Since joining the EU the Spanish economy has become one of the most dynamic in Europe. But as business flourishes in what was once a rather sleepy – not to mention sickly – backwater, old habits – and clichés – die hard as growth of the second pillar pensions system continues to be stifled by a bloated system of compulsory state provision.
The system provides a replacement ratio of over 90% for those earning up to the social security ceiling of just over E30k. Consequently the financial burden of the system on state finances is huge. According to the European Social Observatory the cost of the first pillar system accounted for 9.4% of GDP in 2000; by 2030 this will be 12.6% - if the system is not reformed; by 2050 it will represent some 17.3%.
Meanwhile, the cost to employers of 30% of salary makes the prospect of additional provision in the form of an occupational scheme difficult to contemplate for many companies.
This is evident in the relatively low membership of second pillar schemes of just 1.3m, although the figure is up 81.9% on the previous year due to the addition of just over half a million civil servants. AUM are nothing spectacular either: at the end of June second pillar pension assets accounted for E26.6bn, an increase of 10.9% over the previous year. Including third pillar assets the total is E66.4bn.
The first pillar pension is based on the average of the 15 best years of earnings. The government is now considering extending this to an average of the whole career. But there is nothing in the draft legislation to change the basis for calculating the pension.
Yet the need to reform the first pillar is well known. One line of study recommends defer the age of retirement from 65 to 70 or to extend the period of calculation to the whole career. “The question is which government will reform the system?” asks Igor Alonso, senior investment consultant at Hewitt’s office in Madrid. “The present government is not in the majority so it will be very difficult to reform. It is also a very sensitive issue among voters. So we shall have to wait several years for change.”
Ignacio Maino, head of investment consulting at Novaster goes further. “I don’t think we will take further steps to reform the system,” he says .“To reduce the replacement ratio is a very tough political decision. Waiting for reform is like waiting for Godot.”
But Javier Mazarredo, director of business development at Santander Asset Management in Madrid, predicts no movement on reform over the next two to three years, but he is optimistic about the longer term. “There is no doubt that reforms will come and that the Spanish asset management industry will show very healthy growth rates in the next decade,” he says.
A number of factors have taken the urgency out of reform. There has been a lot of immigration from Latin America, and meanwhile the number of pensioners is set to slump due to the effect of the Spanish civil war. Luis Peña, CEO of Fonditel believes that the effect will be short-lived. “Demographics will be a problem again in around five years’ time,” he says.
The issue of educating the public is also significant. “The population doesn’t see a time when the pensions will be cut, even though they can see that the number of old people is increasing and the number of young people is decreasing,” says Maino.
But Peña disagrees: “If people have the capacity to save they will do so in a pension fund because of the tax incentive,” he says. “They fear an increase in the retirement age from 65 to 70 so they are starting to think that it is a good idea to make additional provision.”
Pension fund management is dominated by the big Spanish banks; their pension management units are known as gestoras. Only they are allowed to manage pension assets directly at present. Foreign managers can only get in on the act through outsourcing agreements.
Peña believes that the gestora will remain dominant. “With E70bn of assets in second and third pillar plans the 200 gestoras are sufficient,” he says. “So there is very limited opportunity here. Foreign houses would need to work hard to get the confidence of the trustees in terms of independence and track record. The market is small and very competitive.”
Access of foreign managers to management of Spanish pension funds as required in article 20 of the European Pensions Directive may be a way off. As David Menendez, president of OCOPEN, the Spanish Association of Pension Consultants explains, “the impact of article 20 of the European directive is still to be seen; our country may be more sensitive to this article because a great part of the companies in Spain, especially amongst the big companies, are multinational firms, both European and American. These could choose to implement their pension schemes in their countries of origin and let Spanish workers join them.”
Christian Lux, technical leader at Watson Wyatt in Madrid notes that the matter of the European passport authorising foreign pension funds to operate in Spain and vice versa has yet to be resolved. There are also concerns about tax discrimination on contributions to foreign pension plans. He explains that the government had prepared two draft texts, one on the single passport and another one dealing with the tax discrimination issue. However both drafts are still undergoing the standard legislative process.
Furthermore legislation requires that all social and labour aspects of the pension management function have to be carried out in accordance with Spanish standards – communication with members is one example. “This would make it particularly challenging for a foreign newcomer in the face of the Spanish players which are already geared up to the needs of their pension fund clients,” says Lux.
Peña agrees: “Foreign managers have to understand that it will be very hard to have better systems than commercial banks have now,” he says.
Systems are all very well, but let’s not forget about performance. Lux believes that local managers have often been disappointing in this regard. “We are starting to see sponsoring companies asking for specific managers,” he says. “We keep on Spanish managers for the things that they are good at which typically is Spanish fixed income and equities, not corporate bonds or global equities. Companies are starting to realise that the competence of Spanish managers is not quite as broad as they had once thought.”
However, it appears that performance may not be uppermost in the minds of Spanish pension fund trustees. “The most important barrier is cultural,” says Lux. “Most pension fund committees don’t speak English and are not very sophisticated in investment matters. That would be a huge barrier to the pensions directive being effective.”
This situation derives partly from the fact that half the membership of Spanish pension fund boards of trustees – known as the Comision de Control – consists of trade unions, with the other half being employer representatives. Typically unions are keen to see jobs remain in the country, and the use of a foreign manager in a managing or subcontracted capacity may be seen as a threat in this regard.
Mazarredo disagrees: “I really believe that the Spanish market is already open. The problem for foreigners is… their lack of a distribution network, which is key in Spain.”
But skepticism prevails. Not least because the communist trade union CCOO and its socialist counterpart UGT each have a 15% share in one of BBVA investment management company, one of the major gestora. Both unions are also shareholders of Fonditel, another main investment management player. “So some fund representatives may have a biased opinion when it comes to chosing a foreign manager,” says Lux.
He adds that there is mentality of ‘you scratch my back I’ll scratch yours’ in the relationship between the plan sponsors and fund managers in Spain. “The decision to go with a given manager is not always taken based on the most professional standards,” he says.
But are the unions reluctant to use foreign managers? “That is by no means the case,” says David Carrasco, responsible for pension fund clients at BBVA. “The reason why foreign managers do not have a relevant role in pensions is price.”
He points out that the mean price for the pension management including administration and all the associated information for beneficiaries as well as the investment service is 20 basis points plus an additional 6-7 basis points for custody. “So if a foreign manager is charging 50 basis points just for the investment means that he cannot be competitive in a market where price matters, as is the case here. Foreign managers will have to lower fees in the main asset classes.”
Carrasco stresses that the low fees that are the norm of the Spanish occupational pensions market derive from the fact that Spanish managers are the most efficient in Europe. “Lower than average labour costs and a permanent focus on IT investments to gain efficiency and reduce costs while management fee incomes are under stress are the levers that give Spanish managers the edge on cost,” he says.
Price means that pension management is likely to remain the preserve of the larger players. Jaime de Lacalle, president of Urquijo Gestión de Pensiones, the pension fund – with some institutional – management arm of Banco Urquijo notes: “As a private bank for high net worth individuals, we are more focused on private pension funds. We do not seek to be an active player in managing external corporate pension funds, partly because of the market’s aggressiveness in terms of fees but also because of our sector positioning which only necessitates a small branch network and presupposes no extensive retail base, thereby limiting the ability to generate ancillary customer revenue from corporate pension fund management.”
Enrique Ruiz, managing director of Barclays Vida y Pensiones in Madrid believes that there is more to it than size: “Big banks and savings institutions are more active in the occupational pensions area,” he says. “Margins are traditionally very slim but they want to increase their AUM as a matter of prestige.”
Even if we disregard these competitive pressures the prospects for foreign players are limited by the fact that the costs which may be charged for the management of pension funds are limited to 2% a year with a further 50 basis points for custody. “The regulator has limited the total expense ratio which has been going against external products because of the layers of commission,” says Michel Escalera, CEO of the Spanish subsidiary of Credit Agricole AM. “This also means that there are limited possibilities to use funds of hedge funds.”
There is not the same pressure in emerging markets, hedge funds or corporate bonds and high yield, where foreign managers have more experience than local players. “There has been some interest to hire foreign managers in these areas,” Carrasco notes.
Escalera has witnessed this development: “We are trying to be subcontracted through or sell existing products to the major pension fund management companies,” he says. “They use us for certain underlying products in which we have particular expertise such as international fixed income.”
Javier Dorado, managing director at JP Morgan Asset Management in Madrid, notes: “The market is just starting to become more sophisticated in respect of outsourcing to foreign players.”
BBVA has global agreements with around 15 foreign managers with whom it has negotiated a reduction in the fee, most of which, bar a minimum fee which pays for the costs incurred in the selection process, is passed on to the pension fund client. But he too points to cultural issues. “Boards of trustees are not yet convinced that foreign managers represent value for money,” says Carrasco. “In such a competitive market where price is the main issue it is difficult to break that mentality. They are worried about taking risk because fund members, who as a general rule in Spain have a very conservative approach to investments, may blame them for losses, as happened in the period between 2000 and 2002.”
He adds: “The average comision de control is very conservative and is just beginning to think of emerging markets and non-traditional assets such as private equity and corporate bonds while they are, to a certain extent, afraid of hedge funds.”
Ricardo Pulido, senior investment consultant at Hewitt is not so patient. “Managers are not chosen because they are the best investment managers,” he says. “For them the administration problems are more important – ensuring that the information to members is delivered in the right way, for example.”
He adds: “Clients have all the information and work from their consultants but don’t want to use it to make changes. They use the consultant only as a means to monitor performance.”
But sometimes the sponsoring company doesn’t even want to use the consultant for that. “In the end the trustees ask us to do the performance attribution because they don’t want to pay the fees that the consultants ask,” says Carrasco. “Price and size are big issues in this market.”
The reluctance to use consultants is particularly alarming given that, as Lux explains, “many pension funds are not sophisticated enough to design their own mandates – they give benchmarks that are easy to beat. Local pension funds are very low on detail – the benchmark is usually fits onto one page drafted by the manager itself. Some comision de control have been disappointed with the results so they now realise that they must draft a proper mandate.”
Pulido is keen to underscore the lack of sophistication of Spain’s pension market: “Pension funds prefer the image of the big local players. Yet the big fund managers in Spain don’t want to fight to achieve the best performance – only the smaller managers want to take risk. The big Spanish managers compete on price, not performance.”
Meanwhile, Escalera is upbeat about Spanish managers pointing out that they have developed a lot since he first came to the Spanish market in 1997. “They are much more skilled and sophisticated,” he says. “For a long time the culture was dominated by fixed income – with double digit interest rates there was no need to diversify into equities. When interest rates started to converge internationally Spanish banks started to build skills in blue chip and open architecture. Furthermore Spanish managers have quite a lot of expertise in emerging markets – in the case of the Spanish market this means South America.”
Escalera does not sense any antipathy on the part of the unions towards foreign managers. “They just want the best return with risk control,” he says. “They are pushing to take into account some ideals of corporate governance, interests of workers when voting at AGMs. They are pragmatic - if the best SRI fund is managed by a foreign company they will go with that. Overall the market is very open to innovation. There is also huge interest in hedge funds and funds of hedge funds.”
ETFs and indices feature strongly in Spanish pension fund investments, which may contribute to the low cost ratio of Spanish managers. Spain’s E26.6bn of occupational pension assets are spread among 1,700 pension funds. “So the average size of a pension fund in Spain is very small,” says Carrasco. “This means that allocations of direct mandates are very difficult. So the most efficient way to buy is through indices, ETFs or mutual funds, especially the first two given the higher cost of mutual funds.”
Dorado notes: “Spanish pension fund managers outsource to us using our mutual funds – this accounts for 80-90% of the business we do with them. We offer Asian, Japanese US and even European equities as well as high yield and investment grade corporate bonds. Exposure to equity products will be higher in the future.”
In terms of investments one of the main bugbears of the industry is the new reglamento introduced last year which stopped the use of funds of hedge funds. The regulator’s objective was to protect pension funds from the extra layer of costs which funds of hedge funds entail; the 2% limit puts paid to this option anyway. “We had been very active in funds of hedge funds,” says Fonditel’s Peña. “In 2002 they produced the good results of the portfolio.”
Escalera notes: “If fee limits were lifted the Gestoras could be much more flexible regarding their investment options and outsourcing. But this won’t happen in the short term.”
The fund industry regulator is expected to publish its implementation of the UCITs directive before the end of the year. This will create a new investment class of hedge fund and fund of hedge funds available to private individuals. “If this happens the life insurance (pensions) regulator will have to change too,” says Escalera.
The limit imposed on OTC derivatives is also causing concern. Because they are considered illiquid it is not possible to purchase more than 2% from one counterparty. “A guaranteed pension fund needs derivatives and will need six or seven different counterparties so the limit makes it difficult to implement one,” says José Maria Castellon, director of special projects at Barclays.
But Peña is optimistic: “The regulator understands. It will change the regulation whereby if the manager is considered to have sufficient risk control systems it will be able to invest in credit derivatives commodities and fund of hedge funds. The investment policy document must allow this.”
The trend among banking groups is to merge the teams for mutual funds and the pension area and have one team managing both sets of assets. “This simplifies our dealings with the banks,” says Dorado.
According to Carrasco BBVA has carried out such a merger of its mutual fund and pension fund asset management functions, to obtain synergies and share best practices while ensuring that pension fund clients continue to receive dedicated asset allocation through a separate ‘multi asset’ department.
Currently legislation only allows for one investment profile per pension fund, regardless of its age profile. “We need at least two different investment profiles,” says Peña. “We are expecting legislation to allow the lifestyle fund. The unions are all for the collective system – I absolutely disagree. So we’re trying to negociate this as part of a big regulation package.”
So what of the outlook for Spain’s second pillar? “The government announced that tax regulation for pension schemes should be modified and it has been suggested that the tax break of E8,000 on second pillar contributions might be cut to approximately E6,000 by the end of 2006, effective in the fiscal year 2007,” says Castellon.
Both unions and government saying that the tax breaks have benefited the more comfortably off.
Amid the gloom of cost burden and inadequate tax breaks Peña is optimistic, “I expect 10-15% growth this year,” says. “I believe that the civil servants scheme will be extended to the whole public sector, so could be talking about two million members.”
The civil service scheme currently has assets of around E100m for its half a million members, so it is still in its early stages of development. “If the civil service scheme develops well people will realise that the first pillar is not sufficient,” Peña continues.
But a change of attitude among the population must be supported by that all important ingredient: political will. Today, not tomorrow.