THE PENSION SYSTEM IN ITALY

by

Marcello Messori (Mefop, Italy)

 

1.      The three pillars of the Italian pension system

The Italian Pension system is divided into three pillars:

1st pillar:  Public, compulsory and unfunded pay-as-you-go system (PAYG).

Until mid-Nineties this pillar was largely the dominant one, and it was based on an earnings related scheme since the pension level of each retired employee was determined by the amount of salaries she/he earned in (the last years of) her/his working activity. Consequently, the rate of substitution between pensions and salaries was up to 80%.

The reforms introduced in the second half of the Nineties keep up the PAYG system; however, the current reformed system mimics a funded system, in the sense that the pension level of each retired employee will be based on the amount of contributions she/he poured in the public pension scheme during her/his working life. In particular, the individual pension level will be determined by the sum of the individual amount of contributions and its capitalization at the rate of change of the nominal GNP. As a consequence, in the current public pension scheme the mean rate of substitution between pensions and salaries will decrease of almost one third. However, this reduction will have a different impact on the different categories of employees. First, the new scheme will be applied only gradually, so that it will not affect the older class of employees. Moreover, as to the younger class of employees, it will severely affect the rate of substitution of self-employees who have a significant and growing weight in the Italian economic system, but it does not significantly change the rate of substitution for the decreasing group of workers with a regular employment and an early career.

2d pillar:  Private, voluntary, and ‘collective’ funded system.

From the beginning of the Nineties (1993), the Italian legislation introduced Pension funds; however, the actual rising Pension funds date back to the last two years. The Italian Pension funds can be divided into two broad subsets: (i) the so-called “Contractual” pension funds which are mainly created by employers’ associations as well as trade-unions on the basis of occupational schemes, geographic areas, or individual big firms, but these funds can also be the result of direct agreements between (self-) employees, and (ii) the so-called “Open” pension funds which are founded by banks, insurance companies, and savings management companies.

At present the “Contractual” pension funds (from now on, PFc) are the core of the second pillar of the Italian pension system. Conversely, the “Open” pension funds (from now on, PFo) play a role in this pillar, when they offer a social security product to a given class of employees (for instance, the workers of a given firm), but they act in the third pillar when they offer a standardized or peculiar social security product to individual employees and other savers. This fact opens at least two crucial questions: (1) which is the efficient degree of competition to be ensured in the markets of the social security assets, and (2) which is the optimal regulation of these markets. Currently, the PFc take advantage from temporary barriers, and PFc and PFo enjoy different fiscal incentives. However, both categories of Pension funds have common features: they generally ask for given rates of contribution, and do not guarantee predetermined rents. In this last respect, the Italian Pension funds act as institutional investors in the domestic and international capital markets. This  means that they choose an asset allocation for their financial portfolios based on given benchmarks and entrust their wealth to management companies. Social security rents collected by the employees enrolled in a given Pension fund during their retirement life, will depend on several factors such as the gross rates of return realized by the financial investments of this fund, its operating costs, the fiscal regime for the social security sector, the life expectancy of the retiring employees, the institutional and operative setting of the rents payments, and so on.

3d pillar: Private, voluntary, and individual social security schemes.

In the third pillar there is competition between financial products offered to individual employees by the PFo, and the more traditional social security assets offered by insurance companies and other financial intermediaries. The working of the market is probably twisted by the fact that the same economic agents supply the competing assets. In this connection it should be pointed out that, for the moment, the PFo have not significantly eroded the market shares of the more traditional assets.

2. The legal and contractual  framework of the Italian Pension funds

Here we are particularly interested in (1) the working of the 2d pillar, and in (2) the relationship between the 2d and the 1st pillar.

Let me start from the last point. The above analysis emphasizes that the future decrease in the substitution rate of the 1st pillar attributes growing importance to the 2d pillar, and hence requires a more active role of the Pension funds. However, the fact that the new retirees will have lower public pensions, and hence they will need supplementary life rents made available by the Pension funds, does not exhaust the links between the two pillars; for these links also relate to the sources of finance to the public and private pension schemes. Moreover, the relationship between the two pillars of the Italian pension system do not sufficiently highlight the complex relations between PFc and PFo within the 2d pillar.

The PAYG is financed by a compulsory contribution rate on the gross salaries which is equal to 33% for the employees, and it is much lower for the various types of self-employees. The flows of contributions are collected by a number of National Social Security Organizations, which will directly provide the payment of public pensions to the employees during their retirement period. Moreover, when Italian employees retire, they are entitled to cash a kind of deferred salary (the stock of the so-called TFR, “ending job reward”) given by the sum of additional compulsory contributions (nearly equal to 7% on the gross salaries), and their yearly capitalization at a rate equal to 1.5% plus 0.75% of the actual inflation rate. It must be noted that this deferred salary is paid to each retiring employee by her/his firm, since the TFR accumulation is held by the firms themselves during employees’ working life and represents for firms a medium-term loan from employees at an implicit interest rate lower than the market rates.

There are two financial sources in the Italian Pension funds: (i) the contributions poured by employers and/or employees which have a minimum level determined by contractual agreements between parties, and (ii) the shares of the flows of TFR rescued from the firms to be allocated to the Pension funds. In the Italian Pension funds employees’ registration is voluntary; however, once enrolled, the employees have to fulfil legal as well as contractual arrangements. Generally speaking, the registered employees must meet three main obligations: they have (a) to join only the PFc related to their sectors or areas of activity, and not to move to another PFo for at least three years (five years in the case of a new PFc), (b) to pour into their Pension fund the share of the flows of TFR and the minimum rate of contributions determined in the contractual agreement, signed by employers’ associations and employees’ trade unions for their specific sectors of activity, and (c) to cash a maximum share of 50% of their capital accrued at the Pension fund when they retire. It must be noted that: as to point (a), an employee can firstly choose a PFo only if in her/his sector of activity there is neither an operating nor a prevision for a future PFc; as to point (b), the employees who got their first job after the end of April 1993 and now choose to participate in the Pension fund system, must poor the entire flows of TFR by law in their Pension fund, whereas the self-employees do not have any flow of TFR available, and hence must only poor their contributions; and, as to point (c), the enrollment into a Pension fund will be an efficient choice for the employees only if their loss of liquidity (when retiring) and the riskiness of the financial portfolio of their Pension fund are more than compensated by expected returns higher than those realized by the flows of TFR invested in the firms.

Obligation (a) shows that there is a segmentation of private social security markets between PFc and PFo, obligation (b) needs to be integrated by some reference to fiscal incentives, and obligation (c) points out that any transfer of finance from a PAYG to a 2d pillar (the so-called “opting out”) also involves an increase of riskiness in the allocation of employees’ social security savings. Here, I do not analyze the possible economic efficiency of a certain degree of market segmentation since this analysis would require a lengthy comparison between the organizational and operational features of PFc and PFo. Conversely, I shortly refer to the importance of fiscal incentives, and I will later go back to the “opting out” problem.

The fiscal regime plays a crucial role in the financing of Pension funds since the fiscal incentives bind the contractual agreements between parties and actually set the maximum amount of contributions poured by employers and/or by employees into the Pension funds. In Italy the allocation of any flow of TFR to a PFc or (when allowed) to a PFo is tax-exempted, whereas the amount of tax-exempt contributions is limited. By now, each employee and employers can pour into the Pension fund an amount of tax-exempt contributions equal to 2% of the yearly gross salary of the former up to almost 1,300 Euros, provided that there is an equivalent transfer of flows of TFR to the Pension fund; in the case of self-employees, the rate on the yearly gross salary is increased to 6% up to almost 2,600 Euros, and the reference to TFR obviously disappears.

3.  The basic figures of the Italian 2d pillar

The problem is that the above-specified sources of finance of the Italian Pension funds were not sufficient to develop the related industry.

At the end of December 1999 there were 42 constituted PFc and 86 constituted PFo. However, a slight minority of the former have fulfilled the woolly set of rules and become operative. In particular, 8 out of the 42 constituted PFc were still waiting for the first authorization to the enrollment of the employees, 27 (26, in January 2000) PFc were allowed to pursue this first step but – together with 10 PFo - were still waiting  for the authorization to the activity, and only 7 PFc (8 in January 2000) plus 76 PFo were operational. Moreover, in 1999, only 4 out of the 7 operational PFc selected the management companies to whom to entrust their wealth, and only 1 of these 4 PFc realized its asset allocation. The rate of return of this fully operational PFc has been higher than 11%, and the provisional investments of some other operational PFc have reached rates of return higher than that guaranteed by the stock of TFR left within the firms.

These few numbers point out that the Italian Pension funds industry has a wide potentiality of expansion but is still in its infancy. The contradictory evidence offered by the rates of registration and wealth accumulation confirms the picture. The set of authorized PFc caters for a potential floor of over 9,000,000 employees, which represent 45% of the Italian workers; the problem is that, at the end of 1999, the rate of the registered employees on the potential floor of this set of PFc was slightly higher than 6%. On the other hand, the number of the operational PFc is still limited, but at the end of 1999 the rate of the registered employees in this small subset of Pension funds overcame 30% of their potential floor. This last promising enrollment rate did not flow into a significant accumulation of wealth in the Pension funds industry. Always at the end of 1999, the total wealth of the seven operational PFc was lower than 525 million euros; and the total wealth of the Italian Pension funds industry did not reach 800 million euros.

Compared with the amount of the Italian financial wealth, these last figures are really negligible and hinder the development of our Pension funds system. In particular, they possibly prevent the  evolution of the PFc as institutional investors and as the core of the 2d pillar. A proof is that the financial portfolios of the few operational PFc are (or will be) allocated in a number of different investment lines, but the performance of each line is (or will be) merged into a unique rate of return. If the amount of wealth of the single PFc did not dramatically increase, it would be difficult to transform the different lines of investment in independent financial products to be offered alternatively to the registered employees.

4.  The innovations in the legal and contractual  framework

The difficulties in the start up of the Italian Pension funds industry justify the evolution in the legal and contractual framework.

In January 2000 the Italian government undertook a fiscal reform of the 2d and 3d pillars of the social security system, which will become effective at the beginning of 2001. There are three main innovations in this reform. The first refers to tax-exempt contributions. As stated above (see sect. 2), the maximum tax-exempt amount now is bound for each employee and her/his employer by the minimum level between (i) 2% of the yearly gross salary of the former, (ii) almost 1,300 Euros, and (iii) the flow of TFR transferred to the Pension fund (see above, sec. 2), whereas this same maximum level is bound for each self-employee by the minimum between (iv) 6% of her/his yearly gross salary, and (v) almost 2,600 Euros. The fiscal reform implies that each employee or her/his employer can, at most, pour a tax-exempt amount of contributions equal to the minimum between (a) 12% of the yearly gross salary of the former, (b) almost 5,200 Euros (overall), and (c) twice the flow of TFR transferred to the Pension fund, whereas the tax-exempt maximum contribution of every self-employee will be subject only to the previous points (a) and (b). The second innovation regards to the maximum share of the capital accrued at the Pension fund that a registered employee can cash when she/he retires. As stated above (see sect. 2), now this share is equal to 50%; the reform will decrease the ‘normal’ share to 33% and will fiscally penalize the still possible cashing of the additional 17%. The last main innovation is the taxation of the capital gains realized by the Pension funds on the capital market. Now the capital gains are exempted; the fiscal reform will introduce a taxation of 11% (compared to 12,5% for the other long-term financial assets), and will thus adopt an ETT rather than the European EET model of tax regime.

Let me only analyze the consequences of the first innovation. The average salary of the employees’ in Italy, the weight in it of the flows of TFR (lower than 7%) and the prevailing contractual shares of these flows poured into the PFc (lower than 50%) imply that the maximum amount of the tax-exempt contributions is bound for the employees by the constraint (c) above, that is by the limit set by twice the TFR yearly transferred to the Pension fund. This means that, in general, the employees will not be able to exploit the tax exemption up to 5,200 Euros. Conversely, this level of tax exemption will be possibly exploited by the richest subset of self-employees, who are not bound by the transfer of TFR. To re-balance the position of employees with respect of self-employees, it is thus suitable to allow the registered employees to transfer their entire yearly flow of TFR to their Pension fund. This solution would not reduce employees’ freedom of choice in relation to her/his possible registration at a PFc or (when allowed) PFo. Moreover, it will strengthen the frail sources of finance of the Italian Pension funds, which have dramatically restricted their wealth to negligible figures up to now (see above, sect. 2).

The important remark that is often moved against this solution is that social security contributions, transferred to the 1st and 2d pillar of the Italian pension system, could thus reach 40% of the gross salary of each employee. According with the suggestion of several analysts, a possible alternative could be that  the voluntary transfer of the entire flows of TFR to the Pension funds is subordinated to the decrease in the compulsory contributions poured by the employers and the (self-)employees into the 1st pillar. This alternative, which would introduce a mild form of “opting-out” into the Italian pension system, correctly emphasizes that an efficient three-pillars-social-security system has to relate and to harmonize at least the working of its first and second pillar, whereas the working of these two pillars are still independent in the Italian system. However, this alternative undervalues that (1) the recent reforms of the PAYG has already reduced its future relative weight, and that (2) an additional decrease in the weight of the PAYG and a related increase in the weight of the 2d pillar would not only imply a raise in the expected returns on the social security portfolios, but also a raise in the riskiness of employees’ social security position.

It follows that the quantitative balance between the 1st and the 2d pillar of the Italian pension system must satisfy an equilibrium among several variables: an adequate level in the rate of substitution between pensions and salaries, a ‘reasonable’ total amount of social securities contributions due by employers and employees, a moderate risk in the allocation of the financial assets which will feed the future pensions. It is impossible to figure out which is this optimal equilibrium without an accurate analysis of the empirical evidence that is still lacking.

5. The role of Mefop in the Italian Pension funds system

Mefop, the company for the development of the Italian Pension Fund market, was founded by the Italian Treasury a few months ago in order to satisfy the needs of the Italian Pension Funds and meet the demand with the supply of this growing market. At present Mefop is still under control of the Italian Treasury.

Mefop operational areas are the following:

Financial area:

·         evaluation of  benchmark construction methodologies;

·         determination of quantitative and qualitative standards to select and evaluate management performance;

·         definition of tools in order to cluster the potential Pensions Fund members in homogeneous risk outlines;

·         methodologies to control benchmarks and management risk;

·         acquisition and improvement of database for analysing and monitoring pensions market.

Organizational area:

·       comparative analysis of outsourcing activities: management, custodians, etc…;

·       definition of an ethical code to solve interest conflicts;

·       definition of marketing and communication activities;

·       training activity.

Normative and institutional area:

·       opening of institutional channels with European Union and domestic legislator;

·       reports about domestic, European and international legislation in force;

·       relationship with national and international institutions acting in saving industry.

Moreover, Mefop has just started to publish its Newsletter.