Iceland
Compiled by Allianz Global Investors
Pension System Design
The Icelandic pension system consists of three pillars: a tax-financed public pension, a compulsory second pillar and voluntary, tax-incentivised private pensions. Major reforms to the legislation on pension funds and voluntary pensions were undertaken in the late 1990s to strengthen the system for future developments.
Compared to other European countries, the Icelandic pension system will not be hard hit by demographic changes. The strength of the system lies in a relatively young population, high labour force participation and the dominant role of the funded second pillar. In addition, early retirement is not a problem, which ensures a high effective retirement age.
Public Pensions
The Icelandic state pension system is a tax-financed, means-tested scheme that provides a basic provision accounting for 15% of average earnings. For people without appropriate additional old-age income, a supplementary pension is paid. Basic and supplementary pension benefits can rise to 70% of average earnings.
The legal retirement age for private sector employees is 67 and for public sector employees 65. This is slightly higher than the European Union average. However, the effective retirement age is significantly higher than in other European countries. The average male Icelander retires at the age of 68.5. Strong disincentives for early retirement and, in return, incentives for retiring later encourage a longer working life.
State pension system benefits are adjusted according to the development in wages. This takes into account the current state budget, but must at least be indexed to the cost-of-living.
Occupational Pensions
Occupational pensions are the cornerstone of the Icelandic pension system. It is a mandatory employer and employee-financed pension providing benefits amounting to 50-60% of fulltime earnings during employment. The contribution rate must be at least 11% with the employer paying 7% and the employee 4%. Premiums are fully deductible for tax purposes. Compulsory membership of second pillar pension funds, governed jointly by trade unions and employers, was introduced in 1974 for wage earners and in 1980 for the self-employed.
Within private sector schemes, a form of intergenerational risk transfer and coinsurance takes place. These schemes could be defined as hybrid schemes as they combine elements from defined benefit and defined contribution schemes, but are neither pure DB nor pure DC schemes.
Pure defined contribution schemes provide benefits that are actuarially fair as they depend on the contributions paid and the actual investment returns. In Iceland, contributions to most occupational pension funds do not earn rights according to the time horizon and therefore do not reflect the time value of money. In this “equal-earning system,” pension rights are earned independent of age. This means that a 25-year-old member earns the same defined benefit for a given premium as a 55-year-old member.
An aging population, increasing life expectancy and rising volatility of the value of assets through increasing stock investment make the pension funds more vulnerable. Equal-earning systems favour older workers over younger employees. These advantages and disadvantages are balanced if the population remains stable, but leads to huge disadvantages for younger workers when the population is aging. More and more funds shift to age-related systems to provide actuarial fairness.
Public sector pension funds provide defined benefits. The employer bears the whole investment risk as contributions adjust to meet liabilities.
Pension fund landscape
According to the Pension Funds Act of 1998, occupational pension funds must at least have 800 members.
Introduction of the legislation resulted in a decline of the number of pension funds by one third and mergers are still taking place.
There were 40 operating pension funds at the end of 2006. The ten largest funds held 80% of the total pension fund assets in Iceland. In 2006, pension fund assets accounted for 132.7% of GDP or ISK 1,500 billion (EUR 16.4 billion), which placed Iceland at the top of the OECD countries in relative comparison.
Distribution
Benefits are paid in the form of lifetime payments. They are indexed to the consumer price index and can be adjusted according to the financial resources of the fund.
Tax treatment of contributions and benefits
As already mentioned, mandatory contributions to pension funds are tax deductible for the employer as company expenses without limit and for the employee, up to 4% of taxable income. Investment gains accrue tax-free and benefits are taxed as income from employment.
Outlook
Iceland has recorded a steady increase in pension assets since 1969. It is expected that pension assets will account for 150% of GDP in 2050. The investment allocation of the pension funds has changed significantly from domestic bonds and housing loans into equity and foreign assets. Pension funds are big players in the domestic financial markets even if foreign securities accounted for an estimated 30% of total pension assets at the end of 2006.