1) Save more, get more pension income - On the one hand, the 96th place Municipal Employees' Pension Plan of Saskatchewan (MEPP) contribution rate of 8.15% each from employee and employer totalling 16.3% gives a combination 1.5% and 1.8% (two rates for different time periods) per years worked of salary non-indexed pension.
Contrast that with OTPP's current 13.1% contribution rate above the CPP limit and 11.5% up to the CPP limit (both also doubled by employer contributions) that gives a 2.0% per year of salary indexed pension, though the indexation is not guaranteed. HOOPP collects 6.9% up to the CPP limit from the employee and 9.2% above that and 1.26 times each from the employer for 15.6% and 20.8% in total. It pays out 2% per year, 75% indexed for inflation.
An additional thought for an individual investor is that the automatic deduction of pension contributions from the paycheque no doubt makes it far easier to save. The money is never seen in the bank account and the temptation to spend it never arises (see Exploiting Laziness, Procrastination and Conformity in Investing)
2) Plan monitoring and flexibility is essential - Despite being superbly managed, OTPP and HOPP must make adjustments like changing contribution rates, which affects current workers, or inflation-indexing, which affects retirees, to cope with evolving conditions. Factors that are putting pressure on these pension plans also affect us as individuals.
Rising life expectancy is one - the average OTPP member works for 26 years and collects benefits for 31 years. Something, or a combination of things, must be changed to cope - higher savings, longer working career, part-time income, reduced pension withdrawals (like the inflation indexing).
Expected investment returns is another - With 70 or 80% of the pension payout dollars at OTPP and HOOPP coming from investment profits, not from contributions, changes in future returns have a critical impact.
For individuals, that's why we advocate the same kind of annual monitoring and adjustment - posts part 1 and part 2 - that pension plans constantly do.
3) Bond rate returns are lower and the conservatively-assessed cost of providing pension income is thereby higher, while expected inflation remains about 2% - The pension plans assess the cost of providing a pension according to expected real / after-inflation return based on an ultra-safe long term (30+ year) bond rate. With that base a total rate of return is derived that would include an expectation for its higher return equity portfolio components. OTPP in its 2013 annual report used a real expected return of 2.85%, while HOOPP and MEPP used 4.0%.
Individual investors can use this to ballpark a range of possible numbers to answer the "how much do I need to retire?" question. For a 30-year retirement to provide $40k annual income, these are the portfolio "nest-eggs" for the rates of return:
- 2.85% - $799k
- 4.0% - $692k
- 0.65% - $1087k
4) Asset allocation includes equity to boost returns - The pension plans need the higher returns of equity to maintain their fully-funded sustainability while keeping contributions at reasonable levels. It's a trade-off that entails higher annual volatility and more uncertain long term returns. OTPP has about 36% of its portfolio in equities (if the effect of the negative allocation i.e. borrowing / leverage is removed). Non-Canadian equities are much larger than Canadian holdings and the foreign currency exposure is not hedged. HOOPP is more or less the same. Foreign equity provides diversification (volatility reduction) and a return boost. Its approach on currency is opposite to OTPP's as HOOPP hedges its foreign currency exposure. The foreign equity market exposure strategy is something individual investors can apply too by buying non-hedged Canadian funds or US funds. Conversely, many hedged funds are available for those who decide to take that tack.
5) Active management is alive, and seemingly quite well - Rejecting the oft-repeated mantra directed at individual investors, the pension plans believe strongly in active management and the possibility of out-performance.
OTPP's 2013 Annual Report on page 20 says that "Active management is a cornerstone of the plan's investment success". They don't do this willy-nilly, focusing especially on illiquid investments. The numbers seem to bear out their confidence, with their 8.9% ten year returns considerably ahead of the 7.2% figure for their benchmark.
HOOPP takes a similar stance, touting a 2.09% contribution from active management to its total 2013 return of 8.55%.
Whether an individual investor should be trying to do the same must be an individual choice and it should be based on having some sort of insight or advantage that the bulk of other investors do not have. We have previously written about circumstances where the individual investor could gain such an advantage - e.g. small illiquid stocks (which the pension funds will ignore because they are too small) and places where the market can be less efficient.
The other takeaway for investors who cannot copy the active investing success of the pension funds is that we should expect returns more akin to the passive benchmarks. Such benchmark returns are exemplified in broadly-diversified market-representative ETFs.
6) Assessing Environmental, Social and Governance (SRI / ESG) factors of potential investments is worthwhile but not decisive - Both OTPP and HOOPP state quite emphatically that it is important and worthwhile to take ESG factors into account e.g. HOOPP Annual Report 2013 (p24) "Our belief is that enterprises that effectively manage environmental, social and governance (ESG) risks will, over the longer term, generate better financial returns and reduce operating and financial risks." However, the ESG factors must be material - actually have an effect on the enterprise. And ESG factors are not on their own decisive in accepting or rejecting investments. We note in passing that the Canada Pension Plan Investment Board, which manages the investments that help sustain CPP for all Canadians, says the same.
Doing ESG assessment sounds quite practical and sensible, and an approach that the individual investor can apply too, which is why we have written often about Canadian companies and the type of ESG factors that research confirms is material - see the series of posts in the Sustainable Investing section of our Guide to Online Investing.
7) Costs matter - As organizations dedicated solely to providing pensions for members, the pension plans pay close attention to managing costs. Costs are one of their measured performance criteria. Despite the higher costs that active management inevitably entails, OTPP kept overall costs to 0.28% of assets in 2013, while HOOPP was at 0.31%.
The individual investor can benefit from adopting a similar cost control philosophy. Where can costs be controlled?
- Finding ways to reduce foreign exchange conversion costs (e.g. TaxTips's washing trades and Norbert's Gambit guide for conversions between Canadian and US dollars on Canadian Couch Potato)
- Limiting trading by investing for the long term and using automatic free dividend reinvestment programs where available
- Picking lower fee ETFs, or asking hard questions as to why a higher fee fund will perform better
- Keeping income taxes in mind at all times (see the numerous posts in the Taxes section of our Guide to Online Investing)
- Equities - higher returns in the long term but higher volatility in the short term
- Non-Canadian equities - higher returns plus reduction in volatility through diversification (i.e. a degree of non-correlation with Canadian equities)
- Fixed income - lower volatility in the short term but lower returns in the long term
- Corporate bonds - higher returns but more credit risk
- Real return bonds - inflation protection but lower returns
- Real assets (real estate, infrastructure) - long term assets for the plans' long term horizon with cash inflows providing inflation protection to match the expected pension cash outflows
- Natural resources (commodities) - higher returns plus long term hedge for unexpected inflation but greater volatility in the short term
9) Risk means more than asset price volatility - Market price volatility, so often presented as the only measure of risk to individual investors, is important to the pension funds. But other risks matter too, like:
- liquidity risk, the chance of not being able to have cash to pay out when promised or needed;
- foreign currency variations on non-Canadian holdings, since that can affect the value of assets and returns as much or more than market price changes;
- credit risk, the chance of default, which is higher when more yield is sought from bonds;
- inflation, especially unexpected inflation not built into the prices and returns of bonds;
- interest rate changes, which counter-intuitively work the opposite way to what many would expect - when interest rates go down, a pension plan's future liabilities for pensions it will have to pay out go up, and that pushes plans towards being under-funded; an interest rate rise lowers the current value of the bonds held but it lowers the value of the future liabilities even more, so the plan is net better off. One way for the individual investor to think about this is exemplified in point 3 above. If you buy a series of inflation-protected real return bonds that will exactly match your future cash flow needs you can entirely remove the interest rate and inflation risk. That is what is called a fully immunized financial situation. But as the cost for the totally-safe RRB portfolio above shows, it takes a lot more money. Most people, and pension plans, cannot save that much, so it is necessary to rely on higher investment returns to make up the gap. That's why OTPP says "Taking risk is necessary to earn the returns required to meet our pension obligations".
Liability-driven investing (LDI) - For retirement investment, the idea of dealing with risk by tailoring the whole strategy around matching future obligations to assets is now very popular among pension funds, HOOPP being a prime exponent. In our next post, we'll explore how LDI can apply to the individual investor.
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.