Regulation: Frustration paramount
Carlo Svaluto Moreolo finds the Italian pension system is in the midst of a reform process that started 20 years ago. There is a clear effort to make the system more sustainable but a lack of vision means some of the measures being adopted could thwart that effort
At a glance
• Workers have freedom to access their severance pay money, which would otherwise be channelled into their second-pillar pension savings.
• New asset allocation rules offer more freedom but pose tough challenges for Italian funds.
• Second pillar pensions are being taxed at a higher rate.
• Proposed portability of pension savings could affect pension outcomes.
At Montecitorio and Palazzo Madama, the seats of Italy’s bicameral parliament, pensions are on the agenda with remarkable frequency. Since the reforms by Lamberto Dini’s government in 1995, members of parliament have stepped in several dozen times to enact new, or revised, legislation on the pension system.
In late 2011, amid the threat of sovereign debt default, Italy switched to a notional defined contribution (NDC) system to reduce expenditure on pensions. This was part of a package of reforms dubbed Salva Italia (save Italy), which was rushed through parliament by Mario Monti’s technocratic government to earn credibility from creditors. Since then, the public pension system has been deemed sustainable but the country still faces a struggle to ensure future generations enjoy an adequate retirement income.
In the past year alone there have been several legislative changes approved or discussed under prime minister Matteo Renzi’s tenure. While adjustments to the first pillar framework are still under discussion, there seems to be a sense of urgency among lawmakers that the second pillar needs strengthening, at least according to labour minister Giuliano Poletti.
However, among the four major rule changes, debated or approved in the past 12 months, two support the second pillar, while the others risk stifling it. Such contradictory behaviour is not a surprise, given that Italy has dipped in and out of recession since the onset of the financial crisis in 2008. For lawmakers, the incentive to boost spending in the short term is stronger than the need to adopt long-term measures that reinforce future retirement outcomes. This is exactly what Renzi, nicknamed il Rottamatore (the scrapper) because of his radical approach, tried to achieve by allowing workers to cash in on their termination indemnity pay before leaving employment.
Each of the past year’s reforms deserves a detailed analysis.
Severance pay advance
One of Renzi’s first moves in February 2014, was to grant €80 to every worker through a tax cut. That way, he intended to encourage domestic consumer spending, boosting demand. Late last year his government approved a measure allowing workers to ask for an advance of their severance pay through their payslip.
The severance pay, Trattamento di Fine Rapporto, widely known as TFR, has acted as the main first pillar supplementary pension since its launch in 1982. Employees set aside 13.5% of their gross annual salary, and every year the accrued amount is increased by a fixed 1.5% plus 0.75% of inflation. The TFR is then cashed in as a lump sum at retirement, and taxed at the basic income tax rate.
From 2005, TFR was transferred to occupational pension funds in a quasi-mandatory fashion, whereby employees’ must specify that they do not want the TFR to be transferred to a pension fund. As of this April, workers have been able to request that the TFR is paid to them instead of being put on their company’s book reserve, or their pension fund. Obviously, the TFR element adds to workers’ gross salary. But this way, the government reasoned, workers have an additional source of cash that can be spent, giving a consumer-led boost to a sluggish economy.
The measure was widely criticised, both by the pension industry and the employers’ association Confindustria. Pension industry representatives lament that the measure may jeopardise occupational pensions, as people do not see the benefit of setting TFR aside when faced with a choice between saving and having access to cash. Employers noted that, while TFR is a long-term liability on a company’s books, it provided a temporary source of liquidity for many.
Thankfully, data from the Fondazione Consulenti del Lavoro (a body representing independent human resource consultants) shows that, to the end of May, out of 1m workers, only 567, or less than 0.1%, asked to cash in their TFR. The data was met with relief by the industry, with many commenting that Italian workers’ awareness of their retirement needs is improving. However, the data covers a short period, and the survey only polled workers in companies with more than 500 employees, where pension funds have had more success in recruiting members. While the impact of the measure may be limited, it is too early to conclude that Italians have changed their perception of supplementary pensions. The number of workers that take advantage of the measure will depend, among other things, on how protracted Italy’s economic stagnation turns out to be.
New asset allocation framework
After years, the new framework on pension fund investment was finally approved at the end of last year. The Decreto Ministeriale (DM) 166/2014, which replaced a law so antiquated that it referred to the ECU (the precursor to the euro) as a reference currency, regulates pension funds’ asset allocation behaviour, moving from a quantitative to a qualitative regime.
Several quantitative constraints have remained. Non-euro exposure cannot exceed 30% of portfolios and no less than 70% of assets must be invested in listed instruments and alternative funds. Exposure to alternatives is limited to 25%, and funds cannot short-sell. But, according to the new framework, so long as pension funds can demonstrate competence and resources, they can invest in all asset classes.
This is a clear departure from the previous regime, which was based on quantitative limits. Most importantly, pension funds will be able to enter emerging markets, which they were banned from in the old framework. The new one constitutes an incentive for pension funds to build more diversified and efficient portfolios and COVIP, the regulator, has worked to ensure that pension funds embrace this change, by asking that they explicitly state their investment policy and build internal resources. However, investors’ efforts to broaden their portfolio are constrained by capacity.
The real problem for pension funds, however, lies in the details of DM 166. Although, the law allows the use of derivatives, it also imposes limits. This could prove detrimental, as funds needing to switch to flexible asset management strategies may be prevented, because such strategies require free use of derivatives and leverage.
Filippo Battistini, head of institutional and fund buyers at Allianz Global Investors (AGI) in Milan, points out that Italian pension funds are largely invested in sovereign debt. This asset class, he says, is unlikely to behave as it usually does during times of rising interest rates, but Italian investors will struggle to find alternative, uncorrelated assets. At the same time, they are prevented from implementing unconstrained fixed-income strategies that offer protection against turbulence in the sovereign bond markets. Battistini adds that AGI has joined a
lobbying group, represented by the Italian association of asset managers, Assogestioni, which aims to persuade lawmakers to review DM 166/2014, to further relax limits to investment and allow more sophisticated asset management solutions.
A new regulatory framework for casse di previdenza, the privatised first-pillar funds for white collar workers, is on course for approval. This will mirror the rules adopted for second pillar pension funds, but the regulation will go in the opposite direction, posing limits that were not originally there. Historically, these have been free to invest in any asset class, and this has resulted in mismanagement. Among the planned limitations is a 20% ceiling on real estate assets, which may prove problematic, as they may be forced to offload real estate assets.
Judging from the changes in the tax treatment of pension fund investments, lawmakers do not seem committed to encouraging savings into pension schemes. The country maintains exemptions only on the accumulation phase, and taxes returns as well as payouts, while in most European countries returns are tax-free. As part of the 2015 budget law, Renzi’s government increased the tax rate on pension fund returns from 11.5% to 20%, and the measure applied retroactively to 2014 returns as well. Renzi also increased the tax rate on investment returns earned on non-pension fund investments from 20% to 26%, but this higher rate also applies to returns earned by casse di previdenza.
For pension fund members, sovereign debt constitute the only exception to the tax rate hikes, as they are still levied at the original rate of 12.5%.
The measure was criticised by pension fund industry representatives, as they worry that higher tax rates discourage take-up by prospective members.
However, the tax treatment of second-pillar funds compares favourably with the alternatives and, as a result, according to calculations, pension fund holders will still be better off than those relying on the state or those investing on their own.
To mitigate the effects of higher tax rates, lawmakers offered an €80m tax rebate for pension fund investors that invest in the Italian real economy. Casse di previdenza and pension funds will be able to claim back 6% and 9% respectively on taxes on returns. However, the details of what constitutes real economy investments are yet to be unveiled, and both opportunities and interest may be limited. Although the minibond initiative has had some success, Italian investors are not known to like domestic assets outside government issuance. At the end of 2014, they invested less than €1bn in Italian equities.
Perhaps the most important proposal, given its potential impact on the pension system, is the bill on market competition known as DDL Concorrenza. The bill has the stated aim of “removing obstacles to the openness of markets, promoting the development of competition and guaranteeing the protection of customers” and, if approved in its current form, it will allow workers to transfer their savings freely between pension providers, carrying their employers’ contribution with them.
Opponents to the measure say it will favour for-profit pension providers such as banks and insurance companies, as those organisations can afford large and well-established distribution networks. This is believed to constitute an unfair advantage for banks and insurers, which will result in many workers being attracted to their pension products.
Opponents fear that this is not the ideal outcome for employees, since for-profit pension product providers charge significantly higher fees and manage assets in a riskier way, putting future benefits in danger. Organisations with large stakes in industry-wide pension funds, particularly trade unions and employers’ associations, argue that portability should be limited as workers are better off saving with occupational not-for-profit schemes, where member costs are lower and investment strategies more prudent.
On the other hand, lobbying groups representing banks and insurers support the measure, arguing that increased competition will create better pension outcomes.
While it is difficult to draw a comparison of returns from the different products available, there is evidence that membership of bank and insurer-sponsored pension schemes is growing. PIPs, (piani individuali pensionistici) or individual pension plans, have grown quicker than industry-wide pension funds since the 2005 reform of TFR.
It is difficult to predict whether the bill will allow full portability between all providers – from industry-wide funds to pension schemes managed by insurance companies and vice versa – given the power of the lobbies involved. However, whatever degree of portability of pension savings is allowed, it is likely to affect the system in that it becomes more complex, making it harder for fund members to make the right choice.