A recent study highlights three distinct features that have driven the success of Canadian pension funds.

By Ed McCarthy

Investment portfolio performance and the degree of liability hedging are key benchmarks for measuring defined benefit plans’ success. On both measures, large Canadian pension plans outperformed their international peers between 2004 and 2018, according to a recently published report.

“The Canadian Pension Fund Model: A Quantitative Portrait” — by Alexander Beath and Chris Flynn from CEM Benchmarking with Sebastien Betermier and Quentin Spehner from the Desautels Faculty of Management at McGill University — examined performance metrics, asset allocation strategies and cost structures for 250 pension, endowment and sovereign wealth funds in 11 countries for the period 2014 to 2018 and 105 funds for the full 15 years.

Pillars of Success

The study identifies three distinct features that have driven the success of Canadian pension funds. These funds:

  • Manage a greater percentage of their assets internally than the other funds (52% versus 23%), reducing costs by about one-third;
  • Redeploy more resources to their investment teams, including risk management and information technology;
  • Allocate a higher percentage of capital toward assets that increased portfolio efficiency and hedged against inflation risk, such as commodity stocks, real estate and infrastructure.

“What the research says is that the first pillar, which is the internalization of portfolio management, helps to achieve the other two,” said Betermier.

Internalization’s cost savings permit increased spending on portfolio management and other services.They can also generate additional efficiency with economies of scale. This is because the pension fund can afford to build out resources, such as risk management teams, which then can be shared across the organization.

The third pillar seems counterintuitive. A high proportion of Canadian funds’ pension liabilities is indexed to inflation.

By having indexed liabilities, the funds are able to invest more heavily in growth assets, which improved returns and liability hedging over the periods studied.

Non-indexed funds often use liability-driven investment strategies that constrain the fund’s assets largely to long-term bonds, Betermier notes. In contrast, indexed liabilities match well with more growth-oriented asset classes that can produce cash flow, inflation protection and potentially superior investment results.

Can the Model Be Replicated?

It’s natural to ask if other pension fund managers would benefit from adopting the Canadian model.

To answer this question, the authors ran a series of back tests to determine how U.S. pension funds would have performed between 2004 and 2018 with the Canadian model.

Their conclusion: “For U.S. corporate funds, which already hedge a high proportion of their liability risks, the adoption of the Canadian model would have also led to increases in all performance metrics, but mostly in the Sharpe ratios through the reduction of costs associated with in-house management.”

Smaller Canadian funds can benefit from the model with some scale-related constraints and some have implemented what Betermier calls a light version of the model.

These funds focus on cost reduction and rely more on active, internal management than their international peers, but to a lesser degree than the very large Canadian funds.

They also specialize in managing a smaller number of publicly-traded asset classes, such as fixed income, and also invest relatively more in growth-oriented real assets and infrastructure.

There are challenges to replicating the model, however. The authors recognize that moving investment teams in-house requires independent corporate governance and competitive compensation plans to attract and retain talent. It also entails sufficient regulatory flexibility to manage balance sheet shortfalls.

Looking Ahead

The authors recognize that COVID-19’s impact could challenge the Canadian model’s performance status.

They conclude by asking two key questions that they hope will shape future research: “How resilient is the Canadian model to a global pandemic? [And] will two-pronged strategies that increase asset performance and hedge against liability risks change in the post-pandemic world?”

Ed McCarthy is a longtime financial writer and author of three books, including “Foundations of Computational Finance with MATLAB.