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Pension plan pins prospects on market
A massive overhaul of the CPP will create a fund with one of
Canada's biggest pools of investment capital. Ottawa hopes that
a newly acquired taste for stocks will keep premiums in check.
Saturday, April 11, 1998
By Shawn Mccarthy and Rob Carrick
Ottawa -- ACCOMPANYING STORYLINE ON B6
IT'S one of the biggest financial reforms in a generation -- affecting every working Canadian who is planning, or at least hoping, to rely on the Canada Pension Plan in retirement.
The CPP, that godchild of 1960s liberalism, is about to become a disciple of 1990s capitalism -- bull market style.
In the coming weeks, Finance Minister Paul Martin will name 12 Canadians to the board of the fledgling CPP Investment Board. Their job will be to ensure that the growing CPP fund takes full advantage of the best returns that financial markets, especially the stock market, have to offer.
It's all part of a massive overhaul of the CPP agreed to by Ottawa and the provinces in early 1997 and passed into law last December.
The reform will create a financial giant -- a new, public pension fund that will become one of the biggest pools of investment capital in the country, with projected assets in 10 years of as much as $76-billion.
Faced with the daunting demographic challenges of an aging baby-boom generation and lack of real income growth, Canadians -- younger ones in particular -- are skeptical about whether the CPP will be around for their own retirement.
And they have had reason to worry. Pension specialists say that without the reforms, the CPP was headed toward trouble -- by 2015 there would have been insufficient funds to pay out benefits -- because of a relatively smaller base of workers available to pay for the pensions of a growing coterie of seniors.
"I think [the reforms] should have been more drastic," said Lisa Richinger, a 29-year-old government worker in Yellowknife. "I hope it's enough. I hope that during the next 30 years it can cover all those who are using it and have something left for us."
The action by Ottawa and the provinces in moving to shore up the CPP focused on raising premiums more quickly than planned.
But just as important was the decision to take the CPP fund out of the hands of government and invest it just as individuals do with their registered retirement savings plans.
"A higher return on investment was regarded as a solution, or a partial solution, to the dilemma of not wanting to cut benefits and not wanting to raise premiums," Mr. Martin said in an interview. "That was by far the dominant factor," he added, in opting for a market-based investment policy.
Canada isn't acting alone. The U.S. government is considering similar reforms to address looming problems with its Social Security system, which mirrors the CPP's troubles. In a speech this week, for example, President Bill Clinton said Washington has to act now to shore up the U.S. retirement system before the postwar baby-boom generation begins to retire.
Many experts there also see the market as a partial solution -- either having a portion of the payroll taxes directed into individual retirement accounts, or by having the Social Security system itself invest in the stock market.
In Canada this year, about 3.6 million retired or disabled people receive a monthly CPP cheque, with the maximum retirement benefit of $744.79. Under the federal-provincial deal, those benefits will continue and will keep pace with inflation, but for future claimants, the rules will be somewhat tighter, particularly for disability claims.
The finance ministers also agreed to accelerate the planned increase in CPP premiums, raising them from 5.8 per cent of insurable earnings in 1996 to 9.9 per cent by 2003 -- and then capping them. (Premiums are split evenly between employees and employers; the maximum employee contribution last year was $945.)
The increase in premiums will create a growing CPP investment fund. The pot, however, will increase slowly at first as growth in the cost of benefits offsets early premium increases.
Until now, the relatively small CPP fund -- representing about two years worth of benefits or $36-billion this year -- was lent to the provinces at slightly below-market interest rates.
With such a small fund, the investment policy made little difference to the financial health of the CPP, which relied almost exclusively on the earnings of current workers to pay benefits to those above 65, disabled workers, and spouses and children of deceased CPP contributors.
Even under the new system, the CPP will largely remain a pay-as-you-go system, relying heavily on the rising incomes of current workers to cover the increasing cost of benefits for retirees.
But as the fund grows to the equivalent of nearly five years worth of benefits by 2017, the return on investment of that nest egg will become increasingly important.
Ottawa's chief actuary, Bernard Dussault -- who periodically reviews the financial soundness of the plan -- has calculated that the combination of a growing fund and the new investment policy should shave 1.5 percentage points off the premium rate needed to keep the CPP on a sound footing. That's what kept it down to 9.9 per cent -- a big increase from what it is now, but less than it would have been otherwise.
And that's why there was little debate among federal and provincial ministers about whether to invest the growing CPP assets in financial markets.
The ministers -- backed by Mr. Dussault -- forecast that the CPP fund will earn 4 per cent a year after inflation, substantially better than the 2.5-per-cent return projected under the old system.
In fact, while the 4-per-cent expectation is in line with the returns of private pension plans over the past 30 years, virtually all have done much better in the past decade.
Should the healthy returns continue, governments could find themselves with a happy choice to make.
"It is quite conceivable that down the road, future governments will have the opportunity of cutting premiums or increasing benefits," Mr. Martin said.
Of course, the reverse is also true. Should a lengthy bear market result in poor returns, Canadians may once again face higher premiums or lower benefits.
BELOW are some of the key issues facing the new CPP Investment Board as it begins operations this spring with the expectation that it will begin investing payroll deductions early next year.
A search committee, headed by Michael Phelps, the chief executive officer of Vancouver-based Westcoast Energy, is due to hand a list of potential directors to Mr. Martin within days. The federal minister will then confer with his provincial colleagues before naming a board that likely will combine members appointed for their financial acumen with those appointed to reflect the diversity of the country.
The directors' first task will be to hire a top-notch CEO, likely by luring a senior investment officer from one of the country's giant pension funds. It will also need to find office space, likely in Toronto's financial district.
One of the CPP board's first key tasks will be to set an asset mix, much like individual investors do for their RRSPs. Common practice in the pension industry these days is to have a mix of about 60 per cent in stocks and 40 per cent in fixed income, such as corporate and government bonds. It is common practice to also keep a small cash holding.
Some funds invest as much as 75 per cent of their money in stocks and, indeed, some pension funds that have traditionally held lower equity allocations have chosen lately to load up on stocks.
The giant Quebec pension fund Caisse de d‚p“t et placement du Qu‚bec announced this week that it will raise its ceiling for equities to 70 per cent from the current 40. As well, the Ontario Municipal Employees Retirement Board (OMERS) amended its asset mix last month to allow its equity holdings to range between 55 and 65 per cent.
Some big funds also invest in real estate and provide venture capital for business startups, but the CPP Investment Board will likely stick to stocks, bonds and cash.
There is some fear that a CPP behemoth will disrupt Canadian equity markets by buying so much stock that it creates an artificial bubble in equity prices that will ultimately lead to lower returns.
But, according to a recent study by analyst Michael Cohen of William M. Mercer Ltd., this fear may be overblown. He found that the value of new stock offerings on the Toronto Stock Exchange ranged between $6-billion and $25-billion annually since 1991. The CPP fund, at its peak, is expected to invest $3-billion to $4-billion a year in Canadian stocks.
"Clearly, $3-billion to $4-billion is not an insignificant sum, but it is probably one that could be absorbed by the markets without excessive strain," Mr. Cohen wrote.
However, he also cautioned that the fund will have a commanding position in the domestic stock and bond markets and will therefore need to be managed so as not to exert excessive influence.
An obvious way to remove concerns about the CPP fund's impact on the stock market would be to ease or eliminate the requirement that pension funds and RRSPs invest 80 per cent of their assets in Canada.
The investment community has been lobbying Mr. Martin for years to remove the foreign content limit, and both the House of Commons finance committee and the Senate banking committee issued similar recommendations recently.
On the other hand, the Canadian Labour Congress pension experts argue that tax-assisted savings should remain in Canada to help fund domestic economic development, especially since the CPP expects to depend more on a growing economy for its future financial strength than it does on investment returns.
In fact, the CLC argues that the CPP Investment Board should have a dual mandate -- to get a reasonable return but also to contribute to the country's economic development.
Mr. Martin, for his part, has said he's not yet ready to raise the foreign content limit, insisting that, so long as Canada remains a heavily indebted nation, it needs preferred access to tax-assisted investments.
Still, the minister also has signalled that the restriction will be eased in the coming years.
Many in the investment and pension industries expect a higher foreign content limit with the next 12 months. Pension consultant Keith Ambachtsheer, for example, expects the limit to be raised in the next federal budget.
One of the most contentious matters surrounding the CPP Investment Board is a requirement that it invest passively -- in other words, to forget about stock picking and, instead, essentially duplicate the holdings in an index such as the TSE 300 listing of the largest 300 companies on the exchange.
By matching the TSE 300 as it stood at the end of March, the five biggest stocks in the CPP fund would be BCE Inc., Royal Bank of Canada, Northern Telecom Ltd., Canadian Imperial Bank of Commerce and Bank of Montreal.
Indexing, the name given to the practice of matching stock indexes, is a widely accepted investing technique. Many pension funds use it to some degree, as do an increasing number of mutual funds.
But many people believe that the CPP fund will be too elephantine to be a successful indexer. They wonder whether the fund will be able to buy sufficiently large positions in smaller TSE 300 companies, and whether speculators will zero in on the fund's buying and selling activities.
Say a stock was added to the TSE 300, for example, and the CPP fund immediately moved to buy a stake. The price of that stock could be temporarily bumped higher. Likewise, prices could sink if the fund had to dump a stock because it was ejected from the index.
"If you have to sell right away and buy right away, somebody's going to play games with you," said Claude Lamoureux, president and CEO of the $55-billion Ontario Teachers Pension Plan Board.
The rule book for the CPP Investment Board is scheduled for a review in two years. For now, it says the fund must "substantially replicate one or more indexes." Many observers say this instruction appears flexible enough to allow the board to invest effectively without disrupting the market.
It may also be important, in this context, that CPP investment money will flow into the market in stages. The fund will start with $300-million in late 1998 or early 1999, then grow gradually to as much as $76-billion in 2007, when about $8-billion a year in new funds are flowing into the board.
(The provinces have the option of maintaining their current levels of borrowing from the CPP, but at market rates. If they renewed all bonds as they mature, the CPP investment fund would have $57-billion to invest in 2007.)
One advantage of a passively managed fund is that there are lower fixed costs, since there is no need for expensive analysts' and research reports.
However, there may not be savings to be found in terms of trading commissions, the big bonanza for the financial community in the plan to invest the CPP in capital markets. An indexed fund can rack up expensive trading commissions in trying to keep up with changes in the weightings of the various stocks in an index, said Dale Richmond, president and CEO of OMERS.
"There may be more activity trying to keep up to date with the index in a rapidly moving market than there would be stock turnover in an actively managed fund, where you're just going to hold stocks and ride through the peaks and valleys."
Still, there are other points in favour of a passive trading stance.
If the CPP fund is required to duplicate the index, for example, it has the perfect defence against those who might have it invest in one company or another for political and economic development reasons. Indexing provides a shield of impartiality.
Mr. Richmond said this is an important consideration, given that public confidence in the CPP may have been undermined by the former practice of lending cash holdings to the provinces at preferential interest rates.
"There's a feeling when you set up something new that somebody is going to be favoured in the process other than CPP beneficiaries," he said. "So I think that if you want to keep the waters calm as you're setting up, they have done exactly what they should do."
Finance Department officials say passive investing does not necessarily mean the CPP Investment Board will take a neutral position when it comes to voting shares on matters of corporate governance.
However, pension consultant Mr. Ambachtsheer believes that making the CPP a passive investor was done with the intention of making it less threatening as a potential activist shareholder of mammoth size.
"The intent is to signal that this will not be a fund that goes around and dictates how Corporate Canada should be run," said Mr. Ambachtsheer, who was consulted by the Department of Finance in the planning of the CPP Investment Board.
THERE are several giant Canadian pension funds that now ply the stock markets without much commotion. The largest is the caisse with assets of $64-billion at the end of 1997. Ontario Teachers, with $55-billion, is next, followed by OMERS with $31-billion.
All three use some degree of index investing, but consider themselves active managers who are not limited to the traditional asset classes of stocks and bonds.
OMERS, for example, has a $2.5-billion portfolio of office and retail properties that it owns outright or in partnership with companies such as Oxford Properties Group Inc. Ontario Teachers has an investment alliance with the billionaire Bass Brothers of Fort Worth, Tex., who have a reputation for shaking up corporate management to improve shareholder value. The caisse has a $4.5-billion portfolio of venture capital investments.
Clearly, the active approach has its merits. The caisse produced an average annual return of 11.1 per cent over the past decade, while OMERS delivered 10.5 per cent. Ontario Teachers has earned an average 13.8 per cent annually since 1990, the year it was freed from a requirement to stick only to non-marketable Government of Ontario bonds.
Stock market investing is already done by both state-run and privatized pension funds in Japan, Singapore, Malaysia, Sweden, Chile, Argentina and Peru. Switzerland is starting the process. U.S. Social Security trust funds now are invested in special-issue government bonds, but consideration is being given to investing in the stock market.
Having the CPP also invest in financial markets, of course, will be no panacea -- the evidence from countries that have done so already shows results ranging from excellent to poor in terms of returns.
However, the new investment policy is a crucial tool to increase Canadians' confidence in the pension plan, said David Walker, the former Liberal MP who was the point man for Mr. Martin on the CPP reform.
"Canadians would only [support] increased contributions if they had confidence that the money was going to be well invested."
Planning to retire?
Projections
New funds Total funds
flowing to held by
Total CP Investment Investment
assets at Board, Board at
$billion year end annually year end
1998 $36 $0.3 $0.3
1999 36 2.0 2.0
2000 38 3.0 6.0
2001 42 5.0 11.0
2002 48 7.0 20.0
2003 56 8.0 30.0
2004 64 8.0 40.0
2005 73 8.0 51.0
2006 83 8.0 63.0
2007 94 8.0 76.0
**
Schedule of contribution rates
Pre '97 reform Post '97 reform
1992 4.8% -
1997 5.9 6.0%
1998 6.1 6.4
1999 6.4 7.0
2000 6.6 7.8
2001 6.9 8.6
2002 7.1 9.4
2003 7.4 9.9
2004 7.6 9.9
2005 7.9 9.9
2010 8.9 9.9
2015 9.9 9.9
2020 12.3 9.9
2025 13.5 9.9
2030 14.2 9.9
Note: % is payroll deduction split fifty-fifty between employer and employee
Demographics
Life expectancy at age 65 in Canada
1966 15.3 yrs
1995 18.4
2015 19.4
2030 19.8
**
Workers per retiree
1966 8
1997 5
2030 3
Source: Statistics Canada
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