Pension schemes, or how to lose a Nobel prize

 

Turin, November 11^th, 2023

Pension schemes, or how to lose a Nobel prize

This little known Italian retirement integration system, called TFR, is one of a number of good things that we lost due to a patient and relentless drive towards centralization and government intermediation.

Europe has been tinkering with its pension systems for decades. Italy in particular has been particularly active, since we historically had no private pension system tradition.

So when the tinkering started, the discussions were mostly on three aspects:

1. defined contribution vs defined benefits, and modification of the calculation method of the latter;

2. the combined problem of contribution period length and minimum retirement age;

3. “Third pillar” pensions, i.e. private integration schemes, which are part of the object of this piece.

The establishment of a “third pillar” in Italy was due to projections that new entrants in the job market would by the end of their working life receive a much lower pension as a percentage of the last income period than any previous generation. Given that due to our political situation point there was no point in even thinking about getting contribution period and retirement age straight for an extended period of time, the powers that be found resources in a relic of the past. WAY past, 1927, to be precise. The then Fascist government instituted, in its corporatist frame, a kind of hybrid retirement/job loss insurance that also kept money in the productive system: each year, a part of the salary would be capitalized in the firm itself, to be given (or under later legislation transferred if the worker so desired) to the worker at the end of the contract. Initially it was indexed to the last salary period, but later it became a quite clever indexation system, and as a former financial specialist in an insurance company,an intriguing one.

Each year the total of this company reserve would be increased to 75% of CPI + 1,5%. Also, the government instituted a mutual insurance scheme to protect workers from bankruptcy: companies had to pay in a small percentage of that amount in order to be covered.

Now think about it from a “Small /Medium Enterprises” point of view, and to filch words off the ECB, let's take an “holistic approach”.

Workers COULD invest that 1/13^th of their gross salary themselves, but that would have not only given rise to a cage match about WHO would control that pool between workers and employers, it would also have disproportionally give power to the bigger on either side of the fence. Moreover, the chance for any employee to earn that kind of composite rate of return on a then infant/non-existent financial market would be next to zero. Only the establishment of liquid internationally open markets would ensure that probability of getting that would approximate.... zero.

So there was a “method to the madness”, and it was this: such a “mandatory financing” of companies by its employees has a number of positive aspects. First off, there is no specific administrative cost: if you manage payroll, and that's been done for a number of millennia, you can cope with that. Second, it doesn't have a lower size limit and there is no review or renewal. It is not even necessary to do the calculations since these were provided monthly by the finance ministry. Third...it's engineered to provide a financial incentive BOTH to the lender / employee and to the firm employing him or her. 75% of CPI +1,5% looks easy, until it becomes your “liability in your ALM (Asset Liability Management). I can provide a personal recollection of both those aspects, because I was working in Finance in a biggish insurance company in Italy when the government/labor military industrial complex managed to shove defined benefits pension funds down people's throats... and I was actually the one whom the internal powers that be wanted to draw the short stick: manage the “guaranteed” compartment. At the time there was an enormous pressure by authorities to have these units promise to do at least the same performance of that TFR scheme... after fees. And ordinarily, looking at nominal rates, lay people would say it's easy. Strangely enough tough no one volunteered to take that responsibility. The reason was readily apparent when I did what my self preservation instinct imposed. I asked three big international counterparties to price me a total return swap, 100 mln EUR nominal, yearly cliquet, in which I paid EURIBOR flat and they paid, obviously, 75% of Italian CPI + 1,5%. I don't remember the specific number that came back , but it's immaterial since I successfully evaded that job by having in advance told management that the benchmark on which I would be evaluated would have been AFTER that swap cost... which was high enough to get them off my back for the duration.

So, it's practically impossible for any worker to invest small amounts in a riskless way and get annual compounding at that rate. But what of the company, why didn't they whine and cry?

Easy again: if any small company went to any bank requesting a senior unsubordinated loan paying that rate, the bank loan officer would have laughed himself silly. He'd have asked for a rate between twice and five times that interest rate. So, TFR was a marvellous way to disintermediate the banking sector who sits between savers and small corporate debtors, Given failure rates even the insurance payment was not material relative to the problems coming with a bank loan. So its disappearance is but one of the myriad of reasons Italian relative productivity is falling over time: the political galaxy wants to extract ad redistribute resources, at any cost, and growth be damned. In fact the title of this article stems from the fact that I once told an academic friend of mine that a study furthering Reintroducing this TFR could indeed land him a Nobel down the road.

So what happened to TFR? well... it's not there any more. New entrants in the job market are forced to adhere to a "third pillar" defined benefit scheme, fully invested in financial markets, and in some cases real estate. This drew resources OUT of the small /medium enterprises towards government debt / bigger international companies.