Measures by Iceland’s Central Bank to gradually adjust the krona’s exchange rate are forcing pension funds to invest mainly in domestic krona-denominated assets, reports Iain Morse

Loki warned Thor not to try to drink more than he could stomach, a warning he ignored at his peril. Iceland forgot to re-read its sagas during the credit boom. The country sucked in foreign currency, boosting the value of Icelandic krona. Then in 2008, the euro exchange rate collapsed from ISK90 to ISK340 and now sits around ISK159.

Even this exchange rate is artificial, maintained by complex controls set in place by Iceland’s Central Bank, controls which have important consequences for Iceland’s pension funds. Some ISK400bn (€2.5bn) in ‘external’ assets are trapped outside Iceland by these currency exchange controls and are rendered effectively worthless, whether owned by Icelandic or foreign institutions.

If these could be freely exchanged for foreign currency held in Iceland, the fear is that the external krona would flood home, foreign currency would flood out and the current exchange rate would undergo another collapse. Since 2008, sums of offshore krona have been periodically auctioned by the Central Bank, but this system is now replaced by a so-called 50/50 option; an investor seeking to buy krona must buy half at a Central Bank auction and half from an Icelandic bank at what is certain to be a more costly exchange rate. These second amounts must then be deposited with Icelandic deposit takers for periods of at least five years, which is unlikely to make such transactions attractive to many institutions.

The aim is to gradually adjust the krona exchange rate, a little like keeping deep-sea divers in a compression chamber until they adjust to the surface. A general commitment to ending currency controls in 2013 has been made. There is also debate over joining the euro. But many see the measures actually taken as too slight. “They will have little impact because these steps to liberalisation are so small,” says Sigridur Torfadotir, head relationship manager for Treasury services at Islandsbanki.” The currency regime has teeth; this year a Norwegian company is being prosecuted for covertly transferring ‘external’ krona to higher interest paying, ‘internal’, Icelandic bank accounts.

It has other consequences. The 32 pension funds that are members of the Icelandic Pension Fund Association own assets worth ISK2.016trn (€12.6bn) and have almost a quarter of this, ISK43bn, in foreign assets. Investing abroad from the internal krona has been virtually impossible since 2008. In effect, cash-rich domestic institutions, such as pension funds and insurance companies, are being quietly compelled to invest in domestic krona-denominated assets.

Part of the reason for this is the much-rehearsed collapse of several of 11 banks domiciled in Iceland; five commercial banks remain, four investment banks, and 10 savings banks.

Compelling the pension funds and insurance companies has become an important element of government policy in re-capitalising the economy after the departure of foreign capital. Last year, pension funds were offered the opportunity to sell foreign assets to finance the purchase of Housing Financing Funds (HFF) owned by the Icelandic Treasury, paying 7.5% per annum. A total of 26 funds sold foreign assets worth €549m and converted this to ISK-denominated HFFs in a deal that increased the Icelandic Central Bank’s foreign exchange reserves by €512m.

This needs to be placed in context. The aggregate value of ISK bonds and notes is approximately ISK1.8trn, of which housing bonds are worth over ISK758bn and listed corporate bonds, some ISK143bn. Listed equities have a market capitalisation of over ISK246bn, according to the Icelandic Central Bank. Aggregate HFF bonds are currently worth over ISK37.1trn. The role of the pension funds is significant. The equity market collapsed in October 2008, with shares in six banks and related companies suspended, the index down 77% when trading re-commenced some days later. Foreign investors left if they could.

Iceland still imposes a priori investment restrictions on pensions funds. Most conveniently, these permit a 100% allocation to domestic mortgage bonds, as long as the underlying loan-to-value (LTV) does not exceed 75%, a ratio reduced to 35% in the case of specialised commercial property. In theory, a pension fund could invest exclusively in HFF’s.

Equities, sovereign debt, municipal and corporate bonds are all capped at 50% of assets under management, overall foreign currency risk also at 50%. Pre-credit crisis, pension funds were seeking to diversify out of domestic equities, although not so much out of domestic bonds. This trend has been arrested. “The only overseas assets held by pension funds are those purchased before capital controls were introduced in 2008,” says Thory Thordardottir, managing director of the Icelandic Pension Funds Association.

Scheme-specific asset allocation can vary but, in practice, does not do so very widely. Take the largest pension fund, Lifeyrissjoour Starfsmann, a scheme for public services workers, with assets of ISK390bn. Of this, 60.1% is in Icelandic government bonds, 28.3% in foreign equities, 4.9% in alternatives including hedge funds and private equity, 4.6% in cash, 1.6% in domestic equities and 0.4% in foreign bonds (end 2010).

Gildi, a pension fund with ISK230bn, holds 63.5% in bonds, 22% in foreign equities, 6% in domestic equities, 4% in cash deposits, 2.5% in hedge funds and 2% in real estate. Starsfmann holds 30% of its bonds in Icelandic sovereign debt, Gildi 42%. Starfsmann allocates 0.7% to mortgage bonds while Gildi allocates 8.5%. Most foreign equity exposure is either through externally managed accounts and non-domestic mutual funds.

The pension funds are regulated under the Mandatory Pension Insurance Act of 1997 which requires them to act as quasi-fiduciaries being prudent on behalf of their members. Contribution rates are mandatory, set at 12% of the individual’s gross salary, the employer’s contribution equal to 8% and the employee’s to 4% of the same. Both contributions are effectively tax deductible; the employer’s as an expense, the employee’s as fully income tax deductible. Pension fund accruals are tax free. Additional tax-free voluntary contributions by employee’s equal to 4% of gross salary are also permitted, although current legislation will reduce this to 2% of the same.

The ministry of finance is also proposing a 10.5% financial activities tax (FAT) which, if enacted as currently proposed, would include the profits made by pension funds, after Danish practice, and property investments. “We will strongly oppose this proposed change,” adds Thordardottir, “as we have the planned reduction in the 4% allowance on voluntary contributions.”

Pension funds are lobbying for an alternative to taxation, such as an arrangement where they purchase state-owned assets, which might include energy and utility companies. An earlier proposal that pension funds and insurance companies should part-finance interest-free rebates on domestic mortgages had already failed to find agreement. There remain the nationalised banks which could also be privatised, partly or wholly, with the participation of the pension funds and insurance companies.

This is a concentrated market. The 20 largest funds own over 96.8% of pension assets; merger and consolidation has been a feature of the market and is expected to continue as a trend. Some 17 further funds account for remaining assets. The 20 largest funds are closely monitored, reporting each month to the ministry of finance. Expect funds to have an internally employed chief investment officer and small team of internally employed advisers.

These teams rarely exceed 10 people and are often smaller. The role of external investment consultants is very limited; none of the global custodians have offices in Iceland. Risk modelling and related services seem to be provided by Icelandic banks, insurance companies and asset managers which report to the pension funds as part of their service. Some of the banks and insurance companies run pension funds. Membership of some funds is based on occupation, some on employer and some are retail, ‘open’ funds sold via banks or insurance companies.

On the custody side, little has changed since 2008. Only three banks, Islandsbanki, NBI and Arion, remain in the domestic custody market. Last year, Clearstream gained direct access to the market via the Icelandic securities depositary and cash clearing system. Global custodians act through the three local custodians, although this business is small due to currency controls. Pension funds tend to hold bonds to maturity. Stock lending is prohibited. Due to the fairly limited foreign exchange exposure among funds, there is little currency hedging.

For a country with not much more than 318,000 citizens there are no fewer than 12 insurance companies. Like the pension funds, these have assets worth over ISK144bn. These also require custody services. ‘Custody services tend to be plain vanilla,’ judges Kristin Elfa Ingolfsdottir, executive director at Islandsbanki Custody Services. Charge bundling was commonplace but practices are changing. ‘We are seeing the wider use of annual minimum fees and transaction-based charges,’ avers Torfaditor. This may be true but the market remains opaque in terms of hard data on custody; the detail of these relationships tend to be treated in confidence.’