The World’s Best Pensions Are Canadian
Canada’s pension funds are beating peers globally in investment performance and are stronger at hedging against liability risks, according to research from McGill University and CEM Benchmarking.
Their success is partly explained by the fact they are more likely to manage their assets in-house, McGill researchers Sebastien Betermier and Quentin Spehner, along with CEM’s Alexander Beath and Chris Flynn, wrote in a July paper. The authors’ findings are based on a study of pensions, endowments, and sovereign wealth funds globally between 2004 and 2018.
Large Canadian funds in particular outperformed in all measures of the study, which analyzed returns, asset allocation strategies, and cost structures. The authors defined large funds as those managing more than $10 billion in assets in 2018.
“Not only did they generate greater returns for each unit of volatility risk, but they also did a superior job hedging their pension liability risks,” the authors wrote. “The ability to deliver both high return performance and insurance against liability risks is notable because hedging is typically perceived as a cost.”
While the Canadian model has yet to be fully tested by the Covid-19 pandemic, the researchers said the strong performance of the country’s pension plans over the past decades kept them well-funded even as they faced the challenge of falling interest rates and rising life expectancy. U.S. corporate funds, meanwhile, are relatively expensive to run as they outsource a majority of their investments, according to the paper.
On average, Canadian pensions manage 52 percent of their assets in-house, compared with 23 percent for funds outside the country, the McGill and CEM researchers found. The gap was even wider for very large funds overseeing more than $50 billion of assets, with Canadian pensions managing 80 percent internally versus 34 percent for their global peers.
“We estimate that, by managing a high proportion of their assets in-house, Canadian funds reduce costs by approximately one third,” the researchers said. “Moving the investment team in-house requires independent corporate governance and competitive compensation schemes to attract and retain talent.”
Another distinctive feature of large Canadian funds is the “re-deployment of resources to investment teams for each asset class,” according to the paper. While spending less on external managers, Canada’s funds outspend peers on their internally-managed portfolios, the researchers found.
“These patterns hold true within each asset class and style,” they said. “Examples of expenses include risk management units and IT infrastructure where Canadian funds spend more than their peers by a factor of 5.”
Large funds in Canada also stand out for allocating capital to assets that increase the efficiency of their portfolios and hedge against liability risks, according to the researchers. They pointed to commodity-producer stocks, real estate, and infrastructure, saying the savings reaped from in-house asset management allows the funds to invest more in real assets. Although real assets tend to be more expensive to manage than stocks and bonds, Canadian funds allocate 18 percent of their portfolios to this area — or double the allocation of their global peers, according to the paper.
In another distinction, the researchers said large Canadian pensions index their liabilities, making it easier “to hedge against their liability risks by owning a diversified mix of growth assets.”
A high proportion of their pension liabilities is indexed to inflation, driving strong asset-liability performance, according to the paper. “Indexed liabilities tend to correlate more with growth assets than nominal liabilities,” setting the funds up to invest in growth assets that strengthen both return performance and liability hedging, the authors explained.
Adopting the Canadian model could pay off in the U.S., the researchers found.
In doing so, U.S. public funds would have seen a 15 percent absolute increase in the 15-year Sharpe ratio of their asset portfolios, a 13 percent rise in the 15-year Sharpe ratio of the asset-liability portfolio, and a 20 percent increase in the correlation between assets and liabilities, according to the paper. “These estimates do not include any additional performance resulting from the Canadian funds’ decision to spend more in each asset class,” the researchers said.
Their back-testing similarly found that corporate funds in the U.S. would benefit from Canada’s approach to pension investing.
“For U.S. corporate funds, which already hedge a high proportion of their liability risks, the adoption of the Canadian model would have also led to increases in all performance metrics,” the authors wrote, “but mostly in the Sharpe ratios through the reduction of costs associated with in-house management.”
Take the time to read this academic paper here, it's very well researched and well written.
This article came out a couple of weeks ago right when I took some time off blogging, but I posted in on LinkedIn and it was read by over 11,000 people and received 94 likes, mostly from employees at Canadian pensions.
I must admit, this research paper was long overdue, but I can't say the findings surprised me.
I've long known Canadian pensions are the best in the world based on some very simple principles:
- They got the governance right. They are run like businesses with independent boards and have zero or extremely limited government interference (none whatsoever in their day-to-day operations). This ensures the pensions are run solely in the best interests of their contributors and beneficiaries.
- They got the compensation right. Canadian pensions pay their employees very competitive compensation based on long-term returns (four or five year annualized returns over benchmark). This allows them to internalize asset management across public and private markets, significantly lowering costs which explains long-term outperformance. The article above is right, Canada's large pensions manage roughly 80% of their assets in-house as opposed to farming them out to asset managers and getting clobbered on fees (which add up fast and detract from long-term performance, the same way mutual fund fees in Canada can eat away up to a third of your RRSP gains over a 30-year period).
- They got the risk-sharing right. Canada's pension plans, especially the large successful ones which manage assets and liabilities, are jointly-sponsored plans where public-sector employees and provincial governments contribute an equal amount to the plan and have an equal say. Moreover, the risk of the plan is shared equally among retired and active members. Typically this happens through conditional inflation protection where indexation is partially or fully removed for a period when the plan is underfunded and restored retroactively once the plan achieves fully funded status again. Conditional inflation protection is an important lever to maintain fully funded status especially for mature plans where the ratio of retired to active members is 1 to 1 or higher. This effectively ensures inter-generational equity and it's much easier for retired members to temporarily shoulder a small reduction in benefits for a period as opposed to drastically increase the contributions for active members.
These are the main factors behind the long-term success of Canada's top pensions.
Here, I will focus on the top pensions because they are the ones which set the bar for other Canadian pensions and even global peers.
Now, getting back to the academic study, it clearly states the following in the introduction:
"We first examine the large funds and show that, between 2004and 2018, Canadian funds outperformed their peers on all fronts. Not only did they generate greater returns for each unit of volatility risk, but they also did a superior job hedging their pension liability risks. The ability to deliver both high return performance and insurance against liability risks is notable because hedging is typically perceived as a cost. Our results are in line with Ambachtsheer (2017a, 2017b) who finds that Canadian funds outperformed non-Canadian funds on a risk-adjusted basis from 2006 to 2015."
A couple of comments here which are critically important. First, since 2006, Canada's large pensions have diversified away from Canada to buy more public equities in the US, Europe, Asia and emerging markets.
Second and more importantly, since 2006, there has been a concerted effort to diversify away from public equities into private market assets all over the world. These include private equities, real estate, infrastructure, natural resources and private debt which is a hot asset class lately as the world goes ZIRP.
There were particularly sizable and important shifts into real estate and infrastructure assets all over the world and this is important because these asserts have a very long investment horizon and are a better match for their long-dated liabilities (which typically go out 75+ years).
Canada's large pensions also use leverage very judiciously and intelligently to take advantage of opportunities across public and private markets when they arise. In fact, many rightly argue that leverage is a cornerstone of the Canada model (it's not but it is an important factor).
But I would argue the main reason Canada's large pensions have delivered superior risk-adjusted returns from 2006 onward is because of the proportion of their assets in private markets.
The diagram below was taken from CPP Investments' fiscal 2020 highlights:
As shown, 21% of assets are now in Emerging Markets and 79% in Developed Markets.
More importantly, 25% of the total assets are in Private Equity, 11% in Real Estate and 9% in Infrastructure. Add Other Real Assets (4%) and Private Debt which is part of the 12% allocation to Credit and you easily have over 50% of total assets in private markets.
Now, by their very nature, private markets aren't marked to market, so they aren't as volatile as stocks and bonds which explains the better risk-adjusted returns as they are marked once or twice a year.
But critically important is private markets tend to outperform stocks when the market is getting hit (because they aren't marked to market) and they offer important inefficiencies which aren't available in public markets, inefficiencies which the partners of these large pensions exploit.
What this means is large Canadian pensions tend to underperform their benchmark when public equities are in a roaring bull market and outperform during bear markets.
And over the long run, this adds up, which is why Canada's large pensions have outperformed their global peers over the long run, especially on a risk-adjusted basis.
This all begs the question, if Canada has the world's best pensions, why doesn't Canada have the world's best pension system?
The answer, my dear readers, is simple, only the few lucky employees in Canada's public sector get gold-plated defined-benefit plans, the rest of the schmucks in the private sector get to invest in crappy, high fee mutual funds the big banks are peddling to unsuspecting clients.
In other words, unlike The Netherlands, Denmark, Australia and Sweden, all of which have great pensions too, our coverage is woefully inadequate here and even though this is changing ever so slowly, it represents the biggest obstacle as to why Canada doesn't have the world's best pension system.
Now, the article at the top of this post also states that the researchers found adopting the Canadian model could pay off in the US.
Interestingly, Clive Lipshitz and Ingo Walter recently wrote an article for Institutional Investor stating America’s public pension challenges can be Fixed and Canada is proof:
There are about 5,300 public pension funds in the U.S. today, overseeing some $4 trillion in assets. The 25 largest account for more than half the total. The rest of the market is highly fragmented, with thousands of public pension portfolios managed independently and locally. Fragmentation results in less efficient portfolios and higher operating costs, potentially leading to lower net returns and ultimately a greater funding burden on taxpayers. Especially given the impact of Covid-19 on public finances, there must be a better way.
In a comparative study of the largest U.S. and Canadian public pension plans, we explored pension reform in Canada in the late 1980s and 1990s. Prior to those reforms, Canadian policymakers worried about the integrity of the country’s public pension system. Decades later, the system is considered among the best in the world. Our data show that on almost all metrics the Canadians outperform their U.S. peers, so the Canadian experience offers some useful lessons for reforming the American public pension system.
One of the key lessons is that scale matters, and there are ways to achieve scale even for smaller pension funds through the pooling of assets. We call this the consortium model of pension system design.
Larger pension pools allow for staffing investment teams that exceed critical mass and for designing and developing portfolios that are diversified across asset classes and markets. Significant market footprint also helps pension managers effectively engage with asset managers to obtain access to co-investments and reduced fees for larger fund commitments.
On the other hand, we know that scale tends to dissipate at extreme size. Some institutional investors are so large that they cannot make allocations to higher-performing strategies that move the needle in the portfolio, while concentrated positions might move prices against them. Norway’s sovereign wealth fund and Japan’s government pension fund are well known examples.
But there is a sweet spot – perhaps between $50 billion and $250 billion in AUM. In the U.S., about twenty public pension funds cross the lower threshold; in Canada, a handful do. The California Public Employees’ Retirement System and Canada Pension Plan exceed the upper bound.
Another feature of the Canadian public pension system is in-house investment management. This originated in Québec and became prevalent in Ontario in the 1990s. Over the years, the Toronto-based pension funds have become among the most sophisticated in the world. When Canada’s smaller provinces and its federal pension system underwent reform, they adopted key lessons from Ontario. Along the way, they developed the consortium model, one that also prevails in some European markets.
Formed as units of Canadian federal and provincial finance departments, investment organizations managing combined portfolios of pension plans and other government assets came into being. These include the British Columbia Investment Management Corporation, Public Sector Pension Investment Board, and Alberta Investment Management Corporation. More recently, the Investment Management Corporation of Ontario was formed for the purpose of serving smaller Ontario pension plans, while CAAT Pension evolved from serving Ontario colleges to serve smaller pension funds across the country. Preceding all of these was Caisse de dépôt et placement du Québec. Other than CAAT, each is a public sector entity operating at arms-length from government and overseen by representatives of its largest clients. The model continues to evolve, and has recently been considered in Manitoba.
Might the consortium model be adopted in the United States? To some degree, it already has been. The Massachusetts Pension Reserves Investment Management Board is an investment office for the entire Commonwealth. Pennsylvania and Illinois are considering similar approaches.
We believe the consortium model is well worth wider consideration. There are hundreds of mid-size and thousands of small U.S. public pension plans. Investing the portfolios of each of these independently is inefficient.
How might such entities be structured? States – or groups of smaller states – could establish investment units to manage the portfolios of consortia of pension plans. These would operate at arms-length from government, while being held to fiduciary standards set by their clients. Smaller pension funds might pool assets and establish mutually owned cooperatives to invest on their behalf. They might even collectively engage investment management firms using the scale of their aggregate AUM. Full customization would be traded for greater portfolio diversification, access to otherwise inaccessible strategies, and better control over expenses.
State and local governments are searching for innovative ideas to fortify their finances given the impact of Covid-19. The consortium model is attractive because it enhances market efficiency. The Canadian examples provide good case studies.
I had a chance to chat with Clive Lipshitz during my break and think his paper which he co-authored with Ingo Walter is important.
One thing that struck me in our conversation, public sector employees in the US don't contribute as much to their plan as the ones in Canada and Clive suggested this is because of powerful public sector unions down south. This is a glaring structural problem that needs to be addressed.
But I didn't agree with everything he stated. For example, I don't buy that "sweet spot" argument of AUM where pensions managing $50 billion to $250 billion outperform the rest.
In fact, CPP Investments which now manages well north of $400 billion CAD is in my opinion the best pension fund in Canada and size hasn't detracted from its long-term performance.
What else? I truly believe there are powerful interests in the US which don't want to see the Canadian model adopted down south. Why? Because public pensions represent an important cash cow for them, a perpetual source of funding. They don't want to see major reforms to public pensions which jeopardize that source of perpetual financing.
Lastly, Martha Porado of Benefits Canada wrote a great article on how Canada's DB pensions have changed over the last ten years:
Whether it’s battling the challenges of plan maturity, increasing longevity, the changing nature of work or difficult financial markets, these so-called golden handcuffs are looking pretty dented in some cases.
But the 10 years following the great financial crisis wasn’t all bad. Many public pension plans, as well as affiliated administrators and investment managers, have been busy making their organizations more efficient and effective, driven by the fundamental belief that providing the guarantee of a retirement income is worth the effort.
“I think it’s always important to come back to why are we doing this, what makes a DB plan so important to the people — in our case, in Ontario — and also to the economy?” says Annesley Wallace, chief pension officer at the Ontario Municipal Employees Retirement System.
While pension organizations are taking varied approaches to boost their long-term viability, growth through consolidation was a common theme throughout the 2010s.
For example, after years of discussion, Queen’s University, the University of Guelph and the University of Toronto formed the University Pension Plan in 2019.
In the same year, major Ontario players like the Colleges of Applied Arts and Technology pension plan and the OPSEU Pension Trust both kicked off new programs to offer DB arrangements to a wide array of employers, introducing DBplus and OPTrust Select, respectively.
While the OMERS isn’t actively searching for new sources of membership growth, it’s also making some consolidations. During the last decade, it folded in four closed City of Toronto plans that had been established before the OMERS existed. “That was a great example of an opportunity for us to do some consolidation where, in some cases, some of those members were even drawing pensions from two different plans because they had an OMERS pension for service [after] the creation of OMERS and then from this other plan,” says Wallace.
The ability to add new plans into the mix is a fundamental part of the design of Saskatchewan’s Public Employees Benefits Agency, says Dave Wild, its associate deputy minister. “We don’t actively go out and seek new business, but we have structured our organization and operated with an eye to being able to add new plans without much disruption, so scalability comes into our design quite a bit. We can add a new plan and it will have its own governance and its own unique benefits structure, investment policies, everything it wants to do by itself. We can add that without being loudly disruptive to our organization.”
Kids these days
The emphasis on consolidation also plays into solutions to the changing nature of work. In 2015, the millennial generation became the largest portion of the Canadian workforce and along with them came a different approach to building a career. “People no longer spend their entire career from graduation to retirement with a single or one or two employers,” says Weldon Cowan, a trustee on British Columbia’s College Pension Board of Trustees.
He suggests that strengthening the presence of multi-employer DB plans in the overall pension landscape could be part of the solution to this trend. “There is an opportunity here to rethink the way DB works in the private sector. It’s difficult for a single employer to support a DB pension plan for just their company. There is a lot of risk with that. There are all sorts of accounting rules that may make it difficult, so the plans within the private sector need to modernize, look at moving to multi-employer plans or sector-wide plans where different companies could work together, potentially move their plans to joint-trusteeship, because it really changes the nature of how the plan is administered.”
And as multi-employer plans grow, so does the likelihood that plan members will change employers and still end up covered by their previous plan, says Derek Dobson, the CAAT’s chief executive officer and plan manager. The CAAT, in particular, has made special efforts to help members stay put. “We have 76 employers in the plan and sometimes people move between contracts for six months, so they’re out of work for six months. Rather than force them [to choose], ‘Do I take a commuted value? Do I take a deferred pension?’ we leveraged the [Pension Benefits Act] rules; we have an extension of membership so members don’t have to do anything for two full years and if they find another job with any of those 76 employers, they have time to think about it. Because when you lose your job, it’s probably not the right time to be making a decision of, ‘Do I want to manage my money forever or do I want to leave it with CAAT?’”
Grandparents these days
But for plan members closer to retirement, pension plans have to take longer life expectancies into account and that’s caused some sponsors to make some design changes, says Cowan. “Over the last decade, the plans have modernized themselves, changed their plan design to address shifts that have occurred in life expectancy, in employment patterns, peoples’ choices about retirement age. Essentially, if you would have looked at the plan designs 10 years ago, they were effectively the plan designs created in the 1960s with the rise of the [Canada Pension Plan], with some public policy elements baked in, like supporting early retirement, with strong early retirement incentives integrating with the CPP.”
In 2016, the B.C. College Pension Plan was the first of the province’s public plans to de-integrate from the CPP, establishing a flat accrual rate and significantly reducing early retirement incentives to make the early retirement reduction factors more actuarially correct, he says. The B.C. Teachers’ Pension Plan and the B.C. Public Service Pension Plan followed soon after. While early retirement becomes the goal for fewer and fewer plan members, moving away from incentives to do so also makes the plan more affordable, adds Cowan.
Saw it on the ‘gram
At the beginning of the 2010s, social media was just beginning its meteoric rise in popularity. Instagram started the decade with 15 million active users and ended it with more than a billion, half of whom use the app daily. And while the average influencer isn’t raving to followers about their pension contribution rate, effective digital communication is all about getting a message in front of its intended audience.
“We’ve started to communicate more via social media channels,” says Wallace. “We’re on Facebook and LinkedIn and, in the last six months, we launched Instagram because we have almost 100,000 members between the ages of 19 and 36 and we want to be where they are. So our Instagram account really showcases the people of OMERS, including our members and our employees.”
The prevalence of digital communications also makes it easier for pension plans to contact members who may otherwise fall through the cracks and become unreachable, she notes. And, while the OMERS doesn’t have email addresses for all of its 500,000 members, it’s aiming to close the gap. “That’s a big effort for us, trying to fill in those missing pieces so all members are able to elect to receive electronic communications. We currently have about 135,000 members who’ve elected to go paperless, which is great and we would like to see that number go even higher if we could.”
The OMERS’ members can also be more autonomous in their retirement by using digital tools. “They can now go into the member portal and actually see updates through the transaction process as opposed to having to call in and say, ‘Can someone check on the status of my transaction?’” says Wallace.
Enabling and emphasizing this type of self-service for plan members has to go hand in hand with efforts to ensure they’re able to make informed decisions, says Wild. Whether it’s providing direct information, tools or access to financial counselling, the PEBA’s aim is to reach a higher level of engagement.
“We’ve had, for several years, certified financial planners as part of our service offering. We have them on staff to do that education and counselling for our plan members. So that’s been a real drive over the last decade to put members in a better position to understand their plan and to make good decisions.”
Continuity and coronavirus
The digitization of the communication process over the last 10 years has also helped pension plans continue their normal, daily operations in the wake of the coronavirus pandemic, says Cowan. “The [B.C. Pension Corp.] has roughly 400 employees. They’ve been able to get over 350 employees to work from home and continue doing their job in a secure fashion, which means much fewer employees are having to go to the worksite.”
That digitization also means employees who planned to retire in 2020 can still do so without interruption, he adds. “That would have been impossible if this event had occurred nine years ago. Everything would have ground to a halt. So it’s been a very smart move; this has been an excellent test of whether we can cope with a crisis.”
Wallace agrees, noting the implementation of tools like secure messaging just happened to coincide with a crisis where the tools became critical to business continuity. “The emphasis we’ve placed over the last two years on digital transformation and some of the things we’ve implemented like secure messaging, we never would have appreciated at the time, but we now realize how important all of those things actually are to our being able to continue to deliver service.
“We’ve seen some of the highest sign-up rates for our webinars over the last couple of days just around people interested in getting more information and likely having the time to do that. So I think we’re fortunate from an administration perspective that we are able to continue to operate and ensure that every pensioner is getting their pension cheque every month and that we are processing all of the other types of transactions that we would do on a regular basis.”
A crisis like the coronavirus pandemic emphasizes the need for pension committees and boards to always be looking around the corner for the next problem, says Joseph De Dominicis, senior vice-president for group retirement solutions at People Corp. He recalls one plan he worked with that periodically bought annuities to cover off the inactive portfolios of its member population whenever the opportunity arose.
“They were able to go back to the board every year and say, ‘Look, we know all of our competitors have gone [defined contribution]. We believe in DB and here are the steps we’ve taken to make sure it never becomes a driver of our business decisions.’ And they did that by removing liabilities from the balance sheet at opportune times; when they had the funding available and when the annuity market was primed for purchase. And I thought that was a very astute strategy.”
The temptation for DB plans to take advantage of achieving a funding surplus — by taking a contribution holiday, for instance — is very real, he says. “And then, invariably, you get a shock like we have now and all that goes away.”
Adapt or die
A decade ago, the last major financial crisis shook some pension plans into realizing they needed to regroup and revaluate whether their current systems could survive market shakeups.
New Brunswick took on this challenge by becoming the first province to allow a target-benefit or shared-risk approach, says John Sinclair, president and chief executive officer of Vestcor Corp. “I think it was helpful to be able to focus on the specific missions of these various target-benefit plans that we provide services for with unique opportunities as well. And when we find ourselves in an uncertain or volatile period, my expectation is these plans will hold up a lot better — first of all, from a more risk averse investment policy, but also having the ability, if needed in the future, to potentially have to defer indexing for short periods of time. Having that flexibility certainly is more helpful for the long-term sustainability of the pension plan.”
For some, the current crisis feels like an echo of the last historic market downturn, says Chris Brown, president and chief executive officer of Alberta’s Local Authorities Pension Plan Corp. But plans that shelter members from a number of sources are all the more significant in their ability to maintain their promises to pensioners in hard times, he adds.
“The pandemic and the resulting economic crisis really has the potential to be a tragedy that will almost undoubtedly bring on hard times for a great number of people. Plans like ours and others in the country, we have this Canadian model that is so well-respected around the world. And we have an opportunity, and perhaps even an obligation, to look at what we can do to help people who aren’t in our plans.”
You can download a PDF file of the 2020 Top 100 Pension Funds Report here.
The purpose of this post was to give you a glimpse as to why Canada has the world's best pensions.
What else does Canada have? The world's best pension blogger, someone who works tirelessly to bring you the most up-to-date and relevant content on pensions and investments.
Let me remind all of you that this blog runs on donations, is fully transparent, fair and balanced and relies on the generosity of supporters who take the time to donate via PayPal on the top left-hand side under my picture. Just because it's free, it doesn't mean you can't show your appreciation.
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Below, Mark Machin, President and CEO of CPP Investments, discusses who invests in the Canada Pension Plan, why CPP Investments was created and a lot more (see all clips on CPP Investments' YouTube channel here). Watch these clips and you'll understand why Canada has the word's best pensions.
Update: Bernard Dussault, Canada's former (former) Chief Actuary, shared his general thoughts with me after reading this post:
I think that Canada has the best in the world public pension system because although there is more coverage under the Netherlands, Denmark, Australia and Sweden programs, none of these is as well financed at the Canadian system.
And anyway I find that the level of the Canadian coverage is just OK.
I thank Bernard for sharing his thoughts and he's right, our pension system is much better financed than anywhere in the world.