Thursday, September 4, 2014

Meet Ontario's New Pension Suckers?

Among the list of arguments advanced for the proposed Ontario Retirement Pension Plan (ORPP), which with the re-election of the Liberal government will now suck up $3.5-billion of Ontarians’ savings every year to invest on their behalf, efficiency was near the top.

Not only are the province’s hapless citizens chronic under-savers, as the recent budget lectured them, but if left to invest unchaperoned they would simply blow it all on things like mutual funds, with their notoriously high management fees. That much is true: people who invest in mutual funds, of the kind that blanket the airwaves with claims of their superior returns at RSP time, are suckers — of which there are, by one estimate, more than 525,000 added to the population every year.

But the premise, that by forcibly merging everyone’s savings into one big, government-sponsored fund, such waste can be avoided, does not necessarily follow. I’ve had a look at several years’ worth of annual reports from the Canada Pension Plan Investment Board (CPPIB), on which the ORPP is to be based (indeed, the government cites the plan as a fallback from its preferred position, of simply expanding the CPP). It was hard slogging: the figures on costs are buried in acres of print near the back. But the picture that emerges is unmistakable, and gives the lie to any claims of savings.

In the last fiscal year (ended March 31), the board incurred costs of about $1.74-billion, or nearly 1% of the $183.3-billion in assets it started the year with. (The fund now stands at $219-billion.) Of this, about $1-billion was in fees paid to external managers, who invest on the board’s behalf. Another $200-million or so was in transaction costs — the cost of executing trades and acquiring assets. The rest, nearly $600-million, was in general operating costs. In the last four years, total costs have more than doubled; since fiscal 2007, they are up roughly seven-fold.

The choice of year is significant: 2007 was the year the board switched from a purely “passive” investing strategy — that is, simply “buying the index,” seeking to replicate the performance of the broad market in each asset class, rather than trying to pick particular stocks or bonds — to “active” management, including a major plunge into private equity and other relatively risky assets, in hopes of earning higher returns than the average. It hasn’t really worked out that way.

In the eight years since it shifted to active management, the CPPIB’s return on investment, net of all costs, has beaten its “reference portfolio” — made up of the indexes for each of the asset classes in which it invests — just four times: 2007, 2008, 2011, and 2012. The other four times it lost. To be sure, in those four good years, it beat the reference portfolio by an average of two percentage points. Add it up, and the board estimates its efforts “added value” to the tune of a cumulative $3-billion, meaning the fund is worth about 1.4% more, eight years later, than it would have been without them. But it spent more than $7.5-billion to do so. And there’s no guarantee even that meagre gain won’t be wiped out next year.

A not inconsiderable part of the bill went in salaries to its senior executives. The seven top managers listed in the annual reports collected an average of $3-million apiece in total compensation last year. (Admittedly that was a good year, but it’s commonly in excess of $2-million.) There’s no need to begrudge them that — they’d probably pull down something comparable in the private sector. But that’s the point: in the private sector, it’s sucker money they’re collecting. Whereas with a compulsory fund like the CPPIB, it’s all of our money.

CPP execs were in the papers boasting of the 16.5% return they earned last year — 16.2% after operating costs. Great: the reference return was 16.4%. That’s the average, meaning it’s the return you could expect to collect, on average, just by picking stocks (and bonds) at random — the proverbial flinging darts at the stock listings, if newspapers still had stock listings. You don’t need to pay people $3-million each to slightly underperform the average. (For example, I would be willing to do it for a third as much.)

That’s not quite fair. Nobody earns the same return as the index: there’s always some costs involved. But the costs the CPP is incurring are vastly higher than they would be had it stuck with the original passive strategy. My own little portfolio of exchange-traded funds (ETFs), all of them strictly index-based, has an average management expense ratio of 0.19% — less than a quarter the CPP’s.

I don’t mean to suggest the CPP is doing anything wrong, or corrupt. As investment funds go, I’d guess it’s better managed than most. Certainly it hasn’t behaved anywhere near as foolishly as Quebec’s Caisse de dépôt, which lost a quarter of its value in 2008 after betting heavily on asset-backed commercial paper, nor does it compare to the continuing mess at the Alberta Heritage Savings Trust Fund. It’s only making the same mistake as all the other actively managed funds — or rather the people who invest in them: thinking they can beat the market.

The evidence on this is overwhelming: in any given year, two-thirds to three-quarters of actively managed funds get taken to the cleaners by their index. Over a 10-year period, it rises to 90%. Their managers aren’t stupid: they just aren’t any smarter than all the other smart managers out there. The only way you can beat the market is if you know something everyone else doesn’t — new information, not previously public — and not just once, but routinely. That’s not just hard to do. It’s damn near impossible. Which is why the smart money buys the index, and leaves the sucker money to do the heavy lifting.

And yet the CPP is spending $1.74-billion a year of your money and mine in the same futile attempt to beat the index. And the Ontario government is about to copy them. Because God forbid they leave it up to you. Suckers.
For a second there, I thought it was Burton Malkiel writing this commentary and he forgot to call it "A Random Walk Down the Canada Pension Plan." In another article, Coyne criticized CPPIB's active management stating it's a "crock."

I like Andrew Coyne. I read and listen to his political commentaries and even agree with some of his positions. Unfortunately, when it comes to pensions, he's completely and utterly clueless and falls into the same trap that many lazy reporters do when they want to rail against "big government" and the "big, bad CPPIB."

First, let me give him a break. He's right, most active managers stink. In fact, 2014 is shaping up to be a particularly brutal year for all active managers, including hot hedge funds. Eighty percent of mutual fund managers are underperforming their index, which reinforces Malkiel's thesis that investors should be diversifying their holdings through low cost exchange-traded funds (ETFs). That much Coyne got right.

He also correctly points out that the cost of running the CPPIB is significant. The CPPIB invests in public and private funds as well as hedge funds. Their private equity and real estate investments are done via funds and co-investments. Their partners are some of the best funds in the world and they dole out big fees to invest with them.

But there is a reason why the CPPIB has invested a significant chunk of its assets in private markets. By their nature, private markets are not as efficient as public markets, so there is greater potential to unlock value over the long-run and make significant gains over public market indexes, ie. their passive benchmark or reference portfolio.

The key in all this is to measure the CPPIB's value-added over a long period, not just one or two years. Why? Because investing in private markets is a money-losing proposition in the short-term (the so-called J-curve effect) and it takes at least four to five years before the money really starts coming in for private equity investments.

None of this is mentioned in Coyne's misleading article. Go back to read my comment on CalSTRS taking CPPIB to school as well as my comment on CPPIB's FY 2014 performance. I explain why CPPIB tends to under-perform when public markets are surging and why it outperforms when a bear market strikes. Over the long run, this has generated big gains for CPPIB.

Importantly, gross value-added over the past eight years considerably outperformed the benchmark totalling $5.5 billion. Over this period cumulative costs to operate CPPIB were $2.5 billion, resulting in net dollar value-added of $3.0 billion.

There is something else that really bothers me about Coyne's slanted piece. If he thinks investing in ETFs is a retirement policy, he's really a lot more clueless on pensions than I think. He completely ignores the benefits of defined-benefit plans which include bolstering overall economic activity, increasing tax revenues and more importantly, lowering costs and pooling investment and longevity risk.

You see while investing in a diversified portfolio of ETFs is fine, if another 2008 or worse strikes, Mr. Coyne and his followers will suffer significant losses and a big hit to their retirement accounts. If they are getting ready to retire when disaster strikes, they're really screwed whereas members of a defined-benefit plan have peace of mind that their pension payments are secure, allowing them to retire in dignity.

I can go on and on about the case for boosting DB pensions and enhancing the CPP, but suffice it to say that the trash the National Post is publishing is completely inaccurate and misleading. The only thing I like about his comment is that it can be used to trash PRPPs which the Harper government is pushing for.

Let me end by congratulating Mitzie Hunter who was named Ontario’s associate finance minister, reporting to Charles Sousa, responsible for the new retirement pension plan. She has a big job at hand and I really hope they get the governance and risk-sharing right (see Newfoundland's new pension plan deal).

Below, Mark Wiseman, CEO of CPPIB, talks about the importance of thinking long term. Also, Leo de Bever discusses taking the long view on pensions. Take the time to listen to their comments, they understand why it's important to think long term when managing pensions.

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