At the end of April, slightly more than 66% of the pension funds’ total assets, or ISK 3,989bn, were domestic. The majority of them took the form of loans and marketable bonds, as has been the case in recent decades. As a share of total assets, however, these asset classes have declined steadily in the past ten years, from 60% at the beginning of 2011 to just under 45% according to the most recent figures. Conversely, the share of equity securities and foreign assets has risen strongly over this period.

The pension funds’ foreign assets have been a frequent topic of discussion in recent years, as it is clear that the funds’ rapid growth during a time of relatively limited domestic investment options would call for large-scale investments outside Iceland. The funds’ foreign assets have grown markedly over the past five years. In ISK terms, they totalled the equivalent of ISK 2,039bn at the end of April and had nearly trebled since the beginning of 2016, when they amounted to ISK 700bn.

Foreign assets have also grown strongly as a share of total assets over this five-year period, although this increase is naturally more moderate. At the end of April, foreign assets came to just under 34% of the pension funds’ total assets, up from 22% at the beginning of 2016. It can be said that a considerable share of the current account surplus of the past few years has been used to bolster the pension funds’ foreign assets, as Iceland’s positive net international investment position, measuring more than a third of GDP as of end-March 2021, is largely reflected in these assets.

By law, the pension funds’ exchange rate risk is capped at 50% of their foreign assets. In other words, their foreign-denominated assets may not exceed that percentage unless they hedge against the risk above that level. On the other hand, there are limits on how much they can protect these assets against exchange rate risk with hedging instruments, given the large amounts of money involved. This could put the funds in a tricky position, given that the vast majority of their assets are in equities and mutual funds. When foreign stock markets rise steeply and the ISK depreciates at the same time – as was the case last year – the share of foreign assets can increase very quickly.

As a matter of fact, it was noted in the CBI’s April 2021 issue of Financial Stability that some of the pension funds had sold hefty amounts of foreign currency in late 2020, presumably because they had been close to their internal FX asset thresholds. Although these internal thresholds are generally well below the statutory limit, this episode shows clearly how fast the situation can change.

Iceland no outlier in terms of pension funds’ FX assets

The share of FX assets held by pension funds differs widely from one OECD country to another. As could be expected, the ratio is higher among small countries outside the eurozone or other currency unions.

As the chart shows, Iceland is by no means an outlier among OECD countries in terms of foreign-denominated pension assets. It is worth noting, though, that the Norwegian Oil Fund, which constitutes a sizeable share of Norwegians’ pension assets, invests solely in foreign assets.

Robust real returns in 2020

In spite of the global pandemic and the crippling economic contraction, 2020 was a bountiful year for the pension funds. Their assets grew by over 15% last year, owing to a number of factors that pulled in the same direction.

• As is mentioned above, the depreciation of the ISK and surging foreign share prices pushed the value of the funds’ foreign assets sharply higher.
• Domestic share prices rose strongly as well; indeed, Iceland’s OMXI10 index rose by more than 30% during the year.
• Domestic bond prices rose also, albeit far less dramatically.
• And finally, the funds continue to enjoy significant net inflows, as their incoming premiums are still well in excess of their pension distributions plus associated expenses. For instance, in 2019, the last year for which CBI figures are available, pension premiums net of distributions and operating expenses came to more than ISK 93bn.
  It should be borne in mind, though, that last year, when third-pillar pension savings withdrawals were authorised due to the COVID-19 pandemic, these distributions alone totalled nearly ISK 23bn, according to data on the Government offices website.

Even if adjustments are made for inflation and net inflows of premiums, the pension funds’ real returns were handsome in 2020. According to estimates from the Icelandic Pension Funds Association (IPFA), their real returns averaged just over 9% in 2020. This came in the wake of another bountiful year, 2019, with real returns averaging 11.8%. IPFA estimates that over the past decade, the funds’ real returns have averaged 5.8%, well in excess of the 3.5% actuarial benchmark.

Their returns have also been robust in 2021 to date. The MSCI World Index, which reflects developments in global share prices, has risen by nearly 11% year-to-date in US dollar terms, and Iceland’s OMXI10 index is up 17% over the same period. Bond prices, on the other hand, have tended to sag thus far this year, but it should be noted that a large share of bonds are recognised at the so-called purchase yield in the pension funds’ accounts, and changes in market price therefore have limited impact on the bookkeeping entries.

Nevertheless, the strong returns of the past decade could prove elusive in years to come. Overall, the outlook is for global interest rates to be lower than they have been in the past, and productivity growth could turn out more sluggish and investments in companies less profitable in the long run.