Moving the goal posts
Many in the European pension fund industry would consider their Icelandic colleagues to be in an enviable position. A series of agreements between trade unions and employers since the late 1960s created a structure that has nearly universal coverage, was robust enough to shrug off the financial market meltdown of the early years of the century and has amassed assets that are equal to the national GDP.
But constructing a pension system from scratch entailed taking decisions, which, under the pressures of social change, have resurfaced as structural problems.
“When we established the system the state pension was so paltry that people dependent on it were very poor,” recalls Gylfi Arnbjörnsson, general secretary of the Icelandic Confederation of Labour. “So we negotiated with the employers to build a system that would secure our members down the line. It takes 50 years or so to build up a pensions system but in 1969 those who were at that time about 50 and had a relatively short period before pension age did not have any pension rights. Consequently, we decided to establish the system on the basis of equal rights between young and old. As a result the more elderly workers are now getting a 25-30% better pension than they would have had had we instituted an age-related system with pension rights dependent on the time that payments have been made.
“But an equal-right system has a certain degree of flow-through characteristics, and because the younger generation is fewer in number this has now turned out to be a problem. We could call this the second half of financing the generation consensus from 1969, and a solution has to be found. This part of the problem involves about 10-15% of the assets in the system.”
And it has been exacerbated by changes to Icelandic society over the past 30-odd years since the system was created.
“We have the highest participation rate in the world for older workers,” says Tryggvi Thor Herbertsson, director of the Institute of Economic Studies at the University of Iceland. “People don’t retire. The work ethic here is very strong and people work for a long time, not only long hours but also to late in life. The age of retirement is 67 but people don’t usually retire until 70 as they are rewarded for staying on. But perhaps as a result of better education people tend not to stay as long in their jobs as before, they switch companies and even industries. It’s no longer a case of somebody working in the fish factory their whole working life.”
And greater job mobility has exposed the system’s rigidity.
“The benefit formula is linear in terms of the age of the contributor,” explains Thorgeir Eyjólfsson, managing director of the Pension Fund of Commerce, Iceland’s second-largest fund. “The contribution of a 25-year-old will thus give rise to the same pension benefits as that of a 65-year-old, even though the former is much more valuable than the latter as it will earn a return for a much longer period. This is, or course, not actuarially fair but as membership is mandatory members will gain when they are older what they lost when they were younger.
“The challenge has arisen because a few pension funds have age-dependent benefit formulas. If linear and age-dependent formulas exist side by side and there is a possibility of moving between funds the system as a whole might become unstable. With full freedom to move between funds members could chose funds with age-dependent benefit formulas when they are young and those with linear formulas when they are old. And that is clearly not sustainable.”
Bjarni Brynólfsson, managing director and CIO of unskilled workers pension fund Framsyn, agrees: “If you have only the one system and the population is paying all the time moving money over from the young to the old is OK. But when you get two systems, and most of the banks and some pension funds have already converted to the age-related formula, it is unbalanced.”
Brynolfsson’s response is to make the shift. But he is able to contemplate doing so with relative ease because Framsyn is in the process of merging with the seamen’s pension fund, Sjomanna. “We have moved a little faster in this direction than most other pension funds because of the merger, and so we are changing from a linear to an age-related formula when we write the statutes of the merged fund,” he says.
Arnaldur Loftsson, managing director of Frjalsi Pension Fund, the pension fund of KB Bank, Iceland’s largest financial institution, sees the transformation to an age-related formula as both inevitable and advantageous. “Initially Frjalsi was just a DC private pension where members had an individual account. But when legislation in 1997 required every pension fund to pay life-long pensions and disability pensions we established a co-insurance department to ensure we could fulfil these conditions. At that point we decided to use an age-dependent system not the linear system.
“I think the change from a linear to an age-related system will increase the pressure to give fund members greater freedom to change pension fund,” Loftsson notes. “And greater freedom would increase competition between the funds.”
“The current discussion is to change the system and have age-related rights accumulation. We have been in favour of this aged-based shift but it is only after many years that we have been able to persuade unions,” says Ari Edwald, managing director of the Confederation of Icelandic Employers. But he advises caution. “I think that it is important not to make too radical a change. Two funds in the general system are already age-based, but it’s very harsh today if you have been an unskilled worker from the ages of 30 to 55 and then you become a craftsman and have to pay into an age-based system. We have to come up with a formula that softens the shift between accumulation systems for individual workers.”
“It’s something we will be able to find a solution to,” says Eyjólfsson. “We will have to be sure that there is a transitional mechanism to ensure that people who were in a linear system for most of their working life do not go down hill in its later years if they go into an age-dependent system. We have to make some adjustments to the way that the benefit formula is composed and it is difficult to design a transition from a linear to an age-dependent system that will not hurt a generation that already lost when young and has yet to gain when older. But this is not a problem, it is a challenge and we are working on it. While we have not come to a complete agreement a solution is definitely in sight. The proposal that is on the table now will require a change to some laws but I’m sure that there will be no opposition from any of the parties to ensure that the system continues to be fair and sustainable.”
And there is a deadline. “In December employers and unions agreed to find a way before 1 May to change the system totally to an aged-based rights accumulation formula and to make the final decision on such a transition. The transition itself could then take place immediately after. We are looking for a soft transition that will be completed over four decades. We have already increased payments into the funds and we are focusing on calculating members’ rights more accurately, which will help to avoid negative results for certain funds from demographic changes, shifts from one category of work to another and from an increasing awareness of how to manipulate the system. And I think it was a victory for all of us involved in the discussion, that we agreed to attempt to tackle the problem all at once.”
But steps to resolve one issue have uncovered another. “One of the challenges is the system’s lack of portability,” Edwald adds. “Workers have been tied to a pension fund by their place of work and so if they changed job, from being an unskilled worker to a carpenter or craftsman, for example, they were obliged to change fund and had to start anew in the new fund. If we manage the switch to an age-based system in the spring, we may be able to formulate an agreement between the funds on portability . But that would not include the funds that have changed already I am afraid. And my strategic worries with regard to portability would concern the public sector funds which have no plans for age-based system and so people might simply not move to private sector employers after a certain age.”
“There has not been much discussion within the pension area about being able to transfer the benefits from one fund to another,” Loftsson notes. “But we have a centralised organisation that an employee can call to find out where he or she has benefits. And if they are pretty low in one pension fund there can be contact between funds and the fund that the person last paid into can take over the benefits, but only when the person retires.” But this process is not really portability. “The agreement between pension funds arose because if such a process is not done pension funds will be paying very small amounts and that represents an administration cost.”
But Hrafn Magnússon, managing director of the National Association of Pension Funds, does not see portability as a problem. “We have a very good IT system and everybody has an IT number,” he says. “All pension fund members are in one register and people can see how many pension funds they have rights in, be it one, two, three or four.”
Magnússon does not see the expense issue as lying with paying out small amounts but in the move from one pension fund to another. “For example, we have blue-collar workers who move from jobs on the east coast to the north coast, and if they took their rights from one pension fund to another each time they changed it would be difficult and bureaucratic,” he says. “It’s a problem in a pension fund scheme with linear rights if people are moving from one to another but it is not if people have rights in many pension funds. We have a group of 20 pension funds that pay their benefits together, they make a collective statement.”
Pension funds are also facing the challenge of competition from banks. “Under a labour market agreement in 1974, it was decided that all members of a trade union should contribute to a pension fund, and a 1980 law required that everyone should contribute to a pension fund and to save 10% - now 11% - of their salary whether they are the managing director of a company or working on the factory floor,” explains Eyjólfsson.
Those who were not trade union members could choose which pension fund to join. Some joined the second pillar funds linked to their business area while banks and insurance companies offered their products.
The open pension fund of Islandbanki, Iceland’s second-largest bank, began in 1965 as a private pension fund, recalls Kristjana Sigurdardóttir, its fund manager. “But we adapted it to 1997 legislation requiring everybody to pay into a second pillar fund. So it is both a second and a third pillar fund.”
And the competition stiffened in 2000 when the social partners agreed to establish a third-pillar scheme under which if an employee decided to save 2-4% of their salary into a supplementary pension, the employer was obliged to pay an additional 2%.
“Banks and pension funds are in the third pillar business,” notes Eyjólfsson. “Insurance companies have a small market share as the high inflation until the early 1980s eroded the value of life insurance payouts and at every big family gathering a hard-luck tale would have been told of how when the policy was taken out the premium had the same value as a sheep or a cow but on payout it was not enough to buy a pocket book. But banks have 60%-plus of the third pillar market. They started offering these products much earlier than pension funds because pension funds only got permission to do so in the reforms of 1997.”
“Banks have money to advertise their services and they have a very close association with many people because most have a bank account,” says Jóhannes Siggeirson, managing director of Lífeyrir, the pension fund for skilled workers. “And a self employed person or a small employer may have a close link to the bank because it may be making a loan to their company and they may have a more positive view of the bank than a pension fund, I don’t know, but I see this as a challenge. But pension funds have a very attractive costs structure, which is one of the reasons for the existence of this pension fund system.”
And the issue of costs is driving yet another challenge facing the funds – consolidation.
“Unfortunately, we decided to establish a lot of pension funds back in the early 1970s because more or less every trade union wanted to have its own pension fund,” recalls Arnbjörnsson. “It was regrettable because there is an actuarial basis to the pension funds so you have to spread the risk by insuring a larger community. It took us many years to merge funds and now the five largest have about two-thirds of the pension funds’ capital assets.”
“The funds are getting to understand that it is better to be big in this business,” agrees Herbertsson. “It enables them to reduce their administration costs, negotiate better fees with asset managers and it’s easier to deal with problems related to infrastructure and disability. So there is consolidation, but I don’t know how much further it will go.”
In addition to the planned Framsyn/Sjomanna merger, three other unions have been proposed and there are reports that a fourth is being considered. A merger between Lifidn, the pension fund for electricians, hotel and catering staff, and Samvinnu, the pension fund for co-operatives, will be put to a vote of their members in late May, while in April a merger of Almenni Pension Fund and Laekna, the doctors’ pension fund, will be put to a general meeting of their members. And regional pension funds Sudurnes and Sudurland are also contemplating a merger. In addition, there have been suggestions that a far bigger merger, between Eyjólfsson’s Pension Fund of Commerce and Lífeyrir, itself the result of the merger of eight pension funds, is a possibility.
Stefan Halldórsson, whose Engineers’ Pension Fund was the first in Iceland to introduce age-related accruals that reflect the time-value of money, having bitten the bullet 50 years ago, identifies other challenges facing pension funds on the investment front. “Last August a dramatic attempt by the Icelandic banks to become major players in the mortgage loan arena, which previously had been primarily served by a government-backed housing loan fund with supplemental loans from the pension funds, drove long-term interest rates down to a level which is no longer attractive for pension funds, as they have to guarantee their members a 3.5% real return on contributions,” Halldórsson says. “As a result the local bond market has lost much of its attractiveness for pension funds.
“Then in December the Icelandic Actuarial Association announced that new life expectancy tables and disability risk tables would be used for the year-end actuarial reports. These tables increase the liabilities of all funds by 2-3% for a longevity increase of one year and for most funds by 3-5% for the increased disability risk. Consequently, most pension funds will have to adjust their benefit schemes by decreasing the future accrual of benefits while some will also reduce the already-accrued benefits.”
And in addition, it appears that the domestic stockmarket, which was Europe’s best performer in 2003 and 2004, is topping out. “There is some slowdown now but the economy is fine and the corporate environment is good so I think it is flattening rather than heading for a correction,” says Sigurdardóttir of Islandbanki, who is also the fund manager for the doctors pension fund. “But most pension funds are holding more Icelandic equities than they would want for the long term, about 15-20% of their portfolio but they aim to have about 10%. They were trying to reduce it in 2004 but the growth of the market meant that even after selling, the remaining equities still made up the same percentage of the portfolio.”
This is driving pension funds to consider the advantages of lifting the current investment restrictions. “Interest rates are going down and we can’t invest in real estate so pension funds are also looking into alternatives,” says Loftsson. “All the money has to find a home so where can we put it? It has to go abroad so the foreign currency ceiling should be lifted.”
“But the ongoing strengthening of the Icelandic krona has lowered the book value of existing foreign holdings, which further increases the actuarial deficit of the pension funds,” notes Halldórsson. “Icelandic pension funds are facing an interesting, although not comfortable situation.”