What U.S. pension plans can learn from Canadian pension funds

Canada’s federal and provincial public pension plans tend to be much better funded than U.S. state and local pensions. Canadian pensions investments have also largely outperformed U.S pension investments in the last two decades. Preliminary analysis reveals that key differences in investment strategy, cost-sharing, and risk appetite are the reason for Canada’s success. There are several valuable lessons American cities and states can learn from these differences and Canada.

Figure 1 below highlights four pension plans in Canada that are fully funded or close to it. The large Ontario Teachers Plan falls just short of full funding at 95% but their excellent investment performance in 2020 may leave the plan with a surplus in 2021. 

The latest data show that state pension plans in the U.S. had an average funded ratio of around 72% in 2019. While this year’s high investment returns may boost the U.S. average by a few percentage points, it will still be well below Canada’s average funded ratio.

Figure 1: A Snap Shot of Candian Public Pension Plans

Investment Return Assumptions

The biggest difference between Canadian and U.S. public pension planning is how the two nations approach setting investment return assumptions. The median assumed rate of return for state and local pension plans in the United States is roughly 7.25%. The average assumed return for the Canadian plans listed above is 4.7%. This means that American plans assume they will earn over 2.5% percent more on their investments each year. The Ontario Teachers’ Pension Plan has the lowest assumed rate of return of around 2.45% (which was recently lowered from 2.6%). 

This stark difference marks a major divergence in how the U.S. and Canada perceive and manage investment risks as they set funding policies and contributions rates. Canadian plans use more conservative return assumptions and they consistently perform above their assumed rate of return. In contrast, public pension plans in the United States often fall short of their overly optimistic investment return expectations and often fail to make up the difference with increased contributions. In fact, failing to meet investment return assumptions has been the largest contributor to unfunded pension liabilities for state and local plans in the U.S. in the last two decades.

Risk Appetite

The difference in return assumptions between U.S. and Canadian pensions also impacts investment strategies. In their 2021 Annual report, the Canadian Public Sector Investment Board set an asset allocation target of 12% for private equity assets. Similar allocation targets were set for the British Columbia and Ontario Teacher Pension Plan at 12% and 15% respectively. The lowest target was from the New Brunswick Pension Plan which had a private equity allocation of 4%. While alternatives assets like private equity have the potential for high investment returns, they also come with more volatility and a greater risk of loss.

Some U.S. public pension plans have much higher targets for alternative assets. The New Mexico Educational Retirement Board (ERB), for example, sets an allocation target of 45% for all alternatives (private equity, hedge funds, etc.). The plan, which serves New Mexico’s teachers, might be an extreme example but according to national data, the average allocation toward alternatives for state pension plans and the largest local plans was close to 20% in 2020. And U.S. plans are rapidly increasing their interest in these assets.

Canada’s more risk-averse strategy has paid off. A 2020 research paper, “The Canadian Pension Fund Model: A Quantitative Portrait,” found that U.S. pension funds would have performed better between 2004 and 2018 had they used Canadian investment strategies. The authors of the paper stated:

“We find that a central factor driving this success is the implementation of a three-pillar business model that consists of i) managing assets in-house to reduce costs, ii) redeploying resources to investment teams for each asset class, and iii) channeling capital toward growth assets that increase portfolio efficiency and hedge liability risks.”

Cost-Sharing By Employees and Employers 

Canadian pension plans also approach cost-sharing, which is how a pension plan divides contributions between the employee and employer, more conservatively than American pension plans.

In the U.S., employers typically contribute more towards a pension plan than employees. The most extreme example of this is the Louisiana State Employee Retirement System, which requires employees to contribute 8% of their paychecks towards pension savings but requires employers to contribute 40%. Due to growing unfunded liabilities, many U.S. plans are raising employer contribution rates more quickly than employees’ rates. Ultimately taxpayers are on the hook for these increased public pension costs.

Workers and employers in the Canadian Public Sector Plan both contribute around 9.5% to their plan. In Ontario, teachers and employers contribute 11%. Most Canadian pension plans follow this trend.

According to a report by Clive Lipshitz and Ingo Walter, this cost-sharing model is key to Canadian plans’ success. In their 2020 paper on “Lessons from Canada for the U.S.” they suggest that U.S. pension plans need to, “Understand pension funding within the framework of total compensation and if appropriate, consider a more equitable share of funding from plan members.”

The stark difference between Canada’s excellent public pension funding and the U.S.’s growing state and local pension debt proves that our nation’s policymakers and pension managers should consider emulating the Canadian approach to public retirement risk. Doing so would greatly reduce the risk of runaway costs for taxpayers and better secure the retirement funds of public workers.