The 2011 nationalisation of pension assets reduced Portugal's supplementary pension savings by a third, writes Gail Moss. Development of the second pillar remains a priority

In late 2011, the new Portuguese government - elected the previous June - started to nationalise the pension fund assets of banks financing first pillar schemes.

In December, Decree Law 127/2011 was published, enabling the transfer of certain pension liabilities and the assets financing those liabilities, into the state social security system.

These liabilities and assets relate to the banks' own pension plans, affecting pensions already in payment as at the end-2011. The related pension payments will now be made by social security. No second pillar private pensions were affected.

The transfer was considered essential to reduce Portugal's public sector deficit and meet its targets for 2011, as part of the adjustment programme agreed with the European Union, the European Central Bank, and the International Monetary Fund.

In all, around €6bn of assets has been transferred; around €3.3bn in 2011, with the rest by 30 June 2012. The total amount represents nearly one-third of the total assets managed by Portuguese pension funds as at end-September 2011, and affects around 30,000 pensioners.

Austerity has brought further changes. In April this year, the government suspended the rule allowing early retirement within the social security system. Until then it had been possible under some circumstances to retire at 55, instead of the normal retirement age of 65. Now, early retirement has been restricted to special cases.

The government's manifesto also included two major changes to the existing social security model.

State pensions are earnings related, and one change introduces a wage ceiling for both state pension contributions and the level of pension paid. Above this ceiling, workers would be able to choose between making contributions to the public system, or to mutual or private schemes.

The other change creates individual savings accounts within the public pension system.
However, the government has postponed implementing these plans, because of the austerity measures.

And Pedro Mota Soares, the minister of solidarity and social security, recently admitted that introducing a ceiling for contributions would better be carried out over the course of one or more administrations, rather than as a knee-jerk reaction.

To some extent, Portugal's economic belt-tightening appears to be having results - for example, its current account deficit narrowed substantially in 2011, and is expected to shrink further as economic adjustment continues, according to recent OECD forecasts.

But the short-term prospects are still grim. "Deep fiscal consolidation, bank deleveraging and weak external demand will leave the economy in recession until mid-2013, and the unemployment rate is set to rise to around 16%," says the OECD.

The recent changes to the pension system have been only the latest of a number of reforms in recent years.

The 2007 social security reforms - which included linking pension benefits to life expectancy - led to a big reduction in the state pension.

"Despite previous pension reforms, the social security system faces some serious challenges from the reduction in contributions as a result of high unemployment," says José Veiga Sarmento, president of the Portuguese Association of Investment Funds, Pension Funds and Asset Management (APFIPP). "From this perspective, we are convinced that an urgent rethink of the pension system is needed in order to ensure its sustainability. We believe the solution lies in the development of the occupational pensions market."

Gert Verheij, senior investment consultant at Towers Watson in Lisbon, agrees: "The current financial and economic situation in Portugal needs to be resolved before other reforms take place," he says. "We think a further drop in the level of public pensions could drive further changes in the company pension fund market. In any event, we see a continuation of the trend from DB to DC for smaller company plans."

In countries such as Spain, Ireland and Greece, the relatively generous state pension means that occupational pensions are to an extent seen as a bonus, so the hunt for returns is not absolutely crucial. But that is not so much the case for Portugal.

"People are now looking more for returns," says Joao Palmela, head of institutional client services, F&C. "Our own returns come from our diversified portfolios in equity investment, both active and passive, and from our overweighting in corporate credits and equities."

F&C's open-ended pension funds, covering three different risk profiles, delivered a year-to-date performance to end-August 2012 ranging from 3.94% to 6.54%, with an average return of 5.48%.

"We are not shifting weightings because of the financial crisis, although it has had a qualitative impact on our investment process," says Palmela. "We have been dealing with the situation for the past five years."

This stability in asset allocation seems to be common across the board.

"We have not changed the core asset allocation because of the crisis, though we have made some minor changes," says José Luís Borges, head of asset allocation at BPI Gestão de Activos. "In general, our clients' investment policy is defined for a three-year period, reflecting the long-term horizon of their liabilities."

He says BPI's recommended asset allocation is generally split between global bonds (from 50 to 80%) and global equities (from 10 to 50%), depending on the client's liability structure.

However, investment choices have become much more conservative over time, both in DB and DC structures, says Veiga Sarmento. "And in DC schemes where participants have freedom of investment choice, these choice reflect worries about capital preservation."

Nevertheless, there have been some shifts in allocation. The figures of the Portuguese Insurance and Pension Funds Supervisory Authority show changes in holdings both of equities and corporate bonds and equities over the past year.

"There was a reduction of 5% and 3% respectively between June 2012 and June 2011 in those categories," says Veiga Sarmento. "As of June 2012, debt continued to be the most significant category, forming 43% of the total. This was made up 25% of government bonds and 18% corporate bonds. Next came investment funds (28%), real estate (14%) and bank deposits (9%)."

Another reason why asset allocation has not changed radically because of the crisis is because many asset managers, such as BPI and F&C, are global investors. Portfolios often, therefore, have no domestic bias.

This might give them some protection against any local problems, but still leaves them open to other troubled economies. "Pension funds are still exposed to the weaker euro-zone countries, but in most cases this is limited to Italy and Spain," says Verheij. He adds that most Portuguese pension funds are also exposed to the Iberian financial sector, for bonds as well as equities.

But north European countries are also represented. "After the Greek crisis, pension funds discovered that Europe was not a sovereign risk-free environment," says Veiga Sarmento. "The beneficiary of that discovery has been, and continues to be, German Bunds."

Borges says that BPI's client portfolios are generally conservative in terms of debt composition, so that most sovereign debt is debt issued by core European countries.

"Generally, portfolios also have a relatively small allocation to corporate debt from peripheral Europe," he says. "In these cases, we invest in debt from companies which we consider to be of good credit quality and which have, in our view, been unduly penalised by the sovereign debt crisis."

A small portion of the portfolio, in general well below 10% of the fixed income allocation, is invested in domestic corporate credit maturing in most cases at end-2013. The other fixed interest holdings are mainly euro-denominated government bonds.

At present, client portfolios do not include Portuguese government bonds, with the exception of one portfolio whose investment policy allocates 15% to this asset class. Some portfolios, however, have a small allocation to Portuguese treasury bills.

 "We're underweight in sovereigns because yields are too low," says F&C's Palmela. "However, we are overweight in spread products. We are hunting for yields, and corporate bonds look sound vis-à-vis euro government paper."

In the same way, he says that the argument for equities is that they provide a more risk-balanced approach than euro-zone sovereign debt: "It depends on each client's liability profile, but at asset class level, we are slightly overweight equities as against fixed income."

As a whole, the portfolio has a euro bias because pension fund liabilities are in euros; there is, in any case, a legal requirement for Portuguese pension funds to invest at least 70% of assets in the currency of their liabilities.

While the bulk of F&C's equities are in euro-zone countries, there has been no exposure to Portuguese stocks for some years.

"We are, however, overweight in US equities because we see that market as a source of global growth compared with the euro-zone, while emerging markets still present too much risk," says Palmela.

But he says that, since 2008, alternatives have lost their appeal: "We try to avoid illiquid investments, so we're not holding alternatives, apart from passive vehicles which give us more liquidity than mainstream hedge funds," he says.

Verheij says that most Portuguese pension fund managers have a bias towards active management, and are trying to deal with the market environment on a short-term basis.

"This implies an increased volatility in performance," he says. "We are now discussing with our clients the choice they could make between a more liability-matching approach - which becomes more important in a more volatile interest rate market - or a more absolute return approach, which could also make sense in the current low interest rate environment. The final decision our clients will make will be driven by the ultimate risk budget."