## 1islea2023009

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### Overview and system structure
- Iceland’s mandatory occupational pension fund sector: 21 autonomous pension funds operating 25 schemes; large majority categorized as defined ambition (DA).
- Four defined-benefit (DB) schemes are closed for new members.
- Targeted minimum replacement rate: "72 percent" (the targeted DA rate); effective replacement rate determined by pension fund performance.
- Total assets of the pension fund sector: "176 percent" of GDP at end-2022.
- Pension funds provide mandatory Pillar II pensions and Pillar III personal pension savings.

### Role in the domestic financial system and concentrated exposures
- Pension funds act as significant investors and lenders in the domestic financial sector.
- Key domestic exposures and market shares:
  - Exposure to Icelandic banks: increased from ISK "250bn" in 2017 to ISK "670bn" in 2021; accounted for "10 percent" of total pension fund assets and corresponded to 14 percent of banks’ financial liabilities.
  - Mortgage lending outstanding: ISK "526bn" — "8 percent" of pension funds’ assets and 18 percent of the outstanding mortgage volume.
  - Holdings in domestic sovereign bonds: ISK "1,409bn", or "21 percent" of pension fund assets.
  - Share of foreign-denominated assets: "34 percent" of assets as of September 2022 (up from 27 percent at end-2017); individual funds range from 11 to 40 percent.
  - Currency breakdown for DA schemes’ FX exposure: US dollar "81 percent", Euro "15 percent".
- Concentrated sovereign–banks–property nexus identified as significant.

### Recent performance, funding, and cashflows
- Long-run real investment returns (1995–2021): "4.9 percent" on average.
- Median DA scheme real yields:
  - 2017–2021 average: "7.1 percent".
  - 2019–2021: between "8.7" and "9.9 percent".
  - 2022: negative real return of around "-12 percent".
- Median DB scheme real yields:
  - 2019–2021: between "7.0" and "7.5 percent".
  - 2022: "-12.5 percent"; five-year average prior: "5.7 percent".
- Funding ratios and flows:
  - At end-2022, median DA scheme funding ratio: "92.6 percent".
  - 80 percent of DA schemes in range between "86.7" and "100.0 percent".
  - DA schemes generally in accumulation phase; annual net inflow in 2022: ISK "134bn".
  - Annual contributions to DA schemes: ISK "217bn" in 2018 and ISK "298bn" in 2022.
  - Annual benefit payments (including expenses) for DA schemes: ISK "89bn" in 2018 and ISK "164bn" in 2022.
  - DB schemes outflows: ISK "79bn" in 2022 and rely on special additional contributions from sponsors.
  - Distribution of Pillar II payouts in 2021: old-age pensions "78 percent", disability pensions "13 percent", survivor’s pensions "8 percent", children under 18 less than "1 percent".
- 2022 expected to end with significantly negative real return of around "-12 percent", driven by negative returns on stocks and bonds and relatively high inflation.
- Funding ratios of several DA schemes have dropped below "100 percent", potentially requiring adjustments to accrued and/or future benefits.

### Demographics and labour market context
- Population and projections:
  - Iceland population around "370,000" by 2021 (up from "200,000" in the late 1960s).
  - Statistics Iceland baseline projection: population will reach "474,000" by 2067; high-growth scenario up to "600,000".
  - Almost "42 percent" are 30 years or younger; "20 percent" are 60 years or older.
  - Old-age dependency ratio (OECD definition, 2021): "26.6"; comparators: OECD average "30.4", EU Member States average "32.3".
  - Projection: old-age dependency ratio expected to increase to almost "50" by 2070.
- Employment:
  - Employment increased to "223,000" in 2021, corresponding to "60 percent" of the population.
  - Employment cyclical with downturns in 2008/09 and the Covid-19 pandemic in 2020/21.

### System size, Pillar III, and key statistics
- Total pension savings (Pillar II and III combined) at end-2021: ISK "7.08trn" (219 percent of GDP).
- Assets at end-December 2022: ISK "6.90trn" (183 percent of GDP, of which 176 percent managed by pension funds).
- Pillar II assets (end-2021): ISK "6,032bn" (o/w ISK "5,611bn" DA, ISK "421bn" DB).
- Pillar III assets (end-2021): ISK "1,051bn" (o/w ISK "706bn" in pension funds).
- Pillar I basic amount: ISK "359,046" per month (single person, 2022).
- Mandatory contribution rate: minimum "15.5 percent" of wages (since 2023) o/w "11.5 percent" paid by the employer and "4 percent" by the employee; was "12 percent" until 2022 o/w "8" by the employer and "4 percent" by the employee.
- Pension funds covered around "50,000" pensioners aged 67 and higher and paid ISK "144bn" in old-age pensions in 2021 vs ISK "92bn" paid out by Pillar I.

### Sector consolidation and market concentration
- Number of active pension funds: "87" in 1990; "62" in 2000; "33" in 2010; "21" as of now.
- Only eight pension funds open to the general public.
- Largest pension fund manages more than ISK "1.3trn" in assets (end-2021); some smaller funds manage less than ISK "50bn".
- Number of active members ranges from less than "100" to around "50,000".
- Market concentration: three largest funds account for "51 percent" of total market by assets; five largest funds hold "71 percent" cumulated share.

### Asset allocation, credit quality, and liquidity
- Investment composition (end-2021 highlights):
  - Investment funds share: DA "38 percent", DB "34 percent"; Iceland-domiciled investment funds: ISK "288bn" (23 percent of outstanding investment fund shares).
  - Directly held stocks: DA "19 percent" of assets, DB "18 percent".
  - Inflation-linked bonds and loans: "36 percent" of total pension fund assets (range 27–77 percent for individual funds).
  - Fixed-income assets largely unrated (domestic corporate bonds and mortgage loans); average remaining maturity of fixed-income assets: around "8.2 years".
  - DA schemes government bonds declined to "20 percent"; DB schemes "29 percent" in government bonds.
  - Fixed-income rating focus: DA schemes targeted towards lower investment-grade ratings and BB-rated assets; DB schemes increased investment-grade share from "26" to "31 percent" over last four years.
- Liquidity indicators:
  - Liquid assets / total assets – DA+DB: 2017 "64.1", 2018 "61.3", 2019 "57.5", 2020 "55.2", 2021 "54.2", 2022 "54.4".
  - Contributions / benefits – DA: 2017 "99.4", 2018 "57.3", 2019 "57.7", 2020 "57.0", 2021 "57.1", 2022 "56.3".

### Foreign exposure, hedging constraints, and derivatives
- Share of foreign-denominated assets: "34 percent" as of September 2022 (2017: "24.5 percent", 2018: "26.3 percent", 2019: "30.7 percent", 2020: "34.2 percent", 2021: "36.4 percent").
- Hedging is rare; currency risks mostly borne by pension funds.
- Hedging market constraints:
  - Commercial banks’ forward foreign currency position versus each counterparty limited to "10 percent" of the capital base; gross total forward position cannot exceed "50 percent" of the capital base.
  - Counterparties for pension funds are almost exclusively Icelandic banks; overall hedging capacity limited.
- Derivatives: June 2021 restrictions on derivatives trading involving the Icelandic Króna lifted by Foreign Exchange Act No. 70/2021; Rules on Derivatives Transactions No. 765/2021 expanded authorizations.

### Institutional and supervisory arrangements
- As of January 1, 2020, Central Bank of Iceland (CBI) took over tasks of the Financial Supervisory Authority (FSA) with responsibility for almost the entire financial services sector.
- Ministry of Finance and Economic Affairs (MoF) retains tasks: authorizing new pension funds and approving changes to Articles of Association (including mergers and acquisitions); this split has caused delays and inefficiencies.
- FSA resources for pension fund supervision stretched; Pensions and Insurance Department headcount around "8" full-time equivalents at end-2021 (up from 6.5 in 2016).
- Pensions and Insurance Department conducts horizontal analyses and issues non-binding guidelines and circular letters to mitigate statutory shortcomings.

### Legal, governance, valuation, and actuarial issues
- Pension Fund Act No. 129/1997 (entered July 1998) predates provisions for other financial sectors; key gaps:
  - Act silent on board nomination processes.
  - Defines risk management and internal audit as control functions but not actuarial or compliance functions.
  - No closed list of infringements/sanctions; refers to Act No. 87/1998 (fines between ISK "10,000" and "2,000,000"; periodic penalty payments between ISK "10,000" and "1,000,000").
- Valuation of liabilities:
  - Annual actuarial examination required (Article 24 Pension Fund Act).
  - Discounting assumptions: fixed real interest rate of "3.5 percent" set by Regulation No. 391/1998 and unchanged since 1998; no established mechanism for future adjustments.
  - Assets backing liabilities must equal actuarial valuation; allowed deviation maximum "10 percent" for single observation and "5 percent" over time — implying funding ratio to be maintained between "90" and "110 percent" and not outside "95" and "105 percent" for five consecutive years.
  - DB schemes guaranteed by plan sponsor are exempt from full funding requirement.
- Actuarial profession capacity: Association of Icelandic Actuaries: eleven active and seven associated members; only two qualified actuaries serve the entire pension fund sector; University of Iceland does not offer actuarial courses.

### Supervision, ORA, stress testing, and inspections
- FSA supervisory model: risk-based and forward-looking; no minimum frequency set for on-site inspections.
- Minimum engagement model and impact classification:
  - Financial institutions impact scale 1 (low) to 4 (high).
  - Three pension funds classified medium-high (around half of sector assets); remaining 18 classified medium-low and low.
  - Meetings with board chairpersons and managing directors: every 1–2 years for medium-high funds; every 1–3 years for medium-low and low funds.
  - Detailed reviews of individual risks: every 2 years for medium-high funds; every 3 years for other funds.
- On-site inspections:
  - Between 2018 and 2022, CBI conducted 13 on-site inspections (i.e., between "two and three" per year) at nine different pension funds covering about half of the market by assets.
  - Main inspection focus areas: risk management, actuarial examination, governance, and outsourcing arrangements.
- Own Risk Assessment (ORA):
  - Required at least annually and whenever material change occurs; ORA must be forward-looking, include all relevant risk factors, and be sent to FSA no later than 30 June each year.
  - FSA does not set minimum stress-testing requirements; methods should be commensurate with fund complexity.

### Outsourcing, governance enhancements, and transparency
- Outsourcing of key functions common, especially among smaller funds; some smaller funds outsource all operations.
- FSA aims for a strict approach to outsourcing, targeting funds that have outsourced entire operations including managing director function.
- Governance and internal controls: Chapter VI of the Pension Fund Act provides broad requirements but is less detailed than for banks or insurers.
- Fit and proper regime: in place for board members and managing directors (Article 29 and Article 31; Rules No. 180/2013); ongoing obligation to report changes without delay and no later than two weeks.
- Member communications:
  - Annual member statements assume constant "3.5 percent" real investment yield; current statements lack scenario detail.
  - Recommendation to provide statements with different scenarios and cost breakdowns in line with IORP II best practice.
- Climate/ESG:
  - Supervisory and industry approach to climate risks at early stage; SFDR and Sustainable Finance Taxonomy transposition into Icelandic law planned to enter into force in 2023.
  - FSA preparing sector guidance and a sector-wide climate exposure assessment for banks before rolling out to pension funds.

### Macroprudential aspects and reporting
- Macroprudential supervision includes pension fund sector but reporting to the Financial Stability Committee is infrequent (generally once per year).
- Pensions and Insurance Department conducts horizontal analyses; Financial Stability Department analyzes pension funds as lenders and market participants.
- Pension funds active in mortgage lending subject to comprehensive data collection; borrower-based macroprudential measures apply equally to all lenders.
- Recommendation to report more frequently to the Financial Stability Committee with regular briefings and updated risk assessments.

### Main policy recommendations (prioritized and timed)
- 1 Allocate supervisory powers under the Pension Fund Act fully to the FSA (Addressee: MoF; Timing: ST; Priority: M).
- 2 Ensure commensurate resources with expanding tasks (Addressee: MoF, FSA; Timing: C; Priority: M).
- 3 Delegate rule-making powers on technical matters under the Pension Fund Act to the FSA (Addressee: MoF; Timing: ST; Priority: M).
- 4 Define infringements and sanctions in the Pension Fund Act (Addressee: MoF; Timing: ST; Priority: H).
- 5 Review investment rules and consider removing (most) quantitative limits (Addressee: MoF, FSA; Timing: MT; Priority: M).
- 6 Develop a process for a regular review of the methodology to discount pension liabilities (Addressee: MoF, FSA; Timing: MT; Priority: M).
- 7 Publish clear guidance and best practices with regard to changes in benefits and accruals (Addressee: FSA; Timing: MT; Priority: M).
- 8 Align rules on governance, internal controls, risk management with IORP II or Solvency II (Addressee: MoF, FSA; Timing: ST; Priority: H).
- 9 Enact more stringent rules for outsourcing, and ensure an appropriate level of corporate substance within each pension fund (Addressee: MoF, FSA; Timing: ST; Priority: H).
- 10 Prescribe more detailed pension benefit statements, e.g., in line with IORP II (Addressee: MoF, FSA; Timing: ST; Priority: M).
- 11 Communicate clearly on the supervisory strategy and upcoming focus areas of supervisory work (Addressee: FSA; Timing: C; Priority: M).
- 12 Perform regular on-site inspections for large pension funds, and re-establish an institutionalized supervisory dialogue (Addressee: FSA; Timing: I; Priority: H).
- 13 Explore ways to expand and strengthen the actuarial profession (Addressee: MoF, FSA; Timing: ST; Priority: M).
- 14 Intensify engagement with pension funds on climate risk management, and provide guidance for the upcoming SFDR transposition (Addressee: FSA; Timing: I; Priority: M).
- 15 Report more frequently on developments in the pension fund sector to the Financial Stability Committee (Addressee: FSA; Timing: C; Priority: M).

*IMF staff technical note: EXECUTIVE SUMMARY (based on the 2023 FSAP material).*

### EXECUTIVE SUMMARY __________________________________________________________________________ 5

### EXECUTIVE SUMMARY

### Overview and system structure
- Iceland’s mandatory occupational pension fund sector is provided by 21 autonomous pension funds operating 25 schemes; the large majority of schemes can be categorized as defined ambition (DA). Four defined-benefit (DB) schemes are closed for new members.
- The system targets a minimum replacement rate of 72 percent (the targeted DA rate); the effective replacement rate is determined by pension fund performance.
- Total assets of the pension fund sector amount to almost twice the GDP: "176 percent" at end-2022.
- Pension funds provide both mandatory Pillar II pensions and Pillar III personal pension savings.

### Role in the domestic financial system and exposures
- Pension funds act as significant investors and lenders in the domestic financial sector:
  - Exposure to Icelandic banks more than doubled from 2017 to 2021 and accounted for "10 percent" of total pension fund assets.
  - Mortgage lending by pension funds outstanding volume amounted to "8 percent" of their assets.
  - Holdings in domestic sovereign bonds amounted to "21 percent" of assets.
  - The share of foreign-denominated assets reached "34 percent" of assets as of September 2022.
- The concentrated exposure towards the sovereign–banks–property nexus is significant.

### Recent performance and funding
- Historically, Icelandic pension funds have a solid track record of achieving real investment returns.
- The year 2022 is expected to end with a significantly negative real return of around "-12 percent", driven by negative returns on stocks and bonds and relatively high inflation.
- Funding ratios of several defined-ambition schemes have dropped below "100 percent", which may require funds to adjust accrued and/or future benefits for members.

### Institutional and supervisory arrangements
- As of January 1, 2020, the Central Bank of Iceland (CBI) took over tasks of the Financial Supervisory Authority (FSA) with responsibility for almost the entire financial services sector in Iceland.
- Resources for pension fund supervision at the FSA are stretched, creating key person risks.
- The Ministry of Finance and Economic Affairs (MoF) retains certain supervisory tasks, including authorizing new pension funds and approving changes to a fund’s Articles of Association (thereby approving mergers and acquisitions). This split of responsibilities has resulted in delays and inefficiencies.
- The Pension Fund Act predates corresponding provisions for other financial sectors and is silent on several governance aspects:
  - The Act is silent on board nomination processes.
  - It defines risk management and internal audit as control functions, but not the actuarial function or the compliance function.
- Outsourcing of key functions, including internal control functions, is common, particularly among smaller funds; some smaller funds outsource all operations to outside parties.
- To mitigate statutory shortcomings, the FSA issues non-binding guidelines and circular letters; supervised entities sometimes resist, arguing guidelines lack a statutory basis.

### Supervisory practices and coverage
- The FSA has adopted a risk-based and forward-looking supervisory model; there is no minimum frequency set for on-site inspections.
- The FSA sets an annual plan for on-site and off-site work based on a minimum engagement model, detailed risk analysis, and supervisory strategy focus areas.
- Between 2018 and 2022, the FSA conducted between "two and three" on-site inspections in the pension fund sector per year.
- Recent inspection focus areas: risk management, actuarial examination, governance, and outsourcing arrangements.

### Structural risks identified
- Outsourcing: The FSA aims for a strict approach and targets funds that have outsourced entire operations including the managing director function.
- Scarcity of actuarial resources: The actuarial profession in Iceland relies on a very small number of pension fund experts, viewed as a risk by both pension funds and authorities.
- Climate risk management: The supervisory and industry approach to climate risks is still at an early stage and lags peers in Europe.

### Macroprudential aspects
- Macroprudential supervision includes the pension fund sector, but surveillance findings and current risk assessments are not reported frequently to the Financial Stability Committee.
- The FSA’s Pensions and Insurance Department conducts horizontal analyses to identify sector-wide risks in a forward-looking manner.
- Pension funds’ activity in mortgage lending subjects them to comprehensive data collection; borrower-based macroprudential measures applying to mortgage lending apply equally to all lenders in banking and non-banking sectors.

### Demographics and labour market context
- Population developments:
  - Iceland’s population reached around "370,000" by 2021 (up from "200,000" in the late 1960s).
  - Statistics Iceland baseline projection: population will reach "474,000" by 2067; a high-growth scenario could reach up to "600,000".
- Employment:
  - Employment increased to "223,000" in 2021, corresponding to "60 percent" of the population.
  - Employment has been cyclical with downturns during the 2008/09 financial crisis and the Covid-19 pandemic in 2020/21.

### Key statistics from system tables and descriptions
- Pillar II assets (end-2021): ISK "6,032bn" (o/w ISK "5,611bn" DA, ISK "421bn" DB).
- Pillar III assets (end-2021): ISK "1,051bn" (o/w ISK "706bn" in pension funds).
- Pillar I basic amount: ISK "359,046" per month (single person, 2022).
- Mandatory contribution rate: Minimum "15.5 percent" of wages (since 2023) o/w "11.5 percent" paid by the employer and "4 percent" by the employee; was "12 percent" until 2022 o/w "8" by the employer and "4 percent" by the employee.
- Pension funds covered around "50,000" pensioners aged 67 and higher and paid ISK "144bn" in old-age pensions in 2021 vs ISK "92bn" paid out by Pillar I.

### Main policy recommendations (prioritized and timed)
- 1 Allocate supervisory powers under the Pension Fund Act fully to the FSA (Addressee: MoF; Timing: ST; Priority: M).
- 2 Ensure commensurate resources with expanding tasks (Addressee: MoF, FSA; Timing: C; Priority: M).
- 3 Delegate rule-making powers on technical matters under the Pension Fund Act to the FSA (Addressee: MoF; Timing: ST; Priority: M).
- 4 Define infringements and sanctions in the Pension Fund Act (Addressee: MoF; Timing: ST; Priority: H).
- 5 Review investment rules and consider removing (most) quantitative limits (Addressee: MoF, FSA; Timing: MT; Priority: M).
- 6 Develop a process for a regular review of the methodology to discount pension liabilities (Addressee: MoF, FSA; Timing: MT; Priority: M).
- 7 Publish clear guidance and best practices with regard to changes in benefits and accruals (Addressee: FSA; Timing: MT; Priority: M).
- 8 Align rules on governance, internal controls, risk management with IORP II or Solvency II (Addressee: MoF, FSA; Timing: ST; Priority: H).
- 9 Enact more stringent rules for outsourcing, and ensure an appropriate level of corporate substance within each pension fund (Addressee: MoF, FSA; Timing: ST; Priority: H).
- 10 Prescribe more detailed pension benefit statements, e.g., in line with IORP II (Addressee: MoF, FSA; Timing: ST; Priority: M).
- 11 Communicate clearly on the supervisory strategy and upcoming focus areas of supervisory work (Addressee: FSA; Timing: C; Priority: M).
- 12 Perform regular on-site inspections for large pension funds, and re-establish an institutionalized supervisory dialogue (Addressee: FSA; Timing: I; Priority: H).
- 13 Explore ways to expand and strengthen the actuarial profession (Addressee: MoF, FSA; Timing: ST; Priority: M).
- 14 Intensify engagement with pension funds on climate risk management, and provide guidance for the upcoming SFDR transposition (Addressee: FSA; Timing: I; Priority: M).
- 15 Report more frequently on developments in the pension fund sector to the Financial Stability Committee (Addressee: FSA; Timing: C; Priority: M).

*IMF staff technical note: EXECUTIVE SUMMARY (based on the 2023 FSAP material).*

### 8.      Iceland has a relatively young population, compared to peers, and a low old-age

### 8.      Iceland has a relatively young population, compared to peers, and a low old-age

### Population demographics and projections
- Almost 42 percent are 30 years or younger.
- Only 20 percent falls in the category of 60 years or older.
- The old-age dependency ratio—calculated by the OECD as the number of individuals aged 65 and over per 100 people of working age defined as those aged between 20 and 64—was 26.6 in 2021.
- Comparators: OECD countries average 30.4; EU Member States average 32.3.
- Projection: the old-age dependency ratio is expected to increase to almost 50 by 2070, however still below most other Western economies.
- Drivers: Iceland’s population is comparably young, mainly due to significant net immigration over the last two decades.
- Projection note: projections hint at a large number of employees reaching retirement age between 2050 and 2060.

### Pillar II: system design and replacement rates
- The DA system in Pillar II is fully funded, and all risks are borne collectively by the members.
- The system does not guarantee any pre-determined pension payment, but has a targeted minimum replacement rate of 72 percent based on an average career income of 40 years reflected in age-based accrual tables.
- A study conducted by the FSA and the Icelandic Pension Fund Association in 2014 projected the actual replacement to be closer to 54 percent.
- Pensions are by default paid out as a life annuity.
- DA schemes have adjustment mechanisms allowing funds to adjust accrued pension rights and future accruals if the actuarial funding ratio deviates by more than an allowed margin.
- The Pension Fund Act does not prescribe an exact method on how to reduce or increase existing pension rights and benefits; responsibility rests with the pension fund according to its Articles of Association.
- Legacy DB schemes for civil servants are underfunded but fully guaranteed by the employer.
  - The guaranteed replacement rate in the DB system is at least 72 percent based on flat rate accruals.
  - Members of DB schemes that joined prior to 1998 can continue accruing pension rights if they have maintained their appointment since then.
  - DB schemes are closed to new members; all risks are borne by employers/sponsors (state and local government municipalities).
  - Civil servants’ “A-division schemes” were transformed from DB to DA in 2017, granting existing members a right to continued flat rate accruals.

### Size of pension savings and recent asset levels
- Total pension savings (Pillar II and III combined) at end-2021: ISK 7.08trn, equivalent to 219 percent of GDP.
- Comparable countries at end-2021: Denmark 211 percent; the Netherlands 210 percent.
- Asset decline during 2022: assets at end-December 2022 amounted to ISK 6.90trn (183 percent of GDP, of which 176 percent managed by pension funds).
- Pillar II assets:
  - Pension funds managed ISK 6.03trn at end-2021.
  - Around ISK 5.90trn twelve months later (end-2022).

### Contributions, benefits, and cashflows
- Since 2023, minimum mandatory contributions to Pillar II funds increased from at least 12 to 15.5 percent.
  - Note: collective wage agreements had introduced higher contribution rates already since 2016 for most pension schemes; this came along with a higher replacement rate targeted to reach a minimum of 72 percent after a full career (instead of 56 percent previously).
- Annual contributions to DA schemes:
  - ISK 217bn in 2018.
  - ISK 298bn in 2022.
- Annual benefit payments (including expenses) for DA schemes:
  - ISK 89bn in 2018.
  - ISK 164bn in 2022.
- DB schemes outflows: ISK 79bn in 2022; outflows exceed regular sponsor and member contributions and rely on special additional contributions from sponsors.
- Distribution of Pillar II payouts in 2021:
  - 78 percent related to old-age pension.
  - 13 percent to disability pensions.
  - 8 percent were survivor’s pensions paid out to spouses.
  - Less than 1 percent was paid out to children under the age of 18.
- Most DA pension funds are still in an accumulation phase, with contributions exceeding benefits.
- Annual net inflow picked up again in 2022: ISK 134bn.

### Sector consolidation and market concentration
- Number of active pension funds:
  - 87 in 1990.
  - 62 in 2000.
  - 33 in 2010.
  - 21 as of now.
- Membership and fund structure:
  - Pension fund membership is in most cases determined by participation in the workforce under a collective wage agreement.
  - Most pension funds are open only to employees in a specific trade or profession.
  - Only eight pension funds are open to the general public.
  - Largest pension fund manages more than ISK 1.3trn in assets (end-2021); some smaller funds manage less than ISK 50bn.
  - Number of active members ranges from less than 100 to around 50,000.
  - The three largest pension funds account for 51 percent of the total market (based on assets).
  - The five largest pension funds hold a cumulated share of 71 percent.

### COVID-19 impact
- Investment performance during Q1 2020 was negative, but market valuation losses were caught up quickly.
- Government measures enabled individuals to access voluntary Pillar III savings:
  - Total withdrawals in 2020: ISK 23bn.
  - Total withdrawals in 2021: ISK 13bn.
- DA sector was slightly affected due to high unemployment in the tourism industry resulting in temporarily lower contributions.
- DB schemes were even less affected.

### Asset allocation and credit risk
- Investment assets dominated by stocks and inflation-linked assets.
- Investment funds share (end-2021):
  - 38 percent of the portfolio for DA schemes.
  - 34 percent for DB schemes.
  - 11 percent of investment funds domiciled in Iceland: ISK 288bn (equivalent to 23 percent of outstanding investment fund shares).
- Directly held stocks:
  - 19 percent of assets of DA schemes.
  - 18 percent for DB schemes.
- Inflation-linked bonds and loans amount to 36 percent of total pension fund assets, ranging from 27 to 77 percent for individual funds.
- Fixed-income assets are to a large extent unrated (domestic corporate bonds and mortgage loans), highlighting the need to comprehensively monitor credit risks.
- Average remaining maturity of fixed-income assets: around 8.2 years.
- DA schemes: government bonds declined to 20 percent; DB schemes: 29 percent in government bonds.
- Fixed-income ratings: DA schemes targeted towards lower investment-grade ratings and BB-rated assets; DB schemes hold an even lower share of investment-grade assets but increased from 26 to 31 percent over the last four years.

### Domestic exposures: sovereign-banks-property nexus and mortgages
- Exposure to Icelandic banks increased from ISK 250bn in 2017 to ISK 670bn in 2021 (from 6 to 10 percent of pension fund assets).
  - This corresponds to 14 percent of banks’ financial liabilities.
  - Partly driven by post-crisis privatization IPOs in 2018 and 2021.
- Pension funds’ outstanding mortgage lending: ISK 526bn.
  - This is 8 percent of their total assets and 18 percent of the outstanding mortgage volume.
- Holdings in domestic sovereign bonds: ISK 1,409bn, or 21 percent of pension fund assets.
- The concentrated exposure towards the sovereign-banks-property nexus is significant.

### Foreign-denominated assets, currency exposure, and hedging
- Share of foreign-denominated assets has increased:
  - 34 percent of assets as of September 2022 (up from 27 percent at end-2017).
  - Shares among individual funds range from 11 to 40 percent.
- Currency breakdown for DA schemes’ FX exposure:
  - US dollar: 81 percent.
  - Euro: 15 percent.
- Among foreign-denominated investments, equity funds are the most relevant type.
- Currency risks are mostly borne by pension funds; hedging of that risk is rare.
- Rationale: foreign-denominated investments seen as partial inflation hedge given historical correlation between the Króna and inflation.
- Hedging market constraints:
  - Commercial banks’ forward foreign currency position versus each counterparty limited to 10 percent of the capital base.
  - Gross total forward position cannot exceed 50 percent of the capital base.
  - Counterparties for pension funds are almost exclusively Icelandic banks; overall hedging capacity is limited.

### Investment returns and funding ratios
- Long-run real investment returns (1995–2021): 4.9 percent on average.
- Distributional note: in about half of the years in this period, returns between 6 and 12 percent were achieved; negative outliers include 2008 (-22 percent).
- Median DA scheme real yields:
  - From 2017 to 2021, the real investment yields averaged 7.1 percent for the median DA scheme.
  - 2019–2021: returns between 8.7 and 9.9 percent for the median DA scheme.
  - 2022: negative real return of around -12 percent for the median DA scheme.
- Median DB scheme real yields:
  - From 2019 to 2021: between 7.0 and 7.5 percent for the median DB scheme.
  - 2022: median DB scheme yield -12.5 percent, preceded by 5-year average annual yield of 5.7 percent.
- Funding ratios (DA schemes):
  - DA schemes need to be maintained within narrow bands around 100 percent; schemes breaching tolerance levels must adjust members’ pension benefits.
  - At end-2022, the median DA scheme had a funding ratio of 92.6 percent.
  - 80 percent of schemes were in a range between 86.7 and 100.0 percent.
- DB schemes are exempt from the requirement to maintain a funding ratio close to 100 percent; sponsors (state or municipalities) pay special contributions, typically on a regular basis.

*Source: Statistics Iceland; IMF staff calculations based on CBI data.*

### 21.      The voluntary third-pillar pension savings system complements the mandatory regime

### 21.      The voluntary third-pillar pension savings system complements the mandatory regime

### Third-pillar system: design and market structure
- Voluntary third-pillar pension savings are tax-incentivized: employees can deduct contributions to authorized personal pension schemes from taxable income.
- Providers: 13 domestic pension funds, five domestic banks, and two foreign insurance undertakings.
- Market shares: pension funds hold about two-thirds of third-pillar savings — ISK 703bn out of 1,0bn in total as of end-2022.
- Product design:
  - Pure defined-contribution (DC) system with individual accounts.
  - No guaranteed components, apart from pension products offered by the two foreign providers.
  - Pay-out phase typically as programmed withdrawal.
  - Savings can be inherited.

### Risks, asset allocation, and liquidity
- Higher liquidity risk for third-pillar providers because pensioners have more withdrawal options.
- Investment allocation (third-pillar providers):
  - Bonds: 38 percent
  - Bank deposits: 21 percent
  - Stocks and investment funds: 41 percent

### Institutional and supervisory structure
- The Financial Supervisory Authority (FSA) integrated into the Central Bank of Iceland (CBI) as of January 1st, 2020.
- Post-merger organization included Banking, Pensions and Insurance, Markets and Conduct, and Compliance and Inspections; an organizational restructuring in early 2023 merged banking, pensions and insurance supervision into a Department for Microprudential Supervision and created a Department for Conduct Supervision.
- Financial Supervision Committee composition and governance:
  - Chair: Deputy Governor for Financial Supervision
  - Vice-chair: Deputy Governor for Financial Stability
  - Three external experts appointed by the Minister of Finance for a term of five years
  - Governor chairs in specific procedural and major-capital/liquidity/funding decisions.
  - The Committee normally meets ten times a year.
- Resources and capacity:
  - Pensions and Insurance Department headcount: around 8 full-time equivalents at end-2021 (up from 6.5 in 2016).
  - Half of the department staff has supervisory experience of 10 years or more.
  - Additional support from Conduct Supervision Department: about one to two further full-time equivalents.
- Ministry of Finance and Economic Affairs (MoF) retains certain supervisory tasks:
  - Authorizes new pension funds and approves changes to funds’ Articles of Association (including mergers and acquisitions) after requesting FSA expert opinion.
  - Publishes mortality tables (updated every few years by the Association of Icelandic Actuaries); process for implementing the 2021/22 mortality tables and related changes was perceived as lengthy.

### Recommendations (supervision and institutional)
- Recommendation 1: Allocate supervisory powers under the Pension Fund Act fully to the FSA. Licensing of pension funds and changes in Articles of Association should be subject to FSA approval. Mortality tables should be published by the FSA based on calculations by the Association of Icelandic Actuaries.
- Recommendation 2: Ensure commensurate resources with expanding tasks. Regularly evaluate resources and skills of the FSA’s Pensions and Insurance Department and reflect additional tasks in headcount.
- Recommendation 3: Delegate rule-making powers on technical matters under the Pension Fund Act to the FSA, specifically regarding:
  - Actuarial valuation
  - Investment policy and risk management
  - Information provided to pension fund members (including prospective members, members prior to retirement, and retired members)
- Recommendation 4: Define infringements and sanctions in the Pension Fund Act. The Act should clearly define infringements and ranges for administrative fines to be enforced by the FSA.

### Pension Fund Act, regulation, and enforcement
- Pension Fund Act No. 129/1997 entered into force July 1998; multiple amendments since entry-into-force; significant amendments on investment authorizations and risk management effective July 1st, 2017 (Chapter VII).
- Allocation of secondary legislation between MoF and FSA is not always aligned with technical expertise (example: FSA can issue rules on financial statements and auditing but not on risk management or actuarial valuation).
- Sanctions framework:
  - Pension Fund Act does not include a closed list of infringements or sanctions; refers generally to Act on the Official Supervision of Financial Activities (Act No. 87/1998).
  - Fines range: between ISK 10,000 and 2,000,000.
  - Periodic penalty payments range: between ISK 10,000 and 1,000,000.
  - In recent years, no sanctions were issued by the FSA based on Act No. 87/1998; monetary fines imposed on pension funds related to securities markets laws only.

### EU/EEA legislation (IORP) and national transposition
- IORP I Directive transposed into Icelandic law in 2007 with Act No. 78/2007, but Icelandic Pillar II occupational pension system is compulsory and falls under social security perimeter and thus not subsumed under IORP.
- IORP II Directive entered into force January 2017 (enhanced governance, own risk assessment, depositary, enhanced supervisory powers, information transparency, cross-border procedures).
- Iceland, as an EEA member (not EU), follows a separate timeline for transposition; IORP II Directive planned to be transposed into Icelandic law during the first half of 2023 under the EEA-EFTA timeline.
- Scope of IORP II does not change applicability: Icelandic pension funds will not be subject to the legislation.

### Government review and planned reforms
- Government plans a comprehensive review of the pension system in cooperation with social partners and pension funds by end-2023 (Green Paper announced in coalition agreement of November 2021) with focus on simplifying the system.
- Areas of focus:
  - Pension funds’ ability to invest in a diverse, responsible and secure manner given growing economic importance.
  - Increasing pension funds’ involvement in infrastructure investments to accelerate public projects and support innovation and green solutions.
  - Expanding choices for supplementary pension savers by increasing the number of investment options.
  - Promoting digitalization in the pension system to facilitate communication between institutions and improve user access to information (in collaboration with Digital Iceland).

### Investments: quantitative limits and policy recommendations
- Quantitative investment limits in Pension Fund Act (Articles 36a-36d) include:
  - 80 percent cap to the combined investment in corporate bonds (except certain covered bonds) and money-market instruments, stocks, investment funds, property, and derivatives.
  - 60 percent cap to the combined investment in non-financial corporate bonds and money-market instruments, stocks, investment funds, property, and derivatives.
  - 20 percent cap to assets not listed on a regulated market; in addition, a maximum of 5 percent of assets listed on EEA multilateral trading facilities.
  - 10 percent cap to exposures towards an individual counterparty (except for certain instruments such as government bonds); 25 percent cap to combined exposures through deposits and financial instruments towards a commercial bank or savings bank.
  - 20 percent cap to holdings in the shares of an individual company (this cap does not apply to companies that perform services for the pension fund).
  - 25 percent cap to holdings in the units of a mutual fund.
  - 50 percent cap to holdings in assets which do not match the currency of the liabilities.
  - 75 percent cap to the loan-to-value ratio for residential mortgage loans, 50 percent for other real estate.
- Observations:
  - The prudent-person principle was introduced in 2017 but many quantitative limits were retained.
  - The coexistence of extensive quantitative limits and the prudent-person principle is considered unusual.
  - Solvency II implementation in the EU removed virtually all quantitative investment limits for insurance undertakings.
- Foreign-denominated assets:
  - Pillar II pension funds currently capped at 50 percent foreign-denominated assets (Art. 36d Pension Fund Act).
  - Proposed bill would gradually allow a higher allocation to foreign-denominated investments, up to 65 percent by 2036.
  - Bill proposed implementation path: annual steps of 1.5 percentage points until 2027, and further annual steps of 1 percentage point until 2036.
- Derivatives:
  - June 2021: restrictions on derivatives trading involving the Icelandic Króna were lifted with Foreign Exchange Act No. 70/2021.
  - Rules on Derivatives Transactions No. 765/2021 greatly expanded authorizations for derivatives trading involving the Icelandic Króna; transactions no longer subject to purpose restrictions nor require CBI confirmation.
- Recommendation 5: Review investment rules and consider removing (most) quantitative limits. Any remaining limits should be justified and explicitly formulated as exceptions to the prudent-person principle (examples: related party exposures, limits to foreign-denominated assets, macroprudential borrower-based instruments such as loan-to-value limits). Strengthening governance and internal controls in pension funds is a prerequisite.

### Accounting principles and valuation of assets
- Accounting framework: Pension Fund Accounting Rules No. 335/2015.
- Valuation principles in Chapter V:
  - Stocks and residential real estate: Fair value.
  - Loans: Amortized cost.
  - Bonds held to maturity: Amortized cost.
  - Other bonds: Fair value.
- For assets valued at amortized cost, potential credit losses must be reflected in balance sheet and income statement based on established accounting principles.
- Notes:
  - Bonds designated to be held to maturity must document intent at date of purchase and cannot be transferred from fair value to held-to-maturity valuation; annual financial statement notes must detail debt securities held to maturity and indicate their fair value.

### Valuation of liabilities and funding ratios
- Pension funds required to value liabilities annually via an actuarial examination by an appointed actuary (Article 24 Pension Fund Act).
- Actuarial examination includes evaluation of accrued liabilities and expected future liabilities conditional on continued premium payment for existing active members.
- Discounting assumptions:
  - Future cashflows from projected pension benefit payments and projected future premiums are discounted with a fixed real interest rate of 3.5 percent.
  - This rate is set by Regulation No. 391/1998 and has not been changed since 1998.
  - No established mechanism exists for future adjustments (contrast: ultimate forward-rate mechanism in Solvency II).

*Source: IMF staff, "The voluntary third-pillar pension savings system complements the mandatory regime" (content unit 1islea2023009).*

### 40.      Assets which back pension liabilities must equal to the actuarial valuation of liabilities.

### 1islea2023009 - 40.      Assets which back pension liabilities must equal to the actuarial valuation of liabilities.

### Funding rules and actuarial position
- Assets which back pension liabilities must equal to the actuarial valuation of liabilities.
- Allowed deviation: maximum of 10 percent for single observation and 5 percent over time.
- Implied funding ratio requirement: permanently maintain a funding ratio between 90 and 110 percent and not outside 95 and 105 percent for five consecutive years.
- If the funding ratio exceeds these thresholds, the board is required to adopt necessary changes in its Articles of Association.
- DB schemes guaranteed by the plan sponsor (state or municipalities) are exempt from the requirement to maintain fully-funded liabilities.
- Historical adjustment: After the 2008 financial crisis, the allowed margins for the funding ratio were widened to +/-13 percent as a temporary measure; most DA schemes applied equal reductions for all members as investment losses were realized on the balance sheet.
- Note: No detailed methods are prescribed in the Pension Fund Act or secondary legislation on how to adjust accrued pension rights or future accruals and how to ensure fair treatment of all pension fund members.

### Recommendations on valuation methodology and benefit changes
- Recommendation 6: Develop a process for a regular review of the methodology to discount pension liabilities, including the discount rate.
  - The review should, as a minimum, incorporate the past experience of the real interest rate over the last 25 years since the 3.5 percent rate has been introduced.
  - The methodology should include a smoothening mechanism which spreads out larger changes in the discount rate over several years to minimize potentially disruptive effects on pension liabilities and funding ratios.
- Recommendation 7: Publish clear guidance and best practices with regard to changes in benefits and accruals.
  - Intergenerational transfers involving different treatment of accrued benefits and future accruals should be laid out clearly.

### Governance, internal controls, and fit & proper regime
- Governance framework:
  - Current governance and internal controls framework for pension funds is not aligned with the systemic role of the sector; Pension Fund Act provisions pre-date corresponding provisions for other financial sectors.
  - Chapter VI of the Pension Fund Act sets out governance requirements in broad terms, less detailed than those for banks or insurance undertakings.
  - FSA has emphasized harmonizing pension fund governance with the framework of other financial market participants.
- Fit and proper assessments:
  - Fit and proper assessments in place for board members and managing directors (Article 29 and Article 31 of the Pension Fund Act; Rules No. 180/2013).
  - Pension funds must notify the FSA of new appointments and subsequent changes without delay.
  - Pension funds are excluded from having board members from non-EEA Member States (contrary to rules for banks and insurers).
  - Ongoing obligation: requirements for fitness and propriety must be met on an ongoing basis; changes affecting eligibility must be reported to the FSA without delay and no later than two weeks after changes occur (Article 19 of Rules No. 180/2013).
- Internal controls and audit:
  - Risk management and internal audit are defined as control functions (Chapter VI of the Pension Fund Act; Articles 29, 34, 35).
  - Regulation No. 590/2017 and Rules No. 577/2012 further detail requirements for risk management systems and audit departments/independent internal auditors.
  - Pension funds must have an audit department or contract an independent internal auditor; internal auditors must be professionally qualified and independent (Article 34 of the Pension Fund Act; Article 3 of Rules No. 577/2012).
  - Pension funds must appoint an employee responsible for analysis, measurement and reporting on risk; risk management must be independent and have direct access to the board (Article 35a of the Pension Fund Act; Regulation No. 590/2017 Article 8).
- Actuarial function:
  - The board must conduct an annual actuarial examination (Article 39 of the Pension Fund Act); actuary must be approved by the FSA.
  - The actuary is not defined as an internal control function and is not subject to the overall governance requirements as in IORP II or Solvency II.
- Outsourcing:
  - Outsourcing of key functions is common, especially among smaller funds; outsourcing contracts must follow Guidelines No. 6/2014 on outsourcing.
  - When internal control functions are outsourced, the FSA must be informed in advance.
  - IORP II suggests limits to outsourcing, including effective run by at least two persons (subject to competent authority assessment).

### Risk management, ORA, and stress testing
- Risk management framework:
  - Main risk management requirements set out in Article 36(e) of the Pension Fund Act and Regulation No. 590/2017.
  - Boards are responsible for implementing risk management policy, including a risk appetite statement and quantifying risk tolerance (Article 3(2) and Article 5 of Regulation No. 590/2017).
  - Investment decisions must follow the Prudent Person Principle; investment policy must analyze security, quality, liquidity, and profitability and ensure diversification (Article 36 and Regulation No. 916/2009). Investment policy should consider age composition and actuarial factors.
- Own Risk Assessment (ORA):
  - Pension funds must perform an ORA at least annually and whenever there is a material change in risk profile; FSA guidelines supplement Rules No. 590/2017.
  - ORA must be forward-looking, include all relevant risk factors, be consistent with management and policies, and consider main operational risks and dependencies via stress tests and sensitivity analyses.
  - Actuarial assumptions and factors affecting changes in actuarial position shall be included; ORA implementation and conclusions must be documented and reviewed by the board.
  - No later than 30 June each year, the pension fund sends the FSA a copy of its ORA.
- Stress testing:
  - FSA does not set minimum requirements for pension funds’ own stress testing; methods should be commensurate with fund nature and complexity.
  - Methods range from simple top-down shocks to scenario-based shocks, with primary focus on assets and implications for actuarial position; actuarial assumptions usually not stress-tested apart from future inflation.
  - Prior to 2019, standardized stress test submissions were required; since then replaced by own stress tests as part of ORA.

### Recommendations on governance, outsourcing, and key functions
- Recommendation 8: Align rules on governance, internal controls, risk management with IORP II or Solvency II, taking proportionality into account. Specific proposals:
  - Set out the board nomination process in more detail to ensure board members act solely in the interest of pension fund members; establish staggered renewals of board members’ terms as best practice.
  - Remove requirement to recruit board members only from EEA Member States to broaden pool of experts.
  - Define the actuarial function and the compliance function as internal control functions in addition to risk management and internal audit (in line with Solvency II).
  - Require key function holders to meet fit and proper requirements.
  - Require key function holders to inform the FSA about any instances of material non-compliance they reported to their board that have not been addressed by the board through appropriate and timely action.
- Recommendation 9: Enact more stringent rules for outsourcing and ensure an appropriate level of corporate substance within each pension fund.
  - Minimum level of operations should be retained in-house, particularly the managing director position and—for medium-sized and larger funds—the risk management function.
  - Ensure outsourcing does not impair governance, increase operational risk, impair supervisory monitoring, or undermine continuous service to members and beneficiaries (cf. Art. 31(3) IORP II Directive).

### Transparency and member communications
- Member statements:
  - Pension members are informed annually about accrued benefits and expected future pensions; statement assumes a constant 3.5 percent real investment yield.
  - Active members receive a half-yearly statement on employer contributions.
  - Current statements lack details on different scenario outcomes; IORP II best practice suggests including an unfavorable scenario in addition to a best estimate.
- Climate and ESG disclosures:
  - Pension fund disclosures on climate risks remain to be implemented.
  - Directive 2019/2088 (SFDR) and Directive 2020/852 (Sustainable Finance Taxonomy) will be transposed into Icelandic law and enter into force in 2023; pension funds are in scope of the proposed bill regarding disclosures to (prospective) members.
- Recommendation 10: Prescribe more detailed pension benefit statements in line with IORP II Directive.
  - Statements for active members should include future pension payments based on different scenarios for future investment returns and a breakdown of costs (both investment and operating costs).
  - Review information disclosed to prospective and retired members, including disclosure on ESG and climate risks.

### Prudential supervision and reporting
- FSA supervisory model:
  - FSA has adopted a risk-based and forward-looking supervisory model; regular supervision includes monitoring compliance and annual risk assessment; FSA publishes an annual report on supervisory activities.
  - Supervisory Strategy 2022-24 focuses on sound governance, comprehensive risk management, effective internal controls, board independence, oversight of outsourced functions, and actuarial assessment frameworks.
  - Recommendation 11: Communicate clearly on the supervisory strategy and upcoming focus areas through industry roundtables, “Dear CEO” letters, or institutionalized supervisory dialogue with management and key function holders.
- Supervisory reporting templates provided by pension funds:
  - Annual accounts;
  - Report on actuarial examination (annual);
  - Report on mortgage lending to households (monthly for the nine largest pension funds);
  - List of assets (quarterly);
  - Investment policy (annual);
  - Report on returns of asset classes (annual).
  - Additional monthly reporting: balance sheet composition with sectoral breakdown of assets.
- Risk assessment:
  - The risk assessment follows the FSA Supervisory Handbook, monitoring key risk indicators such as funding levels, return on investments, concentration of assets, accessible via a risk dashboard; qualitative aspects are specified for monitoring.

*Source: 1islea2023009 - 40.*

### 65.      The FSA’s minimum engagement model foresees different frequencies for reviews and

### The FSA’s minimum engagement model foresees different frequencies for reviews and interactions with a pension fund’s management

### Engagement model and supervisory contacts
- Financial institutions classified on an impact scale ranging from 1 (low impact) to 4 (high impact).
- Three pension funds (around half of the sector based on total pension assets) are classified as medium-high; the remaining 18 entities are classified as medium-low and low.
- Minimum engagement model determines frequencies for general reviews of annual and quarterly returns and other reports—this is done regularly with almost no differentiation across impact classes.
- Meetings with chairpersons of the board and the managing director:
  - Every 1-2 years for medium-high funds.
  - Every 1-3 years for medium-low and low funds.
  - During the Covid-19 pandemic, such meetings took place less frequently than anticipated by the engagement model.
- Meetings with other key function holders and the external auditor:
  - Mostly every 2 years for medium-high funds.
  - On an “as needed” basis for other pension funds.
- Detailed reviews of individual risks:
  - Every 2 years for medium-high pension funds.
  - Every 3 years for other funds.

### On-site inspections (Compliance and Inspections Department)
- On-site inspections conducted with support from relevant experts of the Pensions and Insurance Department.
- Inspection report contains main findings and shortcomings; does not set out requirements for corrective actions.
- Corrective actions are defined separately by supervisors of the Pensions and Insurance Department.
- Often the FSA requires the pension fund’s internal auditor to review actions taken and confirm appropriateness to the FSA.
- Follow-up to on-site inspections is typically performed off-site.
- No minimum frequency set for on-site inspections; annual plan for on-site and off-site work is based on:
  - Minimum engagement model.
  - Results of the detailed risk analysis.
  - Focus areas of the supervisory strategy.
- Between 2018 and 2022, the CBI conducted 13 on-site inspections (i.e., between two and three per year) at nine different pension funds covering about half of the market in terms of assets.
- Main inspection focus areas: risk management, actuarial inspection, governance, and outsourcing arrangements.

### Recommendation on inspections and institutional dialogue
- Recommendation 12:
  - Perform regular on-site inspections for large pension funds, and re-establish an institutionalized supervisory dialogue.
  - For the largest pension funds, define a minimum frequency for the inspection cycle, taking into account available resources.
  - Hold regular meetings with managing directors, board chairpersons and key function holders according to a framework aligned with the FSA’s minimum engagement model.

### Governance, internal controls, and risk management (supervisory approach and tools)
- Supervisory approach consists of:
  - Regular monitoring based on reported data.
  - Interviews with key employees and board members.
  - Risk assessment and assessment of the ORA.
  - Periodic submission of dedicated questionnaires for low impact pension funds.
  - Thematic reviews focusing on governance and targeted off-site and on-site inspections.
- Fit and proper assessments:
  - Assessment involves review of written documentation and, if appropriate, an oral assessment.
  - All managing directors of pension funds and board members of the largest pension funds are subject to an oral assessment.
  - Board members of smaller pension funds receive oral assessment when there is doubt about eligibility, especially regarding sufficient knowledge and experience.
  - Between 2019 and 2022, five individuals have not passed the assessment due to inadequate expertise or failure to appear.
  - In 2022, the FSA conducted 36 assessments of pension fund board members and managing directors.
- Board effectiveness assessment:
  - Review compliance with rules of procedure, minutes of board meetings, and interviews with board members.
  - Assess whether issues discussed align with board roles and responsibilities and whether information from subcommittees and key functions is sufficient for oversight.
  - Recent emphasis on board role in monitoring operations, communications within the board and with risk officer and internal auditor, and boards’ self-assessments.
- Collective competence:
  - No Pension Fund Act requirement on collective competence of the board.
  - Since 2018/19, FSA periodically requires board self-assessment to evaluate collective competence.
  - FSA’s goal is identifying weaknesses and recommending improvements in skills and knowledge, not to change or remove board members.
- Concerns on board nominations and conflicts of interest:
  - Employee representatives in several pension fund boards are nominated by trade unions.
  - Staff of the Ministry of Finance and Economic Affairs represented in the board of the public sector pension fund.
  - Potential for political interests to interfere with pension fund members’ interests.

### Internal control functions and actuary function
- Internal control functions assessed via risk assessment, targeted off-site work, and on-site inspections.
- Interviews with internal audit and risk management function holders occur periodically, typically every two or three years, based on impact class; ad hoc interviews when warranted.
- Actions taken if deficiencies noted.
- Actuary function identified as an internal control function; interviews conducted periodically by impact class and ad hoc when warranted.
- Legal framework lacks supervisory powers regarding performing duties of the appointed actuary.

### Actuarial profession capacity and recommendation
- Actuarial profession in Iceland relies on a very small number of pension fund experts; seen as a risk.
- Association of Icelandic Actuaries: eleven active and seven associated members.
- Only two qualified actuaries serve the entire pension fund sector.
- The University of Iceland does not offer courses in actuarial sciences; actuaries typically trained in the United Kingdom or other Nordic countries.
- Recommendation 13:
  - Explore ways to expand and strengthen the actuarial profession.
  - Possible measures: sponsoring scholarships, academic projects, closer collaboration with actuarial societies in other jurisdictions, especially in the Nordic region.
  - Remove any direct or indirect hindrances for actuaries from other EEA countries to work in Iceland, if relevant.

### Risk management, outsourcing, and climate/ESG
- 2018/19 on-site inspections assessed pension funds’ risk management systems after Regulation No. 590/2017 implementation.
- Shortcomings identified in quantifying risk appetite and setting risk tolerance.
- FSA assessing whether further guidance on risk appetite and tolerance is needed.
- Outsourcing:
  - FSA aims for strict approach and targets pension funds outsourcing entire operations including managing director function.
  - Outsourcing contracts reviewed considering the outsourcing policy and procedures of the person responsible within the pension fund.
  - Concerns about pension funds outsourcing both the function of general manager and the risk management function and the board’s oversight role.
- Climate and ESG approach:
  - Approach to climate risk management still at an early stage.
  - Pension funds acknowledge methods and practices for identifying and managing climate/ESG risks lag behind peers in Europe.
  - Preparations for SFDR implementation have started; gathering required input data is challenging.
- Recommendation 14:
  - Intensify engagement with pension funds on climate risk management, and provide guidance for upcoming SFDR transposition.
  - Adjust available EIOPA guidance to specificities of the Icelandic market.

### Supervisory approach to climate risks (Box 1 highlights)
- Pension funds recognized as crucial actors for greening the financial market.
- Workshop jointly organized with Icelandic Pension Fund Association in March 2022 to raise awareness on sustainability and ESG.
- FSA’s Supervisory Strategy 2022-24 includes sustainable finance as one of four priorities.
- CBI became a member of the Network for Greening the Financial System (NGFS) in 2021, but has not finalized a strategy for climate-related supervisory activities.
- Process underway to develop a strategy and assess resource requirements for climate- and environment-related activities; implementation planned to align with NGFS recommendations.
- FSA aims to emphasize sustainable finance and ESG criteria, increase information disclosure, and boost transparency to prevent greenwashing.
- FSA has proposed changing Article 36(5) of the Pension Fund Act (which currently requires “pension funds shall set ethical standards in investments”) to require integration of ESG considerations and related risk assessment in the investment process; further changes proposed to reflect ESG focus in risk management and investment policy.
- FSA has not yet undertaken an assessment of climate-related exposures and potential losses for pension funds.
- A sector-wide climate exposure assessment is under preparation for the commercial bank sector as a learning exercise before rolling out to the pension fund sector.

### Macroprudential supervision and reporting
- Macroprudential supervision targets the pension fund sector, but surveillance findings and current risk assessment are not frequently reported to the Financial Stability Committee.
- Pensions and Insurance Department conducts horizontal analyses to identify sector-wide risks forward-lookingly.
- Reporting to the CBI’s Financial Stability Committee is not frequent and has generally occurred only once per year.
- Financial Stability Department focuses on pension funds as lenders and participants in the domestic financial market.
  - Pension funds active in mortgage lending subject to comprehensive data collection.
  - Macroprudential borrower-based policy measures targeted at mortgage lending apply equally to all lenders in banking and non-banking sectors.
  - As major players in domestic bond market, pension funds included in CBI analyses on corporate debt.
  - Role in foreign-exchange market analyzed using monthly segregated data submissions covering investments in all asset classes and transactions.
- Recommendation 15:
  - Report more frequently on developments in the pension fund sector to the Financial Stability Committee.
  - Pensions and Insurance Department, together with the Financial Stability Department, should submit regular briefings with updated risk assessments to the Financial Stability Committee.

### Financial Soundness Indicators of the Pension Fund Sector (selected indicators, In percent)
- Funding level
  - Assets / Liabilities, median – DA: 2017 100.6, 2018 99.8, 2019 101.2, 2020 106.2, 2021 97.3, 2022 92.6
  - Assets / Liabilities, median – DB: 2017 28.3, 2018 43.1, 2019 43.5, 2020 42.1, 2021 42.8, 2022 40.4
  - Share of assets of PF outside +/-5 percent range – DA: 2017 19.3, 2018 20.8, 2019 18.8, 2020 17.5, 2021 13.6, 2022 83.1
  - Share of assets of PF outside +/-10 percent range – DA: 2017 0.0, 2018 0.0, 2019 0.0, 2020 17.5, 2021 0.9, 2022 16.8
- Contributions and benefits
  - Change in contributions – DA 1/: 2017 ..., 2018 -2.6, 2019 8.1, 2020 2.4, 2021 8.8, 2022 16.9
  - Change in contributions – DB: 2017 ..., 2018 -38.2, 2019 8.2, 2020 5.8, 2021 9.5, 2022 5.2
  - Change in paid benefits – DA 1/: 2017 ..., 2018 10.6, 2019 12.1, 2020 18.6, 2021 10.9, 2022 13.8
  - Change in paid benefits - DB: 2017 ..., 2018 7.2, 2019 7.3, 2020 7.2, 2021 9.3, 2022 6.6
- Asset quality and investment performance
  - Equity investments – DA+DB / Total investments 2/ 3/: 2017 40.4, 2018 41.1, 2019 46.2, 2020 50.9, 2021 56.0, 2022 53.2
  - Bond investments – DA+DB / Total assets 3/: 2017 54.9, 2018 55.7, 2019 50.6, 2020 45.9, 2021 41.4, 2022 44.9
  - Non-investment grade – DA+DB / Total fixed-income assets: 2017 33.6, 2018 ..., 2019 27.6, 2020 ..., 2021 24.2, 2022 ...
  - Foreign-denominated assets – DA+DB / Total assets 3/: 2017 24.5, 2018 26.3, 2019 30.7, 2020 34.2, 2021 36.4, 2022 34.0
  - Real investment return, median – DA: 2017 5.3, 2018 1.8, 2019 9.9, 2020 8.7, 2021 9.9, 2022 -12.0
  - Real investment return, median - DB: 2017 4.6, 2018 1.9, 2019 7.5, 2020 7.0, 2021 7.4, 2022 -12.5
- Liquidity
  - Liquid assets / total assets – DA+DB 4/: 2017 64.1, 2018 61.3, 2019 57.5, 2020 55.2, 2021 54.2, 2022 54.4
  - Contributions / benefits – DA: 2017 99.4, 2018 57.3, 2019 57.7, 2020 57.0, 2021 57.1, 2022 56.3
  - Contributions / benefits – DB: 2017 266.2, 2018 234.5, 2019 226.2, 2020 195.3, 2021 191.5, 2022 196.7
- Notes:
  - 1/ Includes pension funds’ defined-contribution schemes in Pillar III
  - 2/ Equity includes investment fund shares.
  - 3/ Data as of 2022-Q3.
  - 4/ Liquid assets includes cash and deposits, marketable bonds and bills, equity (excluding investment fund shares).

*IMF staff calculations based on CBI data.*

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_Source: https://www.imf.org/-/media/files/publications/cr/2023/english/1islea2023009.pdf_