The $25-billion pension ‘haircut'
The deadly combination of investor naiveté and industry marketing savvy is costing Canadians investing though mutual funds as much as $25-billion per year. Sustained wealth reductions of this magnitude will cut the retirement income of Canadians investing their retirement savings through the mutual fund sector in half or worse.
This is a case of market failure on a massive scale, seriously undermining the retirement prospects of millions of Canadians, especially those working in the private sector. Rather than fiddling with ABM fees, it is this potential massive private sector pension shortfall that our politicians should be focusing their attention on.
The Rotman International Centre for Pension Management at the University of Toronto recently directed a study comparing the investment results of similar investment mandates between Canadian pension funds and mutual funds. It found that the pension fund results bettered the mutual fund results by a startling average 3.8 per cent per year. Applying the 3.8 per cent return ‘haircut' to the $690-billion Canadians have invested in mutual funds implies a wealth transfer from Canadian mutual fund participants to others (mainly to the mutual fund industry itself) of some $25-billion per year, leading to material shortfalls in retirement income down the road.
These disturbing findings provoke two important questions:
(1) Why do Canadian mutual fund investors willingly put themselves in this highly disadvantageous situation?, and
(2) Why do Canadian pension fund participants achieve materially higher returns relative to their mutual fund counterparts?
Half of the answer to the first question lies in the naiveté of mutual fund investors. Behavioural finance research suggests that most people are far from the rational ‘utility maximizers' theory assumes. Instead, they are financially unsophisticated, lacking in knowledge, self-discipline and firm preferences, and easily influenced by outside ‘experts'. For example, a recent Pollara survey asking Canadians why they had invested in mutual funds, found 85 per cent were persuaded by “someone who provided me with advice and guidance”. This response leads directly to the other half of the answer to the first question. The mutual fund industry has been very good at exploiting the naiveté of its customers. If customers want “advice and guidance”, the industry has been only too happy to provide it, either directly or through its coterie of well-paid financial advisers. And what is that advice? Naturally to invest in mutual funds and prosper!
Regarding the second question, pension funds produce materially better investment results because they do not pad their own bottom-line profitability by exploiting the financial naiveté of their ‘customers'. Instead, their single goal is to achieve the highest possible return for pension plan participants within pre-assigned risk budgets. So pension funds have no marketing costs. They have no obligation to produce profits for owners, the way most mutual fund management companies do. Pension funds also don't need to play bravado games trying to continuously prove they are smarter traders than the competition, often leading to far too high (and expensive) turnover rates. Instead, thought-leading pension funds have recognized that simply trading shares with each other is largely a waste of time and money. Instead, real investing is about transforming retirement savings into new productive wealth, from which future pension payments can be generated. This is why pension funds are becoming increasingly pro-active investors in major infrastructure projects around the world, and why they are willing to take a public company like BCE private when they believe value can be unlocked through that process.
What about Canada's governments? Should they treat the $25B pension haircut Canadian mutual fund investors will experience this year just a simple case of ‘caveat emptor'? Or is this a case of massive market failure requiring aggressive remedial action? The Australian and Dutch government responses to this issue 15 years ago are instructive: mandated coverage of their entire national work forces by occupational pension plans. This is pretty well the case for Canadian public sector workers. In contrast, only 27 per cent of our private sector workers are members of occupational pension plans. And the other 73 per cent? Our governments' current position appears to indeed be ‘caveat emptor'. Not so in the United Kingdom. A British government White Paper on pension reform calls for the creation of a National Pension Savings Scheme, which foresees enrolling the entire non-covered part of the UK work force in occupational pension plans specifically created for this purpose.
Meanwhile, our politicians seem to be content fiddling with ABM fees while almost three-quarters of Canada's private sector work force lack adequate pension provisions. Maybe we should close the honourable members' generous pension plans. That should get their attention.
Keith Ambachtsheer is Adjunct Professor of Finance and Director of the International Centre for Pension Management at the Rotman School of Management, University of Toronto. He is the author of “Pension Revolution: A Solution to the Pensions Crisis” (Wiley, 2007).
Read the full study Losing Ground.
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