Wednesday, 27 April 2011

CPP "Diseconomies of Scale" Study by Fraser Institute - Spreading FUD

FUD, for those unfamiliar with the acronym, stand for Fear, Uncertainty and Doubt. It is a familiar marketing technique to make people doubt and prevent them doing something. In this case, the Fraser Institute is applying FUD against the idea of expanding the Canada Pension Plan.

The FUD is found in Should the Canada Pension Plan be Enhanced? by Neil Mohindra, published and downloadable on the Fraser website here. The Fraser summary blurb says:
"The study concludes that diseconomies of scale present a risk to the CPPIB’s investment performance. The actions that the CPPIB is taking to offset diseconomies of scale in investment returns will likely become less effective as its assets continue to grow."

The first sentence is true, the Mohindra study does arrive at that conclusion. The problem is that neither the research it presents, nor other facts, support the statement in anything more than the sophistical (as in sophistry = plausible but fallacious argumentation) sense - yes, if diseconomies of scale do arise, then there is a risk, although not a certainty, that the CPPIB's investment performance will suffer. Mohindra delves into a series of research papers that address aspects of diseconomies of scale/size associated with investment funds and pension funds. Here is why I think we can dismiss the alarmist rhetoric of the Fraser report:
  1. If diseconomies of scale were inevitable, the CPPIB would have hit the wall long ago. As Mohindra belatedly notes, "A limitation in applying existing literature on economies and diseconomies of scale to the CPPIB is the sheer size of the CPPIB in comparison to the size of funds covered in the literature." The CPPIB years ago had assets that dwarfed any funds in the literature. Why did CPPIB not exhibit diseconomies of scale long ago? The rise in costs that Mohindra documents about the CPP/CPPIB has become apparent only in the last two years (look at his table A1 on page 34).That rise has less to do with scale than other reasons.
  2. The higher admin/expense numbers of the CPPIB can just as plausibly be interpreted as temporary, a result of the financial crisis and markets' recovery process combined with the investment mix of the CPPIB. It all hinges on the considerable amount of private equity, real estate and infrastructure investments that the CPPIB has deliberately made since 2006. While stocks on public markets such as the TSX rebounded sharply in 2009, the other stuff has lagged and the higher overheads that go with those other types of investments has driven up those costs as a percentage of assets. It's possible the CPPIB may be fundamentally wrong about investing in such other assets (along with many other pension plans out there, like the Alberta Teachers' Retirement Fund Board whose 2010 annual report announces that it has switched its investment policy to go in that direction). However, the explicit aim of the CPPIB is that such assets present the opportunity to gain higher returns that more than offset the higher fees. It is ironic that Mohindra quotes a speech by CPPIB CEO David Denison where Denison sets out a vision for using scale as a competitive advantage. If scale is a reality, I think I prefer the "glass half full" view (opportunity) from the CPPIB over the "glass half empty" picture (diseconomies) of the Fraser Institute.
  3. The pursuit of private equity, real estate and infrastructure by the CPPIB, rather than being a symptom of incipient diseconomies as Mohindra claims, is in fact the appropriate response and strategy to keep costs low and maintain superior risk-reward results. One of the studies cited by Mohindra, that of Dyck and Pomorski confirms that the CPPIB is following the successful path of other large funds: "In their private equity and real estate investments large plans have both lower costs and higher gross returns, yielding up to 6% per year improvement in net returns." Furthermore, most of the increase in operating expenses of the CPPIB during 2009 and 2010 came from the ramping up of internal management capability to replace external managers, another factor that Dyck and Pomorski say is a significant source of cost savings for bigger plans. It looks more like like CPPIB is on the road to exploiting increasing economies of scale, not butting up against diseconomies.
  4. Governance matters a lot more than scale. Small organizations can be poorly run as easily as big ones. A much more convincing explanation of what determines the success of a pension/investment fund comes from Keith Ambachtsheer of the Rotman International Centre for Pension Management. Pension organizations properly aligned with the interests of the pension benficiaries, proper definition of roles between a board and professional management, appointment of financially knowledgeable and independent individuals to boards, effective risk management processes - those are what get good results.
  5. The CPP's overheads, if they were to stay at current total all-in levels of about 1% (total operating expenses in 2010 of $498 million Government of Canada plus $236 million CPPIB plus $466 million in external investment management fees on average CPP total assets of $120,721 million per Volume 1 of the Public Accounts of Canada with CPP data starting page 171 of the pdf), or even rise further, are still small compared to the all-in costs of alternatives, like TFSAs and RRSPs. Start adding up the costs of mutual funds where most people place their retirement investments, or even of the best case lowest fee ETFs around, then add fees like deregistration/withdrawal fees from RRIFs, or the implicit charges when buying an annuity to turn the savings into retirement income (read Peter Benedek's series on annuities on this page of his RetirementAction website to see how poor a deal they are). The average person will be losing more in various costs than 1%. This ignores the "costs" from investing mistakes that so many people make along the way when left to do it themselves in TFSAs and RRSPs.
Instead of concluding that "the size of the assets the CPPIB will be managing even without expansion shows that diseconomies of scale is a reason not to expand CPP", Mohindra would be more accurate in saying that "the opportunity to exploit economies of scale is a reason to expand CPP".

The large size of the CPPIB portfolio is NOT a problem. As long as CPPIB governance and management continues to be good, the move into private equity, real estate and infrastructure provides opportunity, not rising risk. In the 2006 speech quoted by Mohindra, CPPIB CEO David Denison also mentioned that the size of private market opportunities is vastly larger than those in public stock markets. It is a good thing for CPPIB and for Canadians who have their money being invested there by the CPPIB.

1 comment:

larry macdonald said...

I'm not sure why the retirement system has emerged as such a big issue recently. It seems we have more pressing probems in areas like healthcare. Directing new resources to alleviate a "fever" in the retirement system comes with the opportunity cost of fewer resources for dealing with the "cancers" in areas like healthcare.

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