Spain’s €57bn reserve fund is intended to help plug the anticipated deficit in the social security budget. Diego Valero Carreras (pictured right) explains the background
Despite the economic and market crises, Spain’s social security budget will be in surplus or balance until 2029, according to the latest report on the national pensions strategy, the Informe de Estrategia Nacional de Pensiones, published by the labour ministry in October. However, unless reforms to the state pensions system are enacted from 2030 it will be necessary to draw down resources from the social security reserve fund, the Fondo de Reserva de la Seguridad Social (FRSS) to pay state old age pensions.
These forecasts are considerably better than those in the previous strategy report, which saw the social security budget stay in balance only until 2015. The 14-year extension is due to the economic and employment growth seen in Spain in recent years, and to the integration of immigrant workers into the workforce.
It is foreseen that the FRSS will reach its maximum level in 2023, with an amount equivalent to 6.5% of GDP. At the end of last year it stood at 4.66%. However, one should note that the pensions paid each year by the social security system amount to around 8.6% of GDP, and this level is forecast to increase gradually over the coming decades to around 15% of GDP by 2050.
It is obvious that in light of the 6.5% of GDP vs 8.6% of GDP gap the FRSS is not going to resolve the social security financing problem given the expected rise in annual social security pensions payments to around 15% due to Spain’s ageing population. However the FRSS could help bridge the transition period while further deep reforms of the social security system’s financing are undertaken.
The FRSS was formed as a result of a 1995 agreement among parliamentary parties and the social partners on the reform of the social security system known as the Toledo Pact. The pact has contributed to an avoidance of social conflicts arising from the pensions reform through the adoption of step-by-step change. But this approach inevitably made the reform process slower than it probably should have been.
At the end of 2008 the FRSS will have invested assets of €57bn. The first payment into it, of €601m, was made in 2000, two years before the Regulatory Law for the Reserve Fund, the Ley Reguladora del Fondo de Reserva, was approved. This law sets out bureaucratic and inflexible guidelines, which now themselves need reform to allow the FRSS’s investments to adapt both to the real requirements of the social security system and to market opportunities.
Discussions about widening the asset allocation of the FRSS have been underway for some time and there were indications last year that the government was willing to allow it to invest up to 30% of its portfolio in equities. The idea was to start with an equity allocation of 10% of the portfolio and increase this percentage gradually to 30%. However, the initiative failed for political rather than technical reasons because it proved impossible to reach a consensus on this between the government and the opposition on the issue. The fact that 2007 was an election year was not conducive to fostering a climate of dialogue. But this situation is changing and consequently there is a feeling that a final agreement may be closer.
Nevertheless, it had generated considerable interest in the market as even the pared down version would have represented an inflow of more than €4bn, which would have been a significant injection.
Had the initiative had gone ahead the investment in equity probably would have had a pas sive strategy, tracking international indices.
As it stands, the investment policy of the FRSS sets out that:
It can only invest in Spanish, German, French and Dutch public debt; The debt must be issued in euros, and be of the highest credit rating, and must be negotiated in regulated markets or in organised systems of negotiation; Spanish assets must account for at least 50% of the portfolio’s total nominal value; The investment strategy will be executed taking into account a temporary horizon that is determined by the planning for future entry flows and the availability of funds to cover the state’s defined contribution pension commitments; The modified duration will be between the 3.5 and five years, although the rhythm to reach the desired duration will be gradual and will be able to vary depending on the economic and financial environment and on the FRSS’s situation; The maturity of the assets in the portfolio values has to be balanced, avoiding excessive concentration of asset maturities on certain periods; Assets must be diversified, with a cap of 10% on the same asset; The nominal value of the FRSS’s investments in Spanish Treasury emissions must not exceed 8.5% of the total Spanish Treasury’s debt in circulation (treasury bonds, bonds and long-term bonds).
This investment policy had generated annualised returns of 3.99% from the funds inception to the end of 2007 and the performance has been declining from the peak of 6.04% obtained in 2001. The portfolio is mostly of relatively short duration - currently the modified duration is 4.02 years, inside the investment policy-determined band. The asset allocation is still predominantly short term, with more than half of the portfolio being less than three years old.
The geographic allocation, as set out by the guidelines, sees the fund invested predominantly in Spain, with close to 51% in Spanish state debt, and the rest being 38% in French debt, 37% in German debt and the remaining 25% in Dutch debt. The latest asset acquisitions have been pre-eminently in Spain to inject more liquidity into the public treasury during this period of credit restrictions.
There are two elements of fund’s investment policy that could be debated. On the one hand, the duration of the fixed income investments, which is around four years, and on the other hand, the lack of diversification as the FRSS is not allowed to invest in equities or corporate bonds. However, given the current state of the markets, the option of being totally covered in the market, apart from the oscillations of the equity, and with a very short duration of the fixed income has its attractions.
But it should not be overlooked that the fact that the whole fund is invested in fixed income was not due to a tactical decision arising from the market turmoil and high volatility but was rather a strategic asset allocation decision. In addition, it should not be forgotten that, although the fund’s valuation follow mark-to-market criteria, the highest quality assets in which it invests allow it to take a calm view, especially because FRSS does not need to compete with other actors to show better results over the short term but rather must maximise its performance over the long term.
According to the labour ministry’s report, the FRRS will begin making payments in 15 years, which allows a longer duration in order to match the expected payments.
Currently the FRSS faces two principal challenges. On the one hand, there is its management structure, which is very close to the managers of the social security system and to the officials of the ministry of economics and finance, but lacks specialists in portfolio asset managers to manage what is by far the largest pension fund in Spain. And on the other hand, there is its short-term objective and a portfolio diversification that should be able to obtain a greater risk/return trade off.
The impact of Spain’s ageing population will begin to be felt from 2030. And if fundamental reforms are not undertaken before then the effects on the balance of the public pension system may be immense.
The measure of the FRSS must be taken within the context of what it is - a source to alleviate the problems of circumstantial financing. While it is not the antidote to a permanent deficit in the social security budget that should not be a handicap for the fund to be managed in the best possible way and to obtain the best risk/return trade off.
Diego Valero Carreras is the president of Madrid-based consultancy Novaster and a professor at the University of Barcelona