Italy: Still waiting
Nina Roehrbein notes potential interest in emerging markets and declining exposure to domestic government debt among Italy’s occupational pension funds
After two months of political deadlock, Italy finally agreed to a grand coalition government in late April under prime minister Enrico Letta. The stalemate that started after inconclusive elections in February could have also been reflective of the Italy’s second pillar pension system over the last few years.
While plenty of reforms were introduced for the first pillar under the previous technocratic government of Mario Monti, the pension industry is still waiting for similar action in the second pillar. “The Monti government substantially increased the retirement age eventually to 67-69 years, thereby improving the long-term stability of the first pillar,” says Ambrogio Rinaldi, central director at Italy’s pension supervisor COVIP. “The already high pension expenditure of around 16% of GDP will therefore stabilise at an estimated 14-15% of GDP, which is considered sustainable in terms of the budget deficit. But this left little room for developments of the second and third pillar. There have been proposals to move some of the 33% salary contribution from the first pillar to the second but that would reduce the money going into the public purse, which Italy is not able to do at the moment.”
Renato Guerriero, head of the Italian Branch at Dexia Asset Management, notes: “The expectations for reforms of the second pillar are much lower for this new government than for the Monti government where welfare minister Elsa Fornero drove many of the first pillar reforms.”
Leading the way in the wait for reforms is the review of decree 703/96. In its current form the decree limits investment options for Italy’s second pillar pensions, including the pre-existing funds that were founded before the 1993 reform.
Industry players already expected a new version of the decree to come into force last year.
It is currently pending approval. But its publication is believed to be imminent after it was cleared by COVIP.
Pension funds performed well during the financial crisis, partly because of the investment limitations of the 703/96 decree.
“However, a review is long overdue,” says Michele Boccia, head of institutional clients for Eurizon Capital. “When enacted, the new decree should allow for more flexibility in investments, especially for pension funds with a sound control and finance structure.”
Marco Fusco, head of southern Europe at State Street Global Advisors, says: “All pension funds and asset managers want the new 703 article to be approved because it is going to allow pension funds to diversify their exposure a lot more effectively than they are able to do today. The article requires them to invest in OECD countries only, which is very limiting in today’s global environment, and severely limits investments into less liquid asset classes such as alternatives.”
However, the final version of the decree is unlikely to be a free-for-all – instead limits are expected to be broader and replaced with a more qualitative framework, according to Alessandra Pasquoni, head of investment at Towers Watson in Milan.
Interest in emerging markets
Though the revised version of decree 703 is eagerly anticipated, few market participants expect it to significantly change the asset allocation of Italian pension funds. The main difference is expected to be in emerging markets, to which exposure is significantly restricted.
“Some consultants have already been pitching emerging markets in Italy,” says Francesca Ciceri, head of wholesale and institutional distribution for Italy and Greece at Pioneer Investments. “They were trying to anticipate the new law so that when it comes into force they can immediately introduce the asset class in their clients’ benchmarks.”
Guerriero believes that only a minority of pension funds will take advantage of an enlarged investment universe because of the control of the underlyings and look-through principles required by the regulator.
“The Italian pension market – although growing – continues to suffer from a size issue compared to other European pension markets,” he says. “It is difficult for a pension fund with €800m under management to opt for segregated mandates, so in order to invest in alternative strategies, they have to use commingled instruments, which tend to lack the full visibility required. In addition, alternative investments such as private equity are relatively expensive given the regulatory constraints, which is why it is difficult to imagine a surge into alternatives by pension funds.”
According to COVIP, returns on investments by pension funds were good in 2012, despite the relatively conservative asset allocation.
“Pension funds have not taken advantage of the alternative investment opportunities that they already have – however, the supply of investment opportunities, in particular for Italian private equity, is quite limited,” says Rinaldi. “Any slight increase in equities in 2012 was a result of the rise in share prices.”
According to Fusco, a typical asset allocation among Italian pension funds today is 70/30 in favour of bonds.
“We continue to see a lot of balanced mandates although some pension funds have been moving into more specialised types of approach,” he says. “However, this has been limited. Asset classes such as emerging markets, commodities, real estate, infrastructure, especially the most illiquid of asset classes tend to be ignored.”
Pasquoni says: “Many second pillar pension funds have limited exposure to alternative assets partly because of legislation rules but also because members can withdraw up to 30% of their capital whenever they need it, adding unwanted portfolio management complexity for governance-constrained funds.”
On top of that, the selection of investment lines remains in the hands of the employees who have tended to opt for a low-risk investment lines with a heavy exposure to government and corporate bonds.
But Claudio Pinna, managing director at Aon Hewitt in Rome, believes investment lines with real estate might prove attractive to members. Since around 80% of the population owns property, the reasoning is that they will be able to relate to it.
Domestic debt reigns supreme
Movements in asset allocation have been few and far between in recent years. Government bond exposure is high, especially in guaranteed lines, which are usually managed by insurance companies.
“Italian equities make up on average only 3% of the overall equity investments by second pillar pension funds, which is why home bias is mainly displayed in sovereign bonds and some corporate bonds,” says Andrea Canavesio, partner and director of consultancy MangustaRisk. “Those bonds suffered in 2011 but have been rallying again since 2012.”
There are many more RFPs requesting low volatility or tracking-error mandates, according to Guerriero. “But the reality is that balanced mandates do still represent more than half of the mandates,” he says. “Occupational pension funds today have approximately 250 mandates, of which over 140 are balanced. Investments in real estate and private equity have remained marginal so far.”
However, because of the crisis in Europe, many pension funds aim to leave their euro-centric past behind and diversify their fixed income allocation more globally.
Guerriero says Italian sovereign debt has given way to more exposure to government debt of core European countries – pan-European government indices – or investment-grade corporate bonds.
“The issues related to the Italian debt crisis have been quite a problem for some pension funds,” says Guerriero. “The majority of them decided to put in place measures to ensure that the exposure to Italian debt does not exceed a certain percentage above the weight of some of the benchmarks. Italy represents roughly around 20% of the euro-zone debt benchmark, which is why most pension funds did not want to exceed 30%. Others have chosen to take a different stance and put an overall limit on issuers. Still more pension funds decided to adopt investment-grade bond benchmarks and a minority decided not to do anything at all.
“We have always been diversified, we even took some exposure to other OECD countries that issue in euro and have strong fundamentals, such as Poland. We also invested in bonds issued by the EU or the European Financial Stability Facility (EFSF), in other words diversified into sub-sovereign or international agencies. Equities, however, have remained a subdued asset class and few pension funds like non-traditional cap-weighted indices, such as smart beta indices, which Dexia AM suggests.”
Appetite for diversification
The proportion of Italian sovereign bonds relative to overall fixed income investment dropped from 36% in 2010 to 29% in 2011, according to Luigi Ballanti, general manager at MEFOP, the association for the development of the Italian pension funds market. “However, it is impossible to determine how much of this drop is down to divestments and how much is due to increasing interest rates,” he says.
Corporate investments and mutual funds accounted for 10% and 15% of invested assets respectively in 2011. Equities made up 15%, in line with previous years. The effective exposure on equity, held directly and through mutual funds, was equal to 20%.
MangustaRisk advised a change in the asset allocation of the closed fund for mechanical workers Cometa in 2009 to include real estate, private equity, commodities, and inflation-linked bonds.
“Due to its internal regulations, Cometa was only able to invest in certain new asset classes,” says Canavesio. “But many pension funds are now looking at changing their internal bylaws in order to be able to fully invest in all the asset classes they are already allowed to invest in. Closed funds, for example, are allowed to invest in real estate and private equity, but their bylaws have restrained them from doing so.
“One of the main problems with these asset classes is that a lot of pension funds do not feel comfortable with the different types of risks they come with, such as illiquidity risk, despite the possible attractive returns. In addition, their management fees are higher than the ones pension funds were used to paying until now. However, because they have limited their costs so far they have the opportunity to move into these asset classes.”
Other pension funds are also talking about moving into other asset classes. “The interest in alternatives is increasing,” says Ballanti. “In 2012, the first occupational pension fund, Eurofer, started real estate investments. Alternatives, mainly real estate, are widely used by pre-existing pension funds and because of this as a whole account for 6% of invested assets.”
Canavesio adds: “New asset classes should help stabilise and even increase returns, so it is extremely important to include them. Returns are crucial, as they are always compared to the return of the severance pay, the TFR, which is 75% of inflation plus a fixed rate of 1.5% per year.”
Regulatory and governance changes
With changes in asset allocation expected to be slow even if the new 703 decree is published soon, last year’s COVIP regulations have had a bigger impact on Italian pension funds.
In 2012, the supervisor required all pension funds to strengthen their internal structures, particularly regarding finance and control functions, and to issue investment documents that clearly communicate the risk and return objectives of the different investment lines offered.
The new rules meant that all pension funds are on course for a sophisticated risk-management strategy and a clear governance process.
The statement of investment principles and evidence of a financial office for the largest pension funds was received at the end of 2012. COVIP is reviewing them at present.
“From the submissions we have received, we believe that the new rules will contribute to better governance of the investment process,” says Rinaldi. “But the process has just started and smaller pension funds have until the end of this year to submit their statement of investment principles. At that point the picture will be more complete and we may offer some guidance on what we believe could be improved. Better governance should clarify pension fund responsibilities and ease communication with members, stakeholders and trade unions.”
Some pension funds have decided to outsource functions, for example risk management and auditing to local financial advisers, to keep costs under control.
And as a result of the new COVIP regulations, custodian banks will take greater responsibility, as pension funds will require their support to produce more transparent financial reporting and control systems.
“Depositary banks played an important role for the Italian pension funds market even before the COVIP regulations of 2012 because they provide the checks on eligible-asset regulation,” says Ballanti.
But there are few depositary banks in the market. “Not all pension funds have a custodian bank,” says Pinna. “Most of the first pillar funds for professionals, the casse di previdenza, for example, do not have them. Pension funds in a similar situation struggle with collecting all the information related to their assets in order to monitor the risk of the investment.”
The casse di previdenza came under COVIP’s supervision in 2012.
“It became evident that some kind of prudential supervision was needed for the casse di previdenza, although they are part of the first pillar,” says Rinaldi. “In the past, they lacked specialised control on their investment decisions, resulting in some controversial actions, which is why they were moved to the same prudential supervision that is in place for pension funds. But some responsibility for them still lies with the ministry, as COVIP only has the operative power to control their investments, not the power to impose changes, for example, in benefits or to check their long-term equilibrium.”
In 2012, on the initiative of the then welfare minster Fornero, the casse di previdenza were tested to determine their 50-year financial sustainability.
Many of them changed from defined benefit to defined contribution. The first to change was commercialisti, the pension fund of the statutory auditors.
“Based on these strong reforms and after presenting a projection of their situation in 50 years’ time, it seems that the funded status of these pension funds is stable and they are funded for the long term,” says Pinna. “The characteristics of the plans did not change but they changed the rules regarding their guaranteed benefits by linking them to contribution.”
Guerriero says: “In terms of asset allocation, most casse di previdenza have done well in diversifying their assets, compared to their past where they would almost only hold Italian securities. This was helped by the fact that they were not directly regulated by the 703 decree, which allowed them to allocate to emerging markets and, in particular, debt. They also tried to align their assets with their liabilities. The largest ones have separated alpha from beta and taken a lot of exposure to passive funds or mandates.”
Where will growth come from?
Altogether, pension fund assets made up €104bn at the end of 2012. The casse di previdenza made up an additional €51bn, according to COVIP.
But while the market may be growing in terms of assets, one major reform issue that refuses to go away is the stagnation in membership of the second pillar. At the end of 2012, 5.8m people were part of the second pillar pension system.
“The second pillar accounts for just 20% of the potential membership so 80% of workers in the country either do not have pensions savings or have third pillar savings,” says Alberto Salato, head of institutional client business at BlackRock in Milan. “Together with the casse di previdenza, second pillar pension assets make up about 10% of Italian GDP, compared to 65-70% in the UK and over 100% in the Netherlands, meaning the system urgently needs to grow to cover the future liability of our population.”
In 2012, overall new memberships increased by 6%. However, the gain stemmed from personal pension saving schemes. In fact, occupational pension scheme membership decreased by 1.2%, while open pension funds and insurance contracts grew 3.7% and 22.2% respectively. This asymmetry could be explained by the well-established commercial network of banks and insurance companies, while trade union membership is still irregular, says Ballanti.
Pinna expected an increase in the number of second pillar members after the 2011 reforms when it became clearer that state pensions would be lower than anticipated in the future. But the number remained flat.
“Pension funds need to prove their credibility with employees because all of them will need additional pensions coverage to what they will get from social security,” says Pinna.
Canavesio agrees: “The recession has been putting families in difficulties with regard to savings in general and therefore also second pillar pension schemes. People have been withdrawing their pension savings, meaning that there has been a lot of drainage from the second pillar. New contributions have also ground to a halt.”
One proposal in the labour market reform by minister Fornero suggested that companies should be allowed to terminate employment four years ahead of the official social security retirement age or to move them into part-time work. “This is why the government, employers and unions are thinking about allowing earlier access to second pillar pensions and use the annuity to bridge the income gap until employees qualify for a full state pension,” says Pinna.
“Some employers in the Lombardy and Veneto regions already offer their workers aged 62 and above to work part-time and to cash in the annuity of their pension savings,” adds Guerriero. “This could make second pillar pensions more attractive to the rest of the working population. There has also been a lot of discussion on how pension funds can provide services to members that go beyond annuities, such as the integration of insurance policies for long-term care, death of members or health issues to provide a one-stop-shop for welfare.”
But unless there is a national effort to promote second pillar pensions, it is going to be increasingly difficult to attract new members, according to Canavesio. “The only other solution then is to make the second pillar compulsory for everyone through auto-enrolment,” he says.