Domestic interest-bearing assets remain the cornerstone of the Icelandic pension system’s asset portfolio, however. At the end of October, domestic loans and marketable bonds came to ISK 2,591bn, or just over 37% of the total asset portfolio. At the same time, domestic equity securities totalled ISK 754bn (13.7%) and foreign assets ISK 1,838bn (33.3%).

It has been very interesting to follow developments in the pension funds’ foreign assets in the recent term. A few years ago, there was major concern that the funds’ vast pent-up need to invest abroad would prove a millstone around the neck of the ISK for the foreseeable future. However, their foreign assets have grown rapidly, as the chart indicates, increasing by some 165% in the past five years. They have also grown significantly as a share of total assets. For example, foreign assets accounted for just under 22% of total assets at the end of 2016, but by the end of October 2020 they had grown to the aforementioned one-third. There are no signs as yet that this portfolio rebalancing has torpedoed the ISK, and we think it is unlikely to do so in the next few years.

The vast majority of the pension funds’ foreign assets are holdings in mutual funds and individual company stocks. The surge in these assets (in ISK terms) thus far in 2020 stems from two main causes:

• The depreciation of the króna pushes the ISK value of foreign assets upwards. As of end-October, the ISK was down by 15% year-to-date in trade-weighted terms. As it happens, a large share of the pension funds’ asset portfolio is denominated in the US dollar, which had strengthened by nearly 16% against the ISK over that same ten-month period.
• The funds have continued to buy foreign assets in significant amounts despite a virtual freeze in foreign investment between mid-March and mid-September. According to the CBI’s last Financial Stability report, published in September, the funds bought foreign currency for ISK 30bn in H1/2020 and made some purchases in July and August as well.

Since the end of October, prices in foreign stock markets have risen sharply. The MSCI World Index, for instance, has risen by nearly 15%. Offsetting this, the ISK has appreciated by just over 8% in trade-weighted terms and about 11% against the US dollar. As a result, the weight of foreign assets in the pension funds’ portfolios has probably not changed significantly since the end of October.

Residential mortgage financing contracts

Providing direct and indirect home financing has always been an important part of the Icelandic pension funds’ activities. In general, such financing falls into three categories:

• Bonds issued by the state-run Housing Financing Fund and its predecessor institutions
• Covered bonds issued by the banks
• Loans to pension fund members

Early in the last decade, the first of these categories was by far the largest. The pension funds’ holdings in HFF bonds and other public mortgage lending institutions’ debt instruments accounted for over a fifth of their total assets at the beginning of 2016. At the same time, loans to fund members accounted for another 5% and covered bonds issued by the bank a further 3%.

By October 2020, however, bonds issued by the HFF and similar institutions accounted for 12% of the asset portfolio, loans to fund members came to nearly 10%, and covered bonds totalled just over 5%. Therefore, residential mortgage financing as a share of total pension fund assets has declined from just under 29% to just under 27% in the interim, despite a significant increase in issuance of loans to fund members over most of the period. The total amount of fund member loans peaked at ISK 545bn in mid-2020 but has fallen by some ISK 30bn since then, in response to increased interest in the banks’ non-indexed loans and correspondingly reduced interest in indexed loans, where the pension funds’ competitive position is strongest.

A runner-up prize in pension savings?

Few countries have pension systems as strong as Iceland’s coinsurance and third-pillar pension schemes. Figures from the OECD show that at the end of 2019, only the Netherlands outperformed Iceland in this regard. On average, assets held in such pension savings equalled nearly 40% of GDP among OECD countries. But it is important to remember that pension systems in the OECD are as varied as they are numerous. A good example is Norway, where defined coinsurance and third-pillar savings equal only 11% of GDP. But this is supplemented by Norway’s enormous oil fund, which actually goes by the formal name Government Pension Fund Global. Other countries rely primarily on unfunded pension schemes, where current taxpayers pay the pensions of eligible pension recipients.

Strong real return expected for 2020

This year looks set to be relatively bountiful for Iceland’s pension funds in spite of the Corona Crisis. The depreciation of the ISK has boosted the nominal value of foreign assets, and domestic securities markets have been generally robust despite considerable fluctuations. As is noted above, the pension funds’ total assets increased by 11% in the first ten months of 2020. We estimate that, after adjusting for consumer price movements and estimated inflows net of pension payments and expenses, their real return over the period has averaged 5-6%. Developments since then have been affected by the ISK appreciation over the past few weeks, offset by price hikes in foreign and domestic equity markets.

When all is said and done, however, we think it quite likely that the real return for 2020 will be above the 3.5% actuarial benchmark, which is astonishing in view of the economic headwinds characterising the year. Needless to say, though, it will be good news if the funds’ returns are indeed this strong. It will be challenging for the pension system to maintain real returns of 3.5% in the future, however, as the outlook is for lower interest rates, with the distinct possibility of weaker productivity growth and generally less profitable business investment in the long run.