mar guðmundsson : the icelandic pension system and the financial crisis speech by mr mar guðmundsson, governor of the central bank of iceland, at the opening dinner of the european pension convention 2010, reykjavik, 2 may 2010. * * * chairman, ladies and gentlemen, it gives me great pleasure to address you here tonight, and i would like to thank the organisers for inviting me to do so. this is due not least to my past interest in and work on the icelandic pension system and, more generally, my interest in the optimal design of pension systems. during my tenure as chief economist of the central bank of iceland from 1994 – 2004, i was convinced that the pension system that had developed in iceland, partly by historical accident, was one of the strengths of iceland ’ s economy. this conviction had taken root earlier, when i was involved with pension reform and served for a while as the chairman of the board of a pension fund that has long been among the top ten in iceland in terms of size. however, this view was reinforced around the turn of the century, when i made an in - depth study of the icelandic pension system and tried to analyse its effects on the economy and the financial sector. 1 i subsequently tried to propagate the virtues of the system abroad. i remember that the last thing i did in this respect, before i went to the bank for international settlements in basel to focus on other things, was to try to sell the system to a russian audience that was considering pension reform in their own country. 2 on what was this view based? in order to answer that, i must first remind us of the attributes of a good pension system. of course it is obvious that it must be a mechanism for saving for retirement. but in order to be an efficient such mechanism, it must take due account of the lifetime risks facing individuals, as well as the economic and financial risks facing society as a whole. these are, for instance, risks related to life expectancy, ability to work, demographics, the productivity of labour, and the rate of return on financial assets. furthermore, some at least would make the demand that the system have a certain degree of income equalisation built into it, and most would accept that it should at least not be regressive. then we would want the pension system to have some degree of flexibility and to provide scope for individual choice. finally, we want the pension system to be designed so as to promote economic

##ecd average of 7. 2 %. the occupational pension funds have grown very fast in the last few decades, through mandatory contributions from all wages and salaries, low operational costs, and long spells of good returns. around the turn of the century, they were the third - largest in eu and efta countries in terms of assets as a share of gdp, at around 80 %, after switzerland and the netherlands. shortly before the international financial crisis struck, iceland had overtaken even these countries. the funds were bound to grow much more, as they were far from reaching maturity in the sense that most of those receiving pensions had not accumulated rights based on their lifetime earnings. the clearest measure of this was the fact that the pension burden, or pensions as a share of contributions, was still below 50 %. at that time, it was estimated that, at maturity, the funds would amount to 1½ times gdp. they came close to that just before the financial crisis, but this was not “ real ”, as i will come to later. it is noteworthy that the funds do not obey simple classifications. some of the funds have an employment guarantee and would be characterised as defined - benefit funds, where the employer bears the investment risk, but in iceland only the government, municipalities and banks can guarantee pension funds. but the rest are not pure defined contribution funds. the investment risk is borne collectively by the members, and there is some scope for smoothing changes in benefits and for some risk - sharing among generations. this can matter when you have a once - in - a - lifetime shock to returns, as we experienced during the international financial crisis. the third pillar of the pension system entered the stage rather late here in iceland. it was only in 1998 that legislation on tax incentives for voluntary private pension saving was adopted, but these incentives were subsequently increased. voluntary private pensions saving then increased by leaps and bounds, reaching 10 % of gdp in 2002 and 15 % of gdp in 2007. this saving has proven to be an important cushion during the current crisis, as early repayment was temporarily allowed. so far, these early repayments have amounted to 2½ % of gdp. this is akin to a fiscal stimulus and has supported private consumption this year and last. let me now say a few words about the economic and financial effects of the pension system that we have built up here in iceland. the first thing to note is that it is always those who are economically active today who support today ’ s pension