Amongst other ways that Canada is unique, it has a fully funded pension plan. Not too many countries can lay claim to this fact, and south of the border it is reported that only one (!) state pension is even halfway funded (!). In fact, in the States the problem of unfunded federal government liabilities, like its
Ponzi scheme social security plan, has created a federal debt load today of around $205 trillion, about 13 times the actual amount reported by the Congressional Budget Office.
The fact that the Canada Pension Plan is fully funded is probably a great thing. I caution with “probably” because it is still not immediately clear that having a state pension plan is a net positive, to the extent that it demotivates private savings for retirement and redirects a large amount of capital into the hands of the federal government to fund its preferred investments, typically government bonds.
The other reason that it is only “probably” a good thing that CPP is fully funded is that it brings forth calls for an expansion in its services. Such calls, I maintain, will come forth until the Fund is unstable, at which time attention will be drawn to increasing contributions to “top it up.”
These worries aside, however, the fact that CPP is presently in such good shape is partly by design, and partly by luck.
The Canada Pension Plan is somewhat unique in that it is funded on a “steady-state” basis. Current contributions are set to remain constant for the next 75 years. This is achieved by actuaries estimating and accumulating a reserve fund sufficient to stabilize its asset/payout ratio over time. This system is a hybrid between a fully-funded plan and the more typical “pay-as-you-go” plan.
In layman’s terms what this means is that Canada’s CPP reserve fund currently has insufficient assets to pay for all future benefits accrued until now. However, it does have a sufficient amount of assets to stop future contributions from rising any further. Provided that the Fund’s actuaries make reasonable assumptions about the future, this funding method will be “robust” (pdf) and pension payouts will occur at their expected date without difficulty.
Truth be told, relative to other state pension plans, the vast majority of which are now underfunded and collapsing in Europe and the United States, Canada’s plan is well designed.
There is also a good dose of “luck” in the success of the Fund.
Originally established in 1965 under the Liberal government of Lester B. Pearson, the CPP first saw its contribution rates set at 1.8% of an employee’s gross annual income. By the mid-1990s this low contribution rate was insufficient to maintain Canada’s aging population. As a response, CPP contribution rates were increased to an annual rate of 9.9% by 2003 (to a maximum contribution of $2,306.70 per worker, fully matched by the employer).
While population changes are important for the Fund’s sustainability, equally important is the reasonableness or accuracy of the actuaries’ assumptions as to the rates of return to be earned by the Fund. The fact that it took until the mid-1990s for the government to reassess the sustainability of CPP is none too surprising in light of this. Those of us of a certain age will remember that the 1990s were in many ways a lost decade for Canadians.
Between 1991 and 1998 nominal GDP per capita in Canada remained stagnant. Sustainability of the CPP has much to do with expected investment returns, and the lack of income growth in Canada throughout the 1990s led to a reassessment as to what could realistically be provided to Canadians in retirement. The result was that we could still have the pension plan promised to us, but we’d have to pay for it through higher contribution rates.
Today we see the mirror image of the 1990s reforms. Income growth in Canada has been strong since the late 1990s, in fact, the strongest since the introduction of CPP in 1965. Despite a smallish blip following the 2008 global credit crunch, Canada’s economy has proven resilient, in large part to the continued commodities boom sustaining other commodities producing countries such as Brazil, Russia and Australia.
As CPP’s sustainability relies in large part on the accuracy of the expected investment return, the prevailing view of CPP has being well-run should be expected. Indeed, annual returns on CPP’s portfolio have been quite good in recent years, notwithstanding a large loss in 2009.
These high investment returns are not the result of better Fund management, however. They are the product of increased risk taking by CPP’s investment portfolio managers.
Consider how the investment mix of CPP has changed over the past decade. As recently as 2000 (if that can still be considered recent), the Fund’s portfolio was heavily weighted in fixed income assets. Only a meager 5% of its assets were in equities. This prudent approach to investing is that which you would think is appropriate for a Fund whose purpose is not to take undue risk with other peoples’ money, but to secure the retirement of tens of millions of hardworking, tax-paying Canadians.
What a difference a decade makes. By 2007 65% of the Fund’s portfolio was invested in equities, with its fixed income holdings cut by about two-thirds. This exposure to increased risk has blessed the Fund with greater returns, as could be predicted. However, it also exposes the Fund to the greater bouts volatility apparent in equity markets.
Indeed, the Fund is not even exposed primarily to Canadian equity volatility. The CPP owns almost as many shares of companies in emerging markets as it does Canadian firms. There are about $4 of investments in foreign companies located in developed countries, such as the U.S., for every $1 invested in a Canadian company.
Diversification can be seen as a good thing, but if the shares you diversify into turn out to be rotten investments (as high-risk emerging market equity investments are wont to be) such a mix can prove unwarranted. Indeed, I would hazard a guess that the median reader of this article doesn’t even have a personal investment portfolio with as much risk as Canada’s Pension Plan.
The chief actuary of CPP has publically stated that the Fund is sustainable at its current contribution rate for 75 years, assuming it earns a real return of 4% a year on its assets. To underscore the point, the homepage of CPP provides the following attractive graphic.
Is there anyone who believes his investment advisor when he tells him that his investment portfolio will not suffer a loss for any of the next 30 years?
In fact, since the actuarial forecast of future returns is based on past history, and since the Fund needs a real return of 4% per year to be sustainable moving forward, it is instructive to see how Canada’s economy has performed in real terms since the Fund’s inception.
Since 1965 there have been 7 years when Canada’s economy has grown by more than 4% in real terms per capita. The average real growth rate of the Canadian economy over the past 47 years of the Fund’s existence has been 1.9%. (If you were to take the geometric average, which one should when looking at compounding investment returns, the real growth rate is a little lower at 1.8% per year.) The Canadian economy has not enjoyed real growth of over 4% since 2000.
The CPP’s investment managers have assumed that they will be able to wisely invest over $180 billion of funds and earn double the historic real rate of return of the Canadian economy over the next 75 years. I’m sure they are talented individuals, but I don’t think they specialize in miracles.
So as the provinces get together to debate whether Canada’s recent good fortune should be expanded on in the form of an enlarged CPP, it might prove instructive to see where the Fund’s past performance has come from. It has performed admirably over the past decade, though this is not from prudence but rather from shouldering more risk. More to the point, it is imperative to ask where the future growth will come from to sustain the Fund’s current expected payouts. To the extent that CPP’s investment portfolio must more than double the historic growth of Canada’s economy, it is questionable whether the country can support the system it already has.