received. We believe this is a best practice principle; however, many schemes have gone wrong in their attempts at minimising - rather than optimising - the cost structure.
Would the industry-wide schemes have outperformed the TFR in the last 12 years if they had selected those asset managers that were priced out of the market due to the low management-fee mentality? Will new members be more attracted by the lowest cost available in the pension marketplace or by an appealing risk-return at an adequate cost? The same applies to operational aspects. We recently conducted an analysis on the explicit costs of a custodian arrangement and we discovered that the fees were exceptionally low. But what about the implicit costs? Will the relatively high management turnover recently pointed out by COVIP be a catalyst for action? These are questions that need further exploration.
Meanwhile, the draft decree contains quantitative limits that are fairly reasonable. For instance, a pension scheme cannot invest more than 30% of assets in financial instruments non-exchanged on regulated markets; can only use derivatives for efficient portfolio management and risk reduction; cannot adopt short selling (even though short selling may be an effective tool for asset managers with skills in the non-traditional asset classes); can invest in closed and alternative funds within conservative limits; can invest in funds related to commodities within a limit of 5%; and can have currency exposure within a limit of 30%.
The last section of the draft decree addresses conflict-of-interest policy, which needs to be formalised and managed by scheme trustees. But do trustees have enough knowledge? It might be more prudent to have independent experts assess the effectiveness of any policy on conflicts. While we strongly agree with the ban on asset managers and custodians having managing roles in the schemes, why not broaden this to include investment consultants? This would put an end to some sub-optimal approaches.
Ultimately, Italy's ambitious efforts at pension reform have the potential for vast improvement of an unwieldy and entrenched pension system. But the key to success lies in a best-practice approach to governance, internal structures, investment processes and management. For much of Italy's first and second-pillar pension market, adapting to change and complying with complex regulations will be difficult; but with expert guidance and renewed commitment to the pensions industry, solutions will be found.
Armando Piccinno is a senior associate with Mercer's investments & retirement business