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An alternative to ordinary mandatory insurance funds

The Frjálsi Pension Fund was established in 1978 and is one of the oldest and largest non-mandatory pension funds in Iceland, Traditionally, pension funds in Iceland have used all of the 10% mandatory contribution to provide coinsurance rights but the founders of the scheme wanted to create an alternative to ordinary mandatory coinsurance funds. At first, Frjálsi had no coinsurance elements and members could pay into the fund and get separate individual accounts that were fully inheritable. But in 1997 the board decided to meet the minimum claim with less than the total 10% contribution and give members the opportunity to get individual accounts that are inheritable, as well as coinsurance.
Frjálsi offers two alternatives to its members: Insurance Department 1 (ID1) and Insurance Department 2 (ID2). Members choose one or the other depending on whether individuals wish to focus on maximising pension payments or maximising the part of the 10% that is inheritable. Both alternatives grant the same rights to disability, spouse and children pension payments. The principal goal of both departments is to secure mandatory minimum insurance protection. ID1 also aims to maximise pension payments to fund members, while the objective of ID2 is to maximise returns with regard to risk on the part of the 10%, which goes into a separate (inheritable) individual account.
Members can choose between different individual separate accounts depending on their age and risk profile but have to bear the investment risk alone. The objective of the separate accounts is to maximise risk-adjusted returns. Frjálsi offers three risk-based alternatives, and also a Lifepath selection where the cash in value and future premiums of each fund member automatically transfer between paths as the fund member grows older.
The funding ratio of the insurance departments of Frjálsi has been positive since its establishment. The fund has paid bonuses from the insurance departments to the individual accounts of each fund member in 2001 and 2003. (The average funding ratio of the 12 largest funds in Iceland has been lower and seven of them have had to lower benefits in the same period). Since 1982 the fund has also shown a positive return every year with the exception of 2000 when returns for Icelandic pension funds were generally poor.
In ID1 71.4% of the contribution goes to the coinsurance department (non-inheritable) to ensure the minimum pension payments from the age of 70, as well as disability, spouse and children pension payments. The remaining 28.6% goes into a separate account (inheritable) and can be withdrawn from the age of 60.
In ID2 95.4% of the contribution goes into guaranteeing the minimum claim payment, of which 65.5% goes into a limited individual account (inheritable) representing pension payments from the ages of 70 to 85, 29.9% goes into the coinsurance department (non-inheritable) representing pension payments from the age of 85, spouse and children pensions and disability pension to the age of 70. 4.6% goes into a separate individual account (inheritable), which can be drawn on from the age of 60.

The principal objective of both insurance departments is to ensure that the minimum insurance protection is provided and that the fund does not need to reduce benefits. But the mandatory actuarial calculation is an imperfect risk measurement tool. It is based on average mortality and disability rates and the conclusion is just a single number with no dispersion.
Asset-liability studies are used to evaluate the investment policy of the departments. The investment policy and management aim to minimise the probability of having to reduce benefits (or increase contribution). If the investment returns of the department are higher than they need to be to meet the minimum benefit (set by law) then a bonus is paid from the coinsurance department into the separate account of each fund member.

Highlights and achievements
The Icelandic pension fund system has elements of both DC and DB pension schemes. Coinsurance has long been one of the cornerstones of the system. The Icelandic model is similar to the DC system in the sense that all people in employment between the ages of 16 and 70 are obliged to pay at least 10% of their total salary into a pension fund.
The ordinary funds are not actuarially fair in that they have a high solidarity and coinsurance regarding the rights to benefits and a lifelong old age pension is guaranteed in all cases. By law, funds must pay a minimum of 56% of a fund member’s average wage in the form of a monthly pension from the age of 70 (provided that the individual has paid a full premium into the fund for 40 years) as well as spouse and children pension in the case of death and disability pension. The funds are therefore similar to DB funds where members collectively bear the investment risk.
All pension funds are subject to an annual actuarial calculation that involves comparing the present value of assets and future premiums against the present value of current and future liabilities for the part of the fund that represents the minimum claim. The maximum difference between assets and liabilities can lie between 5% and 10% for five years and 10% for one year. If the difference between assets and liabilities is greater then the funds have to change the benefits or adjust the contribution level. The pension fund system is therefore fully funded. Historically, many pension funds have been able to increase benefits substantially due to investment returns.

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