Italy
compiled by Allianz Global Investors
Pension System Design
Italy’s pension system consists of a PAYG public pension pillar as well as voluntary occupational and private pension plans. With a total of approximately EUR 350 billion pension assets under management in 2004, Italy is one of the larger European pension markets. Its life insurance market ranks fourth out of all the European markets and is set to continue outpacing the European average growth rate. Although Italy’s invested pension market is still small, the outlook for this sector has brightened with the passing of a new bill that was signed in October 2006. The bill encouraged the transfer of indemnity payments (severance pay, which is compulsory in Italy) to the private pension market. We expect new pension funds to grow at a compound annual growth rate of around 30% until 2015, making Italy one of the most exciting European markets. Total pension assets in the market are expected to grow at an annual rate of 5.9% to EUR 914 billion in 2020.
Public Pensions
The first pillar consists of a compulsory pay-as-you-go insurance comprising various branches. The most important are pension insurance for employees and for the self-employed and retirement pensions for civil servants.
As there were various reforms and amendments to the Italian pension system, the pension level and the statutory retirement age depend on a set of complicated pension rules. The Dini reform in 1995 implied a gradual introduction of notional accounts and with it a shift from a defined benefit to a defined contribution system. The new system applies to all who started working after January 1, 1996. For people already insured for 18 years on January 1, 1996 the pension level will continue to be calculated according to the old (defined benefit) method. Pensions for people who were already working on the cutoff date but had not paid contributions for 18 years by that time are calculated on the basis of a mixed formula: the periods before January 1, 1996 are counted as earnings-related and the periods thereafter as contribution-related. Given the long transition periods, the full impact of the reforms will not be felt until 2035.
The 2004 pension reform tightens the previously very generous conditions for early retirement: the age at which employees can draw a seniority pension will be gradually raised from the current 57 years to 62 years by 2014. This measure has been long overdue as the effective pension age was just 59.9 years in 2002.
Under the old system the pension is calculated on the basis of the formula ’2% x pensionable earnings x contribution years’ (max. 40), that is: the maximum pension after 40 contribution years is 80% of the last year’s earnings before retirement. Up to now, the replacement rate has averaged 69% for old-age pensions.
In the new system (after the Dini reform) the amount of pension benefits will not depend on salary levels but on the contributions made. To this end a notional capital stock is formed from the contributions paid in. Calculation of the pension benefit takes into account this notional sum and the recipient’s remaining life expectancy at the time of retirement. Due to these reforms the average pension level of a 60-year-old is set to sink from 67% today to 48% by 2050. However, means-tested social assistance pensions and supplements to social security pensions will guarantee a minimum income level beyond the age of 65.
Occupational Pensions
Due to the very generous first pillar system , additional occupational pension schemes were not widespread in Italy. At the end of 2005 the entire supplementary pensions sector only had three million contributors which, corresponds to a coverage ratio of 13%.
1. Pension Funds
In Italy there are two types of pension funds:
- Closed or contractual pension funds which are implemented either as company pension funds by a single company or as industry-wide pension funds set up by the employers’ association and the trade unions for a specific group of participants;
- Open pension funds that are offered by banks, insurance companies or investment management companies for a generic group of participants, i.e. the self-employed.
The new legislation allowed the employee to choose between open and closed pension funds and the individual pension plan FIP. It remains to be seen if this step will introduce real competition between the three core pension products, i.e. closed pension funds, open pension funds and the individual insurance plans, as the trade unions are clearly in favour of the closed pension funds.
All pension funds have to sign an agreement with an external investment manager that can only be an insurance company, a bank or a registered asset management company (‘Società Gestione Risparmio’ or SGR).
Today, all pension funds now operate on a defined contribution basis, as this is the only permitted type of pension plan. Defined benefit plans are restricted to the pre-existing funds. There are no minimum funding requirements.
Investment regulation
The investment regulations in Italy basically follow the Prudent Person Principle and have no general limits concerning overall investment in bonds and equity traded on regulated markets in the EU, the US, Canada or Japan. But this basically liberal approach is thwarted by a very detailed list of diversification regulations.
Closed pension funds, created after 1995, predominantly offer one single investment strategy for all their members, ignoring factors such as age or risk profiles. Therefore, asset allocation has traditionally been based on balanced portfolios with a heavy weight in bonds and cash. Recently, multiple investment strategies have become more widespread. This trend towards multiple investment strategies strongly favours the outsourcing of asset management activities in occupational pension funds to external managers. Although balanced and bond mandates still constitute a healthy portion of the overall investment, there are emerging signs that investors are demanding a more active approach to strategic asset allocation and are seeking higher risk/return strategies to achieve yield enhancement. ‘Risk budgeting’ is also increasingly applied to assess the strategic and active risk taken.
2. Termination indemnity payments (TFR)
Upon termination of employment for any reason, employers have to pay a termination indemnity (‘Trattamento di fine Rapporto’ or TFR) to all employees. In Italy the TFR serves as a backup in the event of redundancy or as an additional pension benefit after retirement. Severance pay is calculated as 6.9% of each year’s annual salary, revalued on the basis of 75% of inflation plus a fixed rate of 1.5% during the period of accrual, and is paid as a lump sum. Assuming that the TFR benefit is accumulated throughout a full career, it is expected to provide a pension of 10% to 15% of final pay.
Collective agreements between employers’ associations and trade unions can, and frequently do, increase the percentage of the severance pay (approximately 2-3% depending on the work contract), particularly in the event of redundancies. Through 2006 TFRs were traditionally funded by book reserve allocations, but it was also possible to use insurance policies.
The new 2006 legislation now formally requires the transfer of the TFR from companies’ book reserves to a pension fund, unless the employee explicitly forbids it. The rules were implemented with effect from January 1, 2007. Workers had to decide within a period of 6 month until June 2008 whether they want to keep their TFR in the company or to transfer it to a supplementary pension fund. The following scheme points out the devolution rules:
Companies with less than 50 employees are exempt from the compulsory TFR rule and can continue to manage the TFR as before.
Companies that have been using the TFRs as internal financing vehicles since the 1930s were previously reluctant to give up this long-established financing vehicle, which was the main obstacle to successful market growth in Italy. The new law implies that companies will have to invest the TFR of their employees into a pension fund that is legally separate from the company and that they must appoint an external asset manager. This provides a better protection for the employees, at the same time potentially enhancing returns on assets.
3. Pre-existing funds
Before 1993, there was no coordinated legislation governing pension provision and the only private pensions available were the pre-existing funds, which had no clear legal structure or processes. As a consequence, employers who established pension plans were able to structure the benefits they offered and the means of funding them almost as they wished. Pension funds established before November 15, 1992 (pre-existing funds) may preserve their old tax treatment, provided that they were closed to new entrants by April 28, 1993.
Tax treatment of contributions and benefits
The following tax treatment of contributions applies:
- Annual TFR accrual is 6.9% of total salary and is wholly paid by the employer;
- Employee and company contributions are tax deductible at the lesser of the following amount:
- 12% of total income;
- EUR 5,165;
- 2 times the amount of TFR accrual contributed to the fund;
- Company contributions are tax-deductible as labour costs;
- The self-employed may contribute to an open pension fund on a tax-deductible basis up to 12% of their income with an annual maximum of EUR 5,165;
- Contributions made by the employer, except those coming from an annual allocation of TFR, are subject to the social security solidarity contribution of 10%. Contributions made by the employee are subject to the normal social security contribution rate.
Benefits paid out as an annuity are taxed as normal income, but the amount corresponding to the investment earnings is payable tax-free. Benefits paid out as a lump sum are subject to completely different taxation regulations and are taxed at the average income tax rate of the last 5 years prior to their payment.
Outlook
Italy has begun to move away from a first pillar-centred to a more multi-pillar system by encouraging occupational pensions and introducing third pillar pension plans. Greater diversification of retirement income seems critical for Italy to cope with demographic change and to ensure pension sustainability and security. The short and medium-term outlook for Italy’s pensions markets will clearly depend on employee willingness to transfer TFR contributions into pension funds. The implementation of individual choice may also help create an awareness of individual responsibility for retirement. In the long run, the outlook for Italy’s pension markets depends on the path towards political reform and acceptance of funded pensions as an integral part of old-age retirement income provision.