Oil for extra virgin wheels
Italy’s new defined contribution (DC) schemes have got off to a slow start. Having become operational only a few years ago, assets under management of the industry-specific contrattuali - literally contractual, or closed - schemes were just short of E6bn at the end of September, with just over a million members. The total institutional wallet stood at E38.5bn, just 5% of GDP. “Peanuts,” says Livio Mocenigo, partner of the benefits practice at Watson Wyatt in Milan.
The introduction of the DC funds followed a period of high inflation in Italy between 1986 and 1993 when it became much more costly to provide defined benefit schemes. As a consequence of this issue, legislation brought before parliament in 1993 introduced a set of defined contribution schemes: the contrattuali served industry sectors and were set up by way of collective agreement; alongside these were the fondi aperti or ‘open’ funds which were directed at the self-employed and companies that did not have access to closed schemes. Industry service providers like banks and insurance companies also chose to set up open schemes.
Development has been hindered by a number of factors, not least the fact that the 1993 law did not become effective until 1998. With the fledgling system still dogged by a range of structural faults, a new law was passed last August to give a boost to the hitherto lacklustre progress. Opinions vary as to when the implementation decrees will be passed – the more pessimistic suggest that we may have to wait until after the next election due mid-2006. Meanwhile an uneasy combination of hope and skepticism abounds as the industry strives to build a more solid platform for efficiency and growth.
One of the measures designed to stimulate funds involves the TFR, a deferred compensation fund retained in the employer’s books. The sum, equivalent to 7% of salary, earns a guaranteed annual return of 75% of the rate of inflation plus 1.5%. The annual value of the TFR is around E14bn, and the government has targeted this as a means to boost the flagging fortunes of Italy’s second pillar pension system.
As it stands the regulations regarding its use are set out according to the following categories of employee:
q Those who had a pension fund established prior to the pension fund legislation in 1993 do not have any obligation to pay the amount to a pension fund and can put it to whichever use they please;
q Those who started to work prior to the legislation but didn not have a pension fund: If they want to join a pension fund, Italian tax law says if an employer contributes to a pension fund then a portion of the TFR equivalent to 50% of that must be added to ensure tax deductibility;
q Those that started to work for the first time from 1 January 1996 have to pay all the money to the pension; they have no choice.
The legislation proposes replacing these three categories with a system of ‘silenzio assenso’, or silent assent, whereby if an employee does not state a wish to the contrary the TFR will be paid automatically into a pension fund.
Participation in the contrattuali stood at 7.7% as of last September, according to the Italian Association for the Development of Pension Funds (MEFOP). Taking the new measures into account the consultancy Prometeia says that this should increase to 17% within three years. Good news for asset managers.
Jean-Marc Crépin, managing director of State Street in Milan believes that the silenzio assenso will help grow the market, “not least because some 28% of Italian employees do not know which pensions they need. I believe that most of these will default to a pension fund.”
He believes that the most important aspect that people will focus when deciding whether to go for the pension fund option is the fiscal advantage that they will enjoy by taking this option.
Currently the amount that can be invested as a tax deductible amount in a pension fund is the lower of E5,164 and 12% of income. According to Luigi Ballanti, director of MEFOP, the new law will make this amount the higher of the two.
The other element of taxation that needs to be addressed is the tax on the yield on investment returns, currently 11% for pension funds compared with 12.5% for other financial instruments. “This is a major obstacle to pension funds taking off,” says Piero Mariggi, partner at Milan-based consultancy Institutional Advisers.
But Ballanti provides reassurance: “We think the tax on the pension funds’ returns may be reduced to 6%,” he says.
And then there’s that old chestnut – disposable income, a key issue in this discussion. Mariggi notes that the combination of the substantial deduction made for the state pension and the TFR of more than one third of salary and 7.5% of salary respectively - before tax - have stifled growth of the contrattuali since their introduction in 1998. “So unless the very high percentage deduction for the state pension scheme is reduced - with the consequent reduction in state pension - it will be very difficult to have a dramatic increase in the amount that is paid to pension funds,” he says.
The other issues that will affect the popularity of the pension fund option are market conditions and investment return. Mariggi is sceptical. “When the new pension funds came on stream the market was bullish so people were inclined to divert their TFR to a pension fund,” he notes. “But the present atmostphere of low gains will not encourage people to invest in a pension fund.”
He sums up: “So we think between 20% and 25% of the TFR will be channeled to the pension fund system.” He describes the 50% quoted by a broad spectrum of industry players as “quite optimistic”.
One proponent of the optimistic view is Stefano Kihlgren, head of institutional investment at RAS Asset Management in Milan. “Last year the majority of pension funds reported results that were better than the TFR,” he says. “This is a very strong argument to pressure people to adhere to funds. To beat the TFR is a challenge for managers.”
Indeed. In Italy, where the propensity to save is high, the guarantee offered by the TFR is appealing. So ultimately, as Alessandro Gandolfi, head of pension fund clients at Milan-based San Paolo Asset Management notes, “how much goes to the pension fund of the TFR depends on the ability of the asset managers, the insurance companies, the funds and the unions to acquire the trust of the people”.
So how do they go about this task? Piero Marchettini is managing partner of Adelaide Consulting in Rome. “Funds’ first challenge will be to generate more than the formula but without risking that they deliver less. So I believe that funds should have at least one investment option that replicates the guaranteed return of the TFR. Others can allow more.”
The legislation specifically makes provision for the guaranteed option. But the guaranteed return has in some cases become something of a straitjacket. “The TFR is seen as an implicit benchmark by clients and hence asset managers,” says Marco Avonto, San Paolo IMI’s head of institutional portfolios. “This misperception could lead to a disconnection between the optimal long-run strategy and the need to meet - or beat - the TFR.”
Until the TFR is diverted to a pension fund it remains on the company balance sheet and, in so doing, provides a valuable source of company financing. Last month approval was granted to a E750m package of measures to promote the transfer of TFR to the pension funds, and this also includes assistance to the companies who will be most affected by this loss of financing.
The extent of the loss is explained by Gandolfi: “The TFR is a financial facility that allows companies, regardless of their rating, to finance at 3% rather than paying 8% on a company bond. So it is important to compensate for the loss of this facility. But the adequacy of the amount approved by parliament to assist the companies will depend on how many people go to a pension fund.”
So the withdrawal of this facility could have serious implications
for companies. As Giambattista Chiarelli, head of business development for southern Europe at Pictet notes, “there is a conflict of interest. Companies will try to convince their employees not to move their TFR to a pension fund – and therefore away from their balance sheet. In particular SMEs with serious funding difficulties have a great interest to keep the TFR at the company level.”
In addition to the obstacles to potential inflows, the fondi contrattuali are also subject to a number of investment restrictions, the main ones being that they may not invest in hedge funds, private equity or real estate. These clearly limit the tools asset managers have at their disposal with which to deliver performance. The result, notes the manager of one major pension fund, is that “you select a good asset manager, but they have achieved their good track record with a larger tracking error and a wider variety of investment instruments to chose from. So some asset managers fail to make even the benchmark”.
He adds: “We are lobbying for a change in the law to have more freedom to manage different asset classes.”
Crépin agrees that pressure needs to come from the demand side: “If a pension fund demonstrates that it has a strong risk management model I doubt that the regulator will not approve it. The regulator will approve a relaxation of the guidelines when plan sponsors prove they have better control of their future.”
The situation is more liberal for the funds that were established prior to the 1993 law, known as ‘preesistente’ or pre-existing, which were established by professional bodies such as banks, insurance companies and multinationals. The restrictions do not apply to the fondi aperti either. Ballanti explains that the state felt particular responsibility towards the contrattuali with their union involvement and large and relatively uneducated membership.
He assures us that the new legislation will lift many of the investment restrictions including the need to stick to a benchmark. “We will see an evolution,” he says.
Strategy is also influenced by the fact that mandates and asset allocation are set for three years. Does this deter investors from taking risk? “Yes absolutely,” Mariggi says. “And as a result clients have fragmented their mandates into many asset classes, so the average mandate size is around E30m.”
In some ways the three-year rule is appropriate. A case in point is the fact that investors are not allowed to use consultant databases for the purpose of manager selection. “So it is a huge repetitive workload for any asset manager wanting to participate in a tender,” says Chiarelli. “Pension funds have to tender publicly so an asset manager cannot just apply once per asset class.”
The efficiency of institutional asset management in Italy is further hindered by the level of fees which is among the lowest in Europe. The major pension fund source notes that “the fierce competition where too many banks seeking too little business results in a situation where the fees are far too low.”
But as we know, you get what you pay for. Marchettini explains that the average fee for an equity fund could be in the order of 20 basis points and for a bond fund it can be as low as 10 basis points. “The fee is so low that asset managers cannot finance the necessary expertise,” he says.
Some argue that it is an investment in the country’s market potential that is behind the acceptance of low fees. “Banks are focusing on market share so that they will have a chance to capture the growth,” notes Kihlgren.
Trezzi does not believe that the problem lies with the asset managers. “The low fees are driven more by the demand side,” he says. “The clients have played the game well as they know the new legislation means a lot of business.”
Mocenigo notes: “Some funds even introduce byelaws which state, for example, that no more than five basis points should be spent on administration, for example. This is very transparent but not efficient.”
In addition to this is the more visible aspect of the slow growth of funds which means that financial resources are limited and that cost focus reigns supreme.
But things are changing for the better, as Chiarelli at Pictet explains: “At the beginning of 1998 when the law was passed, the key selection criteria was cost. Now cost has 30% to 40% of the weight in the decision. In the best run selections in Italy today the main issues are track record and organisation. A more international market perspective and the increasing role of consultants has driven this.”
But there are also cries of foul play. Marchettini suggests that the low fees are due to the fact “Italian managers wanted to protect the market from foreign competition. They charge high fees to retail clients to make up for it.”
Crépin disagrees that the Italian players are protectionist: “Regulators and legislators are much more interested in solving the pension fund issue than preserving local dominance of an embryonic market,” he says.
If local managers have the lions’ share of the market perhaps it is more down to the approach of the trustees. Keyword: insularity. “It is easier and more comfortable to select a big local name,” says Chiarelli. “If I chose a well known local name and something goes wrong, people - press, fund beneficiaries and the financial community - will never blame me. But if I chose a great international asset manager unknown in Italy - I can easily be blamed if things don’t go well.”
The size and immaturity of the institutional market in Italy means that pension funds are even less experienced than many of their counterparts elsewhere in Europe. Key to the level of opportunity will be the trustees and how they direct, or fail to direct investment strategy.
Boards of trustees are made up of an equal representation of unions and employers. Neither side is willing to put their head above the investment strategy or manager selection parapets – even if they were willing and able – as neither side wishes to be saddled with the responsibility.
Fundamentally it is a resource issue. Trezzi notes: “Sometimes pension funds prefer to replicate the law rather than use the law. They do this to save time and to avoid taking risk. As a result they have missed some opportunities.”
The fact that the new DC contrattuali funds are in the accumulation phase means that the scope for risk-taking should be significant. But, as Fabrizio Gualco, managing director of CSAM’s Milan office notes, “trustees still have the idea that return has to be positive each year because they feel the need to compete with the guaranteed annual return of the TFR.”
But the new legislation should set in motion a shift away from cost focus. Currently an employee must use the closed fund of reference for the industry. For example, a metal worker that opts for a pension fund may only use Cometa, the fund of reference for metal workers. The new law will make it possible for companies to move from the closed to an open fund - or to any other closed fund, for that matter. “Freedom of movement will accelerate performance competition,” says Gualco.
Marchettini stresses the urgency of this competition: “The banks may start to use qualified asset managers if they realise that there is an opportunity to attract significant business generated by the transfer of the TFR.”
But there is clearly more to efficient competition than lifting restrictions. As Ballanti points out, “it will be important to draft the same rules for transparency and governance for the contrattuali and aperti. This is important for fair competition.”
Preparations for competition are already evident. Anima has an independent asset manager, have just acquired the license for a fondo aperto. “We want to take advantage of the new law to be in the pension fund game,” says Alberto Foà, Anima’s managing director. He adds: “For us the target would be small firms with or without a contrattuali fund. Big firms will be the focus of the big banks.” The costs of distribution are significant and for that reason Anima is planning to sign distribution agreements with banks and financial consultants.
The contrattuali are also considering the need to become more competitive. The decision taken by the Fondodentisti - the dentists fund to offer a variety of investment options (multicomparto) from the start in spite of their relatively small size - E31.7m of assets under management compared with Fonchim’s E986.7m and Fondenergia’s E320.5m - was driven, as Trezzi explains, “by their desire to remain competitive when freedom of movement to fondi aperti is introduced by the new legislation”.
This also demonstrates the level of sophistication of small funds with highly educated members. Further illustration of this can be found by comparing funds and their relative allocations to the different investment lines. ßßThe larger funds whose membership is predominantly manual labour have a far higher allocation to low risk investment lines than those with a highly educated membership, like the dentists’ fund. At the end of last September, Fonchim, the fund for chemical workers has 92.5% of its assets in an investment line it calls ‘stabilita’; Fondenergia, for workers in the energy sector had 92.1% of its assets in a balanced fund; Fondodentisti on the other hand had 50.1% of assets in its ‘espansione’ fund.
The level of education will be vital in stimulating interest in other investment options. “When funds started to move from single to multicomparto offering several investment choices 80% to 90% stayed with the same allocation,” says Chiarelli. “This is a problem of information and marketing. There is no network to educate apart from the unions and employers associations, and that is not a very professional way to sell a product.”
The move to multicomparto is good news for asset management because it increases the number of specialised mandates on offer. But with a few exceptions like the relatively sophisticated dentist fund specialised, funds will be confined to the larger funds – which, in advance of the new legislation, are very few and far between.
As the local banks crank themselves into gear, the challenges facing the market remain significant. As Kihlgren notes, “five years ago we expected more rapid growth in the market and more competition. But there has not enough by way of fiscal incentive, social security provision is still high and the passage of reform has been slow.”
Would somebody pass the olive oil!