However, building expanded-CPP and/or PRPP (incrementally voluntary or mandatory) on top of the existing CPP administrative infrastructure would reduce incremental administrative costs to close 0%. Furthermore, using a passive portfolio implementation (either a fixed asset allocation or a target-date type glide-path) the investment management cost could be kept well below 0.3%. Independent of the level of the incremental contributions, this level of costs (<0.3%) over a 40 year accumulation period would result in 25-30% higher level of retirement income than if savings were invested at a cost of 1.32% cost, and 75-100% higher than a retail mutual fund based RRSP/RRIF implementation (2.5-3.0%).

Adding a compulsory (pure) longevity insurance option, and requiring that about 8-10% of the accumulated incremental funds be allocated to this at age 65, would insure a lifetime income stream starting at age 85 and still have over 90% of the incrementally accumulated assets be available for covering age 65-85 expenses, emergencies or an estate..

The details

Recently there have been a number of articles which questioned the commonly held belief among Canadians that that the CPP was low cost (and guaranteed).

In the Financial Post’s “Canada pension myths”Neil Mohindra writes that proponents of pension reform by an expanded CPP option have spread “inaccuracies and myths” and “The reality is that the CPP is not risk free or as low cost, as advocates of expansion pretend. The Canada Pension Plan Act, governing the CPP, includes an automatic mechanism to adjust benefits and contributions to bring the plan back on track if at any point it is no longer considered sustainable in meeting its obligations… the CPP Investment Board is strictly the investment manager for the CPP so its costs do not include all the administrative costs of the CPP such as the costs involved in collecting premiums and paying benefits.”

In the Financial Post’s “Pension myths” Greg Hurst writes that “Myth 5 (is that) CPP administration is low-cost….CPP is very expensive to administer and does not reflect reasonable expectations for lower costs from a very large (in the Canadian context) economy of scale. Even medium-sized pension plans in Canada’s private sector easily achieve similar or lower cost structures. The consolidated financial statements of the Canada Pension Plan for 2008-09 show operating expenses of $694-million, investment management fees of $383-million and investment transaction costs of $93-million for a total of $1.17-billion. Average assets of the CPP Investment Fund for the period were $118-billion. Thus investment-related expenses amount to approximately 0.40% a year, with administrative expenses of approximately $41 per year per CPP contributor/beneficiary (based on 17 million contributors/beneficiaries).” 

Let’s look at the facts.

CPP costs

According to the December 31, 2009 25^th CPP Actuarial Report(thanks to Bernard Dussault, former CPP Chief Actuary for the reference to the report and pointers to the specific data provided below):

-administrative expenses in 2009 were $711M (0.56% of assets) projected to increase to $820M (0.61%) in 2010 (p.137) (Mr. Dussault pointed out to me that the percent of assets is not the best measure for measuring the effectiveness of a CPP like plan because: (1) the variables driving administrative costs are not size of assets under management but the number or contributors and current beneficiaries, and (2) on a fully funded basis the CPP assets would be 5-6x larger than they actually are (which would translate expenses to the 0.1% implied assets level)

-given that there are about 16.6M CPP participants (12.6M contributors (p.24) and 4M current pensioners (p.26)) then the $820M 2010 administrative cost represents $49/participant.

-“ CPPIB operating expenses for fiscal year 2010 amounted to 19.8 basis points, i.e. $0.198 for each $100 of invested CPP assets. Transaction costs amounted to 12.4 point, for a subtotal of 32.2 points. External management fess amounted to 39.1 points, for a grand total of 71.3 points” (Referring to p.56 in private correspondence from B. Dussault). Note that CPPIB manages the funds in an active rather than passive fashion

Therefore total or ‘all-in’ cost for the CPP in 2010 is 1.32% of assets, comprised of 0.71% of assets associated with investment related activities (operating, transaction, and external management fees) and administrative expenses of 0.61% or $49/participant.

I assume that the $820M administrative costs are allocated to the entire asset base in a uniform manner, so even though these costs are incurred due to a very large number (16.5M) small ($8000 on the average), the ‘all-in’ cost must be considered to be 1.32%.

Performance: CPP return

The CPP assumes and targets a long-term 4.2% real rate of return for the assets under management. As to what was the recent CPP performance, the May 20, 2010 CPPIB news releaseit says that:

“For the five-year period ending March 31, 2010, the CPP Fund generated an annualized rate of return of 4.0 per cent, or $18.5 billion of cumulative investment income. For the 10-year period, the Fund had an annualized rate of return of 5.5 per cent, or $39.3 billion of cumulative investment income. Canada’s Chief Actuary has estimated that an annualized 4.2 per cent real rate of return, or approximately a 6.2 per cent equivalent nominal rate over the last 10 years, will be needed to sustain the CPP at its current contribution rate.”

And on performance against benchmarks:

“As noted above, CPPIB measures performance against a market-based benchmark, the CPP Reference Portfolio. It seeks to generate value-added returns above this benchmark over the long-term. For purposes of accountability CPPIB looks at performance over rolling four-year periods. While absolute returns for fiscal 2010 were strong, value-added returns for the four-year period ended March 31, 2010, underperformed the benchmark. For the four-year period ending March 31, 2010, the annual total portfolio return underperformed the CPP Reference Portfolio by 0.34 per cent. The annual total portfolio return for fiscal 2010 was 5.87 per cent below that of the CPP Reference Portfolio, and offset the value-added performance recorded in each of the previous three years.”

The CPPIB switched to an active approach to managing its portfolio in 2006 as described starting on p.20 of the CPPIB’s 2010 Annual Report. The results are just another demonstration of how difficult it is to consistently outperform a passive investment benchmark, after costs/fees! So you might wonder why even try except perhaps at the margin.

A cost benchmark and comparative analysis

The Deloitte report entitled “Defined contribution/401(k) fee study”summarizes its findings in a simple graph below (p.7 of the study), showing the ‘all-in’ fee variability with number of participants and average size of individual account. Note that on this graph, given that the average CPP account is about $8000 ($130B/16.6M participants), would put the closest comparable point to the CPP on this graph to the left of the  $10,000 average account size point on the 50,000 members curve, i.e. at an all-in cost slightly above 0.8%. (If you wanted to look t it on a fully funded basis at around the $50,000 average account size point for an ‘all-in’ cost of about 0.4%. (As indicated above, the administrative portion of the cost is more a function of the number of participants than the assets under management.)

Consider the lowest cost point on this graph, the Average Account Balance= $150,000 on the 50,000 participants curve; it is about 0.1%. If we assume that the $40-50/person fixed cost is applicable here as well the fixed costs are about 0.03% and investment management fees are 0.07% (consistent with available institutional low-cost index funds). Therefore the investment related costs (excluding administrative costs) is about an order of magnitude lower than the 0.71% CPP costs.

Trying to make sense of the CPP vs. the Deloitte numbers, then if administrative cost per member in the Deloitte report for the 50,000 members curve at the $10,000 account size is the same as the  $49 CPP cost, that would leave about 0.3% for investment management. This 0.3% for investment management expenses is easily achievable when you consider the fees charged by Vanguard to retail investors about 0.18% for target-date funds and 0.5% for managed (monthly) payout funds, and 0.07% or even lower for institutional index funds. Another benchmark is that I manage my passive portfolio as a retail investor for about 0.3% of assets. At an institutional level 0.3% for investment management fees should be a ceiling.

Conclusions