Playing economic Master and Commander is just too much fun, I suppose. The temptation of other people’s money fuels the ambition of dirigistes the world over. Why bother with free markets and limited government when you know you’re better than everyone else? This week finance committee chair MP Karina Gould expressed concern when she learned that the Canada Pension Plan (CPP) invests only 12% of its total fund in Canada. She wants to understand why so little of the fund invests in Canada when, as she puts it, we could use the CPP to “bolster the Canadian economy”. And so the game begins!
To understand investment means understanding risk, return, and asset pricing – something to which our Prime Minister has purported expertise. Of all the publicly traded companies in the world, about 50% of the total market capitalization is American; just 2% is Canadian. A hard-nosed efficient market approach would therefore allocate a portfolio in the same proportion. If the whole world puts only 2% of its capital in Canada, why should anyone deviate? If anything, the CPP is already overweight Canada. On the other hand, when you have a political agenda and you see a big pile of money, thinking about optimal asset allocation becomes entirely secondary.
I find Ms Gould’s surprise this week itself surprising. Like almost all Canadians with her level of earnings, she almost certainly has investments and uses the help of an advisor. Her portfolio probably looks similar to the CPP with most of her assets invested outside of Canada and with about half in the United States. Not too many investment advisors will advise investing primarily in Canada. So if Ms Gould pays any attention to her own investment portfolio or that of her family and friends, the CPP allocation should not surprise her. Perhaps she’s playing at being naive – at least I hope so.
Of course “re-purposing” the CPP confers certain political advantages – the warnings from Public Choice Theory echo loud and clear. The real questions are: Why do we have a Canada Pension Plan at all? What problem does it solve? And more to the point, what problems does it create?
The usual answer we get from our betters: we need a national pension plan to prevent people in old age from slipping into penury. Without a national pension plan, the story goes, we would find grandmothers eating cat food. To avoid such national calumniates, the government takes some of your paycheck – for your own good – and puts the money into a fund where “top minds” make wise investment decisions. When you retire, you’ll reap the benefits. Yeah, yeah; it’s all bullshit.
First, “top minds” at the CPP do not beat the market on a risk adjusted basis. They do ridiculous things like invest in many different hedge funds at once. The problem is, the more hedge funds you invest in, the more your returns start to look like the index only at higher cost. They chase illiquid private equity with valuations that are at best guesses. The Plan has become a giant actively managed fund with fees of over $6 billion dollars per year (almost 1% of assets under management, if you believe the value of the almost certainly favourably priced private equity assets). The entire approach is silly. Markets are not so inefficient that the CPP can generate alpha. Canadians would do better using their CPP contributions to buy the S&P 500 along with a bond fund.
Second, in reality the CPP increasingly acts more like a disability benefits scheme with a pension attached to the side. Unless you become disabled, you will not receive what you contributed and you have no capacity to bequeath your share of the plan’s assets after death. While politicians sell the CPP as a great deal for Canadians, if you carefully look at how much you’re paying and what you’ll actually receive in retirement, few would voluntarily sign up. People can and do save for their own retirement while also using those assets as part of their estate planning. CPP contributions lower take home pay which displaces private investment. Sure, some people won’t save enough for retirement but it’s nowhere near as bad as fear-mongers suggest. Having the government take your money and invest it for you smacks of paternalism.
Finally, allowing the CPP to invest in risky assets makes little economic sense. The government has created a riskless liability in that it promises to pay you an exact pension amount in retirement according to some formula. But the government has tied this obligation to risky assets! Imagine that I make a promise to pay you $100 a year from now. If the riskless interest rate is 4%, I need $96.15 from you today to make good on the promise. If the risky rate is 10%, on average I only need $90.91 from you but if something bad happens I won’t have the $100 I promised. Tying riskless liabilities to risky rates of returns fails finance 101 but the government does it all the time, including with the public sector pension funds. Discounting with risky rates gives a rosy picture, but there is no free lunch. Implicit taxpayer funded bailouts provide the stopgap but if risky assets fail to perform, it probably means we hit bad economic times with a taxpayer who won’t be able make up the difference. It’s all fun and games while it works, and better yet, it will be some other government’s problem if it all goes sideways.
Compounding these three problems with the giant-pile-of-money-temptation and we can easily see that creating a national pension plan might not be such a good idea. As for seniors at risk of poverty or the disabled, we can handle that with special on-budget programs, not by reaching for yield with hedge funds. We don’t need the government to take people’s money for retirement, invest it in a risky actively managed high fee fund, all while transforming the program into a disability benefits scheme. People can invest their own money and make those who want to play Master and Commander find something else to do.