Lessons from the Canadian Pension Plan Investment Board (CPPIB) Pamela Dries-Smoley and Stuart Smith We have noted over the past few years, many articles appearing in the media referencing the suggestion by various financial advisors that an individual or family s investment portfolio should be managed like a pension or endowment fund. This appears to be the new way to attract clients, by saying they invest the same way the largest pension funds do. In most cases, we find that the article or marketing piece refers to buying alternative asset classes or hedge-funds as investing like a pension fund. But what does it really mean to invest like a pension fund. Is it even possible? What does it cost to manage a large pension fund? In late 2015, Boston Consulting Group published a report on the 10 largest pension funds in Canada. As one would expect, the largest pension manager in Canada, by assets under administration (AUM), is the Canada Pension Plan Investment Board or CPPIB. If we are going to look at how pension funds are managed, we thought we should take a look at the CPP. Anyone who has worked in Canada (outside of Quebec) will have contributed to CPP, and will eventually receive a monthly pension payment, indexed to inflation, for your lifetime. The website states that there are currently 19 million members, so the CPP pension is relevant to the majority of Canadians. Page 5 CPP Annual Report 2000 The CPP was started in 1966, administered by the Federal Government and was a pay-as-you-go system rather than a fully funded pension plan. For every retired employee collecting the pension there were seven members contributing. Excess contributions were invested in non-marketable federal and provincial bonds with terms to maturity of no longer than 20 years. Registered trademark of The Bank of Nova Scotia, used under licence. Trademark of The Bank of Nova Scotia, used under licence. Scotia Wealth Management consists of a range of financial services provided by The Bank of Nova Scotia (Scotiabank ); The Bank of Nova Scotia Trust Company (Scotiatrust ); Private Investment Counsel, a service of 1832 Asset Management L.P.; 1832 Asset Management U.S. Inc.; Scotia Wealth Insurance Services Inc.; and ScotiaMcLeod, a division of Scotia Capital Inc. Wealth advisory and brokerage services are provided by ScotiaMcLeod, a division of Scotia Capital Inc. Scotia Capital Inc. is a member of the Canadian Investor Protection Fund and the Investment Industry Regulatory Organization of Canada.
Times Change In 1996, a review revealed the plan had insufficient assets to meets its long-term obligations. Things needed to change based on changes in demographic trends, life expectancy, and the rising costs of administering the benefits. Not enough was being contributed (down to 5 contributors per collecting member, and interest rates had been in decline since 1983. It was determined that contributions needed to increase to the 9.9% of Yearly Maximum Pensionable Earnings, and the investment portfolio had to be diversified. Starting in 1999, the Board of Directors adopted a policy of investing all excess cash-flow not required to pay benefits into equities. Establish Achievable Long-Term Objective In 1998, an investment objective was established in conjunction with an actuarial review. Based on a time projection of 75 years, the required rate of return was determined to be 4% after inflation. If inflation is 3%, the required rate of return is 7%, a rate no asset guaranteed at the time. The closest was federal government real-return bonds that yielded 3.50% above inflation, so a broader spectrum of assets classes had to be considered. The transition away from 100% bonds took time and was considered methodically. The CPPIB selected two external fund managers, one to invest in a Canadian stock index and one to manage the investment in foreign stock index funds. The benchmarks chosen were TSX300, the S&P500 and the MSCI EAFE (Europe, Australia and Far East). Only 20% of the equities could be invested into the US and international funds. The first transfer of assets from the government to the newly appointed investment team happened in early 1999. Invested for just one month, the March 2000 Annual Report shows return on the equity portfolio of positive 5%. The Investment Board was probably feeling pretty good. Rebalance By August 2000, Nortel was 35% of the TSX300. The Board felt it was not prudent to have 35% of their Canadian equity exposure or 28% of their total assets at the time, in a single name. Another policy change was required. Required Income and Time Horizon Regulation changed in September 2000 to allow for 50% of the Canadian equity assets to be actively managed. The immediate change was a simple one. Move 50% of the Canadian equity exposure to the TSX299, basically the index without Nortel. This move substantially reduced the loss to be reported in the March 2001 Annual Report to only negative (9.4%). Management stated its intention to now further expand investment into the private markets. Given the portfolio s long-term time horizon, and excess contribution cash-flow, the Board could sacrifice shorter-term liquidity for potentially higher longe- term returns. For Long-term Assets Invest When Cash is Available Don t Try to Time the Market During 2001 and 2002, permanent staff was expanded to 23 people, and $2.4 billion was committed to 14 external managers. The exposure now to public and private equities was up to 26.7% of AUM. The March 2002 Annual Report stated that the CPPIB did not try to time the markets. As cash came in, it was invested. Again, with another substantial commitment to public and private equities and real estate, the CPPIB experienced another year of declines, a loss of negative (21.1%). Was adding private equity the right thing to do? Should they have tried to time the market? The March 2003 Annual Report focused on the CPPIB s long-term mandate. The Board did not let the short-term performance of their portfolio steer them off course.
Establish an Asset Allocation Benchmark In 2006, CPPIB established an asset-mix benchmark target of 60% public and private equity, 30% fixed income and 10% real return assets consisting of inflation-linked bonds, real estate and infrastructure projects. The benchmark is called the CPP Reference Portfolio. Quite the shift from 100% non-marketable bonds 8 years before. Over the next several years, the CPPIB received substantial cash-flows from excess contributions and the transition of maturing government bonds. Recall that the period between late 2002 and the middle of 2008 was one of the longest bull runs in history. By March 2008, the majority of CPP assets were invested in equities and a substantial real estate portfolio. Assets totalled $122.7 million. To the right, is the asset allocation at March 31, 2008. Opportunity in the Emerging Markets but Not Without Volatility Page 3 CPP Annual Report 2008 Over the course of 2007 and early 2008, it was reported that over 100 new employees had been hired, offices were established in London and Hong Kong, and $1 billion of CPPIB s new commitments were to funds primarily focused on Emerging Markets. The Emerging Markets were an area that had some of the largest gains over the past four years. As it turned out, CPPIB invested near the top of the market again, this area seeing some of the largest declines during the financial crisis. To put this into perspective, while $1 billion sounds like a lot of money, it was less than 1% of CPPIBs assets. Stay the Course The portfolio return for March 2009 FYE was negative (18.6%) and the 4-year annualized return was just 1.4% - not the 4% annual real rate of return they had been targeting. Management comments noted that in light of extraordinary market conditions, the Board did re-examine their long-term strategy and concluded it to be sound. They would be adhering to their 65/35 equity-debt exposure as they invested the cash-flow that continued to come in. It is interesting though now to read recent comments on this historical time from the current CEO of the CPPIB, Mr. Mark Wiseman. In a recent Report on Business magazine, Mr Wiseman was interviewed. He is asked about Any regrets?. His answer is very honest and interesting: Page 34 Report on Business Magazine, February 2016
When to Hedge and When Not to Hedge? That is the Question! There is a saying, Never let them see you sweat. The March 2009 Annual Report conveys confidence in the CPPIB strategy and conviction that the strategy will perform long-term. It is interesting to read now that there was truly a struggle to continue with their documented process, but thank goodness they did for the most part. The following year heading into 2010, the portfolio return was positive 14.9%. In the 2010 Annual Report, I noted that on total assets now of $127.6 Billion, foreign assets at 57%, exceeded Canadian assets at 43%. This is interesting because the CAD$ increased in value against the USD$ by about 28%, and also strengthened against most other major currencies. An increase in the CAD$ decreases the value of foreign assets in CAD$. I was looking to see if they had changed their policy on Currency Hedging, which was not to hedge, sighting costs, and how economic ebbs and flows amongst countries balance out currency fluctuations over time. On page 25, they note that the policy continues to be no hedging for the most part, other than specific strategies designed to exploit short- and medium-term behaviour of the international currency markets. CPPIB has both internal and external specialists that monitor this. They do hedge their sovereign foreign bond exposure. Being Very Large Does Not Substantially Lower the Cost of Money Management Finally, I wanted to determine the costs to manage and operate the CPP. While many of the fees are reported in the Annual Reports, CPP does not consolidate all fees and report them as a percentage of assets under management or Management Expense Ratio (MER). Returns are stated as being reported net of all fees so they don t feel it is relevant to report what they are paying to the various external managers they use. In the 2007 report, it is stated that the fees for external management generally vary between 1% and 2%. This is one of the reasons for building out their internal management capabilities - to lower costs. Also interesting to note, the CPP pays their external managers performance fees. Big does not mean they are getting a screaming deal. In the 2015 Annual Report, the fees reported for operations, external management and transaction costs total $2.330 billion. As a percentage of the $265 Billion AUM, the fees total about 86 basis points (a basis point is 1/100 th of a percent) or just under 1%. More than I expected. A study done for the Fraser Institute in 2014 by Philip Cross and Joel Emers, argue that in addition to the costs to manage the investment portfolio, the costs to collect contributions and pay benefits should be included in the calculation. To the right is the chart that they published in the Financial Post on September 2, 2014. It illustrates costs have increased, putting total cost over 1.15%.
Where is CPP Now? According to the CPP 2015 Annual Report: At Dec 31 st 2015 AUM is $282.6 Billion. Returns have been positive annually since 2010. The 10-Year nominal annual rate of return is now 8% so the required real rate of return is being achieved with inflation hovering around 2%. There are offices in Toronto, Hong Kong, London, Luxembourg, New York and Sau Paulo. Employees globally total 1157. The Investment Portfolio consists of 75.9% global investments with the remaining 24.1% invested in Canada. The global footprint is growing. The 2012 Chief Actuary of Canada report indicated that CPP is sustainable over the next 75 years and projected contributions to CPP will exceed benefits paid until 2023, and assets will grow to over $500 billion by 2030. For many years, there was a lot of talk that CPP would not be around by the time we retired. It appears that if the CPPIB continues the discipline they have developed; we will all have nothing to worry about and will receive the benefits of our contributions. What was also interesting for us and should be for investors, is the cost to manage money and pay it out. The bigger you are, the more you re responsible for - the more oversight, due diligence, monitoring, reporting and accountability are required. This does not come cheap. It is important to know what you are paying, what you are paying for, and it is up to you to determine whether or not you feel you are getting value for the percentage you are paying. The value to you of working with a Wealth Management team for the assets not under the administration of the CPPIB or other defined benefit pension is to help you follow the lessons we have learned from the review of the CPP experience. Establish an achievable long-term objective. Consider your individual time horizon, cash-flows and income needs. Document it with a financial plan. Review and rebalance. Don t try to time the market with longer-term assets. Limit currency hedging on longer-term assets. Stay the course. Understand the value you receive for the fees you pay. This publication has been prepared by ScotiaMcLeod, a division of Scotia Capital Inc. (SCI). This publication is intended as a general source of information and should not be considered as personal investment or tax advice. We are not tax advisors and we recommend that individuals consult with their professional tax advisor before taking any action based upon the information found in this publication. Opinions, estimates, and projections contained herein are our own as of the date hereof and are subject to change without notice. The information and opinions contained herein have been compiled or arrived at from sources believed reliable but no representation or warranty, express or implied, is made as to their accuracy or completeness. Neither SCI nor its affiliates accepts liability whatsoever for any loss arising from any use of this publication or its contents. This publication is not, and is not to be construed as, an offer to sell or solicitation of an offer to buy any securities and/or commodity futures contracts. SCI, its affiliates and/or their respective officers, directors, or employees may from time to time acquire, hold, or sell securities and/or commodities and/or commodity futures contracts mentioned herein as principal or agent. SCI and/or its affiliates may have acted as financial advisor and/or underwriter for certain of the corporations mentioned herein and may have received and may receive remuneration for same. All insurance products are sold through Scotia Wealth Insurance Services Inc., the insurance subsidiary of Scotia Capital Inc., a member of the Scotiabank Group. When discussing life insurance products, ScotiaMcLeod advisors are acting as Insurance Advisors (Financial Security Advisors in Quebec) representing Scotia Wealth Insurance Services Inc. This publication and all the information, opinions, and conclusions contained in it are protected by copyright. This report may not be reproduced in whole or in part, or referred to in any manner whatsoever, nor may the information, opinions, and conclusions contained in it be referred to without in each case the prior express consent of SCI.