Yes, Canadian pension plans really do outperform their global peers: study
BY Staff | August 12, 2020
Canadian pension plans outperform their international peers when it comes to asset performance and liability hedging.
According to a new paper from researchers at McGill University and CEM Benchmarking Inc., Canadian pension plans achieve outperformance using three 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.
It also found that the model works best when a pension fund’s liabilities are indexed to inflation. “The explanation for this effect is that indexed liabilities tend to correlate more with growth assets than nominal liabilities. Consequently, by having indexed liabilities, Canadian funds are able to invest in growth assets that improve both return performance and liability hedging.”
A base of literature on what makes Canadian pensions different has been growing in recent years, the paper said, noting independent governance, professional in-house management, scale and extensive geographic and asset-class diversification are aspects that together 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 examined 250 pension, endowment and sovereign funds from across 11 countries, with those having less than US$10 billion under management in 2018 characterized as small funds and those with more as large. Between 2004 and 2018, the large Canadian pension funds outperformed their peers on all fronts, the paper said. “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.”
In-house asset management was a major driver of this outperformance, the paper said. Canadian funds in the study manage an average of 52 per cent of assets in-house, compared to an average of 23 per cent for non-Canadian funds. Very large funds, with over US$50 billion under management, demonstrated this even more strongly, with Canadian funds 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.”
Resource redeployment was another success driver. “We find that Canadian funds spend more than their peers inside their internally-managed portfolio (18 basis points on average vs. seven basis points for the peers). Moreover, even though they invest less externally, Canadian funds spend more than their peers inside their externally-managed portfolio (121 basis points vs 86 basis points). These patterns hold true within each asset class and style. Examples of expenses include risk management units and [information technology] infrastructure where Canadian funds spend more than their peers by a factor of five.”
Allocating capital to assets aimed at increasing portfolio efficiency and hedging against liability risks was the third driver of outperformance, the paper noted. Higher levels of in-house asset management mean Canadian pension plans can allocate approximately 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.
Overall, Canadian pensions on average 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.
When looking specifically at smaller Canadian funds, the study observed similar results. They, too, outperformed their international counterparts on all fronts between 2004 and 2018 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,” the paper said. “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.”