Iceland's pension funds aren't in the front line of the crisis but some investments are in grave danger now. Those seeking a safe haven may allocate more to what is tangible - and understandable. Cue real estate. Gail Moss reports

For Icelandic pension funds, as with the country's other institutions, the cataclysmic events of the past few weeks have made any reasoned assessment of investment strategy appear irrelevant. Indeed, the funds have already offered to use some of their assets to help improve the liquidity of Iceland's stricken banks, although any rescue plans are currently on hold.

Certainly, any investment plans in place before October's economic storms will have to be rewritten to reflect the changed financial landscape."It's quite obvious that Iceland has taken the biggest-ever hit on its economy," says Lars Christensen, chief analyst and head of emerging markets research, Danske Bank. "Iceland is not only an island physically, but also financially and economically. It is no longer part of the global financial system."

He adds: "At the moment it's a struggle to survive for everybody. There is severe deleveraging going on. The property market will take a massive hit from this, and it makes no sense to put numbers on it. Furthermore, we are seeing a deglobalisation of Icelandic investments, with fire sales of Icelandic assets abroad."

What makes things worse is a tradition for investing indirectly in the Icelandic residential market, although this has declined in importance over the past two decades.
First, pension funds buy bonds that have been created to finance the state housing loan system. These are issued by the Housing Financing Fund, and at end-August this year, made up nearly 13% of pension funds' net assets of ISK1, 837bn (then worth €15bn), when aggregated with smaller amounts of other housing bonds, according to the Central Bank of Iceland.

Secondly, pension funds make mortgages available to members, secured against residential housing. By end-August, these were equal to 8% of net assets.And domestic property is no longer the gilt-edged asset it once seemed to be."There has been an extreme bubble in the Icelandic property sector," says Christensen. "Reykjavik property prices were higher than in the rest of the Nordic region, when there were no real supply constraints. There is now a complete halt in activity."

The fragility of the situation is complicated by the structure of the loans themselves.
"Most mortgages in Iceland are inflation-linked so, with the currency going down and inflation shooting up, most householders saw their debt double in the week that the banks collapsed," he says."There are two main issues that spring to mind concerning Icelandic pension funds," says Vanessa Rossi, senior research fellow at Chatham House. "First, there is the threat of potential seizure of Icelandic assets held abroad because of the collapse of the banking system. So Icelandic investors will have to grapple with that."

The other concern, she says, is the current financial turmoil, which began with the weakening of global property markets."Two-thirds of assets monitored have lost significant percentages in value," she says. "And the gross uncertainty in the system is going to create more problems."

However, real estate does have its pluses. "If we put the declining property prices against the decline in other asset prices excluding cash, property investment doesn't seem so bad by comparison," says Rossi. "Furthermore, it may well be that investors head back to tangible asset classes. Ironically, institutions could look to property as being more tangible and understandable than financial assets."

"What is happening in Iceland is not such an immediate crisis for the pension funds as it is for the banks," says Professor David Blake, director of the Pensions Institute at Cass Business School. "The banks have the problem that they made long-term loans funded on short-term money. That's fine when things are going well, but when things go badly, people begin to question the value of the loans on your book and you soon have trouble refinancing them. Very soon a liquidity crisis becomes a solvency crisis."

Pension funds are different, especially if they are still immature and have a small number of pensioners, but a large number of active members. "Under normal conditions, pension funds always have sufficient cash flows from the assets they hold to pay the pensioners this year and the next," Blake says. "This is because pensions in payment are small in comparison with the size of a fund's liabilities, typically around 3-4% per annum."

However, he says the crucial question is what kinds of assets are included in fund portfolios, and whether their value will hold up in a financial crisis. "The banking crisis has been such a shock to the global financial system in terms of the volatility of asset values that investors have become very wary, despite the fact that pension plans can wait 5-10 years for assets to recover," says Blake.

He points out that, when the value of pension fund assets falls, there is a medium-term funding problem to be solved, with the gap being filled by the employer putting in more money, by cutting pensions or by persuading employees to work longer.
"In the medium term, if Icelandic pension funds have investments in corporate bonds or credit defaults swaps, then they are clearly going to suffer a serious funding problem," he says. "However, this crisis will probably make property more attractive as an investment. As a slow, lumpy investment, it could influence what happens in the longer run."

Blake says that, as pension funds mature, assets providing steady cash flows are clearly going to be a linchpin of their portfolios. And this applies to Iceland as to anywhere else.
"In the property segment of the portfolio, this would include commercial real estate," he says. "However, although this does provide a cash flow, it is not guaranteed, because commercial property is sensitive to the state of the economy, and in a recession, retail units are closed in shopping malls, while office blocks built at the height of the boom remain unoccupied."

Even more vulnerable could be those portions of pension fund portfolios invested in loans or bonds linked to residential mortgages."These are not looking such a good investment," says Blake. "It's the mortgage-backed assets that have gone belly up in the current crisis. The lesson here is to diversify into the widest range of asset classes you can think of, with the lowest correlation between them."To do this, he says that, in an ideal world, Icelandic pension funds should hold property abroad.

"If they had the flexibility to do so, they should start with geographical diversification, though it does require specialist knowledge," he says. "One drawback, of course, is political risk. Another is currency risk. The world has become a very volatile place for investors in recent times."
 

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