Italian pensions system: rebuilding confidence
Written by Christopher Andrews
Timing is everything. Back in 2005 the Italian government came up with a new pensions system which would put more obligation on individuals and employers, and lower the burden on the state. The reforms, which came into force in 2007 and effectively created the country’s DC pension market, were followed by the biggest economic crisis in 50 years, destroying confidence in the financial services, and making the conservative Italian public question the very idea of a new form of investment vehicle.
To make matters worse, private pension provision, for the majority of Italians, wasn’t something they’d ever really concerned themselves with in the first place. This was because the state pension had been defined benefit, and provided a replacement ratio of around 75 to 80 per cent of final earnings. Who needs private provision?
Back in 1995 though, reforms introduced a gradual shift away from DB to the notional defined contribution based formula, which applies to employees hired after January 1996, and introduces a cap on pensionable earning. These will result in a replacement ratio of more like 50 per cent, and this is expected to come to fruition by 2030.
Of course the old system was incredibly generous, says Jacqueline Wills, consultant at Aon Hewitt, now back in London having spent the last three years in Italy. “But now the state has lots of problems paying for these benefits, and the executives and managers who used to get a replacement ratio of 80 per cent, are now looking at a massive decrease.”
It was to make up the shortfall that the changes to the pensions market were introduced, as again, company pensions were hardly the norm prior to the reforms.
Rather, in addition to that generous state pension, employers had to provide a type of severance package known as TFR (trattamento di fine rapporto). Through TFR, around seven per cent of an employee’s gross salary was held by the employer, with a guaranteed annual growth rate of 1.5 per cent plus three quarters the rate of inflation. This money was paid to the employee upon termination of employment for whatever reason, but the employer could do whatever they wished with the cash up until it was paid out.
“From the first year of January 2007, this changed,” says Wills. “So employers had to make a contribution into a DC pension fund, they now had this cash flow requirement. The only way that they didn’t have to make this contribution was if the employee expressly said that they didn’t want to have their contribution paid into a DC fund.”
So, was there a huge uptake? No, not really. “There was an increase in that before the DC market was completely undeveloped,” says Wills. “But a lot of Italians are very very risk averse, so a lot of them opted just to continue to have TFR accrued as before.”
According to the latest figures from Italy’s pension regulator Covip, there are 5,227,308 people enrolled in pension schemes in the country. That figure is not huge, but as Luca Filippa, managing director of FTSE for Italy points out: “That is only three years from the start of the system so I think that isn’t a bad figure. I think we are suffering the disease of being young, and being young in an industry that had the largest crisis in the last 50 years is not what you want. But I think the reaction has been quite good.”
While the timing of that crisis was about as bad as it could be for Italy’s emerging pensions market, the aforementioned conservative Italian nature, and specifically investment rules which mean pension funds cannot invest in risky assets, meant that Italian funds fared better than many.
“There were low returns, and negative returns of course, but it was not as bad as expected. The market was well regulated,” says Martino Braico, senior manager, pension fund services, at Previnet.
“From the very beginning of the pension fund industry in Italy the law was quite clear in terms of investments and the approach to risk. So pension funds in Italy tend to be quite prudent.”
The current regulation that drives investment rules was introduced in 1996, and those rules haven’t been revised since, though there is a review expected next year.
As it stands though, prudent means only holding in the range of 20 to 25 per cent of funds in equities with the majority of the rest in bonds and cash. The rules don’t allow for hedge fund investment or use of complicated derivatives. And from a member point of view, occupational schemes must offer a ‘conservative line’ which has the same guarantees as TPR, and Braico says a lot of new members went for this option, “which is one of the reasons why the financial crisis did not affect our members that much.”
Beyond that conservative line, scheme design in Italy is not particularly sophisticated, according to Alberto Salato, head of Italian institutional business at BlackRock. Pension schemes offer standard asset allocation, and generally offer members between three and seven funds to choose from. These are usually the standard aggressive, balanced, and defensive funds which the member can switch between. “It is up to each member to decide their preferred approach, so it’s not particularly sophisticated. However, as they grow assets, some of the larger Italian pension funds are starting to implement better risk management frameworks.”
Despite investment options or scheme design, if more Italians are going to engage with the pensions market, there are a number of top down regulatory issues that need dealing with, though whether they actually will be dealt with is another matter entirely.
The government has been pretty hands off since the major reforms went through three years ago, though in July this year, as part of sweeping austerity measures, it announced that the retirement age would be increasing. As Marco Pistamiglio, retirement, risk and finance leader at Mercer Italy says: “From 1 January 2015 the pension age will be linked to expected average life expectancy, which means the higher the life expectancy the longer the pension age. According to this calculation in 2024 the retirement age will be approximately 67 and the expected pension will be lower than 60 per cent of the last remuneration.”
But this is certainly not reform which will improve take-up, and it is unlikely that we will see any such reforms in the very near future. Salato says the latest round of political turmoil in the country has complicated the situation, as complimentary pension provision will fall down the list of priorities until the political situation is rectified.
“However, in the meantime, there are ways that the government can encourage the population to take a more active role in managing their pension provision,” he says.
“At present, there is limited understanding of the scale of the pension problem in Italy. Italy is one of the fastest ageing populations in Western Europe and also has a low birth rate. Coupled with this, the country has a high level of public debt. Subsequently, the pension pot supplied by the government will no doubt contract and result in a poor ageing population, which would be dangerous. To try and prevent this, the government needs to act.”
Salato says government should conduct an aggressive marketing campaign aimed at the working population, highlighting the need to build up additional pension provision.
Then there are some rule changes government needs to consider, particularly around opting out. As it stands, if a worker transfers TFR into a pension scheme, there is no changing their mind at a later date; like it or not, they’re stuck. This acts as a real disincentive for workers to join schemes, particularly in such a new and unknown industry.
“The government should definitely consider reviewing this rule,” says Salato, “It is clear that the government needs to take action over the next few years otherwise it will be too late for a number of people in their 40's who still do not have any private pension provision.”
And then there is the question of tax, as the Italian pension tax treatment is different from most countries in Europe, and not in a good way. “What we need but is not coming, is more tax advantage for members entering the pension fund market, so some triggers to help these members put their money in pension funds,” says Previnet’s Braico.
Italy operates an ETT model, with that E even being pretty limited. The tax emption levels off at €5,164, with annual returns taxed at 11 per cent. “And of course taking out this money every year will definitely decrease the final income for the member by a large amount, which is very different if you take that out at the end of the period,” says Braico. “This 11 per cent is something that if it disappeared would definitely help the pension fund industry.”
Andrea Scaffidi, senior consultant at Towers Watson, says that the ETT model is not in line with the normal European market practice, but this is because “taxation of capital gains is very useful for the state to collect money”.
For the tax exemption, Scaffidi is not that concerned as: “For a large part of the population the average contribution is less than €2000,” he says, meaning they fall well within that exemption level. He agrees with Salato’s idea of education though saying: “The problem I think is that people don’t understand well what the impact is of the social security reforms. I think the state should be focussed on education, not on tax breaks. So if they could set up a campaign to [get people to understand properly] that it is the supplementary pension fund, that will increase their level of income when they go into retirement.”
So the priority then is education, or there could be some nasty surprises for people expecting their final salary pension from the state along with that severance package from their employer. And in addition, as FTSE’s Filippa says: “The main effort of the pension fund industry in Europe is to convince investors that they should not look at the pension fund as a normal fund; it’s not something that should provide revenue in the short term. You cannot evaluate pension fund returns on a two year basis. So the main action is to provide appropriate education.”
Written by Christopher Andrews, a freelance journalist