“Oh, you know we’ve got to find a way to bring some understanding here today” Marvin Gaye
Many investment market participants think that the stock markets are over heated and the fall is near. As I have reported in past commentaries, figuring out the right time to buy and sell investments is not my strength so I usually don’t pay a lot of attention to the prognosticators.
Last week however, a Benefits Canada story titled “CPPIB head worried about expensive assets, stretched market valuations” caught my attention. For those that have forgotten the CPPIB is the Canada Pension Plan Investment Board which invests our now $300+ billion in collective savings which will be paid to us at some future date under the CPP (don’t make me explain that acronym).
The gist of the story is a confession by the CPPIB’s CEO Mark Machin that it is getting harder and harder to find good investments, because there is lots of cash in the world looking for good investments. The conclusion: you must settle for lower long-term yield expectations or you must invest in more risky markets like China, India and Brazil. The article set off some alarm bells in my head. After doing some homework I am unable to find the smoking gun but I am sharing my findings simply to provide readers some ideas to think about.
Reading the article, my mind immediately raced to the actuarial valuation of the CPP. As actuaries, we are trained to be alert to changes in a client’s pension plan investment policy which almost always results in a change in the future returns the client can expect to earn on the pension fund. As clients take less risk and expect lower returns, the plan’s actuary needs to reduce the expected return the plan can expect which directly lowers the long-term going-concern discount rate we use to calculate the plan’s liabilities. Essentially there is no free lunch here. If you want to take less risk, you can expect lower returns, and your actuary will tell you that you need to increase your contributions to compensate for the expected lower future investment income.
So how does this all relate to the CPP actuarial report? I started thinking, if the markets are more likely to go down than up because of this overheating, then has the Chief Actuary properly accounted for the fact that we really can’t expect the future returns to be as rosy as previously projected? Would we need to finally start contributing more to CPP to reflect this new and more challenging investment world? I mentioned my worry to a friend who quickly pointed me in the direction of more information than any Canadian worker would want to read about the CPP and the CPPIB.
The good news is that our Chief Actuary is one step ahead of me!
First, I must tell you something that I forget sometimes. The CPP is not a fully funded pension plan (neither is Sears but it should have been). The CPP funding design is only intended to accumulate enough assets to smooth the baby boom through retirement without having contributions go through the roof for the generation behind them (mine). It was a brilliant move to introduce this partial funding in the 1980s although we knew about the problem from the beginning and should have done it in the 1970s. What this means is that the fund return is not as powerful as a fully funded plan because only 25% of the benefits in the CPP are funded (on purpose).
So back to the Chief Actuary. In the December 31, 2012 report he assumed the long-term real rate of return on the fund assets would be 4.0%. In the December 31, 2015 report he assumed the long-term rate would be 3.9%. In my mind, I had rounded the latter assumption to 4% because my brain sometimes has difficulty holding more than one significant digit. While 3.9% and 4.0% sound pretty much the same, when you get to the magic of compounding over 75 years, there is certainly a difference. Most importantly, as the markets rose from 2012 to 2015, the Chief Actuary reflected a little more caution going forward. Good thinking in my mind.
The bad news is the CPPIB isn’t really telling us how it is going. Maybe they don’t know how to explain things and maybe they just don’t want to. Here are three things to think about:
First, a note of governance. The CPPIB will tell you “Since its inception, CPPIB has adopted a professional approach to Board appointments. This approach is consistent with the founding principle of independence from government, attraction of dedicated and experienced directors…” and then a paragraph later they tell you “Directors of CPPIB’s Board are appointed by the federal Governor-in-Council (GIC) on the recommendation of the federal finance minister…”. Maybe it is sad that I have become so jaded over the past few years – but do we really think that the federal finance minister selects the best candidates to serve on the CPPIB Board? Is it possible that friendships and contributions to his political party count at all? Our current federal finance minister couldn’t even manage his way to avoid completely transparent conflicts – how can we possibly believe that something as opaque as an appointment to the CPPIB Board is purely objective? I am still waiting for my call to join the Board – if you are one of my readers and you have connections, please throw my name in the hat.
Second, a note on returns. The CPPIB will tell you “This fiscal year (March 31, 2017), the Reference Portfolio’s return of 14.9% outperformed the Investment Portfolio’s net return of 11.8%.” To me it is funny how they position ‘underperformance’ of the CPP fund as ‘overperformance’ of its benchmark. Let’s be clear, the benchmark didn’t outperform – it’s the benchmark! CPPIB also reported this year that it sold its 50% interest in four retail properties for $352 million. Glaringly absent from this news was a statement on the purchase price of the properties or the return earned on the investment during the holding period. Are they afraid to be straight with us or are they just that clueless? If they hire me I can show them how to do a rate of return calculation and even how to convert to an annual compound rate of return – the gold standard of investment performance reporting.
Third, a note on risk. CPPIB wants to brag about its diversification. “Currently, 83.5% of the CPP Fund’s assets are invested in international markets in a variety of asset classes, including private equity, infrastructure, real estate and public markets.” What they don’t seem to address is how all this foreign investing increases risk. In addition to the normal investment risks investing in a Canadian business, you now have the additional risks that foreign governments will change the rules mid-stream (Venezuela) as well as the added complexity of changes in currency values as the overall fortunes of the foreign jurisdictions rise and fall (Greece). Diversification is great in moderating volatility which is not a high priority for the CPPIB. On the other hand, diversifying into under-performing investments ultimately leads to poor performance. Finally, how many of these foreign ‘infrastructure’ investments rely on the future ability to ‘tax’ citizens in a foreign country? I am all for smart investing but I wonder if we have too much investment outside of Canada relying on the future prosperity of countries in which we have no direct influence.
I don’t think there is any reason to panic here. And the beauty of the CPP funding mechanism is that we can be patient with gains and losses and spread them over a century or more. But I think we need to demand that the CPPIB do a better job of telling Canadians how things are really going so we can all take comfort in knowing our money is being managed as effectively as possible.