It is a classic case of a southern European overburdened social security system with an undeveloped second and third pillar. Unlike France and Italy, which have recently made some headway in confronting their domestic pension time bomb, Portugal remains stubbornly rigid, and major reform is needed.

“In many ways, there is too much debate,” says Frederico Machodo Jorge, Watson Wyatt’s managing consultant for Portugal. “We talk about things for so long and progress becomes so slow.”

Indeed, very little has changed. The country’s last serious pension reform, apart from various EU directives, was in 1988, and this law only enabled companies and financial organisations to set up their own schemes.

Since the reform, the growth of the second pillar has been disappointing. Only about 1,000 people have signed up for this kind of scheme. Oddly enough, it is the third pillar that has seen the most growth.

Today, the second and third pillar combine for a net value of €21bn, with the largest fund being the €7bn Millenium BCP fund, run by Portugal’s Millenium Bank. However, unfortunately for the Portugese people, most of these schemes are designed for multinational corporations with foreign workers.

The government has made noises about reducing the public spending deficit, but any previous adjustments have proven especially precarious. Even token reductions of social security benefits have been furiously opposed by the public and unions, and this has forced the government to move at a snail’s pace. Mr Jorge jokes that maybe the strategy is to go so slowly that nobody notices how much they have shrunk social security until it is too late.

Currently, social security guarantees 70 per cent of a worker’s career average salary. To fund this, 11 per cent of their salary goes to the state, while the employer chips in for 23 per cent. Just last year it appeared likely that the 70 per cent rate would be reduced, and that this would spur many to run for supplemental schemes. However, the changes have not happened, and the country’s second and third pillar remain small.

The main problem, according to Mr Jorge, is that wages are too low. It is a situation with a large divergance between economic classes, whereby the wealthiest have little need for a pension and the poorest cannot afford to put money away every month. There are also few tax incentives for saving money or creating some kind of stock or salary sacrifice plan.

He says: “The minimum monthly wage is about €400 a month, which is one of the lowest in western Europe. We’ve had low GDP growth over the last few years, and we’ve seen higher unemployment levels compared to previous years.” Inflation has also crept in as a new problem eating into people’s pockets.

The country’s largest fund is the e8bn Fundo de Establilizacao Financiera de Segurance Social (FEFSS) buffer fund. The FEFSS operates similarly to France’s Fonds de Réserve pour les Retraites buffer fund, and is used mainly to meet any shortfalls in the country’s social security system. To date, it has not been tapped, and its assets come from taxes and any surplus funding in the social security system. In the first quarter of 2008, there was a surplus of €919.6m, which was a significant gain from the same quarter last year when there was a €447m surplus.

At the moment, its assets have 70 per cent invested in bonds and 21 per cent in US, European and Japanese equities. Some 3 per cent is in real estate and another 3 per cent is in cash. The remaining 3 per cent is allocated to assets that it labels “strategic reserves”.

But, despite the relatively stagnant system and market, Portugal’s investment regulations are remarkably lax. This indicates that if the market were to open up, and if the second and third pillar grew, there could be a run of new mandates for things like hedge funds and real estate.

As it stands, an estimated 30 per cent of the country’s pension assets are in equities, but even these are well diversified by southern European standards, with 13 per cent domestic, 7 per cent Eurozone and an impressive 10 per cent international. Furthermore, there are no limits on how much Portugese funds can invest in equities. Last year, it was capped at 55 per cent, but this has now changed.

Fixed income makes up 47 per cent of the assets and these too are well diversified. Real estate is the next largest asset at 13 per cent, and hedge funds come in at 4 per cent. The remaining 5 per cent is in cash.

Yet overall, one of the main challenges to foreign asset managers looking to break into the market will be culture. The small market’s mandates are dominated by Portugese fund managers. To get around this, some firms have begun to recruit for domestic staff. However, the fact of the matter is that the market is small, and until this changes, the major pension players will probably stay away.

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