Earlier this year foreign investors began a flight from Iceland on fears that the economy was overheating dangerously. As a result the Icelandic kronur depreciated by 30% and the stock market lost 20% of its value.
"The scare was absolutely overdone," says Tryggvi Thor Herbertsson, director of the University of Iceland's Institute of Economic Studies and a member of the Frjalsi Pension Fund board. "In fact, Frederic Mishkin of Columbia Business School and I published a report, Financial Stability in Iceland, and we stressed that one of Iceland's strengths is its pension system as it allows the implicit liabilities of the state to be very low. After that report was published things calmed down."
Indeed, by August the scare appeared to be over.
"In fact last year was very good for Icelandic pension funds," notes Hrafn Magnússon, managing director of the National Association of Pension Funds. "We had a marvellous real return, we estimate it at 13.5%, because domestic equities rose very fast with the ICEX-15 up about 65% after 59% in 2004. But the correction means it is now down 4.8% since the beginning of the year. And having gained 7.2% on the exchange rate index last year the kronur is down about 22%, and down 24% against the euro."
But Magnússon agrees that the pension funds were aware that the kronur and the stock market were due for a correction. "So they invested abroad and at the end of last year foreign assets made up about 25% of the overall portfolio," he says. "When the kronur weakened it was very good for the pension funds. At the same time the interest rates on domestic bonds have risen. But domestic equities have not done well and pension funds are very neutral on domestic equities today."
"Last year saw the best performance ever for the fund," says Haukur Hafsteinsson, managing director of the Pension Fund for State Employees, Starfsmanna Rikisins, Iceland's largest pension fund. "Overall it was 18.9%, with a real return of 14%. All of our main asset classes gave a good return, Icelandic equities performed well, but also foreign equities. And Icelandic bonds are also very strong. The only asset class that performed poorly last year was foreign bonds, but only a very little part of the pension fund is in foreign bonds."
At the end of the year Icelandic bonds accounted for 57.8% of the portfolio, domestic equities 13.9%, foreign equities 26.7% and foreign bonds 1.6%. "Our performance last year was due to the results of our domestic equity portfolio, where we had a nominal return of 71.8% and a real return of 64.7%," says Thorgeir Eyjólfsson, managing director of the Pension Fund of Commerce, Verslunarmanna, the largest private sector pension fund. "On total assets we had a nominal return of 20.9% which is a real rate of return of a little over 16%. At the end of the year foreign securities, mostly equities, accounted for 25% of our portfolio, domestic equities 19%, and the rest was in bonds."
And the crisis earlier in the year has not had a baleful influence on the result. "We had a comfortable performance at mid-year," says Eyjólfsson. "Our preliminary figures indicate that the size of the fund increased from ISK191m (€2.1m)to a little over ISK217m in the first half. The best performer was our foreign portfolio. We started the year with no currency hedging against the portfolio because we were just waiting for the kronur to weaken, so all the currency gain as the kronur has fallen was returned in-house."
Tryggvi Tryggvason, pension fund manager at Gildi, Iceland's third-largest pension fund, also reports an excellent performance in 2005. "We had a great return, over 22%, that's a 17.6% real return," he says. "The biggest contribution came from equity markets."
Last year Icelandic equities accounted for 25% of Gildi's portfolio, Icelandic bonds of 53%, foreign equities 20% and other foreign assets 2%. "
But what about the future? What are the funds' expectations and what will they do about them?
"One can always see challenges when looking ahead," says Hafsteinsson. "On the domestic front we are seeing increased volatility both in the currency market and the stock market. High interest rates and currently a very high current account deficit represents a challenge but in our view also an opportunity for a long-term investor."
But will these concerns be reflected in the Pension Fund for State Employees' asset allocation? "Mainly we have stuck to our asset allocation and we have maintained the Icelandic equity part at around 10-15% while we have slowly increased the foreign segment over the years," Hafsteinsson says. "So we have not taken any dramatic steps to change the asset allocation."
"We are diversifying the risk in foreign markets and foreign currencies," says Eyjólfsson. "That's what we have considered the right thing to do over the last several years and I believe it will continue to be so over the next several decades because our pension fund is relatively young and we won't have to repatriate our foreign assets to pay pensions for another 30 or 40 years. At the end of last year 25% of our portfolio was in foreign securities and now we have 35%, partly because we have added money to our portfolios abroad but the largest factor here is the currency change."
"We will not make any major changes," he says. "We are working on a three-year plan and are looking for more diversification in our portfolio and getting into new asset classes. We are looking more at hedge funds and private equity."
Gildi is the result of a merger in June 2005 between unskilled workers' pension fund Framsyn and seamen's fund Sjomanna, and its investment strategy is part of their consolidation. "This year has been quite challenging but the outcome for the first six months is very good," Tryggvason says. "While we have about 20% of our exposure in equities in Iceland most are not related to Iceland, their operations are abroad: the banks have about 70% of their income from abroad and other companies get all their income from abroad. We are looking for a 6% real return on an annual basis in the long term."
"I think there is no reason to believe that returns will not be fairly good," agrees Herbertsson. "They will not be good as they were two or three years ago, or even one year ago when real returns were something like 12-13%, but they were abnormal times. However, the outlook is for real returns in the region of 5-6%."
And Herbertsson sees further mergers as being a major characteristic of the Icelandic pension fund arena. "The consolidation we have seen over the last six or seven years is going to continue," he says. "The funds are going to grow bigger and stronger."
"By the end of the year I estimate that the top 10 pension funds will control about 80% of total pension fund assets," says Magnússon. In addition to the creation of Gildi, last year saw the Southern Province Pension Fund, Sudurlands, merged with the Westman Islands Pension Fund, Vestmannaeyja. "The earlier this year the Co-operative Pension Fund merged with skilled workers' pension fund Lifidn, and Almenni Pension Fund merged with doctors' pension fund Laekna," Magnússon adds.
More recently it was agreed that Reykjavik-based Frjalsi, the pension fund of Iceland's largest financial institution KB Bank, would merge with Bolungarvik, which is based in northwest Iceland.