Thank you for inviting us this morning.
We want to talk to you about pension funds, which represent 36% of institutional savings in Canada, only slightly less than the banks. We're talking about a very large pool of capital.
Pension savings and how they are invested have been subject to major transformations over the last 30 years. Many changes have been unintended, and several have been quite damaging for both individual pensioners and the Canadian economy.
The negative effects include a substantial decline in the portion of private sector employees covered by pension plans; a rise in the much less efficient defined contribution plans at the expense of defined benefit plans; an increased reliance on subjective, opaque and illiquid private markets; a disinvestment from transparent and liquid public markets; an increased investment in low-return bonds; and increased herding, to the detriment of independent fundamental analysis, resulting in a decrease in vitality.
The negative effect that seems to attract the most attention has been the exit from Canada of Canadian pension funds. Canadian public equities held by Canadian pension funds fell from 80% of their total equities in 1990 to probably less than 10% now, representing under 4% of their total assets. The argument most often used to justify this behaviour is the expectation of higher returns in foreign markets. In fact, returns in Canada have historically exceeded many other world markets. By comparison, current valuation metrics are quite favourable.
Let's assume for a moment that returns in Canada will be lower. The question remains whether maximizing single portfolio returns to the exclusion of other factors is the correct global strategy for the country as a whole. If pension funds siphon away Canadian savings under the guise of higher expected returns without considering the effect this may have on the ability of their contributors to earn incomes, the return calculations are incomplete from the point of view of the Canadian economy.
Investing $100 outside the country may generate an extra dollar in returns, but the impact of the absence of the $100 invested in the local economy may be much greater. The loss in domestic investment, sales, salaries and profits because of a lack of local investment by committed domestic investors can easily overshadow any small pickup in income that may have come from a higher return elsewhere. We may already have started to see the effects of this dynamic. GDP per capita in Canada in 1980 was 92% of the U.S. GDP per capita. It has now fallen to less than 73%.
Now, consider two cases. In the first case, a Canadian investor takes $100 of savings and invests it abroad. After one year, they bring back the $100 and $10 of profit. Their return is 10%. In the second case, a Canadian investor takes $100 of savings and invests it in a machine that produces $205 of product in the year. The costs are $100 of salaries, $100 of wear on the machine, and $5 of profit. The return is less. It's 5%.
In case one, Canada’s GDP would rise by $10—the profit. In case two, Canada's GDP would rise by $205—the salaries, the machine and the profit. Even though the profit is less, the impact on GDP is much, much greater.
From the Canadian investor’s point of view, the foreign investment gives a higher return, but from a GDP perspective, from a GDP-per-capita perspective, from the perspective of Canada’s ability to save, the domestic investment is by far the better one.
In addition to these considerations, foreign investments can also present governance, political, legal, currency, supply, confiscation and other risks that can sometimes be better managed domestically.
It is unreasonable to think that Canadian pension funds will see the opportunity cost of the loss of investments to the Canadian economy and to the ability of their contributors to earn good incomes and save. They cannot consider what they can't see. As a result, moral suasion cannot correct for these negative effects. Only a national policy reflected in appropriate regulation can constructively deal with the problem.
In 2021, investment in Canada accounted for 20% of GDP, compared to 18% in the United States—so higher—but what these statistics hide is that investment in residential real estate in Canada was 9.7% versus 4.9% in the United States, which left 10.4% for non-residential investment in Canada versus 13.3% in the United States—