"Canada’s pension funds: stronger returns, at a cost" (G&M April 5, 2010)

By Guest Contributors on April 22, 2010

This Globe and Mail article  speaks to how the performance of Canada’s public pension funds are significantly outperforming their peers in the US. The article caused us some discomfort – readers are misled by the lack of background information about the investment environment in which these funds operate and spends considerable time focused on the cost of internal versus external management. We would suggest the advantage is more about alignment, as opposed to cost savings, and offer the following comments in response.

1. The article says that big public sector pension funds in Canada are outperforming their US peers

This is not really true. The market returns in which these plans invest are very different. The article refers to the 10 year return for Canadian public plans to be 5.5% versus US plans at 3.2% (USD) and draws the conclusion that Canadian plans are doing a better investing job than their US counterparts. Meanwhile, the 10 yr TSX return to Dec 31/09 was 5.6% while the 10 year Cdn DEX bond return was 6.7%. In comparison, the 10 yr SP500 return -1.0% and the 10 yr US  bond return 6.4% (USD).

If we assumed the plans were both invested in a 50/50 benchmark mix between local equity and bond markets, the combined benchmark Canadian returns would be 6.2% & US benchmark returns 2.7%. Comparatively, according to eVestment Alliance, the Canadian Balanced Benchmark during the same period was 5.3% while the US Balanced Benchmark was -0.5% Cdn or apprx 2.8% USD. Our proxy mix, therefore, seems reasonably accurate.

Therefore, using a proper comparison, the Canadian plans underperformed our proxy 50/50 benchmark by 0.7% over the 10 year period%. The US plans outperformed the 50/50 benchmark by 0.5% over the same period. This is a more appropriate comparison and is clearly shows the fallicy of measuring US and Canadian plans on a gross performance basis rather than within their current market environments.

2. Internal management teams cut costs compared to external managers

While this may be true to some extent, it is not a fair comparison. With the size of assets managed by the large public sector plans, active equity investment models will hold a large number of securities and provide, at a maximum, limited added value to the overall public markets. However, by internalizing alternative asset investments (hedge funds), private equity, and real estate investing the public plans can reduce costs. Those are the areas where outside managers charge “hefty” fees (to use the Globe’s term).

The Globe reference to the poor governance model previously in place at AIMCO is indicative of a move to provide better governance and transparency to public plans.  Mr. de Bever’s move to internalize investment management will improve the overall efficiency of investing (they continue to invest with 50 external managers according to the article) and will move a variable cost (external managers charge fees as a percentage of assets under management) to a fixed cost. But there is no evidence that this internalization will lead to better returns.

3. Internal managers more aligned to the mission of the pension fund

This is one statement the Globe makes which is completely true. Internal management allows for a deeper perspective on market conditions and produces a formalized approach to asset allocation which is geared to the needs and requirements of the plan itself.

This alignment between plan and investing provides better risk mitigation. With all of the assets managed internally, as well as understanding the liability funding requirements, those responsible for fiduciary oversight are given the ability to make an objective allocation to markets. Allocating investments externally to a broad array of managers complicates the internal allocation process as managers are loathe to recommend a reduction in their asset allocation (thereby reducing income).

Internal management allows for modeling to fit liability streams. For example, despite the illiquidity of infrastructure investing, being aligned with the plan liquidity requirements short and long term allows for optimal infrastructure investing as an income replacement.

Hopefully we’ve added a little more detail and clarity to the Globe and Mail article. Fiduciaries of organizations attempting to manage capital pools throughout Canada are struggling with oversight complexity regardless of whether they are public or private. To focus on the cost differential of internalizing management is misleading – the real strength surrounds aligning the goals of the capital pool with the investments in a transparent and disciplined fashion. This can certainly be accomplished through the use of external managers as well.

See Beyond

Receive Market Commentary + Stewardship Insights.