A new study is the first to use real data to do a quantitative analysis of asset allocation strategies and cost structures for hundreds of pension, endowment, and sovereign wealth funds across 11 countries. The results hold valuable lessons not only for financial planners, but also working Canadians dreaming of retirement.
Whether it’s Freedom 55, 65, or beyond, a comfortable retirement is a sought-after dream for millions of working Canadians.
But, without careful financial planning, the golden years can quickly tarnish. Pensioners – and those hoping to become one someday – face potential financial challenges as people are living longer, interest rates are lower, and, increasingly, we’re left on our own to save as defined benefit pension plans become a thing of the past.
It’s enough to make even the most cautious saver nervous about what lies ahead.
Canada does have an important advantage, however. Its pension plan model is the envy of the world, with Canadian plans outperforming their international peers on all fronts over the past two decades, according to new research from McGill University.
“Canada is fairly unique,” says Sebastien Betermier, associate professor of finance at the Desautels Faculty of Management and study co-author. Alexander D. Beath, Chris Flynn, and Quentin Spehner of the global benchmarking firm CEM Benchmarking also contributed to the research.
The McGill-led study is the first to use real data to do a quantitative analysis of asset allocation strategies and cost structures for 250 pension, endowment, and sovereign wealth funds across 11 countries between 2004 and 2018. Researchers examined the performance of large and small funds, depending on whether their assets under management exceeded US $10 billion in 2018.
In doing so, researchers sought to gain a clearer understanding of the way the Canadian model functions – and unlock the keys to success not only for financial planners, but also for current and future retirees with a pension.
“The insights that we get from this paper about the way Canadian funds invest on behalf of thousands of people can be useful for individuals who want to think more strategically about how to design their own portfolios,” says Betermier.
Lesson 1: In-house always wins
From the early days of the Ontario Teachers’ Pension Plan, dating back to the 1980s, Canadian funds are well known to manage high proportions of their assets in-house compared to non-Canadian funds, which rely more heavily on outsourcing the work to external managers.
But just how wide is that gap?
On average, the study finds Canadian funds manage 52 per cent of their assets in-house, while non-Canadian funds manage 23 per cent of their assets internally. For the very large funds, the gap is even more pronounced: 80 per cent for Canadian funds versus 34 per cent.
The result is the Canadian approach reduces costs by approximately one third — money that can be better used elsewhere.
“The main difference is a reduction in fees,” says Betermier.
He notes that not every country enables funds to move their investment teams in-house. To do so requires independent corporate governance and competitive compensation packages to attract and retain talent. It also requires a regulation system that provides some flexibility around balancing sheet shortfalls should the fund make a decision that doesn’t pay off.
Lesson 2: Spend more to make more
Critically, it’s what Canadian funds do with the savings that really sets them apart from international peers.
“And this is where the research makes a new contribution,” says Betermier.
Specifically, the study finds Canadian funds aren’t short on spending in areas that help them make better decisions, including talent, tech, and specialty teams.
Tallied up, it makes a big difference: Canadian funds outspend peers inside their internally-managed portfolio by an average of 18 basis points (bps) to 7bps. And even though they invest less externally, Canadian funds still spend more than non-Canadians inside their externally-managed portfolio — 121bps compared to 86bps. The patterns hold true within each asset class and style.
Examples of expenses include risk management units and fund-wide IT infrastructure where Canadian funds spend more than their peers by a factor of five.
In doing so, says Betermier, “You now have bandwidth to take on more sophisticated strategies, which you could not do before.”
Lesson 3: Diversify. Diversify. Diversify.
Those cost savings also give Canadian funds an important edge when it comes to investing in different asset classes that increase the portfolio efficiency and hedge against liability risks. This includes real assets such as real estate and infrastructure, which tend to be more costly to manage than stocks or bonds.
In particular, the study finds that large Canadian funds are able to allocate 18 per cent of their assets under management to real assets. In comparison, non-Canadian funds allocate just nine per cent to real assets.
In the end, this asset-allocation strategy is a game-changer: Those real assets help Canadian funds to diversify their portfolios and make them more efficient; moreover, they generate cash flow streams that tend to mimic the pension payments that they owe to pensioners, helping to align the assets with the liabilities that need to be paid out.
Put another way, says Betermier, “it gives Canadian funds access to asset classes that are able to kill two birds with one stone.”
Broadly, the findings reveal an integrated business model that enables large Canadian funds to spend more on each asset class and allocate more capital to strategic assets while spending less than their peers.
The research also shows a complementary factor driving the Canadian funds’ success is the indexation of their pension plan liabilities.
Notably, it also heralds good news for much smaller funds which, because of scale constraints, can only adopt a light version of the three-pillar model. Even so, the research confirms small Canadian funds also outperformed their international peers on all fronts within the study’s timeframe.
Like the big players, smaller funds in Canada follow a similar business model: they invest more of their assets in-house than their peers (13 per cent vs three per cent, on average), allocate more capital to real assets (10 per cent vs seven per cent), and redeploy more resources toward active strategies (82 per cent vs 72 per cent).
Additionally, small Canadian funds tend to reduce costs overall, 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.
Finally, even those of us managing our own pensions through defined contributions aren’t too small to draw value from the findings.
Namely, says Betermier, “Any asset class that you can invest in that can align with your own pension needs down the road can only help design a better portfolio.”
The authors conclude their research with a nod to COVID-19, and the subsequent hit on commercial real estate, equities, and corporate bonds.
“The years ahead will put the Canadian model to the test,” they write, adding its resilience against a global pandemic is a matter for future research to determine.