© Copyright 2006 Rogers Publishing Ltd. The following article first appeared in the April 2005 edition of BENEFITS CANADA magazine.
Foreign content limits may have cost retirement plan members $3 billion annually, says economics professor Joel Fried.
Joel Fried, Professor of economics at the University of Western Ontario and co-author of “The Foreign Property Rule: a Cost-Benefit Analysis”, a report commissioned by The Association of Canadian Pension Management and the Pension Investment Association of Canada.

BC: Can you tell us a bit about the history behind the Foreign Property Rule(FPR)?
JF: The FPR in its current form on assets was initiated in 1971. Before that, there was a rule which was based on foreign income from interest and dividends. To avoid that constraint, pension plans began switching to equity; hence the change to the asset-based rule. It was initially set at 10% of book value, raised to 20% in the early ‘90s and later upped to 30% in 2000.

The rationale of the FPR is somewhat murky. The two major reasons given are that it supports the Canadian dollar and Canada’s balance of payments, and that it also decreases the cost of capital to Canadian firms and therefore allows the Canadian economy to grow faster. The first of these economic arguments is inconsistent with the data: increases in the limit in the early ‘90s and in 2000 had no statistical or economic significance, or effect on the exchange rate. If you think it through, what the FPR is doing is in some sense increasing the effective total cost of labour, including benefits, rather than decreasing the cost of capital. So, even if this argument of reducing the cost of capital were right, then workers would be paying a tax to subsidize domestic capitalists.

Workers do indeed gain from the removal of the FPR if they’re in a pension plan, and most unionized workers are: the sponsors and the administrators of their plans certainly understand the cost of this restriction to members.

BC: How about plan sponsors?
JF: It’s strongly in the interest of the sponsor to provide the best plan possible for their members, and the reason being is that pensions are part of one’s total package of compensation— if you provide something that’s less efficient, it’s not in the firm’s best interests if it wishes to hire and retain good people.

It’s the convenience of the regulators— it’s not at all in the member’s or sponsor’s interests. The FPR does not provide any benefits; sticking to it in principal, if not in fact, means that you are not doing your fiduciary duty.

BC: Is the industry devoted to circumventing the FPR in jeopardy?
JF: There’s $27 billion [in clone funds], and [with fees] at 40 basis points on average, there’s over $100 million removed right there in income to derivative suppliers. Certainly, the prices charged for those products are going to be reduced. [However, from a currency hedging perspective] there may still some desirable use for futures contracts on the S&P. For example, if you choose to have passive indexing, you hold the underlying Canadian securities, effectively denominating that asset in Canadian dollars. The other way to have a Canadian dollar hedge would be to buy the cash S&P and buy a futures contract for Canadian dollars to overlay it. It’s not clear whether one’s more expensive than the other, since both will be using futures contracts. The issue for Canadians is to separate out the decision where you want to hold your assets from what sort of currency you want them denominated in.

BC: You opined in your paper that cancelling or removing the FPR could result in savings of $1.5 billion to $3 billion annually.
JF: That is correct. Somewhere between $500 million and $2 billion comes from the possibility of improved long-run diversification among those funds and individuals that were constrained—either in principle or in fact—by the FPR. The remainder is attributable to cutting plan administration costs that resulted from the FPR.

More than that—and one of the areas in which we believe there will be significant gains—is that the FPR acted as a constraint on competition in the supply of mutual and pooled funds. It kept out foreign firms, because at the [earlier] lower percentage levels [such as 10% or 20%] the Canadian market wasn’t large enough for non-resident managers to come in and provide some expertise.

Even with the movement from 20% to 30%(in 2000), you started to see greater competition coming in— that, ultimately, will be translated into lower fees across the entire industry. You should be seeing firms come in who will either partner or merge with a Canadian supplier, so that they could offer a full array of funds.

BC: Do you think that we’ll see people go out and overallocate temporarily to foreign content, or will we see a more cautious and conservative approach?
JF: Evidence from the past doesn’t suggest there’ll be a mad rush. The fact is that Canadian fund managers in both the retail and institutional markets have an awareness of foreign markets through derivative investments, and are aware of what kind of foreign exposure makes sense for their fund.

There are other factors: for instance, it’s all for the better if they’re going foreign for greater asset diversification. Another issue is whether they’re going to unnecessarily expose themselves to foreign exchange risk. Well, if some of your members intend to retire in Florida or southern France, then holding assets denominated in U.S. dollars or euros is not really a terrible risk; in fact, it’s making your life a little bit safer.

So, I don’t see individual investors or institutional ones making major changes immediately. There will be a slow change as people become more comfortable with these positions. Even investors in Britain—which is a bit more than twice the size of the Canadian market—hold around 50% of their assets in the U.K. So, there’s this home country bias, which in part has to do with your consumption patterns when you retire.

BC: That is the other part to this: Canada’s demographic profile. From that standpoint this is probably a timely announcement…
JF: Perhaps this movement on the FPR can be translated into some better understanding of how people make decisions in their own interest, and how plan sponsors act in their members’ interest, [and] regulators [will] begin to make rules that are sufficiently reasonable and flexible. That is something all Canadians can benefit from.

James Lewis is a contributing editor of Benefits Canada. james.lewis@bencan-rci.rogers.com

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Copyright © 2020 Transcontinental Media G.P. This article first appeared in Benefits Canada.

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