Sunday, 11 December 2011

Introduction To The Icelandic Pension System

Most people will roll their eyes when they hear that a pension system can have a fundamental part in bankrupting the households and private companies in any economy. Yes, pension systems all over the world are burdensome and, well, unlikely to work out in their current form due to too heavy burdens they put on the states' finances. UK, France, Italy, Greece, US and Denmark are just a handful of countries that are going to have to reconsider their pension systems. But that the pension system is to a large extent responsible for high debt of households: impossible!

Except in Iceland.

A very short introduction
The pension system in Iceland is a three-pillar system. The details are of course there but the basic structure of it is on its own enough to understand the essence and the crazy organisation of it. The State takes care of basic social security system; pensions for those that haven't built up their own savings, disablement benefits etc.. That's the first pillar. The second is the pension funds themselves which are divided into General ones and the Public ones. The Public pension funds have the explicit backing of the State while the General funds are not backed up by anything and must therefore, in case they cannot get high enough return on their assets, cut the benefits down. That they are obliged to do according to law and when their actuarial position [the balance between their estimated present value of assets and debts] hits -10% they must cut down their pension promises. Holland has +5% minimum in comparison. The third pillar is the voluntary pension savings.

The interesting part of the Icelandic pension system is the second pillar: the General and Public pension funds.

First the Public funds. In very short, they are for everybody that work for the State. Due to the State backing on the Public funds they are never obliged to cut back on their pension promises and in fact, according to law no. 1/1997, they are really nothing else than defined-benefits funds. The actuarial position of the Public funds is negative by around 440 BILLION krona. That's just short of 30% of GDP - which in comparison to many other countries isn't that bad!

Now the punch in the pension system in Iceland are the General funds. Their actuarial position is negative by around 200 billion, obviously showing the need to continue cutting down pension rights, but that's not the bad news. It's the laws that governs them that are.

The law on General pension funds in Iceland
I've mentioned before that the major economic problem of Iceland is high interest rates. High interest rates, especially for the long run, was the source of "the economic problem" of unemployment, fluctuating economic growth and general economic malices according to Keynes. And amongst the European nations, Iceland is always close to the top on the list of countries by the long-run interest in the economy. And I am gong to argue that this is because of the pension system.

The Icelandic pension system needs high interest rates. The law that the governing of the General funds is based on states explicitly that after a work life of 40 years, a pension fund shall secure the pensioner a pension that is equivalent to 56% of their average wages during their working years. To finance that, the pensioner himself and his employer contribute, in total, 12% of the pensioner's wages while he is working. No other contribution is forthcoming. And notice that the pension funds must, according to law, pay out pension that is equivalent to this bizarre ratio of 56% of average wages (I have no idea where this ratio comes from). The general pension age is 67 years in Iceland.

Now, Icelanders live, on average, for rather long - we've for a long time made it into the top 5 on the list of countries by life expectancy. The average Icelander lives for about 14 years after he begins receiving his pension.

Now we have everything we need to calculate how high (real) interest rates the pension funds need in order for them to be able to fulfil their legal obligation of paying out pension equivalent to 56% of average wages over your working age, given you live for 14 years and contribute 12% of your average wages to the pension fund. And the answer is: 1.8% real interest rates. On top of that comes cost of running the fund, other rights that the funds are legally obliged to fulfil such as part of disable benefits and pension in case of death of spouse and last but not least general wage increases during your working age. All this adds up to somewhere between 3-4% real interest rates. This is absolutely fundamental: the General Icelandic pension system needs 3-4% real interest rates if it is going to work out and the Public funds need even more. There is no coincidence that the pension rights in Iceland are discounted with 3.5% real rate of interest according to regulations.

A very important ingredient in the impossibility of the Icelandic pension system is the fact that the funds, as a group, are by far the biggest investors in any sort of financial instruments in Iceland. To name a few examples: they own most of the corporate bonds listed on the Icelandic Exchange, about 70% of the funding from the official Housing Financing Fund comes from the pension funds and they finance 30% of the outstanding bonds of the Icelandic State, registered in the Exchange. About half of all the mortgages in Iceland originate from the pension funds, either directly from themselves or through the Housing Financing Fund. They are, for a lack of a better word, a behemoth on the Icelandic capital market!

Now you're in position to understand how mad the situation gets. What happens when the majority of investors out in the market are legally obliged to get, at least, 3.5% real return on their investment in financial intermediaries? Of course, interest rates don't fall. Why should a pension fund buy a bond from the Housing Financing Fund, which it issues in order to finance mortgages to normal Icelandic households, on a lower rate of return than 3.5% if it is legally obliged to get that return? Would a pension fund finance a mortgage on lower return than 3.5%? Of course not: interest rates for housing in Iceland are around 4-5%, adjusted for inflation (REAL return). And the fault is of institutional origin: if Icelanders want to lower the rate of long term interest in their economy, all they have to do is to reconsider the structure of the pension system.

Long term interest rates in Iceland and the EZ (figures from OECD)

So there is a bizarre situation in Iceland. The pension funds are bankrupting not only the State itself - remember the 440 billion hole on the Public pensions' balance sheet - but directly doing the same thing to households that want to buy a flat or a house. 

I've called the Icelandic pension system a Ponzi scheme. I cannot find any better way to describe it.


  1. It sounds like pensioners are a privileged group in Iceland. Somehow, you have to agree on how to share the cake.

  2. Olafur Margeirsson8 March 2012 at 10:47

    Thanks for the comment Helge. I wouldn't say that pensioners are particularly privileged in Iceland. Care for old people has been cut down, largely due to the crisis, and the money that the funds are paying to the savers isn't something worth celebrating really. Especially once you consider how much has been paid into the funds.