Bigger isn't necessarily better when it comes to expanding CPP

The recent Canadian federal election campaign saw a number of arguments raised both for and against expanding the Canada Pension Plan (CPP). This debate is an important one for Canadians, since it affects their disposable income both during their working lives and in retirement.

Advocates of expanding CPP contributions and benefits argue that many people do not save adequately for retirement and even if they do, they make poor investment decisions. On the other hand, the argument against expanding CPP emphasizes that the plan should focus solely on meeting basic income needs in retirement, and that alternatives to the CPP provide people with the flexibility to meet their financial objectives over their life cycles.

But what’s been missing in the debate is an examination of how expanding CPP contributions and benefits will affect the pension plan itself. As it turns out, expanding the size of CPP could actually hinder the plan’s ability to fund Canadians’ retirement.

The CPP Investment Board, which manages the CPP’s financial assets, had $140.1 billion under financial management at the end of its last reported quarter. The board’s assets are expected to grow to $700 billion by 2038. The size prompts a need for further examination of economies of scale in managing financial assets. Some advocates of CPP expansion have used economies of scale as an argument on the basis that larger size means lower administrative and investment costs. Academic literature on the subject indicates this is true but these economies flatten out and reach a point of exhaustion. The literature also shows that there are diseconomies of scale that set in with size in over all investment returns.

The diseconomies come in three different forms: hierarchy, liquidity and management dissipation. Larger size means more hierarchy and bureaucracy.  Systems and controls to monitor performance, allocate resources and manage risk become more extensive, complex and multi-layered. This results in investment managers spending less time on researching investment ideas and strategies. Instead, investment managers devote more of their time towards convincing the various levels of management to approve their budgets and strategies.

Liquidity refers to the ease with which a security can be traded without causing a price impact (ie. a fluctuation in a share price). A larger asset base can erode fund performance because of liquidity challenges. While a small fund can invest its money in its best ideas, a larger fund has to invest in its second and third-best ideas, and take larger positions in individual securities than is optimal, thereby eroding performance. David Denison, the president and CEO of the CPP Investment Board, acknowledged the problem in a 2006 speech, stating the board sometimes identifies opportunities that it cannot capture because of the market impact of trading in the volumes entailed by the board’s portfolio size.  

The third diseconomy is management dissipation. Because managerial talent is a scarce resource, it dissipates as the scale of operations increase. As highly skilled managers will be allocated more assets to manage, the returns that they will generate will become more in line with less skilled managers.

Large pension plans can adopt strategies to offset diseconomies of scale. For instance, they can move more assets into alternative asset classes such as private equity, real estate and infrastructure where diseconomies set in at a higher level than other asset classes such as public equities. They can expand the number of external managers that they employ to shift towards more specialized managers capable of generating better returns than balanced managers in some asset classes and foster competition amongst external managers. The CPP Investment Board is already actively engaged in these strategies even though this has lead to a significant increase in their administrative costs and external advisory fees. But continuing growth in the size of the board’s portfolio towards the $700 billion mark will limit the effectiveness of these strategies going forward. For instance, the board already has more than a quarter of its assets in alternative asset classes. While the board’s long-term investment horizons provide flexibility to grow these classes as a percentage of total assets, there is a limit to the extent they can continue this prudently.

Despite advocates of CPP expansion stating that economies of scale is an argument in favour of expansion, the size of the assets the CPP Investment Board will be managing even without expansion shows that diseconomies of scale is a reason not to expand CPP. Even modest CPP expansion will add to the risk that the board will not meet its objectives in helping the CPP fund Canadian retirement incomes.

Policymakers who believe that more should be done to improve retirement security for Canadians should recognize the strengths of the existing system and focus on improving the third pillar of registered assets, which includes registered pension plans, individual and group RRSPs, and tax free savings accounts.