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Social security creates space for DC plans

Portugal’s new centre-right government, which came to power in March, could provide a spur to the development of private pensions in general and defined contribution (DC) plans in particular.
This appears to be the consensus of the country’s pensions industry. Publicly, the view is that nobody knows what the new government plans to do and that it is too early to predict what will happen. Privately there is quiet optimism that the new government will go with the grain of the market. One straw in the wind is the fact that the new minister of social security and labour, António Bagão Félix, is a former administrator of Companhia de Seguros Bonança, a subsidiary of BCP.
Leonardo Mathias, general manager at Schroder Investment Management, says: “What we know so far is that the new minister for social security and solidarity is an experienced man who is well liked by the financial and pensions community. And we know from the programmes of the two parties that formed the coalition that one of their objectives is to move on second and third pillar pensions, and to give a much stronger weight to the market and to private pensions.”
More tangible evidence is provided by the manifesto published before the election by José Manuel Durão Barroso, leader of the Portuguese Partido Social Democrat (PSD). The manifesto promised a fully functioning three pillar system, new capitalised individual pension accounts and tax incentives for personal pensions.
Meanwhile, two pieces of legislation introduced by the previous socialist government are putting pressure on companies with pension funds with schemes linked to the social security system. These are funds that complement the state pension by topping up the benefit to reach a guaranteed pay-out (for example 80% of final salary)
According to the Instituto de Seguros de Portugal, 97 of Portugal’s 288 defined benefit pension plans, representing 81,000 people, had schemes linked to the social security in 2000.
In September 1999, a law or ‘decreto’ introduced the concept of flexible retirement. The state pension can be claimed from the age of 55 provided the beneficiary has completed 30 years of contributions. However, the social security ministry imposes a penalty for this, by reducing the benefit by 4.5% for each year of early retirement. Companies linked to the social security will have to pay this 4.5% themselves if they are to achieve the guaranteed pension benefit.
In February this year, another decreto was introduced that changed the formula for calculating the social security pension. The old formula was based on the best 10 years of the last 15 years of a working life. The new formula is based on the whole career.
This change will not happen immediately. People with less than years to go to retirement can chose the formula that is most favourable to them. People with more than 15 years to retirement will be assessed by a combination of the old and the new formulae. Only those who entered the labour market this year will feel the full effect.
Maria João Louro, retirement plan consultant at William M Mercer in Lisbon, says that the eventual effect of both these changes to the social security pensions system will be to lower levels of benefit and compel companies with plans that are linked to the social security system to contribute more. She is currently calculating how much more companies can expect to pay, and will be publishing her conclusions shortly.
“We have estimated that the future pension could reduce for the new contributors,” she says . “We think that in the future, if a company does not change its pension plan, it could have a problem because the social security will give a lower pension. So if the company provides a guaranteed benefit linked to social security it will have to pay more.”
The knock-on effect of this will be to encourage companies to move out of linked plans and into DC plans, she says. “In this new situation companies are going to want to do something in terms of changing the plans. We are recommending that they do it in two stages. We think that the first step should be to make the plan independent from social security, but maybe to stay as a DB plan. The second step should then be to change the fund from a DB plan to DC.”
But will companies necessarily take the second step from DB to DC? Rui Guerra, investment consultant at William M Mercer in Lisbon, says that companies are under increasing pressure to switch. “At the moment there is a situation of high risk for companies with their liabilities increasing so much, particularly where pension plans are linked to the social security and where the company is very big. So because the company will have to finance the additional liabilities they are definitely interested in changing to some other arrangement, and that must include DC.”
However, the greatest incentive for companies to switch to DC plans is likely to come from the new government, which has said that it wants to cap contributions to social security.
This will create a gap or vacuum for other forms of retirement provision, says Francisco Cordeiro, secretary general of the Associação das Empresas Gestoras de Fundos de Pensões (AEGFP) says : “We are now in a very important moment of history because we have a new government and a lot of discussion about the reform of the social security system. One of the possible drivers of that reform will be to create a ceiling or cap on the contributions to social security.
“When you create a ceiling you will make some space for private pension funds to develop. If you start with a ceiling that is relatively high, you leave people the freedom to decide what to do with their income above that ceiling. Do they want to spend it or do they want to save it? If you leave that decision up to people you will leave space for individual pension funds – and that will include defined contribution.
Bernie Thomas, practice manager at Watson Wyatt worldwide in Lisbon, agrees: “If that cap comes in then I would see a significant number of to-up plans being introduced for managers and senior managers, and that would drive significantly the DC market as well, because then you have a natural way of defining how much money to put aside.
Generally, there is a feeling that a number of developments – legal, fiscal and social – have coincided to improve the environment for DC plans. Pedro Silveira Assis, in charge of institutional investment at Schroder Investment Management in Lisbon, says that all the conditions are right for a rapid growth in DC schemes. “DC is a fast growing segment of the market in Portugal and it will be accelerated, we are sure, by the social security reforms that are taking place. The new government is going to be pushing the market in that direction - that is, into second and third pillar pensions solutions. The investment products are there, and the distribution infrastructure is there
“Most important is the expectations management that the government will have to do. Portugal’s pay-as-you-go system will not be able to bear its liabilities in 15 years’ time. As these expectations change, we will see a lot of money put into DC schemes.”

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