Most Icelandic pension funds are based on collective agreement, but Frjalsi is different. David White speaks to Arnaldur Loftsson, Frjalsi’s managing director, about his fund’s innovative benefits and investment structures

The Icelandic word for ‘freedom’ is Frjálsi, and the Frjálsi Pension Fund prides itself on the fact that people are free to choose whether to join it.

Many of the occupational pension funds in Iceland’s second pillar pension system are the products of collective agreements made in 1969, whereby people in certain occupations were obliged to join the schemes relating to their occupation.

In contrast, Frjálsi’s membership is drawn from Iceland’s free-wheelers: self-employed and people in supervisory positions. “Unfortunately, not everyone is free to choose to pay into Frjálsi Pension Fund, since many of them are obliged to join collectively-agreed schemes,” says Arnaldur Loftsson, the managing director of the fund. “Obviously, we think this is most unfair!”

However, Frjálsi Pension Fund is open to members of collective agreement schemes who want to contribute to third pillar, supplementary pension plans.

Frjálsi Pension Fund was set up 30 years ago and has developed as a hybrid of defined benefit (DB) and defined contribution (DC) scheme. In Iceland, the minimum replacement rate required by the law is 56% of an employee’s salary after 40 years of contributions. The mandatory premium, or contribution, is set at 12%.

Most pension funds operate co-insurance funds, which provide disability and spousal benefits in addition to pensions benefits. They will put the entire 12% premium into co-insurance to be able to provide a replacement ratio higher than the minimum 56%.

Frjálsi’s approach is different. It treats the minimum 56% replacement ratio as a maximum and defines how much premium must be paid into the fund to provide this ratio.

On top of that, it provides members with the opportunity to put some of their contributions into private savings and pass on some of the pension to their heirs. Uniquely, it has developed three tiers of insurance plans - which it calls SAM 100, SAM 70 and SAM 30 - to provide these options.

In its SAM 70 plan, Frjálsi pays 62% of the premiums into the co-insurance fund, enough to maintain the minimum replacement ratio from the age of 70. It then pays the remaining 38% of the 12% premium into a private pension which is inheritable and can be withdrawn from the age of 60. The private pension gives fund members a lot of flexibility since it can be withdrawn before the traditional retirement age of 67.

“So we could say that the part of the premium that goes into the co-insurance fund to cover the 56% replacement ratio is a DB plan, because that’s the 56% that we will cover. But the rest of it is a DC plan.”

Frjálsi’s suite of insurance plans has evolved against the background of changes in the Icelandic pension fund environment. SAM 30 was developed in response to the historical lack of inheritance of pension assets in Iceland. The aim of SAM 30 is to maximise the part of the plan (74%) that goes into an individual inheritable account.

The origins of SAM 30 can be traced back to the establishment of Frjálsi Pension Fund in 1978. Until 1999, the fund provided separate individual accounts rather than co-insurance. This was attractive to some, says Loftsson. “People who chose to invest their premiums in Frjálsi did so because they wanted to have an inheritance.”

In 1999, however, changes to pensions fund legislation meant that Frjálsi had to change its structure and establish a co-insurance fund to remain within the law. This process was given a boost in 2005 when Frjálsi merged with another pension fund Lífeyrissjóður Bolungarvíkur.

Following the merger, Frjálsi introduced SAM 100, where 100% of premiums are paid into the co-insurance plan. This was designed to provide a seamless transition for the members of the Lífeyrissjóður Bolungarvíkur scheme, who paid their premiums into a co-insurance plan.

“The net result of these developments has been that Frjálsi Pension Fund has been one of the few pension funds in Iceland that can offer a choice of three insurance plans to fulfil different needs of fund members,” says Loftsson.

Members of the Frjálsi Pension Fund can choose how they want their individual accounts invested. Frjálsi offers three risk-based alternatives - Frjálsi I, Frjálsi II, Frjálsi III and added a fourth in January, Frjálsi Risk, for the more adventurous.

“Everybody can pick what they want, based on their risk profile and age. Some will want to take more risk to get higher investment returns, while others will want to take less risk,” Loftsson explains.

For pension fund members who are unsure of which fund to choose, Frjálsi offers a ‘lifepath’ option, whereby the pension fund itself moves members into different funds at different stages of their life. The moves between funds are made gradually, with 20% of the cash value transferred each year over five years. It is the most popular option, says Loftsson: “Most of our members choose the this option, and that is what we recommend in general.”

The Lifepath option, however, does not extend to the Frjálsi Risk fund. “We decided not to include it in the Lifepath,” says Loftsson. “As its name implies, it’s the fund with the highest volatility and it is designed for members who really want risk.”

Portfolio management of the Frjálsi funds is done in-house by the asset management arm of Kaupthing Bank, which handles around a third of all asset management in Iceland.

Kaupthing uses a balanced portfolio model, with separate teams of four to six people specialising in each asset class. For foreign equities, foreign fixed income and alternatives, the teams will use funds run by third-party managers.

Each month, teams will meet to report on the model portfolios within their asset class and their view of the outlook of these asset classes. These model portfolios are then used to draw up Frjálsi Pension Fund’s allocation to each asset class.

Between these monthly meetings, portfolio managers make daily decisions about managing the portfolio, and can re-balance weightings if necessary.

Each investment path - Frjálsi I, II, III and Frjálsi Risk - has its own policy. The current asset allocation within Frjálsi I, which will be the choice of most members between the ages of 18 and 50, is 55% domestic fixed income, 40% equities, of which 15% is domestic equities, and 5% alternatives.

Within the foreign equities portfolio, Frjálsi has been increasing its exposure to emerging markets, in particular the BRIC countries (Brazil, Russia, India and China) and eastern Europe. The fund is benchmarked to the MSCI World index, which excludes emerging markets. So the exposure to emerging markets is its largest deviation from the benchmark in the equities portion.

The fund also has indirect exposure to foreign equities through structured products, says Loftsson: “We have the option to take indirect exposure to equities by using structured products or principal-protected vehicles. For example, in one vehicle, structured for one year, the principal is protected 95-100% and we get exposure to BRIC and the Nordic countries. We can also get exposure to commodity markets.”

Structured products sit naturally in the riskier funds, he says: “In Frjálsi Risk it is our objective to invest 10% in such vehicles.”

Frjálsi’s investment in alternatives is spread between hedge funds, private equity and real estate, with a current exposure of around 2% to hedge funds and 2.5% in private equity and hedge funds. Investment is mainly through fund of funds, and Icelandic pension funds are not allowed to invest directly in real estate other than their own premises.

The allocation to alternatives is likely to increase, says Loftsson. “We are comfortable with the exposure to hedge funds at the moment, but exposure to private equity and real estate is likely to increase.”


Frjálsi’s investment management has a strong liability focus, and it monitors and attempts to match major risk factors such as inflation and interest rate risk. Notably, Frjálsi has engineered a bond that has the longest duration in the history of the Icelandic financial market. “This will help the fund decrease its interest rate risk relative to its liabilities.” says Loftsson.

The focus on liabilities is central to the pension fund’s approach. Frjálsi has developed a risk management framework to help it answer four key questions: Do the fund’s assets cover its liabilities?; What risk is the fund taking?; What excess return on the fund’s assets is necessary to compensate for taking this risk?; How is the fund performing in terms of risk-adjusted return?

To check whether assets cover liabilities, Frjálsi uses member data to estimate the fund’s liabilities cash flow. These estimates enable Frjálsi to report the balance sheet funding ratio to the fund’s directors. “Our liability modelling allows us to calculate the funding ratio every month although the law only requires it to be done once a year,” says Loftsson.

To find out what risk the fund is taking, Frjálsi uses risk metrics based on option theory - risk premium and credit spread. The risk premium measures the risk in the fund’s portfolio, while the credit spread measures the risk in the benefit promise made to the fund members.

“The credit spread indicates the quality of the benefit promise and can be put in perspective with credit spreads of well-known corporations,” says Loftsson.

The risk premium is based on the price of a put option that would cover the losses in risky investments below liability return. “This insures against the fund’s portfolio falling below risk-free return,” he says.

Finally, the fund measures how it is performing in terms of risk-adjusted return by measuring the performance of the portfolio against the risk-free liabilities and comparing this with the risk premium.

The results of Frjálsi’s risk and asset management have been impressive. Frjálsi’s funding ratio has been above 100% since 1998. It has been able to pay bonuses into fund members’ private pensions four times, which it does instead of increasing the benefits in the co-insurance fund.

The main reason for this is the investment return, says Loftsson. “The real return last year was 9% and the nominal return has been 14.7% for the past five years.”

Another reason why Frjálsi Pension Fund has delivered positive funding ratios, says Loftsson, is that it operates an age-dependent rather than equal earnings benefits scheme.

In an age-related benefit scheme, the accumulation of rights is based on the age of the fund member at the time payment is made and the length of time for which the premium will remain invested in the fund. The accrued benefits are thus actuarially correct.

In an equal earnings scheme, however, fund members earn the same rights for the same premium throughout their working lives.

The impact of poor investment returns between 2000 and 2002 and increasing life expectancy have encouraged Icelandic pension funds to switch from equal earnings to age-dependent schemes. In most cases this has been done by putting new members into age-dependent schemes while maintaining the equal earnings scheme for existing members. By the end of 2006, 49% of pension funds had moved to this arrangement.

Frjálsi was one of the first funds to switch to an age-related benefit scheme when it established its co-insurance fund 1999. “As a result there is stability between premiums and benefits, and premiums have been sufficient to fulfil the benefit promise, which is not the case for many other pension funds which have had the equal earnings system.” says Loftsson.

Other factors include a low level of disability among the fund’s membership and a low proportion of women. The net result is that Frjálsi offers better value for money than any other pension fund in Iceland not carrying an employer’s guarantee, says Loftsson: “Frjálsi provides the highest level of retirement benefit for each kroner paid into the fund.”

Frjálsi will have to work hard to maintain this position in the future. Among the challenges facing the fund in the future, longevity risk is perhaps the greatest, Loftsson says: “Life expectancy has been increasing in recent years and this is affecting not only actuarial calculations but how much benefit we can give out.”

Inflation risk is also challenge, he says, since only part of the fixed income portfolio is inflation linked. Interest rate risk, too, is a constant threat. Under the current system, liabilities and bonds are not marked to market, but are discounted by 3.5%. “So if the interest rate falls below 3.5% there will be a discounting of bonds and a loss in the actuarial calculations.” The only remedy here is a change in the law, he suggests.