Will the Canadian Model survive into the future, as private markets have become more competitive, costs become a more pressing issue and public opinion towards funds changes? A new paper tries to answer this question. We speak with its author, Eduard van Gelderen.
The Canadian Model of operating public pension funds has delivered great investment returns over the past 30 years and it has served as a template for many Australian superannuation funds for both its robust governance framework and willingness to invest in private markets.
But much has changed since the 1990s, when this model first came into existence. So much so that questions have been raised whether it is still the right model in a world that is likely to see lower investment returns and higher volatility.
After all, building large, specialised internal investment teams that placed significant amounts of money in expensive asset classes yielded good results when returns were relatively high. But in a world, where returns are lower, do the costs still outweigh the benefits?
This is an especially important question as Canadian pension funds have started to mature and, in the coming years, will start to see their cash flows reduce, while their liabilities will change too as more members start to retire.
When Eduard van Gelderen moved to Canada in 2018, he became fascinated with the Canadian Model and the very question of the sustainability of the model over the long term.
His previous employer, APG Asset Management (the fund management arm of Dutch pension fund APB), followed quite a different model, placing emphasis on minimising costs and as a result had much a lower allocation to private markets, including infrastructure, private equity and unlisted property.
In his current day job as the Chief Investment Officer of PSP Investments, he has had a chance to study the Canadian model up close, and over the years he interviewed many of his peers on their views of the sustainability of the Canadian Model as part of his PhD research.
His efforts have resulted in a new paper, ‘On the Sustainability of the Canadian Model’, which Van Gelderen has published under his title as PhD candidate at the International School of Management in France, rather than his PSP affiliation.
The Canadian capital market was way too small. So [Canadian pension funds] had to expand their investments in private markets, and then later they also moved into international private markets. But they were an early mover. There weren't a lot of institutional end investors or asset owners doing the same thing and, therefore, there was a premium
[i3] Insights caught up with Van Gelderen and asked him whether he believed the conditions were still in place for this model to flourish into the future.
“One of the real benefits that Canadian funds had was the early mover advantage,” Van Gelderen says.
“When the restructuring of the Canadian pension market took place at the end of the 90s, pension funds were in a pretty poor state, including Ontario teachers, which was basically the first one to restructure.
“They needed higher returns to actually come to a fully funded status and they knew that the baby boomers would lead to significant liabilities in 2020-2040, but the problem was they were restricted to investments in Canada at the time and they couldn’t find the solutions in the capital market.
“The Canadian capital market was way too small. So they had to expand their investments in private markets, and then later they also moved into international private markets. But they were an early mover. There weren’t a lot of institutional end investors or asset owners doing the same thing and, therefore, there was a premium,” he says.
Yet, today most pension funds around the world invest in private markets and the premium associated with straight out private market investing has reduced. Does this mean the case for Canadian funds to invest heavily in this area is no longer there?
Not quite, says Van Gelderen.
Canadian pension funds have internalised the management of their private market assets over the years and in doing so they have obtained a lot of specialist knowledge that still gives them an edge over many other funds, he argues.
“The premium you earned in the early days is no longer there, but over time what happened is that because the Canadian model is also about internal management, those internal teams actually became more sophisticated. They learned a lot about those private markets,” he says.
“So what you see now is that, whereas the yield 20 years ago was in the plain vanilla stuff, the yield is now in the more complex deals. Because there was so much focus on internal management, the current teams of the Canadian plans are actually capable of dealing with those more complex deals. And that’s where they generate the yields again,” he says.
Birth of the Canadian Model
The birth of the Canadian Model can be traced back to 1986, when the Government of Ontario announced the Task Force on Public Sector Pension Funds with the aim to restructure the Teachers’ Superannuation Fund.
This fund had become mired in government bureaucracy and all of its assets were invested in non-marketable Ontario bonds. The restructuring was to introduce a transparent governance framework and seek higher returns on its investments by entering into a broader range of asset classes.
This work resulted in the Teachers’ Superannuation Fund being relaunched as the Ontario Teachers’ Pension Plan.
As more funds restructured in the following years, a common model started to emerge that was characterised by four specific pillars: good governance, large allocations to private markets, internal management and a focus on long-term value creation.
Van Gelderen points out that despite the common principles there are large differences between the top Canadian pension funds, the so-called ‘Maple 8’.
“If you look at the profile of these eight investors, then they are very different in nature,” he says. “Some of them are actually more asset managers than pension funds.
“So a company like AIMCo for example, they are not responsible for any asset allocation or strategic asset allocation [decision]. They certainly advice their clients on the topic, but it’s their client base that is actually telling them what they would like to see and go as far as giving them a benchmark and a tracking error. The focus is on delivering value add within that stricter framework.
“Now, if you go to the other side of the spectrum and take a company like Ontario Teachers’, they are fully responsible for everything that has to do with the pension plan, including the liabilities and the funding policy,” he says.
What is referred to as the Canadian Model is, therefore, more a shared set of principles than a true model that all funds follow. Among these principles the focus on managing private assets in-house is a key one, but the extent to which the different funds allocate to private markets varies significantly.
They try to do most things in-house, but if you look at the numbers then the percentages differ enormously. You cannot say that the Canadian model means 50 per cent in private markets, because some of the Maple 8 don't even have 50 per cent in private markets. It's way less in some cases. So the way they apply those principles is very different
“They try to do most things in-house, but if you look at the numbers then the percentages differ enormously. You cannot say that the Canadian model means 50 per cent in private markets, because some of the Maple 8 don’t even have 50 per cent in private markets. It’s way less in some cases. So the way they apply those principles is very different,” he says.
Private markets remain a key principal of Canadian pension funds, but as these funds continue to mature private markets might become a less dominating part of the portfolio.
“The pension plans are not getting any younger. It is not moving that fast, but they do mature, which means that from a total fund perspective you do have to manage the risk profile very carefully,” he says.
“So, yes, you can scale up the complexity in your privates, but then you have to do something else in your total portfolio to compensate for that. You cannot just fire on all cylinders, and take more and more risk. That doesn’t match with the maturing profile of the pension plans,” he says.
Van Gelderen says most Canadian pension funds still have a long enough horizon to justify large allocations to private markets, but given the maturing profile funds will have to manage their cash flows more carefully than before.
“You cannot have a total portfolio that is not liquid. You need to have some kind of liquidity. And I think that in the past this was, to be honest, not that much of a concern because there was more than enough cash coming in anyway. So I think the more prominent problem is how to manage the liquidity within the funds,” he says.
Facing Headwinds
Where Van Gelderen does see stronger headwinds for the Canadian funds is not so much investment related, but has more to do with the changing attitude of the public and politicians towards these funds.
There are increasing pressures in Canada to invest more pension money locally under the assumption that this will boost domestic economic activity, but Van Gelderen argues this was never the goal of most pension funds and could see them lose focus of their original objectives.
“I think it would be good if the Maple 8 start working together to better emphasise what the licence to operate is,” he says. “The Maple 8 was never there to boost the economic growth in Canada; the core role of the Maple 8 is to provide retirement security. And that requires return wherever that return comes from.
“But the launch of the Canadian model was more than 25 years ago and at the time the restructuring was supported by basically all stakeholders because they realised there are these baby boomers, who will become an issue in 2020 to 2040. We need to pay out a lot of liabilities in that time period.
“So when the restructuring took place, everyone was aligned and was in agreement. Currently, a lot of people have no idea of why these institutions were launched in the first place.
“People are looking at the investment portfolios and say: ‘It’s ridiculous. All our Canadian money is invested abroad’. So you got all these sentiments and political agendas, and that puts a lot of pressure on the Maple 8.
If you think about financial literacy, then it is really quite poor worldwide. Making these people responsible for what is maybe one of the most important financial decisions they have to make in life… How can you do that?
“People have completely forgotten what the real licence to operate is and so we have to re-establish that. Because before you know it, we let go of the Maple 8 institutions and then everyone has a defined contribution (DC) system,” he says.
The DC system might be the dominating system in Australia, Van Gelderen is not a fan of it. He believes it places too much responsibility on individuals to make important financial decisions that they might not even be equipped to deal with.
“If you think about financial literacy, then it is really quite poor worldwide. Making these people responsible for what is maybe one of the most important financial decisions they have to make in life… How can you do that?
“So the likelihood that an individual will actually take proper care of their own pension plan is very slim. And then who’s going to step in? The government. And where is the government going to get the money from? The taxpayer,” he says.
In contrast, the collective nature of the defined benefit (DB) system means that risk can be managed better and individuals don’t have to make complex investment decisions.
Van Gelderen acknowledges that many DB systems have become unaffordable over time, but he says that is not because of inherent flaws in the system, but because plan sponsors kept increasing the liabilities of and reducing the contributions to these plans in good times.
“The problem with the defined benefits systems was that not only was your base pension covered, but it also started to cover additional benefits such as early retirement. The impact on the liabilities was hugely underestimated,” he says.
“And then when the funding ratios were actually very positive, the sponsor said: ‘You know what? I’ll just introduce a pension or a contribution holiday’. So not enough money was paid in anymore and that combination actually created the funding problems with the defined benefits schemes,” he says.
Van Gelderen is concerned about more countries moving towards a DC system to fund people’s pensions and this will ultimately come back to bite them, he says.
“By moving the responsibility to the individual, we’re moving the pension problem out in time and it’s going to be a complete social disaster in 20 years’ time, because no one takes care of their own pension properly,” he says.
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[i3] Insights is the official educational bulletin of the Investment Innovation Institute [i3]. It covers major trends and innovations in institutional investing, providing independent and thought-provoking content about pension funds, insurance companies and sovereign wealth funds across the globe.