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Pension funds set for weak real returns in 2023

The Icelandic pension funds’ assets have grown by 4% in 2023 to date, to 116% of GDP as of end-September. The pension funds finance roughly 2/3 of Icelandic households’ mortgage debt – directly or indirectly – and their indexed mortgage lending has gained steam in the recent term. The outlook is for the funds’ real returns to be negative for the second year in a row, although 2023 should turn out far better than 2022.

According to newly published figures from the Central Bank (CBI), Icelandic pension funds’ total assets amounted to ISK 6,886bn as of end-September. This corresponds to 166% of estimated GDP for the year, and only Denmark and the Netherlands are surpass Iceland in terms of their ratio of total assets to GDP. Since the turn of the year, the funds’ assets have grown by ISK 256bn, with a large share of the increase attributable to fund members’ premiums, which are still well in excess of the funds’ operating expenses and paid-out benefits.

Domestic assets totalled ISK 4,394bn at the end of September, while foreign assets came to ISK 2,492bn. Foreign assets therefore equalled just over 36% of the funds’ total assets, the second-largest share in the history of CBI data. The rising share of foreign assets goes more or less hand-in-hand with the pension funds’ foreign currency purchases, which came to a net ISK 68bn over the first eight months of the year, according to CBI figures.

Pension funds stand behind 2/3 of residential mortgage financing

Iceland’s pension funds are a major participant in domestic mortgage financing. At the end of September, the funds’ direct loans to fund members totalled ISK 609bn, and net new loans to members equalled nearly ISK 50n over the first three quarters of the year. Slightly more than 60% of these loans were indexed and the remaining 40% non-indexed.

As the chart shows, this share of non-indexed loans grew steadily from the beginning of 2016, although indexed loans still dominated. In the past few months, however, household demand for non-indexed loans from the pension funds has cooled. In Q3/2023, net new non-indexed loans totalled ISK 5.5bn, as compared with ISK 12.4bn in net new indexed loans. This represents a major turnaround relative to 2022, when retirement of indexed loans exceeded new issuance by ISK 18bn.

Aside from this, the pension funds provide even more financing for home purchases through indirect means than through outright retail lending. The funds have long been the largest owners of bonds issued by the Housing Financing Fund (HFF) and its predecessors. Furthermore, they have bought a sizeable share of the commercial banks’ covered bond issues, which are intended to finance the banks’ mortgage lending. In all, the pension funds’ lending and their holdings in the above-described bonds total just over ISK 1,603bn, according to the most recent figures, whereas households’ total mortgage-backed debt amounted to ISK 2,498bn at mid-year 2023. In short, then, the pension funds are the ultimate creditors for nearly 2/3 of Icelandic households’ mortgage debt.

HFF bond write-offs uncertain

It should be borne in mind, though, that there is considerable uncertainty about the pension funds’ ultimate recoveries on HFF bonds. The Ministry of Finance and Economic Affairs administers the ÍL Fund, which was established when the HFF’s regular operations were discontinued. The ÍL Fund’s equity was negative by ISK 244bn as of mid-2023. Some insight into the backstory can be found here The Ministry has attempted to negotiate the settlement of the ÍL Fund’s assets and liabilities, which would inevitably involve writing off a portion of the HFF bonds owned by the pension funds.

The pension funds are the largest owners of such bonds, holding HFF bonds with a book value of ISK 609bn at the end of September, or nearly 9% of their total assets. The pension funds have refused to negotiate write-downs of these bonds. In October, the Ministry introduced a bill of legislation on the winding-up of insolvent public entities, which would provide an avenue for subjecting the Fund to insolvency proceedings. Therefore, it looks as though much water will have to flow over the dam before it becomes clear whether, and to what extent, the settlement of the ÍL Fund has a negative impact on the pension funds’ assets and their ability to cover current commitments.

Stormy weather in the securities markets

The imminent HFF bond write-offs are not the only challenge facing the pension funds these days, however. Securities markets in Iceland and abroad have been less than attentive to the pension funds’ interests in the recent term. But thus far in 2023, it has been mainly the domestic markets that have proven difficult. The Icelandic OMXPI index fell by 12% in the first three quarters of 2023, whereas the MSCI World Index rose nearly 10% over the same period. [ATH: I Googled OMXPI and find that it’s a Stockholm index – or seems to be. What’s up?]

Icelandic bond prices have also lost considerable ground since the turn of the year. The impact of these movements on the pension funds’ assets is less clear, however, as a larger share of the funds’ bond holdings are entered at the original claim value rather than on a mark-to-market basis. Short-term volatility in the bond market therefore has a correspondingly weaker effect on the book value of assets, as the pension funds presumably intend to hold the lion’s share of these securities to maturity.

2023 likely to be better than 2022, if not good

In terms of returns, 2022 was the pension funds’ worst year since the 2008 financial crisis. According to information on the National Association of Pension Funds website, the Icelandic pension funds’ net real returns were negative by 11.6%, on average, in 2022. During the years beforehand, their real returns were good, however, averaging 4.6% for the period 2013-2022, more than a percentage point above their 3.5% actuarial benchmark.

The jury is still out on year-2023 developments in their assets, however. Over the first nine months of the year, the pension funds’ assets grew by just under 4% in ISK terms. The CPI as used for indexation rose by 6.5% over the same period, however. Considering that net inflows due to pension fund premiums net of benefits payments and operating expenses were robust during this period, we estimate that the pension funds’ real returns were probably negative by 3.5-4.0%,

which is certainly a significant improvement over 2022. That said, unless that domestic market turns around before the year-end, the pension funds’ actuarial position will probably deteriorate in 2023, and some funds may be forced to cut benefits to redress the balance. But all stormy weather subsides at some point, and as the markets firm up, there is a strong likelihood that the pension funds’ situation – and that of current and future pensioners – will improve again in the next few years.


Jón Bjarki Bentsson

Chief economist