Asset Allocation: Emerging hopes
Rachel Fixsen looks at the lifting of investment restrictions and their effect on the asset allocation strategies of Italian pension funds
At a glance
• Italian pension funds are considering their options for revised asset allocation given the freedoms allowed in the new framework governing second pillar pensions.
• The new 166 decree introduces principles-based approach to investment.
• Tax incentives for investment in the local economy and infrastructure have considerable effect.
• A wider geographical investment pool coupled with a currency exposure limit may bring a need for hedging.
Investment strategists at Italian second-pillar pension funds are in a hiatus. They are caught between last autumn’s substantial change in the law and its deadline for implementation.
A new framework governing second-pillar pension fund investment – DM 166/2014 – has replaced the old 703 decree. The principles-based approach it introduced is in contrast to the previous prescriptive regime.
Importantly for the asset allocation of pension funds, the new framework has increased the range of opportunites available. For example, it is now possible to invest in emerging markets. Quantitative limits have also been rolled back and alternative investments can be included to a greater extent.
So far, the change only affects second-pillar pension funds but similar changes are under discussion for the first pillar. Alessandra Pasquoni, head of investment consulting in Italy for Towers Watson, expects the eventual legislation for the first pillar to contain similar rules.
“The onus will be on the pension fund to set its own asset allocation based on its financial objective and its ability to monitor investments and their underlying risk, so there will actually be more responsibility for pension funds,” she says. The main development in asset allocation that is likely to be generated by the new rule is an increase in diversification, she predicts.
Antonio Iaquinta, head of institutional business Italy at State Street Global Advisors, says there is already analysis going on in the market. This is despite an 18-month grace period for pension funds, ending next May, since the law came into force. “It is still more of a study phase than an implementation phase,” he says
The new approach gives pension funds much more freedom, he says. “They no longer have the OECD [Organisation for Economic Co-operation and Development] limits on investments that they had in the past, which basically counted out all emerging market exposure,” he says.
New framework creates opportunities
• Location: Milan
• Year founded: 1989
• Assets: €1.78bn
• Members: 24,077
Previp pre-dates the 1992 law that opened up the pension fund market, following which many occupational funds were established. According to the Italian regulator there are more than 320 such funds, which makes it the largest group of funds in terms of individual entities. However, these funds manage fewer overall assets compared with their peers, partly due to competition from the new vehicles established after the reform.
Previp was founded in 1989 to offer guaranteed and non-guaranteed pension solutions, and manages €1.7bn, making is among the largest. Livio Raimondi, the chief investment officer, recognises that there are too many small funds and says that the proposed bill on competition, which stipulates portability of pension savings, could be a catalyst for consolidation.
But the main challenge for Previp is adapting its asset allocation to the uncertain environment. Raimondi says the fund is assessing the new law on investment limits, DM 166, which came into force at the end of last year. Funds have 18 months to comply with the few quantitative limitations that remain from the previous regime. But the new framework is based around qualitative principles, such as a fund’s analysis and monitoring resources.
Raimondi says: “I think the framework is based on very sensible principles, and Previp is reviewing its investment policies accordingly. Although, the current strategic asset allocation has given us healthy returns, our priority is increasing diversification, thus decreasing long-term risk. In particular, we are analysing the possibility of introducing new asset classes, both public and private.”
He points out that diversification is needed in Previp’s fixed-income portfolio, which is largely made up of euro-denominated sovereign bonds. The fund, adds Raimondi, has invested in human resources, to increase internal capacity and reduce outsourcing.
The last time Previp’s asset management mandates were reviewed, about three years ago, the fund introduced a European tilt to its equity portfolio. However, while sentiment about the Italian economy is improving, Raimondi says Previp is unlikely to make a bet on the country. “In terms of portfolio allocation, we obviously look at Italy, but we are unable to concentrate resources on an individual country, due to the nature of the mandates.”
Instead, Raimondi suggests that the fund might focus on emerging markets, which Italian pension funds were previously not allowed to invest in. “The improvement of many economic indicators in emerging market countries means they could become part of pension fund’s portfolios, not just as a mean to diversify play, but as real strategic investments”, says Raimondi.
However, any effort towards diversification is complicated by the regulatory developments on taxation. The tax rates on pension fund returns from all asset classes have been raised from 11.5% to 20%, but this excludes sovereign bonds, which are still taxed at 12.5%. Raimondi says: “This was a bad surprise. Given the low returns from sovereign bonds, funds have no choice but to diversify, but they are hit by the fiscal regime.” Higher taxes, coupled with the new rules allowing members to access their severance pay at will, are a disincentive to long-term investment, says Raimondi.
Iaquinta says one way to increase the return profile of pension schemes without changing the risk profile is to include emerging market debt as well as emerging market equity.
“The other thing on the agenda is the wider possibility to invest in illiquid strategies, such as infrastructure,” Iaquinta says. “This is something the old 703 law allowed pension funds to do but they never really did it.”
New legislation coming into force for pension funds in Italy also includes tax incentives for them to invest in specific assets, effectively reversing a controversial tax hike on pension fund returns. “The objective of the government is to try to use the assets to stimulate the growth of our economy,” says Claudio Pinna, managing director of Aon Hewitt consultants in Rome.
As things stand, local pension funds are investing less in the real economy than is the case with funds in many other countries. The government wants to use these assets to boost economic activity.
“The government has included infrastructure of any type, highways, hospitals,” says Pinna.
The new law took more time than expected to be published, and pension funds are considering their options. “Now, we know exactly what they have to invest in to get the old rate of tax, but as there are still some applications that need to be clarified, so it has been impossible, so far, for pension funds to make any changes,” Pinna says.
Silvio Bencini, managing partner at European Investment Consulting, says his firm is advising clients affected by the new law to change their equity benchmark to ‘all countries’.
“The other innovation we are advising is that, due to the very low level of yields in Europe, clients put in place a strategic allocation to global bonds and hedge it back to euros,” he says, adding that at this time the funds have around 95% of their bonds denominated in euros.
Although, there is more freedom geographically under the new 166/2014 regime, Bencini points out that the new law has put a strict limit of 30% on foreign currency exposure. This represents a tightening, as the previous law stipulated that only a third of investments had to be denominated in local currency.
So if pension funds have a 50% allocation to global equities, they start with a mandate that is outside currency limits, he says. “This means they will need to change the benchmark and use a euro-hedged benchmark,” he says.
For Pasquoni adding emerging market investments and alternative funds clearly means taking on higher risk premiums and illiquidity. He emphasises pension funds will have to deal with this shift, which could lead to changes in the pension fund sector itself. “You can reorganise the pension fund internally or get some external support,” she says. “It depends on the dimensions and complexity of the pension fund.”
“The bigger ones can afford internal growth and they can also get some support externally, but the smaller ones will have some difficulty because any extra costs are less easy to absorb, and their ability to appoint an adviser is more limited,” says Pasquoni.
While pension funds are considering emerging markets bonds, Pinna says that ramping up the risk level in the portfolio has to be approached differently by different types of pension funds.
The casse di previdenza, for example, which provide defined benefit pensions, may re-define their investment strategy to include higher levels of risk in the fixed income portfolio as the decision – if made correctly – will have no impact on scheme members, says Pinna. But pension funds which are run as defined contribution (DC) schemes, need to communicate the implications of stepping up the risk level to their members, since the outcome could have direct consequences.
Bencini says there is still much debate about the freedom pension funds will have to use UCITS because, according to the new regulations, funds are not allowed to leverage or short-sell. This is yet to be clarified.
The debate about alternatives is still in its infancy, Bencini says, as only three pension funds so far have ventured into this territory: Laborfonds with a European real estate fund; the Veneto pension fund Solidarietà Veneto with private equity investments (see panel); and Eurofer, which has a real estate fund.
Bencini says that although the pension funds were permitted to invest up to 20% in closed-end funds before the new law, they can now invest in alternatives outside these funds. “Now the definition of the investable universe is much clearer,” he says.
Keeping it local
• Solidarietà Veneto
• Location: Venice
• Year founded: 1990
• Assets: €856m
• Members: 48,000
Solidarietà Veneto is the occupational pension fund for workers of the Veneto, the wealthy region whose main city is Venice. The fund was set up in 1990, to manage pension contributions of regional employees of various industries. As of 2014, the fund managed pensions on behalf of almost 5,800 firms. It is one of the few pension funds in Italy to have diversified its portfolio of investments by adding unlisted assets.
A significant portion of the fund’s unlisted assets is invested in local companies. Paolo Stefan, managing director of the fund, says: “Our relationship with the local industry is in our DNA. It is also what allows us to grow in terms of members when other funds are losing them.” He adds that the fund had been studying investment in unlisted assets since 2009, having agreed with the regulator what the requirements for direct investment would be.
When the assets of Solidarietà Veneto reached critical mass, it teamed up with Finanziaria Internazionale, an asset manager specialising in unlisted assets. In 2013, the fund invested 5% of the assets of three of its investment lines in bonds issued by banks and unlisted companies, including Rigoni di Asiago, Pasta Zara and Corvallis.
With the help of Finanziaria Internazionale, the pension fund has also invested about €2m in private infrastructure assets, by participating in a €120m fund investing in bonds issued by local water utilities. Stefan says that the infrastructure deal is interesting because it involves the participation of Veneto Sviluppo, the regional authority’s fund, and the European Investment Bank. “The involvement of the regional authority and of the EIB gives full investment grade to the fund,” he says. As part of the deal, the regional authority offered a guarantee that it would cover 20% of the loss of value of the fund.
The next step is direct private equity investments and Stefan says the fund is working hard on finding the right opportunities.
Clearly the sizes of the individual private debt and equity investments are small relative to the fund’s European peers. But it is necessary to consider how rare these investments are in Italy as well as the size of the portfolio itself.
Stefan says the shape of the local economy encouraged the fund to pursue its private assets programme. “The [European Central Bank president Mario] Draghi effect is being felt somewhat, with banks willing to start lending again. At the same time, many companies are still reluctant to seek bank financing, and that is where we stepped in. Plus, our local economy is very export oriented, with companies that have survived the crisis and are recovering healthily at the moment.”
Solidarietà Veneto’s interest in private assets, says Stefan, are two fundamental points in the fund’s asset allocation, which is being reviewed. “In a way, we have to start from scratch, given that expected returns on all asset classes are low,” he says. As part of the strategic asset allocation review, however, he identifies themes including environmental, social and governance; emerging markets and active management of currency risk.
As far as the recent political developments, Stefan says: “Sometimes I feel like I am sitting on a time bomb.” He is referring to the fiscal measures penalising fund members and the prospect of full pension portability. “We do feel the competition, but we will do everything we can so that they feel our competitive pressure too. We are not going to bow our heads.”