This year’s federal budget held a shiny policy gem: the removal of a longstanding 30 percent limit on the foreign investment of pension funds. It reflects the important principle that retirement savings be allowed to seek the best financial return, without political constraints. And it opens up other questions. Is the current Canada Pension Plan the best means for doing that? Could other models better serve that purpose? The answers, respectively, are "No" and "Yes."
In 1996, the CPP took in $11 billion and paid out $17 billion. Shocked by the demographic reality of fewer workers keeping more retirees in biscuits and prunes, panicked politicians modified the pay-as-you-go system. They jacked up payroll taxes and abandoned the foolish practice of financing provincial debt with CPP funds lent at low interest rates.
To capture higher returns, in 1997 they established the Canada Pension Plan Investment Board (CPPIB), an independent panel empowered to invest the expanded pool of contributions in private markets. In itself an improvement, the timing of the new strategy could have been better. The board diversified at market highs, and the subsequent fall in prices, especially the collapse of the high-tech bubble, hit hard.
That misfortune didn’t contradict the wisdom of changing directions. Over time, through highs and lows, private equities pay higher returns than public sector debt. In fiscal 2003, for instance, the CPP reserve fund lost more than $1 billion, a return of minus 1.5 percent. But in fiscal 2004, it came back strongly and posted returns of 17.6 percent. It’s averages that count.
The CPPIB’s goals for average returns are quite low. Last fall, its president, John MacNaughton, expressed its cautious approach: "Within these limits, we believe our long-term rate of return will be 4.5 percent above inflation. This is slightly above the 4 percent minimum rate of return that the chief actuary said would be necessary to sustain the plan over the long term."
The CPPIB dodged the ageing time bomb by moving half its assets away from ultraconservative public bonds into private markets. What had been derided as the Canada Pyramid Plan is now solvent on paper for 75 years. The board, incidentally, welcomes the change in the foreign investment rule; it will give fund managers greater freedom to maximize returns.
But we could do much better than 4.5 percent. Here are a few examples:
- In 1981, Chile allowed workers to redirect payroll taxes into approved private investment plans. Average real returns are running better than 10 percent a year. Pensions collected by retirees are almost double those for workers who stayed in the government plan.
- In 1980, municipal employees in three Texas counties opted out of Social Security and invested instead in risk-free private annuities and bonds. Yields have averaged 7.5 percent and the accounts pay retired participants 90 percent of their working incomes, compared with 55 percent from Social Security. Similar plans service employees of five states and the federal government.
- In 1986, Britain allowed citizens to redirect pension funds in a variety of ways. Although performance has varied, private accounts have often delivered real annual return rates of 8 percent. Although higher taxes on private pensions, the infamous mid-’90s "mis-selling" scandal and high administrative fees have tarnished their allure, critics who call the British system a "disaster" are, according to the Economist, wrong and the country’s overall experience positive.
Many countries, including Australia and Sweden, have headed in the same direction, prompted partly by an influential 1994 World Bank report, Averting the Old Age Crisis. It recommended that governments move away from the pay-as-you-go model to compulsory funded pensions, where workers deposit premiums into individual retirement accounts.
In February, the bank assessed the results. "Undoubtedly, many individuals benefit from access to at least the voluntary funded provisions in their retirement portfolio," the new report says. "In view of the documented high financial illiteracy of individuals in the developed and developing world," it cautions, "the value of this benefit is often doubted and, if achieved, may come at a price."
In another key finding, the bank noted the deleterious effect of political meddling in public pension systems and called for improvements in the technical design of private accounts to insulate them from this political meddling. "In a decentralized and market-based structure with well-defined property rights and functioning courts," it states, "the capacity of governments to reduce benefits is considerably less than under unfunded and centralized structures."
Calls by Winnipeg Centre New Democrat MP Pat Martin for the Pension Board to undertake allegedly more ethical "social investments" — no military contractors, for example — precisely illustrate the political risk when large sums of money reside in a single, easily meddled plan.
The ultimate purpose of pensions is old-age security. Private accounts confer that value better than the Canada Pension Plan while eliminating the risk of interference from busybodies such as Mr. Martin. They don’t obviate the obligation of governments to provide a social safety net for everybody, but they more effectively reduce the need for that net.
This article originally appeared in the National Post, March 16, 2005.
