Iceland’s pension funds: Consolidation continues but size of sector a worry

Merger mania continues to grip Iceland’s pension sector as the country’s pension funds seek lower costs, higher returns, operational efficiencies, and the scale to better negotiate with asset managers.

The ISK 190 billion ($1.5 billion) Lífsverk Pension Fund and ISK 477 billion ($3.8 billion) Almenni Pension Fund are the latest duo to sign a merger agreement, which will create a new operational fund by January 2026.

At the end of this year, ISK 562 billion ($4.4 billion) Frjálsi Pension Fund and dental pension fund ISK 11 billion ($87 million) LTFÍ Pension Fund will also merge. Elsewhere, ISK 557 billion ($4.4 billion) Brú Pension Fund has taken over Akureyri Employees’ Pension Fund (LSA), following its earlier merger with the Reykjavik City Employees’ Fund.

The sector’s steady consolidation means the country has 21 pension funds today compared to 96 in 1980.

But consolidation doesn’t solve growing concerns recently flagged by the OECD and Iceland’s Central Bank about the size of the country’s pension funds relative to the economy. Iceland’s pension funds’ combined assets are now larger than those of the country’s banking system and insurance sector combined, and more than sufficient to buy all listed equities, bonds and bills in the country.

Pension fund assets reached almost 200 per cent of GDP by the end of 2022, up from around 150 per cent in 2018. The OECD states that pension funds are a major source of household mortgage lending; they are the largest investors in the domestic equity market and are among the largest owners of two of Iceland’s three systemically important banks.

Moreover, Iceland’s pension funds typically target a real reference rate of at least 3.5 per cent on their assets, typically above economic growth. The OECD flags that in a low-yield environment, pressure for returns could push pension funds into riskier asset classes and warns that authorities should closely monitor pension funds’ risk-taking, including through stress tests.

Central Bank urges pension fund reform

In 2022, pension fund reform allowed funds to gradually increase their holdings of foreign assets to 65 per cent, reducing exposure to Iceland’s small and volatile economy. But Iceland’s Central Bank is now urging for more reform of the Pension Fund Act, arguing that legislation governing the sector has fallen behind reforms in other parts of the financial system.

The Central Bank noted that while consolidation has brought economies of scale, it also raises challenges for how pension funds are managed and the extent to which they should be able to exercise influence as shareholders in Icelandic companies. It urged for more stringent requirements for board composition, risk-management frameworks, internal audit, compliance functions, and outsourcing oversight to reflect the systemic role of pension funds.

“Increased concentration undeniably brings a certain economy of scale, but at the same time it brings challenges involving, for instance, how pension fund management should be conducted and how assertive the funds should be in their role as company shareholders,” writes the bank. “In terms of total assets, Iceland’s pension funds are larger than the Icelandic banking system and insurance companies combined.”

Iceland’s three largest funds manage around half of the country’s total pension assets and the 15 largest manage 97 per cent.

The bank forecasts more pension fund investment within Iceland and abroad. It warned that foreign investment can entail challenges to financial stability, but pension funds should consider the potential impact on the balance of payments when investing abroad, so that they neither create nor exacerbate exchange rate volatility.

“Furthermore, the Bank considers it important to pass more detailed legislation on pension funds’ internal monitoring systems – including governance, key functions, risk management, and outsourcing – which should be harmonised with other financial market legislation.”

In the Bank’s assessment, the requirements made of pension funds’ key functions should be more stringent than they are currently, and special legislation on personal pension savings custodians should be passed. Furthermore, when the Pension Fund Act is reviewed, consideration should be given to the findings of impartial appraisers such as the International Monetary Fund,” states the Central Bank.