Iceland finds a third way
Iceland has privatised its pension system more comprehensively than any other Nordic country, with a fully funded second pillar of private and public occupational pension schemes. As a result, it currently spends only 2% of GDP on basic and supplementary state pensions, while private pension fund assets are expected to reach at least one and a half times GDP by the middle of the century.
Pension privatisation on this scale should provide the ideal conditions for defined contribution (DC) plans. To a certain extent, they do. More than half of the country’s leading private sector pension funds operate schemes that have at least some of the features of an Anglo-Saxon DC plan.
However, the funds also incorporate principles of solidarity and inter-generational support that are absent from the Anglo-Saxon model. These principles were embedded in the industry-wide occupational schemes that were set up by the social partners in 1970, when labour unions traded wage increases for fully funded occupational pension funds.
Principles of solidarity continue in the pension funds established by the Pension Reform Act of 1997 which was enacted to impose some uniformity on private sector provision. This has produced a DC scheme that is unique to Iceland, where the risk is borne collectively rather than individually and where the benefits are usually (though not always) distributed equally rather than according to age.
Hrafn Magnusson, managing director of the of National Association of Pension Funds (NAPF) which represents funds with 98.5% of the total pension fund assets in Iceland, says the Iceland funds do not fit easily into either DC or DB definition: “The ordinary private sector funds are hard to classify exactly using terms such as DC or DB schemes. They are similar to DC funds in the sense that the contribution levels have in most cases been stable for a long time at 10%. But there are no individual accounts and the investment risk is borne collectively by the members of the fund.”
There are currently 51 occupational pension funds in the Icelandic second pillar system. Of these 11 no longer receive premiums and 13 are so-called guaranteed funds. Only the government, municipalities and banks can guarantee pension funds. This exempts them from the requirement of full funding, so that the risk is borne by the guarantors. They are effectively DB schemes.
The remaining 27 pension schemes do not have a guarantee. Many of these operate much like defined contribution (DC) schemes, where the translation of units into benefits is adjusted according to investment returns. These are the closest to DC schemes within the second pillar system.
The system has been designed to encourage industrywide schemes, which pool risk across members. It differs from the insurance arrangements found in other Nordic countries since top ups to the scheme are based on assured or notional rights rather than on accumulated assets.
Contributions to the funds must be at least 10% of gross salary. Of this 6% is paid by the employer and 4% by the employee. Under the Pension Reform Law, the assets and liabilities cannot diverge by more than 10% in a particular year or 5% over a five year period. Otherwise either benefits or contributions must be adjusted.
In principle, the contribution rate could be increase. In practice, the benefits levels are adjusted to take account of any fluctuations. The benefit level is defined in every period by the funds regulations If there is a mismatch between the funds returns and benefits level, the benefits level is usually changed by changing the regulations.
Benefits accrue according to a units system in which the number of points or units earned in a year is the wage in a year relative to the reference wage. Funds must have index-linked benefits that pay at least 56% of average earnings for people working and contributing for at least 40 years. The pensions can only be paid as a lifetime annuity, and there is no lump sum option.
The general rule in Iceland is that benefits accrue linearly, so that pension rights are distributed regardless of age. However, the traditional linear approach to benefits creates a certain unfairness. Mar Gudmundsson, the chief economist of the Central Bank of Iceland, points out that “the funds are far from actuarially fair among their members. They have a high degree of solidarity and co-insurance between contributions, and right to benefits are, in most cases, the same for young and old, men and women, unmarried people and people with children and those without.
However, he suggests that this can be justified because the membership is mandatory and pension rights are guaranteed “Members will in general gain when they are older what they lost when they were younger”.
The trend is away from the traditional linear plan to age-related plans. Assets in age-related schemes have been growing at the expense of the traditional plans, according to the Financial Supervisory Authority (FME). However, four pension funds provide non linear schemes where young contributors earn more rights than old ones.
However, there are problems. Gudmusson points out that “it is difficult to design transitions from a linear system to an age-dependent system that have already lost when young and have yet to gain when older”.
He warns that the Icelandic pension system as a whole may become unstable if linear and age-dependent systems are allowed to co-exist. This would be exacerbated if people were given greater freedom of choice to move from one fund to another: “With full freedom to move between funds, members would choose funds with age-dependent formulas a when they young and linear formulas when they are old,” he says . “That is clearly not sustainable.”
In this sense, Iceland’s DC-style pensions are being pulled in two directions – between the desire for actuarial equity and the need to preserve the solidarity of industrywide schemes. Which pulls more strongly remains to be seen.