Iceland: Full overhaul on the cards
Iceland’s government is preparing for a comprehensive review of pension fund issues
A lot can happen in two decades, and Iceland’s main pension fund legislation – which was laid down in 1997– is in serious need of an overhaul.
Icelandic pension funds operate according to Act No. 129/1997 on the mandatory insurance of pension rights and activities of pension funds, which came into force in July 1998.
The Ministry of Finance and Economic Affairs is preparing to revise the legal framework, but Minister Bjarni Benediktsson warned at a seminar last April in Reykjavik that this will be a comprehensive task and will take some time.
At the event on pensions policy, organised by the Financial Supervisory Authority (FME), Benediktsson said the objective of the revision of the current pensions legislation would be to look into various issues surrounding pension funds, and therefore it would be necessary to divide the task.
Benediktsson said Iceland’s pension funds are robust and demonstrated their strength both during the economic collapse of 2008 and in the reconstruction work following the crisis. But their activities also brought various questions to the fore, he said, about the homogeneity of investment groups, for example, as well as management relationships and competition problems.
The large size of the pension system in Iceland relative to its economy is arguably the main challenge behind the review. According to the most recent OECD figures, Iceland’s pensions assets had grown to 152% of the country’s annual GDP at the end of 2017, making the system the second-largest among OECD countries in these relative terms, after the Netherlands.
This situation became exaggerated in the wake of the 2008 financial crisis, partly because of the role pension funds played in bailing out struggling banks and companies, but also because capital controls that were imposed and remained in place for a decade forced the funds to look within Iceland to invest new inflows.
One important aspect of this development is the pension funds’ ownership in competing companies in Iceland. For example, all three petrol station operators on the island – which are listed on the domestic stock exchange – are about 50% owned by local pension funds. In many cases, the pension funds own a significant stake in all three. The situation has provoked fears about healthy competition in Iceland, and questions about how the pension funds can act as effective active owners.
“For some of them, increased competition is a zero-sum game since they have equal interest in the whole underlying market,” says one industry source.
Benediktsson has said that the fact that a large proportion of the pension funds’ assets are invested in listed equities and bonds raises questions about share prices and the liquidity of bonds.
He told the FME seminar that this would have to be addressed in the review of the pension system to ensure the functioning of markets and the confidence of other investors. He also said the role of pension funds should be clarified before the state sold some of its financial assets.
Thorey Thordardottir, managing director of the Icelandic Pension Funds Association (Landssamtök lífeyrissjóða), says now is the time to put a strong foundation in place for a review of the pension system. She regards the interaction between social security and pension funds of particular importance.
For example, Thordardottir says, the transitional provisions of the current act concerning the interplay between the two systems regarding disability pension payments have been extended several times since 2011, without work being done to create a permanent solution to this for the future.
At the FME’s seminar, Thordardottir said: “When future policy is formulated for the pension system, it is important that a comprehensive view is taken on the issue, seeking expert opinion and reviewing ideas in a professional manner.” She added that there had been recent cases where there was a lack of such consultation.
The Ministry of Social Affairs is working on drafting rules around a new support system and flexible working for rehabilitation and disability pensioners, she says, but regrets that these efforts do not seem to have taken the role of pension funds into account.
- Iceland’s government has started work on revising 1997 pension fund legislation, aiming to create a simple and comprehensive framework
- Large size of pension fund sector relative to the economy seen as main issue in the debate
- Interaction between social security and pension funds must be tackled, says industry association
“It is important not to embark on the process of developing a new support system, without answering the question: what role do pension funds play in paying a rehabilitation and disability pension? Should it be unchanged, or what?”
Things must be reviewed and examined in context, Thordardottir emphasises. She says it must be borne in mind that the Icelandic pension fund system is unique in many ways.
“We have a mandatory insurance scheme based on the idea of ensuring everyone’s participation. The basic idea is that many people do not save unless obliged to. Therefore, there may be a risk that those who do save will end up financing the less-prudent.” she said at the seminar.
But she said that many people in Iceland see little or no benefit from having paid into a pension fund, owing to the interaction between payments from the social security system and the payments from the pension funds.
“The Icelandic pension fund system stands out in comparison with other countries, in that there is so much interaction between social security and pension fund payments. “Currently, the basic pension from the social security system has been abolished and up to 70% of all pension payments to senior citizens now come from pension funds,” Thordardottir told seminar delegates.
This development has been rapid as the system has expanded quickly – maybe too fast in letting the pension funds take most of the payments, she said.
“I have even heard it said that the pension funds are the first pillar of the pension system, and that social security is only a safety net for those who have no rights,” she said. Even if this is the vision for some people, she said, the system has not reached maturity and current pensioners are not happy.
“I think most people agree that some revenue links are normal and necessary, but where are the limits? This question has to be answered, but it is clear that there is no consensus on the current arrangement,” Thordardottir said.
Meanwhile, Gylfi Magnussson, associate professor at the Faculty of Business, University of Iceland, told the seminar that the pension system in Iceland relies too heavily on intergenerational transfers through securities markets. He also said the pay-as-you-go pillar of the system needed to be strengthened.
“In particular, this should be done in a manner where future pensioners acquire rights that enjoy sufficient protection from political risk, unlike our current pay-as-you-go pillar,” he said.
The current pay-as-you-go system is to a large extent dysfunctional, Magnusson said, because payments are linked to pension payments from the investment-based pillar.
“This means that pensioners face a very high tax rate on their pension payments from the investment-based pillar, undermining the popular support for that system.
“This also means that the current generation of pensioners ends up paying twice for their pension, both supporting a pay-as-you-go system and making contributions to an investment-based system while working – but still receiving a fairly meagre pension,” he said.
Another point Magnusson made at the FME event related to the now ongoing pension fund legal reform, concerned the challenge to the pension system from the downward trend in real interest rates, in Icelandic krona and abroad.
“If that trend continues – a big if, of course – the risk-free real rate in Icelandic krona will be negative in about six years. This will obviously make it much harder for the investment-based pillar of the pension system to have an acceptable return on assets and may thus call for either or both, higher pension contributions or lower pensions, or other steps, such as an increase in the retirement age,” he said.
Magnusson noted that part of the explanation for the downward trend in interest rates is the build up of the investment-based pillar of the pension system. He said this increases the supply of savings.
“Since the system is expected to grow significantly faster than the economy well into this century, it will be increasingly hard to find suitable local investments to meet the needs of the system,” he said.
While this can to a degree be met by investing in foreign assets, he said, as has been done since the early 1990s, Magnusson suggested that this also presents some economic challenges.
“The large size of the pension system in Iceland relative to its economy is arguably the main challenge behind the review. OECD figures show Iceland’s pensions assets had grown to 152% of the country’s annual GDP”
Another concern related to the size of the Icelandic pension system is the relative youth of the population by European standards. This means that the influence of the funds will increase still further if nothing is done to prevent it.
Measures have been discussed to counter this likely development, such as allowing pension scheme members to pay down mortgages with their pension savings, according to one source, alongside other changes that would limit the extension of the relatively centralised pension system.