Sunday 29 July 2012

Icelandic public pension zombies

I promised some time ago to get into the Icelandic pension system now that the Financial Supervisory Authority in Iceland has published its annual report on the system, taking into the account the figures as they were at year end 2011.

Few things you have to know about the system before we continue.

It's a classic three-pillar system. The State takes care of the basic social security. That pillar is a normal defined benefits system in the sense that this part is paid for with taxes.

The second pillar is a messy mix of defined benefits and defined contribution system. The second pillar is one part public but the other is private. The public part is backed up by the State and its benefits are predefined. The contributions are as well but the contributions fall way short of covering the benefits as we will see later in this post. This means that the defined benefits must be fulfilled with the State's money. And that's a lot as we will see later as well! In fact, it is so much that I believe the public part of the second pillar of the Icelandic pension system is as good as bankrupt. At least technically.

The private part of the second pillar are the private pension funds. They are messy as well because laws no. 129 from 1997 define the benefits they must fulfil. In the case of old-age pension the funds must pay out the equivalent of 56% of average wages during the working life of the pensioner, given 40 years of working life.

The contributions are also "half-defined". There is a clause in the law that states that the funds can define the contribution needed to back up the clearly defined benefits but the mess is that they all follow the same basic contribution ratio: 12% of wages, up from 10% in 2005. The trick is that there is another clause - clause no. 39 -  that states that the private pension funds must "redefine" the pension assets of their members if the actuarial position is negative by 10% or negative by 5% for five years in a row (yep, the pension funds in Iceland are allowed to constantly be in the negative territory with their actuarial position!). The redefinition of pension rights normally means to simply write them down by whatever figure is necessary to get the actuarial position back into not-as-negative territory. However, the public part of the second pillar never writes down any pension rights since they are backed up by the State.

Right, this is some of the basics you need to understand what will follow. What follows scopes outs only the public part of the second pillar. My argument is that it is as good as bankrupt. You'll see why in a bit.

The bankrupt public pension system in Iceland
Again, the public pension system in Iceland is backed up by the State.

There were 668 billion ISK (5.5 billion USD) missing on the actuarial position of the whole second pillar of the Icelandic pension system in Iceland at year end 2011. The public pension funds were responsible for 547 billion (4.5 billion USD) of those 668 billion, the private funds the rest (121 billion ISK).

This might not sound serious but remember that the GDP of Iceland was around 13.4 billion USD in 2011. The total income of the State - federal and states - was 679 billion ISK (5.6 billion USD) in 2011. So the hole on the public pension system amounts to roughly one third of annual GDP or 80% of the income of the State. And don't forget, the State is the guarantor of the public pension system. A system which hole on the balance sheet is now 80% of the annual gross income of the guarantor.

Something missing on the State's balance sheet?
So there is a massive hole on the balance sheet of the public pension funds which the State is the guarantor for. This means that the money missing in the public pension funds should show up on the balance sheet of the Icelandic State, right?

Apparently not! Booked pension liabilities of the State - federal and states - are 163 billion less than the total hole in the actuarial position of the public pension funds.

There is something missing on the balance sheet of the State in Iceland. The guarantee on the public pension system seems not to be fully accounted for. Amounts in billion ISK.


This mismatch is something which generational accounting would fix. That has of course never been implemented although it seems pretty sensible. But hey, who knows! Maybe we get lucky and just accidentally trip over 163 billion ISK somewhere? I kind of doubt it however. Who cares anyway, 163 billion is only around one fourth of annual gross income of the State in Iceland.

Maybe they  can just monetise the whole thing by asking the Central Bank to print the whole lot for them! Too bad that might be inflationary and the pension rights are indexed to inflation. Wonder who would win that race, the dog or the tail.

The nutshell
The public pension system in Iceland is missing 547 billion ISK on its actuarial position. That deficit will in the end be borne by the State finances but they nevertheless seem not to be accounted for fully on the balance sheet of the State. The State is therefore seemingly so hiding a liability amounting to around 10% of GDP. Hiding public liabilities is an interesting sport.

But the public part of the second pillar of the Icelandic pension system is essentially not that interesting. It is technically bankrupt, needs to be restructured and I'm not going to spend too much time on it. The only question is when the public system comes down crashing and we all know that self deception can go on for a long time before the "sudden realisation" dawns upon everybody.

The more interesting part is the private part of the second pillar. We'll get into that part later.

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