Handsome returns on foreign assets

Although the pension funds’ inflows from pension contributions are well in excess of pay-outs plus operating expenses, the majority of the increase in asset values stems from returns on – and price hikes in – their older assets. CBI data show that contributions net of pension pay-outs and operating expenses came to just over ISK 89bn in 2023. In H1/2024, the funds’ assets grew by just over half that amount (ISK 45-50bn) as a result of such net inflows.

Three-fourths of the growth in asset values came from the funds’ foreign portfolios. At the end of June, foreign assets totalled ISK 3.062bn, or nearly 40% of total assets. In the first six months of 2024, the pension funds’ foreign assets increased in value by ISK 319bn, boosting the share in total assets by two percentage points. As the ISK exchange rate has held broadly steady in 2024 to date, this increase in asset values is attributable mainly to asset purchases and an increase in the value of this part of the asset portfolio.

According to the CBI, the pension funds’ net foreign currency purchases came to more than ISK 36bn in the first five months of the year, or an average of ISK 7.3bn per month. This is close to the monthly average of ISK 6.9bn in 2023 but slightly below the 2022 average of ISK 8.4bn.

Thus the vast majority of the rise in the value of these assets is due to price hikes in international markets. Foreign equity markets were bountiful in 2023, unlike the market in Iceland, and the pension funds’ foreign assets consist mainly of unit shares in mutual funds or direct ownership of foreign stock.

For example, the MSCI World index, which reflects global equity prices, rose by 11% in H1/2024, while at the same time, Iceland’s OMXI15 share price index fell by a full 8%. This is reflected in a decline of ISK 37bn, or 3.5%, in the pension funds’ domestic shareholdings over the first half of 2024. At mid-year, domestic shares accounted for 13% of the funds’ total assets. Although the pension funds are very active in the domestic equity market, the domestic assets in their portfolio carry a weight only one-third of that represented by foreign assets. Naturally, this reflects the small size of the Icelandic stock market, as well as the large size of the pension funds in the local financial system.

Outlook for a more benign year than in 2022-2023

But how have Icelandic pension funds’ assets fared year-to-date, and what lies in store for H2?

As we discussed earlier this year, Q4 saved the day for the pension funds in 2023, after brisk headwinds for most of the year. According to the book of annual accounts maintained by the CBI, Iceland’s pension funds earned real returns averaging 0.4% last year, on the heels of steep decline in 2022.

Obviously, the pension funds are long-term investors, and as we have noted above, inflows from fund members’ contributions exceed outflows and operating expenses by a wide margin. Year-to-year fluctuations are therefore not a deal-breaker for the funds’ ability to guarantee fund members satisfactory returns on their long-term savings when they start drawing their pensions. For example, the funds’ average returns have been well in line with the 3.5% benchmark, both in 2019-2023 and over the past decade. In the former period, their real returns averaged 3.7%, and over the latter period they averaged 4.1%.

As is noted above, the funds’ assets grew by 5.8% in H1/2024. After adjusting for expected net inflows due to fund members’ contributions net of pay-outs and operating expenses, we estimate that the pension funds’ assets generated a real return of 1.8%, or 3.6% on an annualised basis. Foreign assets have been the primary engine for this growth, while domestic equities have pulled in the opposite direction. On the other hand, the bond market played a relatively neutral role in H1, with yields on key benchmark series either rising or falling slightly. Bond prices move in inverse proportion to changes in yields. The majority of bond holdings in the pension system are recognised using the yield at the time of purchase, and their value in the pension funds’ accounts does not fluctuate with short-term swings in bond market prices.

Thus far in H2/2024, global share prices have fallen by an average of just over 4% in terms of the MSCI World index, while Iceland’s OMXI15 index is up 0.6% over the same period. The period has not begun spectacularly well for these asset classes, although a marginal depreciation of the ISK since the start of July offsets part of the decline in foreign asset prices as measured in the assets’ local currencies.

But the second half of the year is still young, and a great deal of water has yet to flow under the bridge by the year-end. The widespread interest rate cuts expected this autumn could also revitalise stock markets around the world, and the global economic outlook is still decent. In its newly updated forecast, for instance, the International Monetary Fund (IMF) estimates average year-2024 GDP growth at 1.7% for industrialised countries and 3.2% worldwide.

By the same token, interest rate cuts in Iceland could put some wind in the local stock market’s sails, and furthermore, financial ratios generally indicate that the market is rather modestly priced. Finally, real rates in the bond market are broadly in line with the pension funds’ 3.5% benchmark at present, and above that level for most issuers other than the Treasury.

While most indicators currently suggest that at best, the pension funds’ real returns will be close to 3.5%, it is quite likely that 2024 will turn out more favourable for the funds and for prospective pensioners than the two years just past.