8. Pension Funds

3. Voluntary

2% burden carried by the employer, 2-4% employee. Can begin 60 years old and equal installments of at least seven years. No later than 67 years old and finish no later than 70 years old. Employees can put money into specific savings programs of own choice. (Mutual funds - stocks, bonds, cash (accounts)) Hægt að nota þennan pening í house payments.

Pension funds

A fund established for the eventual payment of retirement benefits. Financed by employees and employers. A pension is generally not taxed until funds are withdrawn. pension funds are major participants in the financial markets. Not in the spread business. There are 2 types of basic and widely used types of pension plans: Defined-benefit plans and defined contribution plans. And in addition, a hybrid type of plan called a cash balance plan combines features of both these types.

Hybrid plans

A mix of defined benefit and defined contributions. ICELAND. The most common hybrid form is the cash balance plan. It is basically a defined benefit that has some of the features of a defined contribution plan. A cash balance plan is a defined benefit plan in that it defines future pension benefits, not employer contribution and a guaranteed minimum annual investment return. Each participant in a cash balance plan has an account that is created with a dollar amount that resembles an employer contribution and is generally determined as a percentage of pay. Each participant's account is also credited with interest linked to some fixed or variable index such as the consumer price index (CPI). The plan usually provides benefits in the form of a lump-sum distribution in an annuity. Interest is credited to the employee's account at a rate specified in the plan and is unrelated to the investment earnings of the employer's pension trust. The employee's benefit does not vary based on the interest credit. The promised benefits are fixed, and the investment gains or losses are borne by the employer. However, as in a defined-contribution plan, an individual employee can monitor his or her cash balance plan "account" in a regular statement. Sjá mynd bls 162. Cash balance er alveg stöðugt, en traditional er flöktandi.

The 3,5% debate in Iceland.

Acquiring pension rights: should give a lifelong pension amounting to 72% of wages (was 56%). This is generally thought to mean a required real return of 3-4% What is a real return? what is a nominal return? Pension fund liabilities discounted using a fixed 3,5% real interest rate (due to regulation). If real interest rates are below this level, the funds liabilities are being underestimated. Buying bonds at rates below 3,5% means recording an instant loss. Effect on interest rates in the economy. EFfect on risk taking. Is a 3-4 % real return viable in the long term? Many (most) believe this is not the case. What happens if the pension funds returns are below 3,5%. Public pension funds vs general pension funds: Public pension funds are backed by the government. General pension funds will need to cut back pension rights. ISK been so stable, thats why it would be difficult for a investment manager to put money into foreign bonds. Because the interest rates on foreign bonds is much lower than in ICE so it would have been very difficult for pension fund manager to justify.

Icelandic Pension System: assets.

Assets valued around 3.500 billion isk at year end 2017. 150% of GDP (145% direct pension funds). Very high compared to most OECD nations. Defined contributions becoming increasingly common. Defined contribution have co-insurance and benefits included, same for young and old. Lifelong pension guaranteed.

Defined contribution plans

Based on specific contributions, not benefits. does not guarantee a specific amount at retirement => payments determined by investment performance. Individuals usually decide to some degree where $ are allocated. Do not bear the risk if investments do not earn enough to guarantee sufficient funds. Individual accounts. Aldur fólks er að hækka þá lækkar magn peninga á ári, it also depends on how much people contribute and on the rate of return of those contributions are during their lifespan.

Icelandic pension system

Based on three pillars: (1) Public pension. Safety net/poverty relief. (2) Mandatory occupational pension funds, the backbone of the Icelandic pension system. (3) Voluntary individual pension savings.

Allocation always "Wrong"

Easy to blame insurance funds, but they do not operate without constant criticism. % year rule 72. People want pension funds to invest what is in fashion, prudent rule. Yet people want pension funds to do better, than the rest. 72 rule => the percentage that you receive, if you receive constant stream returns that shows how quickly you double your money so lets say your receiving 4% real returns each year. If you divide 72 by 4 that means 18 years, 18 years to double the money, in real value. That is added to inflation so no matter what the inflation would have been your money would have doubled in real terms in 18 years.

2. Mandatory

Every wage earner must contribute a minimum of 15% of his/her salary to an occupational pension fund. 11.5% burden carried by the employer, 4% employee. Acquiring pension rights: should give a lifelong pension amounting 72% of wages after 40 years work (assumes a certain return, more later)

Danger

Icelandic government bonds (short and long) are about 50% of pension funds assets. Inherent risk, if Icelandic government cannot fulfill its obligations the pension fund system collapses. Total losses 2008 were appr. 480 B ISK.

Difference between defined benefit plan and defined contribution plans

In the defined benefit plan, the plan sponsor: (1) guarantees the retirement benefits, (2) makes the investment choices, and (3) bears the investment risk if the investments do not earn enough to fund the guaranteed retirement benefits. In contrast, in a defined contribution plan, the employer does not guarantee any retirement benefits. However, the employer may agree to make specified contributions to the employee's account. The employee selects the investment options, and the employee has for retirement only the return on the investment portfolio (plus of course the employee and employer contributions)

Index linked bonds

Late 1990s. Iceland 5-6% USA 3-4%. Today Iceland just over 2% and USA 0%. Rate of return.

Note

Lets say if a country receives 100$ loan and it is index linked meaning that if it produces at the same time goods worth 100, if in 1 year the inflation is 3% that goods that it produces have gone up to 103 but at the same time the money it owes is also 103. And the only way to be able to produce enough to actually pay back the real return is to make goods, produce goods, more goods tomorrow than yesterday or today. For ex -> Real rates on the stock has been close to the GDP of the economy and the GDP in the long run has been around the growth 3.3 % annually means that the US economy has produced on average #.3% more each year the last decades. the inflation has ben very similar 3.3% And this means that stocks have given approx nominal returns of around 6,7% annual returns. The implication of this incidentally bonds have been providing less returns. If the returns are not met then the public pension funds backed by the government (benefit funds) they would need to be backed up by the government meaning that the government would have to put some extra money into the funds so those defined benefits funds could pay back to their pensioners. Sumir hafa verið cutting back pension rights.

Classification of the Icelandic Pension system

Most fall somewhere in between defined contribution and defined benefits (hybrid). They do have a defined contribution. But no individual accounts. Not directly determined by investment performance (also insurance) but the trend is in that direction. Mainly state guaranteed pension funds which are purely defined-benefit funds. Not directly determined by the investment performance. also how long people live, why? also the amount of contributions. Index linked bonds - definition and implications. Difference between real and nominal interest rates. Also included are disability pension and survivors pension. Index linked bonds => Those are bonds that are linked to some kind off index. An index could be anything, but in ICELAND index linked bonds are linked to consumer price index, that means that if prices in general go up by 2% an index linked bond goes up by 2% so if there is a index of consumer prices in the economy lets say its 100 and it rises up to 102 an index linked bond will also rise from 100 to 102, and after that an index linked bond gains some kind off interest if an index linked bond has a 2% interest rate and the consumer price index also goes up 2% the bond goes up a 100$ become 104$, goes up 4%. 3 factors that determine how much you receive: investment performance, life expectancy and amount of contributors.

Retirement Resources

Pension plans and Personal savings. Something in between would be voluntary pension plans. Pension plans er oft skylda.

1. Public pension

Social security (government is responsible for payments). Basic minimum pension roughly 45% of the average salary in Iceland. Max for someone without any income is min. wage level. Safety net or poverty relief. Funded via SS tax - around 7% of total salaries paid by employers.

Defined Benefit plans

The pension fund agrees to make specified payments after retirement. Assumes the risk of having insufficient funds to satisfy contractual payments. Great amount of uncertainty. Length of service and earnings (age and lenght of service), essentially a debt obligation to the plan sponsor (government), insured benefit plans include life insurance products. (an Insured plan is not necessarily safer than a noninsured plan, since it depends on the ability of the life insurance company to make the contractual payments, whereas the uninsured plan depends on the ability of the plan sponsor) All people receive maybe a minimum pension fund payment once they retire and then through some calculations (how long people worked and wages) they also receive some payments. People contribute money to a defined benefit plan but its the benefit plan or the pension fund that assumes the risk of having insufficient funds so if the interest rates/the returns of the money that is put in the fund are insufficient and provide very little returns it is the fund who has to face that uncertainty and usually these defined benefit plans are sponsored by the government.

Difference between real and nominal interest rates.

The real interest rate of an indexed linked bond that is tied to the consumer price index or also commonly known as inflation if that bond has a 2% interest rate, the real interest would then simply be 2%. But if inflation is 2% the nominal rate is then slightly above 4%. Real + Inflation = Nominal. Nominal - Inflation = Real.

50% of pension fund holding in foreign territory?

Total 2008 1640B ISK, 50% 820 B ISK. Foreign holdings 2/3 safe bonds and 1/3 in stocks, hardly any price difference. Note: If 50% of the pension funds holding it would have been in foreign territory and 2/3 safebonds and 1/3 in stocks. Mest allt var í stocks. When stock markets crashes the price of bonds safe bonds - increases simply because people have an added apetite buying such safe assets, meaning its like a safe shelter, if we assume that 2/3 had been safe bonds that would have risen in value and that would have cancelled out the price drop of stocks having only 1/3 in stocks, hardly any price difference. Icelandic holdings gone up proportionally to the depreciation of ISK. ISK depreciation appr. 80% in 2008. 820 B ISK - 80% return due to foreign holdings. Foreign holding gone up 650 B ISK when nation needed it the most. Foreign holding would have gone up 170 B ISK more than the loss associated with the crash, probably more. Less pressure for pension funds to invest prudent securities if invested abroad.