The Icelandic old age pension system is composed of a tax-financed public pension scheme and mandatory funded occupational pension schemes, mostly run by private pension funds governed jointly by the partners in the labour market. The public pension scheme pays a basic pension from the age of 67 and a means-tested supplementary pension from the age of retirement (usually 65–70). The public pension scheme will guarantee a single old age pensioner a minimum pension that in the spring of 2001 is roughly equivalent to 44% of the average before-tax salary of a male industrial worker.
The occupational pension funds pay somewhat different old age pensions depending on their financial position and the relative weights of other forms of pensions. It has been estimated that according to present rules a typical general occupational pension fund will pay a pension amounting to 45–58% the earnings of 40–60-year-olds and that the basic public pension might add a further 11%, giving a total replacement ratio of 60–70%. The over-funding of many of the funds and the prospects of high returns in the years ahead make it very likely that the replacement ratio will turn out to be higher than this. On present trends the provision of retirement income will in the next century be based on three pillars: a relatively small public pension, dominant mandatory funded pension schemes and voluntary private saving.
According to Icelandic law, all wage earners and self-employed persons are obliged to belong to some pension fund, which operates either according to law or has been approved by the Ministry of Finance. Contributions must be at least 10% of total earnings, but in most cases 4% is deducted from wages and the employer pays 6%.
Membership in occupational pension funds became compulsory for wage earners by law in 1974. In 1980 this compulsion was extended to the self-employed. In 1991 a law was adopted on the annual accounts and auditing of pension funds, giving the bank inspectorate of the Central Bank of Iceland some supervisory role over pension funds. Certain pension funds operated according to specific legislation, as the funds of public employees, mariners, farmers and nurses.
New pension fund legislation
After a consultative process that took several years, involving the partners of the labour market and other interested parties, a bill was adopted by parliament on mandatory pension contributions and the operations of pension funds in December 1997. The legislation is the first comprehensive one on the operation of pension funds in Iceland.
The law incorporates the existing legislation mentioned above, but adds significant elements. The main ones are:
q Minimum pension rights and forms of pension are defined.
q General requirements for operating pension funds regarding size, risk, internal auditing and funding are defined.
q Guidelines and limits for the investment policies of the funds based on the risk diversification principle.
The law codifies the principle of a mandatory payment of at least 10% of wages and salaries to acquire pension rights. The contribution can be split into two parts. The first part shall go towards acquiring pension rights that should for a 40-year period of contributions give a lifelong pension amounting to at least 56% of wages during the contributions period. Similar conditions apply to minimum disability and survivors pensions. The second part can go towards acquiring additional pension rights, also in defined contribution schemes with individual accounts. Banks, insurance companies, securities firms and pension funds can receive contributions for additional pension rights. Married couples will be allowed to split contributions to generate rights for both. The law defines the minimum size of a pension fund as 800 contributing members, provided that the fund does not guarantee a satisfactory risk profile of its liabilities through other means (such as by buying insurance). All pension funds shall be fully funded except those that are guaranteed by central or local government or a bank. Full funding is defined in such a way that the divergence between the present value of assets and liabilities can not be more than 10% for a year or 5% over a period of five years.
The law includes certain ceilings on the asset composition of the funds that are based on the principle of diversification of risk. But it does not put any minimum investment requirement in government bonds. The funds can take foreign exchange risks up to 50% of their assets. The ceiling for equity is 50% of assets. The ceilings on foreign assets and equity are far from being binding at present. The funds cannot take more risk towards a single firm or a borrower than 10% of assets, not own more than 15% of the stock of a single firm and not more than 25% of the shares in any mutual or equity fund.
Voluntary private pension saving
Legislation on tax incentives for voluntary private pension saving was adopted in 1998 as part of the general pension reform. Employees were allowed to deduct from their taxable income a contribution to authorised individual pension schemes of up to 2% of wages. Employers contribute in such cases 0.2% of wages, which is financed by lowering the social security tax to an equal degree. In the spring of 2000 these figures were increased to 4% and 0.4% respectively. At the same time as a part of general labour agreements it was negotiated that employers contributed 1% of wages (in addition to the 0.2% or 0.4% contribution) to employees participating in private pension saving. The employers’ contribution will increase to 2% of wages from 1 January 2002.
The private pension schemes have to be authorised by the Ministry of Finance. They are in most cases defined contribution individual accounts.
The employee part is fully deductible from taxable income if it does not exceed 4%. The employer can charge his part as a cost in his accounts, making it fully deductible for tax purposes, even when it exceeds 6% as is the case with the public sector and the banks. The investment returns of pension funds are tax-free. Pension benefits are taxed in the same way as income from employment.