Why Canada’s Pension Plans Are in Such Good Shape

Art bt Pete Ryan

In a post-financial crisis world, many US public pension plans are finally beginning to see a light at the end of the tunnel, but others are still at their wit’s end on how to crawl out of their obligatory holes.

Canada, on the other hand, is doing just fine.

With most of its pension plans at either fully funded status or close to it, Canadians have achieved a balance that the US has only seen in the corporate sector. In fact, some Canadian plans, such as the Colleges of Applied Arts and Technology ($8.3 billion) and the Healthcare of Ontario Pension Plan ($59.9 billion) have become overfunded.

Eight Canadian pension funds ranked in the top 100 global funds by size in a 2015 Boston Consulting Group study titled “Investing for Canada on the World Stage.” Three were in the top 20.

This begs the question: What do Canadian pension systems do that those in the US don’t?

GOVERNANCE, LOW RISK AND ASSET DIVERSITY

One key element of what asset owners call the “Canadian model” is independent governance. Public US plans typically go through legislatures and governors’ offices  to make changes. That brings a layer of politics into the picture. Canadian plans instead follow a structure free of government intervention, only having to go through their boards.

This is key, Jeff Wendling, senior vice president and chief investment officer, equity investments, of the Ontario healthcare plan, told CIO. “One is this independent governance idea, so you don’t have political bodies or agencies getting involved in how the assets are managed, or when contributions are made, or use of surplus, or all of those kinds of things.”

Result: Canadian funds can make faster investment decisions.

Another element is a more risk-aversive portfolio. Many US plans tend to focus on adding risk by investing in public equities or hedge funds. But Canadian pensions look to de-risk, making safer bets on bonds, private equity, and infrastructure. Many of these assets are also eco-friendly.

“There’s a lot of asset class diversification. There’s a lot of geographic diversification. Canadian funds are looking for opportunities—and a lot of that has been going on for quite some time, so I think that’s part of the story as well,” Wendling said. “Most of these plans here don’t just use private equity funds, they also have direct private equity investing capabilities in house and also real estate.”

Also important: They keep the costs down by avoiding outside managers, preferring to handle their money in-house.

ORIGINS

Despite the Canadian model’s success, it is relatively new. The pension concept began in the late 1980s and developed throughout the 1990s.

Before that, most Canadian pension plans were invested mostly or completely in domestic government bonds and were generally funded on a pay-as-you go basis. Plus, the public plans did not have independent governance. Muted investment returns, lack of future planning, and too much political influence was not an ideal mix. A 2017 report by Common Wealth and the World Bank Group on the model’s history called that approach an “error-prone fashion.”

Fears that the pension plans would fall short of meeting their obligations kicked off the reforms in 1987, leading to the creation of the Ontario Teachers’ Pension Plan as an independent institution.

To start, the government commissioned three reports on public pension structure, which agreed that Canadian public pension plans should move from the pay-as-you-go structure to a fully funded pension financing model. One suggested stakeholder consensus to develop reforms that would give the plans joint trusteeship and governance, joint sharing of risks and rewards between plan members and the government, investment of the plans’ funds in the market, and arms-length organizations that would operate independently of government. These and other changes were made over the next several years.

The Ontario Teachers’ Pension Plan, the king of the Canadian pension world, now controls nearly $200 billion in net assets, boasts a fully funded status, and has returned double digits every year since 1990.

Not all the pension programs did well at the outset, though. The 1990s saw another slew of reforms to the new structure following the  growing instability of the Canada Pension Plan, a contributory earnings-based social insurance program. The fund’s reserves were nearly depleted and its investments had been restricted to nonmarketable federal and provincial government debt. In 1995, Canada’s chief actuary issued a report on its perilous situation that was a call to arms. Otherwise, the fund may have perished. 

The mid-1990s reforms raised the Canada Pension Plan’s contribution rates and reduced benefits, but also created the Canadian Pension Plan Investment Board (CPPIB), an agency tasked with handling the floundering plan’s assets. The founding legislation kept the board’s framework intact, splitting oversight between the federal government and provincial governments, a board with government-appointed directors as recommended by the minister of finance.

The investment board was also given a single mandate to maximize long-term task-adjusted returns on the pension plan’s assets. And the board was also required to produce accountability and transparency measures, which included regular public reporting. In the beginning, regulation restricted the board to passive investments in domestic equities, but this was soon nixed by the government following the organization’s inception.  

The organization currently manages $317 billion in assets.

Over the next decade, other Canadian plans would adopt these rules, leading to an abundance of healthy pensions for retirees.

US ADOPTION 

For US plans to get their funding levels up to snuff, Derek Dobson, CEO of the 118% funded Ontario-based Colleges of Applied Arts and Technology pension, suggests they begin with “overall inroad steps,” such as setting funding goals, getting all plan sponsors, taxpayers, employers, and members aligned with them, and then becoming “ruthless” in making sure “all of your key decisions point to the direction of making those goals happen.”

Dobson also said a “risk appetite statement” (the amount and type of risk an organization is willing to take to hit its targets) is needed to drive those funding goals. To meet the risk appetite, he said that transparency and trust in the boardroom table are “necessary components” to building it.

Oftentimes US plans will struggle with external management fees, but still continue to outsource fiduciary roles. While this does benefit some plans, Canadian plans are more partial to keeping everything in-house. This cuts costs, and also eliminates performance-based agendas outside managers may have.

“If you look at it from a cost perspective, there’s a business case to be made that if some of the large US plans move to an internal pension model, the actual cost or net returns would be higher, all things equal,” said Dobson. Yet controlling that expense is the real challenge, he said.

Wendling, the Healthcare of Ontario Pension Plan’s CIO, said this low-cost structure also helps with risk management because “almost everything is in-house now, so you can really understand your risks and where they lie, I think, much better than if you’ve got a lot of external managers or even hedge funds, where it sometimes even opaque in terms of what the risks really are.”

To bring things in-house, Wendling said plans need a scale as well as the ability to properly compensate their internal talent, an issue he said hits US public plans. “It’s hard to do if all of your investment management is outsourced,” said Wendling.

One US fund that is taking Wendling and Dobson’s advice and putting its own spin on things is the $147 billion Teacher’s Retirement System of Texas. CIO Jerry Albright’s “Building the Fleet” strategy started a decade ago. Now that it has the money to stay afloat, Albright is looking to cut costs as he gradually brings more internal staff to the fund’s investment division to create what he calls the “Texas Model.”

Also Canadian at heart are the classes Albright sees as the most ripe with opportunity. The Texas Teachers’ CIO is looking at private equity, energy, and natural resources allocations as well as watching the fund’s real estate portfolio.

“As we grow to $200 billion we need to maintain that level of real estate transactions and the real estate portfolio turns over quite frequently, so you have to be out there to replace the transactions that turn over,” Albright told CIO.

The fund also has an opportunistic portfolio that sits outside of the private markets team, which picks up assets that don’t quite fit the private bill.

Albright also has other plans for the Texas model that are not typically Canadian, such as looking for “additional authority in the future” where Texas Teachers’ could directly own businesses.  “We could say…own subsidiaries that would have operating companies that would operate effectively directly,” he said.

Another American pension fund seeking to adopt Canadian elements is the $349 billion California Public Employee Retirement System (CalPERS), through its $13 billion CalPERS Direct initiative. The fund will set up two internal funds that will manage leveraged buyouts, cutting private equity management costs.

Despite changing times, pressures, and circumstances, Dobson warned CIOs that once they adopt Canadian measures, they should not stray from their strategies as plans have gotten into “real big trouble” by changing their objectives annually, losing massive amounts of credibility and assets losses as they move to “the flavor of the day.”

“Once you have those goals,” Dobson said, “I think everything else will follow from that.”