Before their modernization, the Canadian pension funds exhibited the worst characteristics of government bureaucracy and very limited diversification. For instance, one important fund held all its assets in nonmarketable Ontario bonds while pension liabilities were indexed to inflation! Most pension funds in Canada restructured in order to have a clear mission, a strong independent governance function, and the ability to attract and retain the requisite talent to be successful.
Today, the Canadian investment model has the following three features:
(1) Professional in-house Asset Management to reduce costs. Canadian funds manage on average 52% of their assets in-house and even 80% for the very large funds that manage more than $50 billion, whereas non-Canadian funds only manage 23% of their assets internally. However, when investment is outsourced, Canadian funds spend 121 bps for their externally managed portfolio (so a more costly delegation but for a smaller proportion of the portfolio), compared to 86 bps for the rest of the World. As such, the main difference between the Yale and Canada models is the choice between external and internal management. The Yale model almost exclusively chooses to delegate investment in both traditional and alternative assets to external managers, whereas Canadian funds manage more assets internally;
(2) The cost savings resulting from in-house management are re-invested in internal capabilities in order to build internal investment teams for each asset class (with extensive geographic and asset-class diversification) as well as well as to invest in private markets. Based on their result, the Canadian model is cost-efficient but not low cost because managing more assets in-house reduce costs but theses saving are partly used to grow the internal expertise and access selected external parties.
(3) Capital is channeled toward growth assets that increase portfolio efficiency and hedge liability risks. This includes investments in commodity producer stocks, real estate, and infrastructure.
Let’s have a look at the performance of the Canadian Model: According to the Journal of Portfolio Management, from 2004 to 2018, Canada’s pension funds outperformed their peers (Dutch, UK and US) in terms of investment performance and insurance against liability risks. In particular, the Canadian model works best for funds whose pension liabilities are indexed to inflation. Canadian funds also generated a higher Sharpe ratio (93% versus 60% for the peers over the five-year sample).
In summary, the success of the Canadian model is a combination of professional in-house management, scale, and asset diversification. However, there is no unique Canadian model. Small Canadian funds lack scale to invest in-house (high level of fixed costs) and in real assets and private equity (that are more expensive to manage) than large funds.
Application for private investors: It is possible to adopt some features of the Canadian model even if the private investor is not in a position to apply the institutional approach entirely.
The solid processes and a structured approach of the Canadian model lead to the best results for private investors alike. Private investors shall also apply the diversification of asset classes and geography of the Canadian pension funds through passive vehicles. For those willing to retire early, the model may also lead to more efficient asset–liability portfolio and greater protection against their own pension liability risks. In fact, you can partly hedge against these liability risks by investing in a diversified basket of growth assets (that have also increased return performance over the last decade). Consequently, access to assets hedging liability and inflation as advocated under the Canadian model (such commodity producer stocks, real estate, and infrastructure) is not always easy but some exposure (through passive equities or private home investment) is surely desirable for private investors.
Sources: The Canadian Pension Model: Past, Present, and Future, The Journal of Portfolio Management, Volume 47, Issue 5, 2021, Keith Ambachtsheer The Canadian Pension Fund Model: A Quantitative Portrait, The Journal of Portfolio Management, Volume 47, Issue 5, 2021, Alexander D. Beath, Sebastien Betermier, Chris Flynn, and Quentin Spehner