‘Spain”, ran the slogan for an international tourism campaign, “is different”. And when it comes to pensions this is clearly true.

While governments elsewhere in Europe have been trying to find ways to encourage people to make their own pension provision and so take some of the pressure off overstretched state systems, or at least trying not to discourage them from doing so, new Spanish tax legislation that came into effect at the beginning of this year reduced the tax incentives on combined employee/employer contributions.

“The fiscal advantages that pension plans had has been diluted or even disappeared compared with other forms of savings,” says Valentin Fernandez, strategy director and responsible for institutional investor relations at Fonditel, the pension fund of Telefonica de España. “So there is no incentive for long-term savings like we had in the past. That poses a major problem in terms of increasing the business, not only for us but for the whole industry.”

And the industry needs all the help it can get. “Some 70% of the total working population is employed by medium and small companies, most of which will not have a pension fund for their employees at all,” adds Fernandez.

“This certainly does not help at all,” agrees Juan Costales, CIO at CASER, an insurer and pension fund management company that co-operates with the Cajas de Ahorro savings banks. “The state is creating problems for second and third pillar funds. It does not help the industry’s development if we see that regulations change whenever the government changes, so every four or eight years. And changing the tax legislation can create confusion about what the tax treatment might be after 10 years or so when somebody retires. The government understands that we will have to face a problem of increasing longevity but there is not a national consensus between the two big parties on how to tackle it.”

The new law attempts to encourage the purchase of annuities by removing the 40% employee’s tax deduction on lump-sum retirement benefits, but this has yet to have an impact. “The government has put different financial tools in place and is trying to encourage the financial sector to put products into the market that can make up for previous miscalculations of the mortality rate,” says Costales. “And it says that, because it is in Spanish culture to own one’s home rather than rent it, people have enough savings so have an annuity for the rest of their life so we have to bring instruments onto the market to give an income. But there are people who say ‘it’s my house and I should decide what I do with it’ so this is a difficult situation.”

In addition, banks and insurers are being encouraged to offer long-term individual systematic savings plans, the planes individuales de ahorro sistemático (PIAS), to supplement pension savings. But PIAS contributions will have no tax incentives and may not exceed €8,000 per year.

“While they do not have such good tax implications for investors, they have wider investment possibilities and the ability to invest in illiquid investments,” says Alberto Ruiz, a partner at Madrid-based consultancy AFI.

“Tax incentives are the main reason people put money into the pension fund system so we have not yet seen much PIAS in the market,” says Costales. “But the pension industry is driven by the large banks so whether the PAIS will be a successful vehicle or not depends on whether the big players think it is a good product in terms of commissions. Only if they think so will they promote it because you have to push products into the market.”

But the main focus of the pensions industry is investment regulation. “We have had new regulations for insurers, mutual finds and asset managers and we are waiting for a new regulation for pension funds by the end of this year,” says Ruiz. “The main players are working on draft regulations on assets that can be invested in pension fund portfolios. The authorities don’t want to have any problems with pension fund members and so there is a very clear bias towards liquid investments and this makes it very hard to construct a strategy. Pension funds have daily NAV, so they have to juggle with the requirements of daily liquidity and a long-term horizon. How can you deal with illiquid investments when the first promise you make to pension fund investors is daily liquidity?”

A key issue here is alternatives. “Private equity and hedge funds are not liquid investments so the issue is what percentage will the regulator allow them to invest in,” adds Ruiz. “We expect that it will be similar to the regulation on mutual funds where there is a 10% free disposal, meaning they can invest up to 10% in hedge funds or private equity, real estate and that sort of illiquid investments.”

“We were a pioneer of hedge funds in Spain and at the time there was no regulation for this asset class,” says Fernandez. “Now it appears the regulation is going to be more restrictive. In fact, the regulation is more focused on the restrictions by percentage on the different investments rather than by the nature of risk control of those investments. So while we are maintaining some investment in hedge funds it is not easy to know exactly how one could manage a portfolio in this asset class and I would say that the potential for the growth of hedge fund investments will be limited. I think the regulations are restrictive because the regulator just does not understand how these investments work.”

“I had to reduce the portion in hedge funds dramatically and currently we do not have any,” says Costales. “We are waiting for the new regulations to see whether or not it is possible to invest in hedge funds.”

But is there an appetite for alternatives? “Just how much alternatives will depend on who you are managing the pension fund for,” says Costales. “If you manage for a corporate then you agree the strategy with it and we define the asset allocation on an annual basis. We can have up to 10-12% in alternative products.”

“Our average portfolio last year was 30% in equities, less than 50% in fixed income, with most of this being on the monetary market, and an alternatives allocation of less than 1%,” says Jorge Bentue, CIO at Barcelona-based Banco Sabadell Pensiones, a provider pensions to individuals and to companies. “The issue is whether it will only be possible to introduced alternative products into the market if they offer a guarantee. Alternatives and guaranteed products mean a very high level of complication and expense.

“But for me at this moment the opportunity is in the equity market and the objective is to capture the dividend performance of shares, and although there is volatility, the volatility is value at risk and the risk at this moment is small. At the end of 2006 we changed the percentage in the Spanish market and switched to the euro. The view of my members was that it is difficult to invest in the IBEX and in the last six or eight months the portfolio changed to Eurostoxx. The Spanish market still has potential but it needs more emphasis on security selection in a few shares. There are more opportunities in Europe than in Spain.”

“Our asset management philosophy has not changed,” says Fernandez. “At the end of last year we had €5.5bn under management, the main investment vehicle being the Telefonica employees’ pension fund with €4.4bn and the rest being other employment pension funds or individual plans. The end-year breakdown of asset classes in the Telefonica fund was 35% equities, 10% alternatives, mainly private equity and hedge funds, and the rest was fixed income and cash equivalents. We follow a core/satellite approach, under which some 80% of our assets are directly invested indices - mainly to derivatives, futures or whatever - in terms of our benchmark both for equities, the Euro-stoxx 50, a small portion in the DAX index and around 6% of the portfolio is in some of the shares included in the IBEX 35, and fixed income, the JP Morgan euro government bonds, and the remaining 20% is in different bets trying to get alpha value and so non-correlated with the indexes, and that means relative value investment or stock picking.

“But we are not very focused on turnover, we don’t have a great turnover in stock-picking or portfolio selection terms. We are an active investor but through indices, we are more asset allocators and we decide to increase or decrease the weight of equities or fixed income depending on our macro views or liquidity or whatever.

“The return of the pension funds depended on their risk profile, but for the Telefonica pension fund it was 5.58% net of commissions, while that for the most aggressive fund, Redactiva, was 14.4%. They represented the minimum and the maximum.”

“It’s impossible to give an average figure for our returns because we have funds that are 90% in equities on the IBEX, which was doing nearly 30% last year compared with the Eurostoxx that was doing 15%,” says Costales. “But the returns for Spanish pension funds are not very high because of the short-term mind set. That means we have less equities than the rest of Europe. I have a rough average of 20-25% in equities. The return on that was 20%, and 20% on 25% of the portfolio gives 4.5%.

“And last year was not a good year for fixed income, so the outturn was zero. So, if you have just 25% in equities, you are not going to lose money but you are not going to beat Spanish inflation plus 200-300 bps which should be the objective.”

Because of its autonomous status, the Basque Country has not had to follow all of Madrid’s legislation. “We don’t pay tax on returns from pension funds,” says Jose Carlos Garay, CIO at Bilbao-based Elkarkidetza, the pension fund for Basque Country provincial and local government employees.

“And because we don’t need to have a pension fund administration company the administration cost is less, as unlike a bank that undertook the role we do not make a profit from it. But the main difference is that under the Basque formula a client who has had money in a fund for 10 years can withdraw it whereas in the rest of Spain it must stay in the fund until the client reaches the retirement age. It is taxed on withdrawal, but at a reduced rate. The problem is that the fund can be used as a financial instrument instead of a pension-securing fund so prosperous people who are not looking for a pension exploit the tax relief on contributions as a tax-avoidance strategy.”

And there are other differences. “In the Basque Country we have been able to use any kind of assets within the remit of a ‘prudent manager’ so, for example, we have around 5% in hedge funds, and this had enabled the Basque pension funds to develop an investment expertise,” says Garay. “But perhaps because of the amount of money that there is in Basque Country pension funds the Basque government introduced additional investment regulations in June.”

Nonetheless, last year the fund’s asset allocation was generally in line with that found elsewhere in Spain. “We had 51.5% of our portfolio in fixed income and 30.5% in equity,” says Garay. “The fixed income was diversified; we had 30% in long duration, around 10% in convertibles, 35% linked to linked to Euribor and 25% linked the 10-year bond. And most of our 5% allocation to hedge funds of funds works like fixed income with low volatility and the expected return is 4-7%. And we had around 6% liquidity. But the most important asset from a return point of view was equities. We had a return of 11.5% on the equities. The return on the fund as a whole was 7.3% net.

“We have reduced our fixed income allocation by 2.5% because this year we prefer liquidity, which was increased by two points, because even with higher interest rates we think that there is still a problem with credit spreads. We intend to keep it around the 45-50% level. We feel we must keep the equity allocation at around 30% if we want to get a 6% return in the long term. So while at the beginning of the year we sold some small cap funds and some funds in eastern European emerging markets we are not reducing the allocation, just taking some defensive measures in case the asset has some problems at the end of the year or the beginning of next.”