There is movement on the state pension front in Portugal,  Iain Morse finds

Until recently Portugal had one of Europe’s most generous, unfunded welfare systems. “The problem is that it grew far too expensive to maintain,” argues Maria João Louro, a senior consultant at Mercer Investment Consulting based in Portugal.

By 2002 all the major political parties agreed that reform was necessary. A career-average formula was introduced for state pension calculation in 2002, replacing a system based on an individual’s average earnings during the last 10 years of employment, with changes to be phased in by 2017.

In May a decree accelerated the transition while capping pension entitlement in most cases at €4,774 per month. It also included a ‘sustainability factor’ to reduce pensions as average life expectancy increases from 2008.

“The main impact of these changes will be a reduction of state pensions for the better paid,” says Bernie Thomas, senior consultant at Watson Wyatt in Lisbon.

They also make it harder to predict future pension levels per individual and are expected to prompt employers to introduce or enhance workplace pension provision. State pension accrual rates will also be staggered by earnings; the lowest accrual rate for pension entitlement will be 2% a year for the highest paid, the higher accrual rate of 2.3% a year for the lower paid.

But the system’s running costs remain high. Employers contribute 23.75% of gross earnings and employees 11%.

Under current legislation there are two types of pension fund provider, pension fund management companies (SGFPs) and insurance companies. Each can provide either defined contribution (DC) or defined benefit (DB) plans to sponsoring employers and also offer what amounts to individual pension schemes.

Employers not running their own independently constituted pension schemes sub-contract the running of the scheme to a selected provider that manages them on a pooled or segregated basis. Most new DC plans used pooled funds.

The 13 SGFPs managed 92% of the around €21bn second pillar assets at the end of 2006, with the balance being managed by 14 insurers. SGFPs are limited companies, run on a for-profit basis, and owned by banks or other financial institutions. The six largest - PensoesGere, BPI Pensoes, Previsao, ESAF, SGFP de Banco de Portugal and Santander Pensoes - manage over two-thirds of all second pillar assets.

These include over 450 separate schemes. Of these, 289 are DB, 146 DC and 31 are hybrid. However, 173 of the DB schemes are closed to new members, as are 16 DC and 26 of the hybrids. A closer look at the remaining open schemes reveals the dominant role of the SGFPs, which run 112 of the remaining 114 open DB schemes, 125 of the 130 open DC schemes and the remaining five open hybrid schemes.

“These vary enormously in size, from a very few members to 10,000 or more,” says Thomas. “A mid-sized scheme might have 100 members.”

Competition between the SGFPs focuses on charges, fund performance and service levels. “Issues like the quality and extent of member communications tends to differentiate providers,” adds Thomas.

The 175 closed pension schemes have over €19bn of the sector’s €21bn in assets. The most important closed schemes are the 25 sponsored by Portuguese banks for their own employees, which manage around 70% of ‘closed’ assets.

The next largest group - the 17 schemes sponsored by employers in the transport, storage and communications industries - account for over 14%. Despite regulatory changes, consultants concede that decision taking and manager selection in closed schemes remains opaque.

The average asset allocation for DB schemes remains heavily weighted to bonds and equities. According to Watson Wyatt, at the end of 2006 euro-denominated bonds accounted for 44% of scheme assets, of which 50% was invested in fixed rate public debt, 12.5% in fixed rate investment corporate debt and the balance in floating rate investment grade debt.

Domestic equities accounted for 19% and other euro-zone equities for 15%. Property, for the most part domestic and directly held, accounted for 12% and cash for 7%. International equities accounted for 9.8%, non-euro-denominated bonds for 2.1% and funds of hedge funds 3%.

Much of this money is run in-house by the SGFPs and insurers, only a small number of mandates are awarded to external managers, usually in non-euro-denominated assets or hedge funds of funds. SGFPs are subject to a number of investment restrictions.

According to Aon Consulting, two-year average performance, expressed net of charges, has not been impressive.

New pension fund investment principles were introduced on 29 June to comply with the EU pensions directive. In the absence of trustees, these principles seek to instantiate the ‘prudent man’ principle in the conduct of pension funds. For instance, fund managers must diversify risk and pension funds make an explicit statement of investment principles. The previous 55% cap on equity exposure applied to a pension fund’s aggregate assets is removed. While a 30% limit on non-euro-denominated assets remains in force, the previous 5% limit on non-euro collective investments has been doubled.

But restrictions and impediments remain. The requirement that a Portuguese pension fund have a Portugal-domiciled SGFP means that foreign asset managers can only manage Portuguese pension money if hired by an SGFP but as most SGFPs are owned by Portuguese banks they will usually look to their parent to manage most assets.

It is difficult to argue that this set of opaque business practices complies with broader notions of best practice in the European pensions market but by the same token the vested interests in its retention are very strong.

There are some notable exceptions to this picture. F&C acquired the asset management business of Banco Comercial Portugues (BCP) in 2001, and more recently in a joint venture with Fortis Bank it took over the management of assets at Pensoegere, which accounts for about a third of Portuguese pension assets.

Schroders has followed a more traditional route into Portugal. “We have 22 wholesale and seven retail agreements,” notes country head Leonardo Mathias. A growing number of foreign asset managers, including JP Morgan and BGI, sell funds in the same way.

Further change is expected. The introduction of second pillar individual savings accounts is under consideration based on the example of Sweden and Poland. Proposed legislation has these being administered by the state but with funds managed by the private sector.

Meanwhile, there is speculation that the Social Security Financial Stabilisation Fund (FEFSS), will invest around €400m, some 10% of assets, in an externally managed equity portfolio. These could further reduce the burden on the taxpayer and might ultimately replace some of the first pillar benefits that remain after their reduction and reform.