In this post I will review the reasoning behind the ICPP Accumulation Fund and why we believe this fund will provide appropriate long-term investment results for members of pension plans in Canada.
We believe today’s retirement industry is failing many Canadians employed in the private sector. Retirement outcomes are unstable when provided through traditional defined contribution pension plans and the fee structures for these traditional plans are too high – much higher than what is enjoyed in the public sector or through defined benefit pension plans in the private sector.
Our experience has taught us that employees place a high value on stable and tangible retirement outcomes and are willing to pay reasonable amounts to achieve those retirement outcomes. Employees want to be able to provide for their basic needs, to maintain a standard of living and to meet other goals in retirement but they need help to achieve those goals.
Canadians in the private sector have been forced to take on an ever increasing burden. More and more they have been required to take a bigger role in managing their savings contributions and retirement accounts. They have been asked to design and build the car – not just drive it! At the same time, research has shown and emerging research is confirming that pension plan Members generally do not make good investment choices and do not manage their retirement accounts well on their own.
In our experience, private sector employers actually support defined benefit pension plans. Most would provide such plans if they could. They want their employees to enjoy a stable retirement life. Unfortunately, contemporary regulatory requirements and governance structures for defined benefit plans have made that very difficult, if not impossible, for most private sector employers.
We therefore decided we would provide the Ideal Canadian Pension Plan (ICPP), a cooperative and collective defined contribution pension solution directed specifically to employees in the private sector, especially those not covered by a current employer pension plan. The ICPP provides a more stable retirement outcome to Members with the lower fee structures that result from collective solutions.
We also want to reframe the discussion with the Members of the ICPP and have the Members concentrate on their outcomes – their personal benefit targets – and not on the ICPP investment process. This is a paradigm shift from traditional defined contribution approaches that focus Members on individual investment decision making.
Our investment philosophy for the Ideal Canadian Pension Plan is very simple. We believe there is an optimal investment approach for all Members of a Canadian Pension with the same retirement benefit goals and that the Management Board of the ICPP is well positioned to establish and monitor that optimal investment approach. Better positioned than individual Participating Employers or Members of the ICPP.
We established a number of separate investment funds to support the various target benefits under the ICPP during the payout stage. If a Member selects a benefit target, his investments are directed to the appropriate supporting payout fund, at the right time, to support actual payout of the Member’s targeted benefits.
Our approach results in one optimal investment for all Members, the same investment return for all Members and the same investment expense for all Members leading to better expected returns and lower expenses.
The ICPP Accumulation Fund is the investment fund for all ICPP Members during the accumulation phase of their membership. To understand why, we need a little background on our investment thinking for the ICPP Accumulation Fund and on the design history of the ICPP.
We define the accumulation phase as the part of the Member’s career that is more than ten years before any targeted benefit is expected to be paid out. Investment funds held ten years prior to expected benefit payout require a long-term investment philosophy. Our primary goal for the ICPP Accumulation Fund is to provide what we believe is the best possible long-term investment outcome. We are not concerned with short-term outcomes for this fund. Long-term to us means more than ten years and can include much longer periods.
This requires us to consider the elements we need to include in the investment process to reflect the long-term nature of our Members’ needs. This also requires us to consider what makes “true long-term investing” different from the typical investment focus of contemporary investment portfolios.
Through our research we concluded that all of the evidence supports using equities, and equities only, as the underlying investment instruments for a long-term investment portfolio. Equities are expected to provide the highest returns over the long term. Other asset classes have a role in a portfolio that has a short-term mandate but not in a long-term portfolio. The opportunity cost (i.e. the expected lost long-term investment return) associated with being in any other asset class is prohibitive over the long term.
Short-term volatility in a long-term investment portfolio does not matter because it does not result in long-term risk. We define long-term investment risk as exposure to investment instruments or funds that are expected to result in insufficient investment income over the long-term. Inadequate investment results will cause the Members to miss their retirement objectives. Opportunity cost is created when a suboptimal investment strategy is selected. In our opinion, opportunity cost’s effect on long-term risk should not be ignored.
An “equity risk premium” is available to anyone who invests in equities (i.e. the expected investment return is higher than for other asset classes). The equity risk premium compensates short-term investors for the short-term volatility of their investment returns. Over the long term, an “equity risk premium” simply becomes an “equity premium”. As long-term investors we must collect that equity premium. Our pension plan Members use the additional investment return resulting from the equity premium to support their retirement income needs that same way as any other investment return.
We also concluded through our research that elements of Financial Economic theory that are commonly used as an underlying principle to determine most short-term investment solutions are not appropriate for long-term investment solutions.
We do not accept Financial Economic theory as sufficient for our long-term investment process because of the failure, in the long-term, of three of the underlying assumptions used to develop and support Financial Economic Theory – the three “I’s”.
The first “I” is Independence (i.e. an investment has significant elements that have nothing to do with other similar investments). The theory goes that markets are random and individual investments have elements that will behave independently from other individual investments. Anyone who lived through 2008, or 1987 or many other periods knows that individual market returns are generally not independent from each other and are not independent at the most inopportune times. Individual investment returns have a huge systemic element. Any randomness is trivial, especially over the long term.
The second “I” is Instantaneous (i.e. the model tells us nothing about tomorrow). Financial Economic theory is built on models that research has shown have a predictive value of no more than a month, at best. This is not very helpful in establishing a long-term investment process.
The third “I” is Intemporal (i.e. the current point in time does not matter). This implies, among many things, that the markets do not have a memory. Current conditions do not affect future outcomes. Past experience does not affect future outcomes. We have never known a professional investment manager to support this belief but it is a necessary component of most past Financial Economic thinking and the thinking used to support short-term investment processes.
While we agree that short-term markets appear to have important random elements and that Financial Economic theory and techniques can be helpful over the short-term, we believe that over the long term, markets are best described as chaotic. In fact, we think markets are chaotic and are only thought of as random over the short-term because chaotic systems generally appear random at first glance.
If markets are chaotic, then we would expect current conditions to matter, previous outcomes to matter, constant monitoring to matter and rules-based management of the investment process to matter. Managers can take advantage of chaotic systems by concentrating on what matters in a chaotic system. We believe that long-term investment management processes must be based on the premise that the long-term investment outcomes are chaotic to be effective.
Since we believe long-term investment outcomes are chaotic, we must use a long-term investment process that concentrates on:
- Selecting a balanced set of investments that represent our best long-term opportunities within the economy (i.e. select market leaders in industries that we believe have a positive long-term outlook).
- Rebalancing our portfolios regularly to ensure we maintain an appropriate set of current conditions in our portfolio (i.e. ensure our portfolio never becomes unbalanced and over invested in any particular equity or industry).
- Rebalancing our portfolios to ensure recognition of past experience (i.e. establish rules that force the sale of a portion of any equity that has exceeded relative growth targets over the short term and force purchases of any equity that has lagged the targets).
- Monitoring the set of investments and selected industries and market leaders to ensure they continue to have a strong long-term outlook.
- Establishing procedures that allow the portfolio to be generally “bought and held” to avoid investment expenses which can significantly undermine investment performance over the long term.
ICPP Accumulation Fund
The long-term process selected for the ICPP Accumulation Fund could be based on a passive investment approach, an active investment approach or some form of rules-based investment approach (i.e. a balance of passive and active approaches). We decided to use a long-term investment management process that is a rules-based active management approach.
We therefore need to be sure that we have an objective measure as a benchmark to measure investment success as we had defined it since the ICPP Management Board, and not a Participating Employer or an ICPP plan Member, would be required to manage and monitor the ICPP investment process.
We need a “benchmark” to measure investment success for the ICPP. In fact, if we were to use a passive approach then the “benchmark” could become the basis for our portfolio. The investment benchmarks being used in the Canadian pension industry are normally based on total market benchmarks that are readily available. For Canadian equity investments, the typical benchmark is based on the S&P/TSX Composite Total Return Index or a variation of this benchmark. For US equity investments, the typical benchmark is based on the S&P 500 Total Return Index or a variation of this benchmark.
We do not think simply adopting these benchmarks would be appropriate for the ICPP for two reasons.
First, we wanted to adopt a new long-term investment approach that would have us invest in well diversified leaders in the Canadian economy made up of Canadian companies (e.g. CP Rail) or multi-national companies available through the US markets with a substantial presence in Canada (e.g. General Electric).
Second, we had concerns about the S&P/TSX Composite Total Return Index being used for Canadian equities because of its high concentrations in a few industries (e.g. Financial and Energy).
We do think a benchmark based on 50% of the S&P/TSX Total Return and 50% of the S&P 500 Total return measured in Canadian dollars is a good start, and even necessary, but it was not enough. As actuaries we thought of this “50/50 benchmark” as necessary but not sufficient.
We therefore designed a new Index that could be used together with the 50/50 benchmark to provide another independent check of our long-term investment success.
Since we want a new Index, we need to design it from first principles. Our goal is to create an Index that is well diversified, can be expected to remain well diversified and is representative of business in Canada. We also need a benchmark that is investible under ICPP conditions (i.e. practical).
Our work resulted in the Total ICPP Index. The ICPP Total Index is based on 20 pairs of Canadian equites and 20 pairs of multi-national equities traded in the U.S. The multi-national companies were selected to complement the Canadian companies, to provide exposure to industries not represented well in Canada (e.g. health care) and to avoid overexposure to any area of the economy (e.g. we had plenty of Canadian banks and did not need to add multi-national banks).
The Total ICPP Index is rebalanced quarterly to maintain the needed diversification.
We settled on “20 pairs” because our research, including a review of research by others, indicated that 20 was enough to provide proper diversification, as long as the underlying equities were selected well (e.g. we didn’t select 10 energy companies).
We settled on quarterly rebalancing because our research indicated that this timing produced acceptable results. Monthly rebalancing would lead to too much in administrative costs and annual rebalancing allowed too much drift.
We also applied Environmental, Social and Governance principles to our selections. We did not want any “corporate welfare recipients” included in the Total ICPP Index. We do not include tobacco companies.
We also want to make sure that the Total ICPP Index was a reasonable long-term index.
Finally, we want an index that is based on the chaotic nature of the long-term investment process. The index would be made up of equal weighted investments in market leaders of industries that we believed have a strong long-term outlook.
We ended up with an index that:
- Has forty pairs of companies that were all selected as market leaders in industries that we believe have a positive long-term outlook (i.e. 20 pairs of Canadian companies and 20 pairs of multi-national companies with a Canadian presence that are traded on US markets).
- Is rebalanced quarterly using a rules-based approach.
- Is rebalanced by selling a portion of any equity that was above a rules-based threshold and buying the equities that had lagged.
- Is monitored by an oversight committee to ensure the forty pairs of companies continued to be market leaders and continued to have a strong long-term outlook.
- Has very low turnover and is generally “bought and held” to avoid investment expenses which can seriously undermine investment performance over the long term.
In other words, our Index was based on a chaotic investment process. It is simple, cheap and invests only in market leaders from a Canadian perspective.
We started to manage the ICPP Total Index beginning in 2012. We back tested it against actual investment returns from 2002. A strange thing happened – we found it very difficult to find an existing investment fund that produced investment returns that “beat” the ICPP Total Index returns consistently. We had an Index that was very hard to beat.
In spite of this knowledge, we think we can establish a real investment fund that could beat the ICPP Total Index returns based on our knowledge of how the ICPP Total Index is constructed. We think a professional investment manager can use short-term investment management techniques to occasionally select one company in a pair over another (e.g. CP Rail over CNR). There may be short-term issues that would favour one company over the other. Most of the investments in the fund would mirror the ICPP Total Index but a few good short-term “ideas” could allow some positive variance from the ICPP Total Index that would result in additional returns. We were not sure that an investment manager could achieve additional returns over the long-term but considered the additional risk well worth the try.
We therefore established the ICPP Accumulation Fund and have actively managed this fund on a prospective basis since January 2016 (and have had active funds under management since February 2017).
It is early, but the ICPP Accumulation Fund has exceeded all of our expectations.
The 50/50 benchmark provides returns that we would have accepted for Members of the ICPP during the accumulation phase of their retirement planning. The ICPP Total Index provides returns that have been consistently better than the 50/50 benchmark based on back testing to 2002 and using an actual managed ICPP Total Index since 2012. The ICPP Accumulation Fund has beat the ICPP Total Index since the beginning of 2016.
We attach a “fund facts” sheet at September 30, 2017 for the ICPP Accumulation Fund to this article. We also attach an Investment Policy Statement for the ICPP Accumulation Fund to this article.
We are very excited about the ICPP Accumulation Fund. Optimal long-term investment outcomes will result in optimal long-term retirement outcomes for Canadians. We think the ICPP Accumulation Fund should become part of any retirement solution in Canada.
One final note, the investment process for the ICPP Accumulation Fund is straight forward. That allows us to offer the ICPP Accumulation Fund using investment fees that are lower than fees currently charged by typical actively managed Canadian Equity investment funds. The ICPP Accumulation Fund therefore meets all five of our long-term chaotic investment process criteria.
The portfolio manager for the ICPP Accumulation Fund has established a fund that:
- Invests in at least one leading company in each industry represented in the ICPP Total Index.
- Is rebalanced quarterly using established rules.
- Does not hold any equity above the established maxima.
- Is monitored by an independent oversight committee.
- Has very low turnover and fees that reflect the required work to manage the fund.