Finnish pension system needs urgent reform

The Finnish pension system must be reformed because they are inefficient when compared to the pension funds in Norway and Singapore, 2 countries with populations of similar size. 

The pension system is dominated by 3 pension funds that operate like natural monopolies, that typically take on high costs that benefit their related stakeholders and not pensioners.

The Finnish pension system is covered by legislation that obliges employees and employers to make joint payments each month of some 25% of gross salaries into the pension funds. Current pensions to retirees are paid out of these funds, while a remaining amount is invested for future payments when working folk eventually retire. Ordinary pensioners currently receive only 50% to 60% of their last salary as a pension after they retire. This is a huge shortfall and a clear indication of inefficient pension fund management.

There are three truths about investing over the long term that every fund manager knows:

  1. The bigger the fund in absolute terms, the easier it is to demand and receive lower management costs. Smaller funds pay higher management costs to third parties.
  2. The lower the costs in percentage terms, the higher the return.
  3. Smaller funds, bigger fund management salaries, and higher administration costs mean  lower total returns for the portfolio, which means that they eat up what pensioners should be receiving!

These pension funds exercise a lot of power in the Finnish economy:

  1. They have commercial and political power through their board positions, and connections in many of Finland’s biggest public companies and banks. Their network is almost perfectly impregnable unless you are from the “right” organisation.
  2. They have political power through their relationships and connections with the main political parties, in addition to their very effective lobby organisations and related think tanks. 
  3. They have very close relationships with the employee and employer unions, bodies that also have strong connections to the biggest political parties, with the exceptions of the Greens.
  4. They also have strong connections with civil servants in the various ministries that are meant to oversee and supervise their activities, A revolving door keeps this supervision muted because who knows what high paying job you could be prevented from receiving if you are too assiduous in exercising your supervisory duties.

The whole system is nicely closed up and works smoothly with the above mentioned boards, senior management and the over 100 administrative representatives from the employee and employer unions all enjoying rather generous benefits.

In fact, it is so well organised that there are no foreign-owned pension funds operating in Finland. Foreign pension managers must set up a fund in Finland as a domestic operation and the current laws here and the state of competition has stopped all efforts to enter this market.

The whole system is so cleverly constructed between the three big funds that even the biggest foreign pension funds see no opportunities to enter such a closed market. 

These pension funds, together with the state and municipal pension funds, largely replicate their investment strategies. The differences are minimal and their results are similar. Their asset allocations are also similar – they say that they must diversify their funds into several asset classes but the results are similar since they all use the same consultants.

They have large equity and bond investments which are separately managed at home and abroad with their annual investment costs, they claim, below 1% of the amount managed. The world’s largest funds make do with one-tenth of those fees. The impact of their annual cost reduces pensioners’ pensions by a large amount because , judging from the results, there appears to be substantial leakage above this figure…

If you invest at 3% real rate of return over 40 years, (this is the rate they claim they want to achieve open average each year), then assuming inflation of 3%, the  on average annual return would be 6%  over this period. In such a case you would only need to invest 12% to 13% of your gross salary every year to receive most 100% of your last salary. 

But today’s pension system does not produce that result. Employees and their employers must invest 25% of gross salary for pension savings in order to receive around 50% or 60%, or less, of your last salary as a pension. 

The costs and inefficiencies of the present system are the only explanation for this huge shortfall. 

This calculation can be made on an Excel spread sheet relatively easily. 

The assumptions are valid for such large groups because this pension system includes all workers and retired pensioners in Finland by law. 

Around 30% of the monthly pension savings are also used to cover some pension payments to current retirees. Thus using that percentage, you can assume that 16% (= 12% + 30% of 12%) should be sufficient for much better pensions for current and future retirees – something close enough to the last salary as a pension!

The numbers speak for themselves along with the three truths:

  1. The bigger the fund in absolute terms, the easier it is to demand and receive lower management costs. Smaller funds pay higher management costs to third parties.
  2. The lower the costs in percentage terms, the higher the return.
  3. Smaller funds, bigger fund management salaries, and higher administration costs mean  lower total returns for the portfolio, which means that they eat up what pensioners should be receiving!

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