Italy: Hamstrung by law 703
Armando Piccinno reviews Italian pension funds' asset allocation behaviour
When it comes to Italy, where the pension market was worth around €85bn at the end of March 2011 according to COVIP, the Mercer 2011 Asset Allocation Survey shows an interesting story.
At the end of 2010, bonds represented nearly 60% of total pension portfolios at an aggregate level, 80% of which were invested in government bonds. The equity component was approximately 22% and was mainly non-domestic.
When compared to the rest of Europe, the bond allocation of Italian schemes seems high: the Netherlands is the only country that has nearly as high an allocation to bonds, 52% are in domestic government bonds. On the contrary, equity allocation is lower than that seen across other European countries. When looking at the second-pillar market segment (probably the most promising area for growth as confirmed by the amount of annual contributions), which is composed of multi-employer pension schemes whose assets amount to nearly €22bn, relatively high exposure to bonds (nearly 76%) becomes more evident, with a clear orientation towards domestic bonds (36%). The average weighting to equities is 23%. It is interesting to note that domestic bias shown on bonds is not replicated within equity allocations (Italian equities account for 1.5%) even though the focus is on euro-zone and US equities, whose portfolio weight accounts for nearly 20%
Although the average asset allocation of Italian pension schemes in the last couple of years seems to be relatively unchanged, there is an increased awareness of the need to diversify investments across the various available sources of beta in the market. It is likely that the Italian market will observe similar trends found in Mercer's European asset allocation survey, particularly upon publication of the new law on investment restrictions which is expected before the end of the year. However, the removal of restrictions is unlikely to be a panacea for the asset allocation of Italian pension schemes. For instance, even though there are currently no investment restrictions on duration exposure - as recently highlighted by COVIP - overall duration exposure tends to be dramatically short. This is evident when compared to the long-term commitment of pension provisions, which seems to be in part justifiable by the need to maintain a cash-buffer for withdrawal requests by members, or by the need to value portfolio holdings at mark-to-market.
From a broad-perspective a well-established governance framework, with a focus on an investment making decision process and investment principles will help pension schemes in broadening their asset allocation through access to multiple sources of beta while keeping a clear focus on risks and operational aspects. In particular, governance on investments is a hot topic for the market segment called Casse di Previdenza, the Italian first-pillar market for the self-employed. Mercer welcomes the adoption of principles that could discipline the investment activities of the Casse allowing them to invest their assets under a liability-driven approach.
Risk management is already on the agenda for many Italian pension schemes, and the adoption of a more structured approach will bring the entire market to the next level even though internal structures seem lacking in this area. Most pension schemes have well-established processes for risk monitoring, however, only a few have put in place risk management processes. It is certainly of some help for a pension scheme to monitor its portfolio holdings on a weekly or even daily basis. However, the equation ‘the higher the frequency of monitoring the better the risk control' does not seem to be fully applicable. A more qualitative approach to risk management is more favourable, with pension plans assessing their risk drivers and regularly reviewing their asset allocations under a scenario-testing environment.
The focus on operational issues seems to be less evident if not absent. Outside Italy an increasing number of pension schemes are carrying out operational due diligence when evaluating asset managers or monitoring the overall level of operational efficiency of the plan. Actions such as these could well help the Italian pension scheme market improve a number of operational aspects. For instance this could impact the relatively high turnover, and related trading costs, recently observed in portfolio holdings of passive or semi-passive mandates, whose turnover was expected be lower.
Investment restrictions within pension funds were regulated in 1996 (law 703) and represent one of the main constraints concerning investments in emerging markets and non-traditional asset classes. However, with the exception of those funds that comply with law 703, pension plans are using a wider range of asset classes to build portfolios to meet the challenges that may emerge in the future. In particular, there is a clear desire to have less reliance on equities to drive returns and also to build portfolios to guard against possible inflation that may emerge in the future. In tandem with this trend an increasing number of pension plans are seeking to improve the robustness of their governance structures to monitor and examine the ongoing operation of the fund assets better.
Armando Piccinno is senior associate at Mercer in Italy