While Canadian pension plans hold a quiet confidence, it turns out they actually do outperform their international peers when it comes to asset performance and liability hedging, according to a research paper from McGill University and CEM Benchmarking.
The paper found Canadian plans achieve this outperformance using a three-pillar model: managing assets in-house to reduce costs, redeploying resources to investment teams for each asset class and channeling capital to growth assets that hedge liability risks and increase portfolio efficiency. This model functions best for pensions with liabilities indexed to inflation.
In recent years, a base of literature on what makes Canadian pension plans different has been growing, the paper said, noting independent governance, professional in-house management, scale and extensive geographic and asset-class diversification are aspects that form a Canadian norm. “These features all contributed to the strong performance of Canadian funds over the past decades and, in turn, allowed the pension plans to remain well-funded in spite of the decreasing interest rates and increasing life expectancy.”
The paper aimed to discover whether this idealized model is true of just a few flagship pensions or whether these practices have spread across the country. It examined 250 pension, endowment and sovereign funds from across 11 countries, characterizing those with less than US$10 billion under management in 2018 as small funds and those with more as large.
Between 2004 and 2018, the large Canadian funds outperformed their peers on all fronts, said the paper. “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.”
The paper noted in-house asset management was a major driver of this outperformance. The Canadian pension plans in the study managed an average of 52 per cent of their assets in-house, while non-Canadian funds only did so with an average of 23 per cent. Very large funds, with more than US$50 billion under management, demonstrated this even more strongly, with Canadian plans managing an average of 80 per cent of assets in house and non-Canadian funds just 34 per cent. “We estimate that, by managing a high proportion of their assets in-house, Canadian funds reduce costs by approximately one third,” said the report.
Resource redeployment was another success driver. “We find that Canadian pension funds spend more than their peers inside their internally-managed portfolio (18 basis points on average versus seven basis points for peers). Moreover, even though they invest less externally, Canadian funds spend more than their peers inside their externally-managed portfolio (121 basis points versus 86 basis points). These patterns hold true within each asset class and style. Examples of expenses included risk management units and [information technology] infrastructure where Canadian funds spend more than their peers by a factor of five.”
The paper noted that allocating capital to assets aimed at increasing portfolio efficiency and hedging against liability risks was the third driver of outperformance. Higher levels of in-house asset management mean Canadian pension plans can allocate about 18 per cent of their assets under management to real assets, which are typically more expensive to manage than other investments. Non-Canadian funds are only able to allocate an average of nine per cent to real assets.
Taken together, these three aspects of Canadian pensions allow them to spend 57 basis points of their assets under management to run their funds each year, whereas their international peers spend an average of 62 basis points.
The study observed similar results when looking specifically at smaller Canadian plans. Between 2004 and 2018, they also outperformed their international counterparts on all fronts and also managed more assets in-house than their peers, allocated more to real assets and redeployed more resources to active strategies.
“These findings indicate that the success of the Canadian model among flagship funds has trickled down to a wide range of smaller funds,” said the paper. “However, the differences in allocation and costs between small and large Canadian funds reveal that there is no uniform Canadian model. Because of scale constraints, small funds only adopt a ‘light’ version of the three-pillar model described above.
“We find that small Canadian funds make a number of adjustments elsewhere: they reduce costs altogether, do more internal active management in public markets that are more accessible than private markets, invest less in hedge funds and concentrate the bulk of in-house management in one asset class: fixed-income.”