Supplementary Pension Plan: C.D. Howe

[parvus]

A taxable fixed investor has practically no chance of earning a positive real return.

Not even with RRBs or TIPS?

[pitz]

A taxable fixed income investor has practically no chance of earning a positive real return.

Not even with RRBs or TIPS?

I'd refer you to Moshe Milevsky's (York University) study on taxable GIC returns, 1974-2003:

Canadian investors currently hold approximately $247 billion in guaranteed investment certificates (GICs), and a little over two-thirds of personal GICs are held outside tax-deferral accounts. A widely held perception exists that the real (after-inflation) rate of return on GICs has been consistently positive over a two-decade period, and therefore GICs provide investors with more assurance of future purchasing power than investment products subject to the uncertainties of the stock market. However, common wisdom fails to take into account the annual taxation of accrued interest income on GICs held outside registered accounts.

This study computes the real (after-inflation) after-tax returns (RATs) on one-year, three-year, and five-year GICs during the period 1974-2003. In our analysis, we assume that on maturity these GICs were rolled over into new GICs with an identical term and an interest rate based on the (historical) average market rate quoted by the major banks and trust companies in the year of the rollover. We show that annualized RATs have been negative for Ontario investors in the top marginal personal tax bracket for most of the study period. For example, any investor whose marginal personal tax rate exceeded 35.5 percent earned, on average, a negative annual RAT from one-year GICs rolled over continuously from 1974-2003. For three-year and five-year GICs, the breakeven tax rate was slightly higher at 42.06 percent. Even when positive, RATs rarely exceeded 1 percent. From the viewpoint of individual investors, these results demonstrate the importance of looking beyond the quoted rates for GICs to determine the reward in future consumable dollars for the investor's current consumption sacrifice.

I've never done a tax return with taxable RRB/TIPS investments, but I suspect they suffer from identical issues.

[parvus]

I dunno. That's why I put the question forward. It will be interesting to track the post-tax IRR of RRBs and TIPS.

[brucecohen]

Some consumers will have GICs and 3% MER mutual funds.

No, "many" have GICs -- especially among RRIF holders -- and the majority -- probably the vast majority -- have mutfunds at 2%+

Some will have portfolios filled with bank stocks that directly capture these MERs.

No, the bank stocks capture only the profit portion of the management fee portion of the MER plus, in the case of funds sold through bank-owned distribution, the profit portion of its share of the MER portion allocated to retailer compensation. The bank stock does not capture these parts of the MER:
-- Fund expenses
-- Marketing expenses
-- Fund sponsor non-marketing overhead
-- Bank distribution overhead
-- Individual advisor's share of retailer comp
-- GST
That's off the top of my head at this late hour. There are likely others.

You're also forgetting that many bank shares are held outside the RPP-RSP system and indeed outside Canada.

So if you net out the MERs paid by RRSP/RPP holders, against the MERs collected by RRSP/RPP holders (through their ownership of, for instance, investment management firms), the net should be zero.

No

The "MER" in the context I raised, is the expense Government pays, in terms of tax revenue, on an annual basis, to manage their 'share' in the partnership interest in RRSPs/RPPs. There *might* be leakage, but isn't it safe to say that the leakage would re-appear as an augmented account value in someone else's RRSP?

Where is this someone else? The net expenditure [s]reported[/s] claimed by Finance is the difference between tax foregone and tax collected.

(or even better yet....on the GST accounts, since GST is collected on fund management fees, which easily covers off the cost of the 8.3bp annualized MER I theoretically calculated.).

No it doesn't. IFIC says total mutfund AUM = $705.2B. That includes both registered and unregistered, but for simplicity let's say it's all registered. The mgmt fee is the smallest or next-to-smallest portion of the MER. Often runs about 30bp but let's say 50bp. That puts total mgmt fees at $3.5B and 5% GST at $176 million -- minus input tax credits.

If you sum everything up owned by Canadians in RRSPs/RPPs, you essentially have a very widely diversified index fund, do you not?

Why? If anything, you have an ersatz balanced fund with a very heavy fixed income skew -- and a very high MER.

When you have literally millions of investors all managing their money, is it possible for the performance of those millions of investors to be materially above, or below that of the average returns of the financial markets?

Yes. And if we accept the Dalbar studies in the US and the few DC/GRSP studies in Canada, we know that, in aggregate, those investors materially underperform the markets' average return.

3) A simple grant of, perhaps, $25k per year per person, of contribution room to a RRSP/RPP, without reference to earned income, would be less complicated to calculate and administer, would ensure fair treatment of all Canadians regardless of their current employment status, and would probably grow government revenues over the long term due to increased government investment in the economy as a silent partner.

No, if you add $25K of RSP/RRIF contribution room, you also have to increase RPP limits by the equivalent amount, and there's no rational reason to break the tie to earned income. If there's merit to what you propose, do it through the TFSA. Indeed, you're already one-fifth there. Of course, there's still the problem of all the Joe and Joni 6-Packers who currently can't afford, or choose not to afford, to use the RRSP room they already have, let along pony up $25K a year each in additional contributions. You still haven't told us why they should pay more tax now to cover govt's cash flow gap from letting the investment banker and spouse stash even more cash.

4) Mandatory pension plan contributions encourage, if not require Canadians, particularly the young, to allocate resources in a sub-optimal fashion

And without mandatory pension plan contributions, Canadians -- particularly the young -- still allocate resources in a sub-optimal fashion. The only difference is that pension plan members can better afford a comfortable retirement and attract the envy of their pensionless friends when those friends hit their late 40s or early 50s.

That chart on P. 44 is just stating the obvious -- that the government suffers a tax loss concerning an investor who exclusively invests in fixed income in a RRSP/RPP versus an investor who holds the fixed income in a fully taxable account. It doesn't reflect the real world, where a substantial chunk of investment made has at least some elements of tax efficiency or deferral already embedded.

Yes, that was one of the criticisms made by the Canadian Institute of Actuaries. Though I notice that they include an all-dividends portfolio, which would be highly tax efficient.

While govt's tax expenditure might be overstated due to the fixed assumption, it's also based on an RRSP program with a very low participation rate. Relatively few contribute each year and their contributions are relatively small.

To assess your logic, all we have to do is extend it. We'll assume that long-term tax deferral is tax-neutral. We'll further assume that there are long-term economic benefits from investment by millions of people. So, let's create a total tax shelter. Nobody pays any tax on money they invest until it's withdrawn. But everybody has to put all of their earnings into this special account. If govt is tax-neutral, it won't have any difficulty in meeting its bills next year, right? Yet where's the money going to come from?

Years ago, when the RRSP retirement tax shelter was under attack by the NDP and a Liberal or two, defenders argued rightly that over the long term it's more or less tax-neutral -- that it's tax deferred, not foregone. Prof. Rob Brown of Waterloo even wrote a monograph showing mathematically how the pension-RSP system held the key to meeting Canada's future medicare bills. But the defenders also acknowledged that on a short-term cash flow basis it's tax-negative, at least until the bulk of boomers are retired and in drawdown mode. Since then the pension income credit has been doubled, pension income splitting has been introduced -- a profound change -- plus the OAS clawback threashold has been fully indexed and marginal tax rates have been reduced substantially. Once these developments are incorporated, I'm not so sure that it is tax-neutral in the long term.

And quite frankly, if RRSP/RPP tax sheltering for fixed income wasn't available, I have serious doubts whether Canadian businesses would have access to such inexpensive sources of funding

Indeed, there used to be speculation that this was the reason why Ottawa maintained the foreign content limit for so long -- to force pension funds to hold high levels of Canadian debt. If so, it was undermined when Ontario Teachers' developed, and won court sanction for, the use of derivatives that enabled retirement funds to go as much as 100% foreign without contravening the foreign content limit.

[George$]

.... Indeed, there used to be speculation that this was the reason why Ottawa maintained the foreign content limit for so long -- to force pension funds to hold high levels of Canadian debt. If so, it was undermined when Ontario Teachers' developed, and won court sanction for, the use of derivatives that enabled retirement funds to go as much as 100% foreign without contravening the foreign content limit.

Bruce, I kinda knew that OTPP was one of first to use derivatives to circumvent the foreign content rule but I don't know any details. When exactly did this take place? Were they the very first? Was there a court challenge?
I think this is one of several examples that provides proof that the OTPP investment managers were /are still(?) innovative and astute.

[brucecohen]

.... Indeed, there used to be speculation that this was the reason why Ottawa maintained the foreign content limit for so long -- to force pension funds to hold high levels of Canadian debt. If so, it was undermined when Ontario Teachers' developed, and won court sanction for, the use of derivatives that enabled retirement funds to go as much as 100% foreign without contravening the foreign content limit.

Bruce, I kinda knew that OTPP was one of first to use derivatives to circumvent the foreign content rule but I don't know any details. When exactly did this take place? Were they the very first? Was there a court challenge?
I think this is one of several examples that provides proof that the OTPP investment managers were /are still(?) innovative and astute.

Yes, they were the first. I don't know if they were challenged or elected to go to court proactively.

The account I have is that Bob Bertram proposed the idea just before or just after Claude Lamoureaux hired him as Claude was creating the initial team. As you'll recall, they inherited a portfolio comprised entirely of non-marketable non-assignable provincial debentures and faced the daunting challenge of having to, in a very short time, turn it into a properly diversified markets-based portfolio. Here's the text of a talk last fall in which Claude and Bob -- perhaps the two most self-effacing men on Bay Street -- recounted the early days. You might find it amusing and interesting.

[George$]

...Here's the text of a talk last fall in which Claude and Bob -- perhaps the two most self-effacing men on Bay Street -- recounted the early days. You might find it amusing and interesting.

Thank you for the link. The following from it answers one of the questions.

Claude
A lot of people wondered whether this was even legal for a pension plan. Some directors had their doubts, and the board asked you to get written approval from the Department of Finance, which we did, but you also had another trick up your sleeve.

Bob
That’s true. Canada’s foreign content rules for pension investing were very restrictive at that time. But derivatives exposure did not count as foreign content under the rules. That made the use of derivatives even more attractive.
Today, derivative contracts are a bedrock of our investment strategies. We buy and sell equity swaps in several countries, notably the United States, Japan and the United Kingdom. We also use derivatives to gain exposure to commodities, interest rates, currencies, credit risk, loans and many other opportunities.
At the end of last year, we had $285 million of notional derivative contracts on our books. This is a business we needed and have come to know very well.

Yes I have met and chatted with both Claude and Bob at ICPM workshops. Very modest and helpful individuals.

[Bylo Selhi]

So using Churchillian criteria they have very little to be modest about?

[Bylo Selhi]

Daw likes it. Pension idea needs your help

Ambachtsheer's proposal for the Canada Supplemental Pension Plan is a version of plans in Europe and Australia and earlier proposals from Liberal Party leader Stéphane Dion, the Canadian Federation of Independent Business and others. A column I wrote earlier about his proposal drew favourable comment from several readers:

"Keep talking on this subject," urged Barrie lawyer George Taylor.

"What a great idea!" added Toronto financial analyst Bev Honsberger.

"My husband and I would join in a minute."

"The politician and/or political party that promotes and supports this concept will leave a legacy that will be remembered for generations to come," wrote Jim Roche.

"Excellent idea – badly needed," added Robert Topolnytsky of Toronto.

"Our children need better protection from what's up ahead," agreed Lucien Hamelin.

Only one reader feared the proposal would amount to a money-grab by governments. She did not reply when I asked her what percentage of her savings now goes to pay investment management and sales fees.

Ambachtsheer told students and other interested observers at Rotman School of Business yesterday that a new supplemental pension could cost contributors less than 0.2 per cent of assets per year, or about 2 percentage points less than mutual fund investors typically pay. That savings could add as much as 40 per cent to the retirement income a person could generate from each dollar of savings.

[Bylo Selhi]

Hi, I'm from the insurance industry and I'm here to help you [for a fat fee, natch]

Canada's life insurers are proposing sweeping changes they say would allow the industry to help fix troubles in the pension system, lobbying against a push by some provinces for a new national plan...

[marty123]

Hi, I'm from the insurance industry and I'm here to help you [for a fat fee, natch]

Yes, that article got me thinking: here's another too-big-to-fail scheme. The government would probably need to provide at least a de-factor bailout insurance to these plans/companies, despite having allowed them and their reps to squirrel away the fat fees

[WishingWealth]

Hi, I'm from the insurance industry and I'm here to help you [for a fat fee, natch]

Yes, that article got me thinking: here's another too-big-to-fail scheme. The government would probably need to provide at least a de-factor bailout insurance to these plans/companies, despite having allowed them and their reps to squirrel away the fat fees

Or the easy catchphrase: Privatizing profits and socializing risk.

WW

[George$]

More on this from CPP

“The Canadian Model: Moving From Sustainability to Sufficiency” 11 page pdf file
Notes for remarks by: David Denison President and CEO CPP Investment Board - 16th Annual International Conference of Social Security Actuaries and Statisticians - September 16, 2009 Ottawa, Canada

In this hybrid approach, there would still be flexibility for individual companies to create
pension arrangements tailored to their specific objectives as well as for individuals to
make choices according to their own goals and preferences. There is also ample
opportunity for both the public and the private sector to provide the administrative,
servicing and investment components for the various elements of Canada’s retirement
system and still achieve the policy objectives I outlined earlier in my remarks.