Canada's Pension Funds Perform, at a Cost?

Janet McFarland of the Globe & Mail reports, Canada's pension funds perform, at a cost:

It's a Canadian success story that has garnered little attention at home, but a strong following abroad: the performance of the country's biggest public sector pension funds.

Big public sector pension funds in Canada are outperforming their U.S. peers, and money managers around the world are taking note.

One key to the funds' performance: Over the past decade, most have shifted management of a larger proportion of their funds in-house to both boost returns, and to avoid paying hefty fees charged by outside money managers.

A Globe and Mail review of average annual returns of major public sector pension funds in Canada and the United States suggests that the new model is paying dividends for Canadian funds through improved performance by internal managers.

The review shows Canada's nine largest public pension funds earned an average annual return of 5.5 per cent over the past 10 years while data from eight top U.S. public pension funds shows an average annual return of 3.2 per cent in the same period.

But better performance comes at a cost.

With top investment professionals moving to public sector pension funds, salary levels have soared.

A decade ago, many funds were largely staffed with civil servants and professional administrators – much the way many major U.S funds are still managed.

The heads of all major U.S. pension funds make a fraction of the income of Canada's pension fund leaders, in some cases earning just one-twentieth of Canadian pay levels.

“You get what you pay for – there's no doubt in my mind,” said Kristopher McDaniel, editor of New York-based ai5000, a magazine aimed at major asset fund managers.

Mr. McDaniel is among the industry watchers who argue that Canada's internal management model for public sector funds is generating the stronger returns.

“If you look at the stats of returns in America, the funds that have the worst returns are always the public pension funds, compared to corporate pension funds and endowments and foundations,” he said. “One thing that correlates to that is investment manager pay.”

Many public sector pension funds are run as part of the state civil service, typically part of a state treasurer's or controller's office. Even funds with a more independent management structure are still part of the civil service and have boards of directors that include elected politicians or top state bureaucrats.

Better managers, bigger salaries

The rapid evolution that has occurred at many major Canadian funds has attracted a chorus of complaints about the climbing pay levels for managers. Critics say the Canadian pension executives don't need outsized private-sector paycheques to manage public money, and should not be allowed to impose their Bay Street salary expectations on unwitting plan members.

David Denison, the 57-year-old Bay Street veteran who now heads the Canada Pension Plan Investment Board, earned $3-million in fiscal 2009 to manage Canada's largest pension plan with assets totalling $124-billion. That's considerably less than the $4.2-million he earned in fiscal 2008 as head of Fidelity Investments Canada Ltd.

Anne Stausboll, by comparison, is paid about one-tenth that amount to run the California Public Employees' Retirement System, which is the largest pension plan in the United States with assets of $205-billion. Ms. Stausboll, 53, earned a base salary of $270,000 (U.S.) and received a bonus of $49,208 for half a year's work in fiscal 2009 as the fund's newly appointed CEO.

Last year, politicians from all parties in the House of Commons voted to support a non-binding motion tabled by the New Democrats, calling on the federal government to claw back bonuses paid to Mr. Denison and other CPPIB executives. The bonuses were left untouched, with Finance Minister Jim Flaherty arguing he did not have authority to interfere in the autonomous organization.

NDP Deputy Leader Thomas Mulcair has also led opposition last year to bonus payments for executives at the Public Sector Pension Investment Board, which manages $34-billion of pension money for federal government workers. In fiscal 2009, ended March 31, PSPIB chief executive officer Gordon Fyfe saw his pay climb 11 per cent to $1.4-million even as the PSPIB lost 22.7 per cent of its value in the market crash.

Despite the higher salary costs in Canada, internal management has been a bigger advantage than it has been a cost, said pension specialist Keith Ambachtsheer, director of the International Centre for Pension Management at the University of Toronto.

But the results talk

Research shows internal teams not only save money by cutting high external money management fees, but also perform better as investors because they are more closely aligned to the mission of the pension fund, he said. According to data from CEM Benchmarking, internal management improves returns by 0.5 per cent annually over external management, Mr. Ambachtsheer said.

“Canada is now leading the world in terms of design and operation of these organizations,” he said.

To put the difference between the big Canadian and U.S. funds' returns perspective, consider the longer-range picture: one percentage point of better return each year translates into 20 per cent more income when the money is compounded over a 20-year span, and two percentage points boosts income by more than 40 per cent over a 20-year span.

Research suggests cost savings from internal management are greatest in areas such as private equity and infrastructure investing, where outside managers typically charge the most for money management. Private equity funds, for example, routinely charge pension funds an annual fee equal to 2 per cent of their invested assets, plus collect an additional 20 per cent of all gains earned above a base threshold amount.

Mr. Denison said at a fund like his with more than $100-billion to invest, these “2 and 20” external management fees are so high that external managers are used primarily in targeted niche areas where CPP staff cannot duplicate the expertise.

“It is a factor of 10 times more expensive to do it externally versus internally,” he said. “But doing it internally means the compensation elements show up in our statements as such, while doing it externally means people don't focus on it.”

In fiscal 2009, CALPERS paid $1.5-billion (U.S.) to external fund managers, consultants and private equity investment partners.

CPPIB, by comparison, paid outside investment managers, consultants and other professionals just over $400-million (Canadian), most of it fees to private equity investment partners.

The Ontario Teachers Pension Plan, which has the longest track record in Canada for internalizing investment functions, paid even lower external management and consulting fees in 2008, totalling $188-million on total assets of $87-billion.

Teachers CEO Jim Leech said good outside managers cost about 5 to 6 per cent per year on assets under management – or $5 to $6 on each $100 invested – while internal investment costs (excluding commissions and fees for external managers) are .0015 per cent. That means internal management costs about 15 cents on each $100 invested.

“It is significantly less expensive for the plan,” Mr. Leech said.

A shift in Alberta

At the new Alberta Investment Management Corp. (AIMCO), created in 2008 as an arm's length manager of $70-billion in investment and pension assets for the Alberta government, CEO Leo de Bever has begun the process of shifting investing in-house, bring the internal management model to the new organization.

In his first year on the job, Mr. de Bever said he trimmed external management costs from $175-million to $150-million, and said the number is heading down toward $100-million.

AIMCO had 150 different external managers when he began – about 50 of them managing private equity funds – and is down to about 75 now.

But the flip side, he said, is that he has to be able to pay top people to work in-house to replace the outside managers.

“I can't hire experts that have commercial alternatives on a civil service salary,” he said.

Canada's internal management model began in 1990 with the creation of the Ontario Teachers Pension Plan. Former CEO Claude Lamoureux said that when he was approached about taking the top job, he insisted on having an independent board free of political influence, corporate job titles, and compensation plans with incentives similar to those in the private sector.

“You can be penny wise and pound foolish,” Mr. Lamoureux says of the compensation debate. The success of Teachers has helped encourage the spread of the internal management model.

But major U.S. funds have long-established practices that make wholesale change hard to achieve. Unlike Canada – where many of the largest public sector pension funds have been launched or retooled in the past two decades – the U.S. has not had many “green field” opportunities to build new structures.

Mr. McDaniel in New York said he believes changing U.S. public plans to bring money management in-house – at higher salaries – would likely be too radical to survive the confrontational U.S. political climate.

“There would be a huge uproar, especially in the California budget situation,” he predicts.

I must admit that my first thought after reading this article was what self-serving drivel. Ms. McFarland didn't bother contacting me because if she did, I'd give her an earful of complaints on the governance structure at Canadian public pension funds.

All she had to do is carefully read my last comment on CPPIB catching the tail end of a monster beta wave, as well as my follow-up on PSP's 2009 annual public meeting. Worse still, I spoon-fed Kip McDaniel details for an article on Canadian pension funds in the winter issue of ai5000, going over how senior public pension fund managers in Canada do not disclose their benchmarks on private markets (real estate, private equity and infrastructure) in order to game these benchmarks and then collect huge bonuses at the end of the fiscal year.

Instead Ms. McFarland exalts "the shift towards internal management" and justifies the pay of senior public pension fund managers who ironically sit on the board of directors of an organization called the Canadian Coalition of Good Governance (good grief, talk about the pot calling the kettle black!).

And again, yet another article that discusses the views of "pension specialist" Keith Ambachtsheer,who knows his stuff but refuses to admit some inconvenient truths which I regularly hammer into on Pension Pulse (who pays your bills Keith?).

And what about Claude "PE" Lamoureux, the man who told me to "shut-up" last year after my testimony on Parliament Hill. He personally benefited the most from this "internal management model" but to me he's just another member of the self-serving pension aristocracy in Canada, so I don't expect him to fess up to some of my poignant criticism on how senior public pension fund managers routinely game their alternative investment benchmarks.

While there is some truth to Kip McDaniel's statement that "you get what you pay for", I take it with a grain of salt. Most US public pension funds were late getting into alternative investments, and were highly exposed to stocks, which is why they underperformed during the last decade (this may turn out to be a blessing in disguise for those late comers).

Also, according to Brockhouse Cooper, Canadian stocks outperformed US stocks in the last 10 years, suggesting that this outperformance is simply due to the respective performance of the markets (beta). This point was subsequently made by Marc Furlotte in the Globe & Mail when he discussed pension fund returns:

Janet McFarland comments that internal managers are cheaper than external managers. One important fact is missing from her analysis. She says that, "Canada's nine largest public pension funds earned an average annual return of 5.5 per cent over the past 10 years while data from eight top U.S. public pension funds shows an average annual return of 3.2 per cent." What she fails to mention is that Canada's stock market, as measured by the TSX 300, earned 3.39 per cent for the 10 year period ended December 31, 2009, while the U.S. market, as measured by the S&P 500, lost 2.72 per cent per year!

Most pension funds, especially those in Canada, have a home country bias, thereby investing a higher than normal percentage of their assets in their home country.

By simply investing in Canada, the Canadian pension funds have earned higher returns. It's simply a case of a "rising tide lifting all boats".

And while many senior public pension fund managers in the United States are "civil servant types", others like Rick Dahl at MOSERS, are among the best of the best in the world, and they don't get paid anywhere near the amounts paid out here in Canada. Interestingly, many US public pension funds are much, much better at disclosing benchmarks governing alternative investments, and some also disclose minutes of board of directors meetings. In other words, they take pension governance much more seriously.

Finally, there is a school of thought that thinks external managers is the way to go because external managers have to produce alpha to get their mandates renewed. It's much easier firing an external manager than an internal manager. If senior pension fund managers were that good at producing alpha, they'd be setting up their own hedge funds or private equity funds to reap in huge rewards.

The fact is that they're nowhere near as good as they think they are, because if they were, they wouldn't be working at public pension funds. There are many good senior public pension fund managers in Canada, but let's not exaggerate and put them up in a pedestal. I am sure the folks at ABP in the Netherlands are just as good if not better, and they're not getting paid anywhere near as well. (Read their latest performance release by clicking here).

Let's stop propagating myths on Canada's public pension fund system. It's among the better ones in the world, but there is a lot - and I emphasize A LOT - more room for improvement. Self-serving articles like this one only serve to maintain the status quo, ensuring more complacency and mediocrity at a time when we need to fix our pension system.

***Feedback***

Some excellent feedback from a senior pension fund manager, which I share with you:

"The myth-making has been underway for some years, and is largely succeeding. The sell side and service providers are feeding well off of these mega fee payers (lawyers, pension consultants), and the media has chosen its celebrity organizations. There is wholly inadequate financial reporting (banks have been opaque and helped set the standard for transparency on everything except things that count), and so much misinformation as a result, that all arguments appear to be supported.

The various spooks in the industry are now populating the think tanks and academia, funded as you note by the industry, and they are reported upon by the media as unbiased experts.

Let's admit, the pension aristocracy is doing a great job for itself, and is coexisting so far with the private sector better than one might expect. The question is whether this aristocracy is better than the traditional ones in money management. It probably is.

You are on the right track to put sunlight onto the goings on, Pension Pulse should be renamed Pension Conscience, for the industry lacks one, too much money to be made by people who are worth less to allow conscience to survive on its own.

But for now, the new paradigm has the ecosystem of support which will make changes of consequence very difficult. As Claude so arrogantly said shut up, he reflects the sense of new entitlement that follows from winning the game. The momentum favours public sector asset management, and will continue for longer than is should, as these things tend to.

As for me, I can see that the fight for common sense had a brief moment of possible success after the derivative led credit fiasco. That moment passed. So for now, being in the game, influencing and keeping some sense of restraint and proportion to all of the ambitions out there is the only contribution I can see making, which of course is an unsung hero type role few find satisfying. But there is still room for positive impact. Such is the difficult and delicate role of a true fiduciary."

Another buddy of mine questioned the methodology of comparing US and Canadian funds:

"How much of that better return is a result of being invested mostly in Canada as Canadian markets have performed better? Currency, real estate, I'm not sure of bonds, equity etc. But I am leaning that the better performance was not a result of better management but rather a beta to the Cdn market." (turns out, he's right)

Regardless of the methodology of this comparison, we both agreed that this article is self-serving drivel.