There are about 5,300 public pension funds in the U.S. today, overseeing some $4 trillion in assets. The 25 largest account for more than half the total. The rest of the market is highly fragmented, with thousands of public pension portfolios managed independently and locally. Fragmentation results in less efficient portfolios and higher operating costs, potentially leading to lower net returns and ultimately a greater funding burden on taxpayers. Especially given the impact of Covid-19 on public finances, there must be a better way.
In a comparative study of the largest U.S. and Canadian public pension plans, we explored pension reform in Canada in the late 1980s and 1990s. Prior to those reforms, Canadian policymakers worried about the integrity of the country’s public pension system. Decades later, the system is considered among the best in the world. Our data show that on almost all metrics the Canadians outperform their U.S. peers, so the Canadian experience offers some useful lessons for reforming the American public pension system.
One of the key lessons is that scale matters, and there are ways to achieve scale even for smaller pension funds through the pooling of assets. We call this the consortium model of pension system design.
Larger pension pools allow for staffing investment teams that exceed critical mass and for designing and developing portfolios that are diversified across asset classes and markets. Significant market footprint also helps pension managers effectively engage with asset managers to obtain access to co-investments and reduced fees for larger fund commitments.
On the other hand, we know that scale tends to dissipate at extreme size. Some institutional investors are so large that they cannot make allocations to higher-performing strategies that move the needle in the portfolio, while concentrated positions might move prices against them. Norway’s sovereign wealth fund and Japan’s government pension fund are well known examples.
But there is a sweet spot – perhaps between $50 billion and $250 billion in AUM. In the U.S., about twenty public pension funds cross the lower threshold; in Canada, a handful do. The California Public Employees’ Retirement System and Canada Pension Plan exceed the upper bound.
Another feature of the Canadian public pension system is in-house investment management. This originated in Québec and became prevalent in Ontario in the 1990s. Over the years, the Toronto-based pension funds have become among the most sophisticated in the world. When Canada’s smaller provinces and its federal pension system underwent reform, they adopted key lessons from Ontario. Along the way, they developed the consortium model, one that also prevails in some European markets.
Formed as units of Canadian federal and provincial finance departments, investment organizations managing combined portfolios of pension plans and other government assets came into being. These include the British Columbia Investment Management Corporation, Public Sector Pension Investment Board, and Alberta Investment Management Corporation. More recently, the Investment Management Corporation of Ontario was formed for the purpose of serving smaller Ontario pension plans, while CAAT Pension evolved from serving Ontario colleges to serve smaller pension funds across the country. Preceding all of these was Caisse de dépôt et placement du Québec. Other than CAAT, each is a public sector entity operating at arms-length from government and overseen by representatives of its largest clients. The model continues to evolve, and has recently been considered in Manitoba.
Might the consortium model be adopted in the United States? To some degree, it already has been. The Massachusetts Pension Reserves Investment Management Board is an investment office for the entire Commonwealth. Pennsylvania and Illinois are considering similar approaches.
We believe the consortium model is well worth wider consideration. There are hundreds of mid-size and thousands of small U.S. public pension plans. Investing the portfolios of each of these independently is inefficient.
How might such entities be structured? States – or groups of smaller states – could establish investment units to manage the portfolios of consortia of pension plans. These would operate at arms-length from government, while being held to fiduciary standards set by their clients. Smaller pension funds might pool assets and establish mutually owned cooperatives to invest on their behalf. They might even collectively engage investment management firms using the scale of their aggregate AUM. Full customization would be traded for greater portfolio diversification, access to otherwise inaccessible strategies, and better control over expenses.
State and local governments are searching for innovative ideas to fortify their finances given the impact of Covid-19. The consortium model is attractive because it enhances market efficiency. The Canadian examples provide good case studies.
Clive Lipshitzis a managing partner at Tradewind Interstate Advisors and a guest scholar at New York University.
Ingo Walter is a professor emeritus of finance at NYU Stern School of Business.