Tuesday, 10 May 2011

How to Invest for Retirement Like a Pension Fund by Using ETFs

Pension funds, by definition, have the goal of providing retirement income for their members. Maybe there are some ideas to be gleaned from their operations for us individual investors to apply in our RRSPs. After all, the pension funds are the pros and we are the amateurs. Therefore, this week we look at the three largest pension funds in Canada (see Benefits Canada article and pdf of the top 100) who lead not only in net assets but in methods that are being copied by many other pension plans:
  • #1 Canada Pension Plan Investment Board: $140 billion in net assets - This is the investment arm of the CPP, from which all working Canadians receive payments in retirement. The CPPIB plans two portfolios. One is the reference benchmark portfolio, consisting of standard asset classes. The other is the actual portfolio, which deviates from the benchmark in specific investments in an attempt to outperform the benchmark, but which the managers still aim to keep within the same risk parameters.
  • #2 Ontario Teachers' Pension Plan Board: $105 billion in net assets
  • #3 Ontario Municipal Employees Retirement System: $53 billion in net assets
Pre- and Post-Retirement Equity vs Fixed Income Allocation
The CPPIB is still in savings mode, with about ten years till it will need to begin drawing on its investment portfolio to partially fund CPP payments. Meantime there is a net inflow of funds as CPP collection from paycheques exceeds payments out. We'll call this analogous for an individual as "retiring in ten years".

The OTTP and OMERS, in contrast, already have substantial numbers of retired members and outflow surpasses inflows. This situation we'll call "retired with a part-time job".

The key result to note (see comparison chart below) is that the CPPIB has a much higher allocation to equities - about 2/3rds in its benchmark - than OMERS and OTTP, which each have about a 50% allocation. As a pattern, the big three follow the familiar advice - when in retirement, the equity allocation goes down. There is also the fact that, even in retirement, the equity allocation remains substantial.

Inflation Protection through Specific Asset Classes
All three pension plans make protection against inflation an explicit key investment objective and they target various types of assets that they obviously feel will help achieve that. For that reason Real Return Bonds, Infrastructure (utilities, pipelines, water systems, airports, seaports, toll-roads) and Real Estate are in all their portfolios. The OTTP adds investments in general Commodities and in Timberland to the inflation-protection category.

We note as well that the allocations to inflation protection assets are: a) substantial and; b) higher for OMERS and OTTP which as we noted are in retirement mode already. This reflects the fact that one of the main retirement risks to income is inflation, even at the steady 2% rate we have been experiencing for the last fifteen years and which all three assume will continue. One of the important and valuable promises of all three plans is CPI-indexed income. As life expectancies have gone up (and retired teachers live longer than the general population according to the OTTP), the cumulative long-term effects of inflation on standard of living can be extremely debilitating. Isn't protection against inflation what all of us would desire too?

Foreign Investments and Hedging
There is a divergence of thinking amongst the three pension funds as to whether it is worthwhile to hedge exposure to foreign currency fluctuations through foreign investments, which all three have in considerable amounts. The CPPIB and OTTP hedge only minor portions relating to certain parts of their portfolios - CPPIB's foreign government bonds and some of OTTP's foreign real estate. The OMERS, on the other hand, hedges a lot - about 40% of its foreign equity portfolio. Readers may recall from our previous post Foreign Investments: to Hedge or Not to Hedge Currency that there are pros and cons to each strategy.

Non-Mainstream Investment Strategies
These funds employ some investment strategies that are not open to the average individual investor, the two chief ones being absolute return strategies and private equity. The OTPP provides this information in its 2010 annual report: "Absolute return strategies (which are managed internally) generally look to capitalize on market inefficiencies and also include external hedge fund assets that are managed to earn consistent, market- neutral returns ..." Private equity simply means that the funds invest money directly, mostly in equity though a bit also as lending, through direct private placements. Unlike absolute return, which is an entirely different animal and for which there are no ETFs available, private equity stills falls within equity or fixed income, so although there are no such ETFs, the individual investor can imitate the effect within ETFs that invest in public market securities.

Investment Returns and Expectations
The diversified and risk-controlled portfolios of CPPIB, OTTP and OMERS can serve as a guide and a benchmark for our own returns. The table below shows some recent results and what they aim for in future. One-year returns in 2010 ranged from 12 to 14%, an exceptional good year after the heavy declines of the financial crisis. Their expectations for future long term average returns are only 6 to 7% including an inflation component of around 2%, i.e. 4 to 5% future real returns.

The ETFs that Best Mimic the Pension Funds' Asset Allocation
Keeping as much as possible to ETFs sold in Canada, an individual investor can construct a portfolio, except for Absolute Return strategy as noted above, that models each of the pension funds. In our detail table, we have colour-coded across to show how one or more ETFs line up with the funds (in certain cases, like Emerging Markets equity where BMO's ZEM and Claymore's CMO can both fill the bill, there a couple of ETFs for an asset class). Only two asset classes - Foreign Government Bonds and Timberland - would require ETFs traded in the USA.

The perhaps surprising bottom line is that it is not complicated to come quite close to building a portfolio that mimics the pension funds' approach. Only six to eight ETFs in all are required.

To find details of the ETFs:
One must note that the massive scale of these pension funds gives them certain advantages (there are disadvantages too in being an investing elephant - see for example, CPPIB CEO David Denison's speech The Challenge of Managing CPP's Assets) that an individual cannot replicate with ETFs. For instance, the broadest Canadian equity ETF, iShares' XIC, contains 248 companies within it, while the CPPIB's portfolio (listed here) as of March 31st this year held over 400 different Canadian companies. Another difference is that their unit costs for investment management are much lower than ETF management expense ratios.

Nevertheless, it is encouraging to know that the small investor can construct a solid portfolio without much complication or trouble simply by imitating what some of our leading pension funds do.

Disclaimer: this post is my opinion only and should not be construed as investment advice. Readers should be aware that the above comparisons are not an investment recommendation. They rest on other sources, whose accuracy is not guaranteed and the article may not interpret such results correctly. Do your homework before making any decisions and consider consulting a professional advisor.


Jas said...

excellent work!
Thank you for sharing your research with us.
Can you please let me know that going forward, where can I check the rebalanced allocations of these pension funds.

CanadianInvestor said...

Hi Jas,
Check the pension fund websites: CPPIB - http://www.cppib.ca/, OTPP - http://www.otpp.com/, OMERS - http://www.omers.com/.
The investment section of each and the annual reports provide lots of data and explanation.

Anonymous said...

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Zap Rowsdower said...

Thanks for putting this information on your blog. Lately I've been thinking a lot more about pension plans and where to invest my money for my future.

Tarah said...

Do you know anything about canada pension plans. Are they similar? Do you know if there are different tax circumstances that I should be aware of?

CanadianInvestor said...

Hi Tarah,
Yes there are tax consequences for various types of domestic or foreign ETFs that suggest which account is best to hold each e.g. past post http://howtoinvestonline.blogspot.co.uk/2011/11/etf-asset-allocation-across-rrsp-tfsa.html