Portugal: Cautious steps towards risk taking
Portugal’s supplementary pension funds have increased their equity weightings but are still cautious on fixed income, writes Gail Moss
The past year has been a torrid time for first-pillar pension provision in Portugal, with the government’s publication of plans to raise the state retirement age and make further cuts to state pensions.
It also intends to bring public sector pensions into line with those in the private sector, which could bring a 10% reduction in pensions above €600 per month.
However, the resulting increase in importance of second-pillar saving has not led to higher inflows into private pension plans, says José Veiga Sarmento, president of the Portuguese Association of Investment Funds, Pension Funds and Asset Management (APFIPP).
“Paradoxically, the impact of some austerity measures, which are heavily taxing private pensions, has introduced doubts in the minds of savers about building pension savings,” he says. “This is a nonsensical situation, because it is clear there is a need to promote and establish long-term savings, especially for retirement.”
“Most people do not yet recognise the significant drop in first-pillar provision,” says Gert Verheij, senior investment consultant, Towers Watson, Lisbon. “In the past, this was about 70% of salary, but is now closer to 50%. A significant change towards putting more money into private savings, facilitated by employers, is the only way to keep the pension system sustainable.”
Within Portugal’s private pension schemes, asset allocation has remained fairly stable over the past year. But there has been a noticeable shift from bonds to equities.
Directly-held equity allocations for pension funds rose by 24.6% from June 2012 to June 2013, compared with an increase of 5.3% for directly-held fixed income, according to the Portuguese Insurance and Pension Funds Supervisory Authority (ISP).
However, from January to June 2013 there was a slight decline in the latter.
Verheij ascribes this to the twin factors of low interest rates in the core euro-zone countries, and high risk levels in the peripheral euro-zone countries.
On average, directly-held equities now make up 9.1% of pension fund portfolios, compared with 41.5% for directly-held bonds. But 27% of portfolios are in investment funds, which APFIPP estimates include 39% in equities and 23% in bonds, giving portfolios a total exposure to these asset classes of 19.6% and 47.7% respectively.
“Managers are cautiously confident on the economic outlook and on the positive prospects for equities,” says Veiga Sarmento. “However, absolute values on investment in equities still remain far off pre-crisis values. And there is also the uncertainty about the length of the debt horizon, which is commanding the attention of managers and fund promoters.”
“Notwithstanding some tactical changes over time, our model portfolios have been continuously overweight equities versus fixed income for the past year,” says Joao Pedro Palmela, head of institutional client services, F&C Portugal.
“Over that period we have seen bond yields rising, and we think they will rise further over the next 12 months.”
Meanwhile, BPI Gestão De Activos’ recommended asset allocation for client portfolios has continued the shift from fixed income into equities over the past year.
At present, the asset managers are 5% overweight the equity benchmark of 25-30%.
“Right now, the relationship between the two asset classes is at a very extreme point historically,” says José Luis Borges, head of asset allocation, BPI Gestão de Activos.
“For decades, equity earnings yields were lower than bond yields but now they are equal or even higher. Of course we should be careful because company profit margins are very high, mainly because of aggressive cost cutting. In spite of this, the valuation of equities, particularly in emerging markets, is very attractive.”
The equity portfolio is spread throughout Europe, the US and emerging markets.
“At the beginning of 2013, we bought slightly more European and emerging market equities, because they looked cheap at the time compared with North American equities, as the US stock market was performing better and valuation was looking less attractive,” says Borges.
Over the next 12 months, he says the portfolios will most likely stay overweight in equities.
“We will probably increase our allocation to emerging markets even further because they are getting cheaper, mainly because China is slowing down,” he says. “Meanwhile, Europe is more of a relative play to the US, because valuation ratios are more favourable.”
One trend possibly underlining this cautious optimism is that liquid assets (money deposited in bank accounts) fell by 29.3% in the first half of 2013, although APFIPP says this was a correction from a periodic maximum at end-2012.
Real estate is also a significant asset, with 12.1% held directly, and a total exposure of 20.2% (according to APFIPP estimates), including what is held via investment funds.
But the asset class makes up only about 2% of F&C Portugal’s model portfolios.
“Real estate doesn’t seem attractive any more, largely because of the overhang of collateral repossessed by the banks after loans were written off,” says Palmela.
Meanwhile, within the fixed-income allocation, Verheij says that exposure to government bonds of southern European countries has decreased, with pension funds moving instead towards higher-rated governments (Germany, the Netherlands, Finland) or towards corporate bonds in the euro-zone.
But he warns: “In this segment, we still see a relatively overweight position in the Iberian financial sector, which is not without increased levels of risk.”
He adds that there is, however, some movement towards bonds outside the euro-zone, mainly US bonds, which might alleviate some of the low yield and high credit risk.
BPI Gestão de Activos is now 10-20% underweight government bonds and even more underweight in terms of duration, and Borges expects this to continue.
“We prefer to keep durations short because of the extreme low level of interest rates, which may continue for a while,” he says. “But we think, medium to long term, the risk of losing money by going for longer-term bonds with higher yields outweighs any short-term gain.”
Over the past year, a few clients have decided to make a strategic allocation to Portuguese bonds, both government and corporate.
“They have done this to get high yields,” says Borges. “We don’t know if this will continue, but it’s possible other clients will do so as well.”
“We are looking on an opportunistic basis for bonds with short-term maturities, as the steepening of the yield curve still does not pay off,” says Palmela. “We are buying European bonds because the rating requirements from most of the IMAs prevent us from investing in domestic issues where ratings are generally below investment grade.”
Palmela says F&C Portugal is currently looking for returns mostly from equities, on the basis of the improved economic situation in developed markets. Portfolios include a fractional portion of domestic stocks held on a short-term tactical basis, but most equities are in core European markets.
Last July, Portugal’s finance minister sanctioned a move allowing the country’s Social Security Financial Stabilisation Fund to invest 90% of its portfolio (up from 55%) in local government bonds.
“How this affects bond pricing is difficult to say,” says Verheij. “There is an extremely dislocated secondary market with yields still above 6% for 10-year maturities, incorporating a premium for country default risk, which is currently above 30%.”
However, the bulk of the fixed-income holdings are international, mainly government and euro-denominated paper.
Germany, France and Italy are the most favoured issuers, because they have the biggest economies, although Borges says these are expensive.
Veiga Sarmento agrees that pension funds are cautious about the weaker euro-zone countries, in relation to government debt.
“Pension managers are conservative and not in a position to take risky bets,” he says. “While some fund promoters may have made some ‘patriotic’ decisions on investment policies, it is because they believe in the prospects of the country and assume that the value of Portuguese debt is mispriced by the market. “
He adds that there is, in fact, a high geographic dispersion for fixed income as a whole, with 30.3% invested in Portuguese issuers and 63.3% from other EU countries, according to the ISP.
In the next 12 months, according to Verheij, Portugal should be ready to go back to the capital markets without the support of Europe and the IMF.
He adds: “The Portuguese economy will be driven by further austerity measures, together with high levels of unemployment, risks in some of the economic sectors – especially the financial sector – and political instability. If a second bailout became necessary, the results of economic recovery would be very uncertain.”