Most Canadians will rely on Canada Pension Plan payments for a significant part of their retirement income.
As things stand, those payments are essentially guaranteed, since Canada鈥檚 national pension plan is solvent. This means CPP will have sufficient assets to cover all its commitments to pensioners, both present and future.
The investment arm for CPP can take the credit for this. Powered by a mandate to 鈥渕aximize returns听without听undue risk,鈥 CPP Investments received the first transfer of $12 million to invest in capital markets back in 1999.
Since then, it obtained an additional $200 billion in net deposits (contributions minus payments to beneficiaries) and generated a cumulative net income of $432 billion on its investments to reach its current valuation of $632 billion.
As I wrote last week, the size of the fund could have been even higher, had fund managers followed a simple passive investment strategy and invested in a basket of low-cost stock and bond index funds.
Still, CPP is one of few solvent national retirement plans. One would think that a status like this is golden, something that Canada won鈥檛 ever risk losing. Yet, in my opinion, CPP Investments is now taking excessive, unnecessary risk, which has the potential to hurt the fund significantly in the future.
The fund鈥檚 market risk appetite is higher than most.听Its benchmark portfolio has an asset allocation of 85 per cent stocks and 15 per cent fixed income, a higher percentage of equities than most other Canadian and global pension and sovereign wealth funds.
PSP Investments (Canada鈥檚 public sector pension fund), Qu茅bec鈥檚 Caisse de D茅p么t et Placement, CalPERS, Ontario Teachers, Norway鈥檚 oil fund, Japan鈥檚 pension fund, the Netherlands鈥 ABP and Singapore鈥檚 sovereign wealth fund all invest more conservatively.
Why is CPP Investments a more aggressive risk-taker than its industry peers of comparable size? This is puzzling to me, given that it is in an excellent financial position, and arguably, doesn鈥檛 need to seek very high returns.
When I put that question to CPP Investments,听Michel Leduc, global head of public affairs and communications, noted that the fund has a solid history of “maximizing returns for the CPP Fund over generations, without taking undue risk.”
He added that higher returns help to shield the fund “not only against non-financial factors, such as shifting demographics, but also against any future variance in financial returns that might persist over longer periods.”
Leduc said that different funds have different risk tolerances, depending on their time horizons and the purpose of the fund. “Insofar as you invest yourself, what is the potential percentage of equities would you tell yourself to hold at 21 compared to at 67?” he wrote.听
In short, he felt that “comparing risk appetite from one fund to the next is nonsense.”
But why? Even if each fund is a different beast, many have similar characteristics and all of them are long-term investors.
I think it is relevant to ask why CPP Investments is placing such a large portion of its assets听鈥 85 per cent听鈥 at higher risk, as indicated by its benchmark portfolio, while other funds don鈥檛. Don鈥檛 forget that loading up on risk doesn鈥檛 guarantee high returns. Things might also go sour, and if the market turns, the damage could be significant.
How significant? Our national fund estimates听that its current 鈥渙ne-year potential loss鈥 stands at $118 billion, or 19 per cent of its value. In a less likely, 鈥渨orst-case scenario鈥 (worse than the global financial crisis of 2008), the fund听would听expect听to lose $141 billion, or 22 per cent听of its value听in a single year.
How much risk is too much?听
My impression is that CPP is attempting to score returns which are higher than it needs to remain solvent. By doing that, it is taking a chance, albeit small, of becoming underfunded in the future. Why would it do that?
Whether this is indeed the case is not for me to speculate. To properly answer this question, one would need to project CPP鈥檚 future contributions (from working Canadians) and expenditures (payments to beneficiaries), considering Canada鈥檚 future demographic and workforce trends. And then, derive the fund鈥檚 required rate of return.
And in fact, this task has been assigned to Canada鈥檚 chief actuary, who works for the Office of the Superintendent of Financial Institutions, and submits a report on the financial state of CPP to the finance minister every three years.
concluded that if CPP Investments earns an average annual real rate of return of about 3.5 per cent (6.2 per cent in nominal terms), it will remain financially sound and sustainable for at least the next 75 years.
Yet, the Fund鈥檚 real rate of return for the past ten-year period was 6.5 per cent (9.2 per cent nominally)听鈥 three per cent higher than the necessary yield.
Is CPP violating its own mandate?
No one, of course, is complaining about returns that have already been realized. But moving forward, if the chief actuary concluded that a six per cent nominal annual return will keep CPP well funded for 75 years, why is the fund seeking nine per cent annually and taking on unnecessary risk?
鈥淚f you are investing for people not even born yet,” said CPP Investments鈥 Leduc, “a prudent risk appetite is higher than the average.鈥
Is it? All of the above listed funds also invest for decades and have a much more conservative portfolios. Moreover, CPP Investments says in its own words that funds with similar profiles (to CPP鈥檚) don鈥檛 need to be so aggressive in their risk taking.
鈥65% equity and 35% debt portfolio is in the typical range for conventional fully funded pension plans.鈥 CPP has the equivalent of 85 per cent exposure to stocks.
My conclusion is that the country鈥檚 largest pension fund is听in fact violating its own mandate 鈥 according to the 鈥 to maximize returns听without听undue risk.
CPP Investments’ CEO听John Graham听 that: 鈥淚t鈥檚 going to be harder to generate returns over the next 10 years than it has been over the past 20.鈥
Lowering the fund鈥檚 risk-appetite is the prudent way to prepare for that.
This would prevent a scenario in which Canadians wake up one day to the news that their mandatory contributions to CPP were bumped up or that their pension payments won鈥檛 be paid in full.
Correction 鈥 July 22, 2024
This article was edited from a previous version to make clear that that the Canada Pension Plan is solvent. The previous version referred to it as being fully funded.
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