Favourable real returns in recent years have put Icelandic funds, traditionally tilted towards the domestic bond market, in a strong position. But the recent domestic slowdown has reminded funds of the risks of having most of their assets allocated to Icelandic bonds and of the benefits of diversification. In the spring, a pair of surprise interest rate hikes had many investors worrying, but since then it appears that the situation has grown steadily worse. On June 4, the Organisation for Economic Co-operation and Development (OECD) said that an Icelandic recession was “imminent” and forecasted a GDP of -0.4 per cent for 2009.

There are question marks over how its pension funds will react to soaring interest rates, a sluggish currency and a fading economy. Early indications suggest that the solution could be in both emerging markets and alternatives, and that Icelandic pension funds will be flocking to these assets in the coming months.

Stefan Halldorsen, chief executive officer of Lífeyrissjódur verkfrædinga, the IKr37.9bn (€300m) engineers’ pension fund, believes Icelandic funds will put more effort into tactical asset allocation to respond to the short-term crisis. This would include more attention and possible allocation increases to some fixed income products, equities and alternatives, and a general move away from structured products. However, he is hesitant about the timing for such changes.

He says: “There’s increasing pressure to move abroad, but the weak currency makes it expensive. But we will once the local inflation goes down.”

Söfnunarsjódur lífeyrisréttinda, the IKr55.6bn Icelandic general pension fund, has become increasingly eager to diversify and is already in the process of diversifying. The fund is looking to add to its already significant allocation to private equity. The fund currently has 6.7 per cent of its assets allocated to the class, but will increase its commitments to about 8 per cent.

“We like private equity very much – it gives us good exposure to all areas of the equity market. It also suits us very well and is good for covering our liabilities,” says Sigurbjörn Sigurbjörnsson, managing director of the fund. The fund has also looked into hedge funds and property, but has so far not invested in any other alternatives than private equity.

Diversifying away from a heavy reliance on domestic bonds has been a slowly emerging trend. Asgeir Thordarson, head of the Nordic region at Fidelity, believes it makes a lot of sense for Icelandic funds to diversify into other asset classes and into more foreign assets.

“It carries a relatively high risk to invest all pension assets in such a small economy. The regulatory environment has held pension funds back, but it is slowly liberalising. Going forward, I think Icelandic pension funds will have the same opportunities to invest in foreign assets and alternatives as elsewhere,” he says.

While it is still prudent to have a large allocation to Icelandic government and corporate bonds, Mr Thordarson thinks pension funds should be looking abroad for equities.

However, far from everyone is convinced. The €1bn Stapi pension fund is moving towards a more defensive strategy by increasing its allocation in cash. While the fund has also increased its fixed income and absolute return assets and cut equities, its way forward is decisively low-risk.

Landssamtök lífeyrissjóda, the country’s pension fund association, has acknowledged that scheme returns are down markedly from previous years, which had typically posted double-digit figures. In 2007, pension funds returned an average of 1 per cent, according to the organisation. While it remains optimistic, it does recognise that the investment climate is challenging.

Hrafn Magnusson, managing director at Landssamtök lífeyrissjóda, says: “The actuarial position of pension funds will be very good, but it’s too early to predict the actuarial position in the end of this year. The current investment climate has not been very good for pension funds in the last couple of weeks and the situation is still very unstable.”

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