This year is one of diminishing uncertainly for the Portuguese State Fund Management Institution (FEFSS). Whereas previous projections envisaged drawing on the €7bn of state reserves from FEFSS, calculations now foresee that the assets will not now be needed until around 2030.

This provides the fund’s management with a degree of much needed certainty and, of course, the ability to steer a longer-term investment policy that may soon invest in riskier asset classes.

In 2005 and 2006 there was a revision to an existing study on Portuguese demographic trends, which said that the fund would be drawn down in 2009 or 2010. “When I arrived here we had an investment horizon of 2009-10 and that was a problem because we would have had to start to think about drawing down the fund within two years, explains Manuel Pedro Baganha, president of the board of directors of FEFSS. “That would not have allowed risky investments.

“Given the changes that are currently being introduced to the Portuguese pension system, studies now show that given those changes, which were introduced at the end of last year and the beginning of this year, the fund will probably not be needed until the mid 2030s,” he continues. “So that creates a longer horizon and currently we are in the process of reviewing the policy so we can make a proposal to the minister in terms of introducing possible changes in the investment part.”

FEFSS was created in 1989 with an initial transfer of €216m. Today it receives surplus cash from the social security system and a share from Portuguese employees’ 11% contribution to the social security system - currently between two and four elevenths - although this contribution is waived if pressures on the national budget dictate. At the end of 2006 the value of the fund - then €6.6bn - amounted to a little over 80% of Portugal’s annual expenditure on pensions, or 9.7 months’ worth. The fund’s political aim is to accumulate reserves to cover two years’ expenditure.

As Baganha explains, funds transferred in 2003-04 were relatively small, while contributions this year and last have been considerably higher.

The fund is now on the threshold of two major developments, perhaps the most significant in its relatively short life. For the first ten years of its existence until 1999 and the introduction of the euro, the fund was only permitted to invest in Portuguese assets. This restriction was then widened to include any country of the euro area and the asset restrictions were lifted to allow additional investment in equities from 10% to 20%. From 2004 the fund has been permitted to invest in assets of OECD countries.

“In 2004 a study was carried out, taking into account what would be an optimal portfolio. This was done with external consultants,” says Baganha, who has been president of the board of FEFSS since the beginning of 2006.

“At that time several portfolio rules were redefined, an upper limit of 25% in the stock market and an upper limit of 10% on real estate. The minimum investment in Portuguese public debt was kept at 50%,” he continues, adding one major caveat: the potential volatility of the social security and demographic projections upon which the fund’s long-term future rest.

For now, Baganha expresses confidence that the new date for drawdown the funds - some time in the 2030s - allows for a long term horizon, even if the actual date fluctuates or reduces by a couple of years.

And a diversification programme is underway. The fund used to own two buildings, but one of these was sold earlier in the year to allow the fund to diversify through indirect real estate holdings. Although it can invest further afield it is currently invested mostly in Portugal: “We will now go through funds and not directly buy property. This requires a lot of people…and that creates some specific problems in order to manage the property although I think that we have been able to get the return,” Baganha comments.

“We are a very small group, basically 25 people. That creates stability and we have been able to manage to work with that number of people,” continues Baganha. Although some of the equity investments are done through mutual funds and structured notes, the fund is essentially run internally, he adds. “There was a time that we used to have more stock picking but I do not think that, given our size, it would make sense to do a lot of it. We would need a lot of resources.”

Although it is a public body, the FEFSS can compete with the private sector in terms of salaries and so is able to recruit the people that it needs for its internal portfolio management team, according to Baganha.

External funds are used for equities and real estate, and a small part is invested in private equity. This latter is within what is called the fund’s strategic reserve, a segregated part of the portfolio that will not be drawn down in the short term whatever eventualities may occur in the demographics of the Portuguese social security system.

This strategic reserve may total 5% of overall assets although it stood at 3.30%, or €218m, at the end of 2006.

Investments are currently made by the investment division in three geographic areas: the United States, Japan and continental Europe, with the UK as a bolt-on to the Euro-zone.

Although investment decisions are decided through weekly meetings of the board of directors, the head of the portfolio management division and the head of macro-economic research, the investment team still has some freedom in day-to-day implementation: “If they want to be overweight one percentage point according to the benchmark, for example, they have freedom to implement that.” Nevertheless, since FEFSS is a public body, final decisions officially rest with Baganha as president of the board of directors.

 

One of the changes recently enacted by the minister for social security and labour, currently Vieira da Silva, include the ability to outsource parts of the fund contractually through external mandates. “The secretary of state for social security has announced that part of this fund will be outsourced to be managed by private companies, so from €7bn part of it will be outsourced. This will mean that we will have to select the managers and control them,” says Baganha.

One reason for this, he says, is that the fund can implement competition: “To outsource to managers with exactly the same rules as we have will create an additional benchmark for the evaluation of our performance.”

As Baganha explains, the fund currently has objectives in terms of return and there is an internal benchmark, based on market indices. However, he would prefer to outsource part or parts of the fund to third parties, which would then create a real benchmark for the internal team, based on competition with the external managers.

“We will have a benchmark based on someone in the market like us. And I think that is a good thing in terms of evaluating our performance and creating different incentives,” as Baganha puts it.

The other benefit, in Baganha’s view, is that the fund will be able to outsource more to other areas in which it does not have internal competence, potentially allocating more to private equity and to hedge funds for the first time.

“For example, if we decide to invest in hedge funds or more in private equity by outsourcing, we could give that kind of investment to managers that have additional competence, a good track record and that would increase our returns,” he says.

This would in effect mean that the fund has two types of outsourcing - one to create a competition incentive for the internal team and another to allow the fund to access areas of investment where it does not have expertise. The change in the investment regime could happen soon, but Baganha says his main concern is a lack of internal resources to implement a competitive tendering process.

Perhaps the most wide reaching change to Portugal’s social security system will be the introduction next January of the Regime Publico Capitalização - or Public Capitalisation System - which will add a defined contribution element to the first pillar.

Under this new regime, individual citizens will pay an extra percentage point of their social security system into a defined contribution account. The main feature is that citizens will be the legal owners of their funds.

These changes form part of a wider reform of the social security system, which will also start next January, and which will change the calculation of the state pension. One of the new rules is that future pensions will partly be determined by national life expectancy at 65, which is likely to reduce the value of pensions generally.

FEFSS has been nominated as manager of the system. But despite the considerable changes that this introduces to Portuguese state pensions generally, Baganha does not foresee dramatic changes either to the structure or operations of his institution. “This will be a challenge for us because we will be managing not only the fund but also all processes that involve all the different social security institutions. We will be the overall managers, but will not have offices delivering information or getting in touch with citizens, which will be part of the regular social security department,” Baganha explains.

“We will have overall responsibility for the project and that is an additional challenge as we will have to conduct activities that we currently do not conduct. Not so much in the financial management of the fund; the challenge will be come will come in the administrative area.” The new system is now in the implementation stage, and is currently determining how many extra staff it needs.

These extra staff, not likely to be more than a handful, will probably be based in a contact centre for enquiries from the general public, with perhaps one or two technical staff.

The regime will provide for one generalised asset allocation for the Portuguese population as a whole, which simplifies the organisational challenge in setting up defined contribution accounts. For the structure of the new fund, Portugal looked to the United Kingdom’s recent Turner Commission on pensions: “One of the things that was very clear in the report of the commission of the British government [Turner Commission] was that they mentioned the problem of financial literacy.”

Baganha adds that FEFSS is currently determining the processes for enrolment in the fund, as well as its relationship with the social security and labour ministry, and is now fine tuning some of the specialised aspects.

There is no need to determine a new structure, he says, even if some of the rules of the fund are not exactly the same as the existing ones. The asset allocation project for the new fund is being conducted internally, but Baganha will not make any estimations as to possible capital inflows: “I do not make estimations before a soccer game,” he concludes.

 

Governance structure of FEFSS

Manuel Pedro Baganha is head of FEFSS’ executive board, which currently consists of two people - himself and Henrique Cruz. In addition there are three main departments: an investment department, a department for macro economics and performance measurement and a third for administration and information systems.

The fund’s mandate is from the ministry of labour and social security. A consultative council consists of five representatives each of labour unions and employers, one from the social security treasury and another from the national treasury and three nominated by the minister. This body meets twice a year, once to approve the activity plan and once to approve the report and accounts.

Resolutions of the consultative council are advisory, not mandatory. While the council does not take a view on day to day management it does express its opinion if the fund’s rules or investment limits are changed.

 

Board of directors

President: Manuel Pedro Baganha

Vice president: Henrique Cruz

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