Nina Röhrbein assesses the impact on pension funds of the collapse of the Icelandic banking industry

Following the country's banking crisis of 2008, the Central Bank of Iceland introduced measures to temporarily restrict currency outflows. A strategy for the removal of those capital controls was approved by the Icelandic government in August 2009 but made dependent on meeting certain conditions, such as a reduction in the perceived risk of investments in domestic assets in order to avoid instability of the economy and currency.
Since then, a new capital account liberalisation strategy, published on 25 March 2011, has replaced the old one.

It says: "The conditions are in place for gradual relaxation of some parts of the controls although more fundamental steps will have to wait until the treasury has demonstrated through borrowing that it has the ability to refinance foreign loans. This has long been delayed, partly as a result of the still-unresolved Icesave dispute."

The report warns that phase II and part of phase I of the liberalisation strategy could be delayed if the Icesave bill was rejected in the upcoming referendum. It was in early April 2011.

The main problem with the previous liberalisation strategy was its lack of measures to channel unstable offshore assets into the hands of long-term investors before other controls were lifted, according to the strategy report.

Following on from the measures that have already been taken place to relax parts of the controls, such as those on capital inflow, the new strategy comprises two main phases: Phase I is the reduction of offshore króna positions, while phase II is the removal of controls on onshore krónur.

"Before phase II of the strategy begins, a major review of the preconditions will be carried out and the sequencing of that phase will, if needed, be spelt out in more detail," the report goes on.

"Unfortunately, there are reasons for maintaining these capital controls," says Ólafur Ísleifsson, assistant professor at the School of Business at Reykjavik University. "The trade in the krónur as a high-yielding currency resulted in the build-up of massive krónur assets held by foreigners against a weak foreign reserve position of the Central Bank, meaning the exchange rate of the króna would fall substantially in the case of quick dismantling of the capital controls. The IMF programme is scheduled to terminate in August but there are discussions of it being extended."

The report from the Central Bank of Iceland says that it is highly unlikely that the capital controls will have been lifted by the time the current statutory authority expires on 31 August 2011, without assuming unacceptable risk of financial and exchange rate stability.
"Hence it is recommended that the statutory authority be extended by four years, which should ensure that it is possible to lift the controls at a pace warranted by circumstances without generating instability, given appropriate prudential regulation. Nevertheless, every effort should be made to lift the controls earlier if conditions permit."

Some market participants are pessimistic whether the restrictions will have been lifted by 2015. "I believe the controls will only be lifted with Iceland's accession to the EU," says Gylfi Jónasson, managing director at the Festa Pension Fund.

With the capital controls remaining for now, Iceland's pension funds are still unable to make new investments in foreign currency denominated assets, leaving them limited room to manoeuvre.

"Prior to the crisis, Icelandic pension funds had ventured into the international markets and held on average close to 30% of their assets in foreign currency, which with hindsight was too low," says Ísleifsson. "Around 95% of domestic equity and a significant share of domestic corporate bonds were wiped out by the collapse of the banks. As a result, the asset allocation of Icelandic pension funds today increasingly consists of government guaranteed paper and bank deposits. It appears safe to assume that this trend will continue for a while."

To boost liquidity in the economy, 26 Icelandic pension funds bought index-linked Housing Financing Fund (HFF) bonds in May 2010.

Around half of pension funds' fixed income assets are index-linked government-backed bonds with long durations of eight years and more, although, over the last two years Iceland has mostly seen a supply of non-indexed government bonds, according to Sigurdur Gudjon Gislason, portfolio manager of VÍB private pension. VÍB is the asset management division of Islandsbanki.

"We have yet to see possibilities beyond the Icelandic bond market," he says. "The first step is likely to be further investment in municipal bonds. Further ahead we will see the new banks go out on the market to get some long term funding. In terms of foreign investments pension funds are mostly invested in equities. Because of the high returns of Icelandic bonds over the years few are invested in foreign bonds. The last years before the crash we saw more and more investments in private equity and hedge funds."

"We have been trying to extend our investments in asset classes such as domestic real estate and private equity," agrees Kári Arnór Kárason, managing director at the Stapi Pension Fund. "We have also done some rebalancing of our foreign portfolios and try to model how we can go forward without adding to the current pool of money that we have there."

At present, Stapi's asset allocation is heavily geared towards Icelandic fixed income assets with more than 50% invested in domestic government bonds, 10% in corporate bonds and 3% in mortgage bonds. Only 2% is currently invested in domestic equity as the listed market remains small and to a large extent not investible for Stapi. The remainder is made up of foreign equity and bond investments, real estate, hedge funds and commodities.

"We have to try to diversify as much as possible within the investments available to us," says Kárason. "We have been increasing our investments in government bonds but are not overly comfortable with doing that, also because the yield has been falling quite sharply."

VÍB private pension's only overseas investments are assets purchased prior to the currency restrictions. "For portfolio managers in Iceland the main option for the last couple of years has been Icelandic government bonds and equity, with only a handful of companies to choose from in the latter category," says Gislason. We try to diversify our portfolio by actively managing the duration of our portfolios as well as managing between indexed and non-indexed bonds. We then try to mix that with the few companies listed on the domestic market. Returns last year varied from 3.1% for our deposit portfolio to about 9% real return on our blended portfolios. These high real returns are the results of lower interest rates, which has benefited our fixed income investments, and lower inflation, which has fallen from over 18% to under 2.5% in two years."

In 2010, Icelandic pension funds' assets continue to grow and are now worth around ISK1.93bn (€11.9m). The average real yield was positive in 2010, estimated at about 2%, according to Hrafn Magnússon, managing director of the Icelandic Pension Fund Association (IPFA).

To fulfil their obligations in full, Iceland's occupational pension funds need to deliver a 3.5% real return on their assets, otherwise they could be required to decrease entitlements of members. Gislason says this 3.5% real return target somewhat prevents Iceland's occupational pension funds from buying any, particularly index-linked bonds, under a yield of 3.5%.

But Kárason warns: "If the yields on government bonds continue to decline and we cannot diversify into foreign assets, it will become tougher and tougher to be able to meet our 3.5% real interest rate obligations with our current set of investment opportunities."
Stapi is just one of the many pension funds that has reviewed its risks and improved its risk management system, a process that is still ongoing.

The 2010 IPFA report on the working methods and investment policies of Icelandic pension funds in the period before the economic collapse concluded that Icelandic pension funds need to put more emphasis on risk management and best practice. Another, more thorough, report is expected to come out in late May.

"Icelandic investors largely underestimated the risks of domestic corporate credit investments," says Gislason. "Once the currency restrictions are lifted, they are likely to diversify more and take more of that risk through foreign assets."

But with the restrictions in place, developments at Icelandic pension funds have almost been at a standstill for the last three years.

"However, pension funds are now more active in trading bonds than they were before," says Kárason. "They have become more tactical in their bond investments. Most pension funds have also been working on different types of investments such as domestic real estate and unlisted, private equity. Immediately after the crisis everyone wanted to invest in something that was government guaranteed. But we cannot continue to do this, which is why Icelandic pension funds look for further investment options. The next natural step is to invest in tangible assets or something that is backed by tangible assets. The recapitalisation of Iceland's financial institutions, which will be done via asset-backed securities, provides another set of opportunities."