Putting DC in its place
Iceland has put ‘pure’ DC plans in what it considers to be their place – the third pillar.
The government introduced legislation to allow optional personal pensions schemes with individual accounts as part of its Pension Reform Act 1997. The aim was to give further encouragement to private pension provision.
DC schemes with individual accounts were available before the legislation However they were an option within the second pillar mandatory occupational plans. “There were pure DC plans, with individual accounts, within the mandatory occupational pension system, before the 1998 reforms but they were not very popular. They represented just 4.4% of the total assets of pension funds in the end of 1997,” says Hrafn Magnusson, managing director of the National Association of Pension Funds (NAPF).
Under the new legislation, it is still possible to have a pure DC scheme within the mandatory second pillar system However it must now satisfy a number of benefit conditions, including the payment of a disability pension, and pension payments to surviving spouses and children, if it is to be legally recognised as a pension fund.
The seven (now six) pension funds that provided only personal pensions schemes with individual accounts before the 1997 regulation agreed to change their benefit conditions.
These funds now dominate the provision of third pillar personal pension schemes within the mandatory second pillar system. At the end of 2001 they accounted for ISK 39bn (E458bn) of the ISK 47bn total net assets of personal pensions – over 80%. The rest of the market is divided mainly between the industrywide occupational pension funds - who offer third pillar personal pensions alongside their second pillar mandatory schemes – and the banks.
The third pillar schemes operate like pure DC schemes. Employees and self-employed people pay up to 4% contribution of total wages towards their pension pot in a private pension fund. The employer contributes a further 2% and the state contributes 0.4%. The accrued benefits are paid out from the age of 60 as a monthly payment over a period of seven years.
Contributions to personal pensions, unlike contributions to occupational pensions, are entirely voluntary. However, since last July employers have made a unilateral 1% contribution on behalf of employees who do not save in a personal pension fund. This is paid to the private pension department of the employee’s mandatory pension fund, although the employee can ask for it to paid into another fund.
Personal pension schemes offer attractive tax incentives. For example, an employee who contributes 2% of a monthly wage of ISK150,000 - ISK3,000 – effectively pays only ISK1,843 with tax relief. The employer will contribute a further ISK 3,000 and the state will contribute ISK300, producing a total contribution of ISK 6,300 a month. Therefore, the employee’s contribution is only 29% of total contributions.
Although the pure DC personal pension schemes were introduced only four years ago, take-up of personal pensions has been rapid. The NAPF estimates that in March last 76% of the total workforce now contribute to a private plan.
The Financial Supervisory Authority (FME) estimates that personal pension savings increased 55% from ISK30.6bn at the end of 1999 to ISK48bn at the end of 2001. Assets of the personal pension divisions of the pension funds – excluding the six funds that used to operate purely as personal saving finds – increased from ISK1bn in 1999 to ISK3.4bn in 2001.
At an individual fund level, the number of accounts is halfway towards matching the number of members. For example, Verzlunnarmanna Lifeyrissjodur, with more than 40,000 office and retail sector employees contributing to its mandatory pension scheme, had 18,553 individual accounts by the end of 2002. Contributions to individual accounts were ISK465m, up 85% on 2001. However, this is still only a small fraction (6%) of the fund’s total pension contributions of ISK7.4bn.
Other providers, particular banks, have seen private pensions assets grow. Personal pensions savings with depositories others than pension funds increased from ISK0.6bn in 1999 to ISK5.5bn in 2002.
The Bank of Iceland’s Gudmusson suggests that, despite their relatively small contribution to pension fund assets, individual accounts are significant because they invite a comparison between the administrative costs of personal pensions in the Iceland and the UK, the only major OECD country to have privatised its social security system.
He points out that Iceland’s system of individual accounts involves relatively small contribution amounts, is voluntary and decentralised and has a large number of providers, which limits economies of scale. All these factors suggest that administrative costs in Iceland are likely to be higher than in the UK.
However, research into Iceland’s private pension costs suggests otherwise. Haukur Benediktsson, Tryggvi Herbertsson and Michael Orszag have looked at the lifetime costs of individual accounts and investment plans for a typical worker in Iceland using typical wage profiles and providers’ current charges
They found that the costs of individual accounts in Iceland were far lower than the costs of personal pensions in the UK, and much lower than would be expected in an emerging DC market. They suggest one of the reasons is the growing competition for business between the banks and the industrywide pension funds.
This competition is likely to increase for two reasons. Iceland’s pension reform has increased the breadth of choice of pension providers. There has also been a growth in non-traditional sectors of employment that are not catered for by the existing pension funds. Both these factors are likely to encourage more people to shop around for their DC plans in future.