Use the CPP as an investment guide.
Many Canadians are or will be entitled to their share of the Canada Pension Plan. Individual investors build their retirement portfolios with the same intent as the CPP – to provide retirement income. Yet compared to the CPP, individual investor portfolios look very different in at least three critical areas.
First, the CPP’s asset allocation is about 60% stocks, 27% bonds and 13% other. Stocks are broadly diversified across 700 Canadian and 1,900 global companies. Bonds and real estate too, are globally diversified. The CPP mandate is to meet conflicting requirements. Current beneficiaries need income from investments like bonds. Future beneficiaries need growth from stocks. Thus the balance between stocks and bonds.
Individual investors too can balance their portfolio to satisfy both current income needs and long term growth requirements. Even if the cash flow is not yet needed, it can provide some stability to the portfolio (it’s fair to assume less volatility is preferred).
A recent portfolio review for an investor, however, revealed a 6% bond allocation. And, of the 94% stocks, 1/3 was allocated to Canadian microcap stocks. (Ouch)! While not necessarily wrong, these are large (and unintended) asset mix bets.
Second, the CPP has 44% foreign content and international diversification will increase. To paraphrase the CPP: ‘A strategy that invests predominantly in Canada would not be in the best interests of beneficiaries. First, it is important to diversify risk exposure beyond the relatively small Canadian economy. Second, greater global diversification allows income from foreign investments to flow back to support future pension payments. Third, there are attractive economic sectors available globally that are small in Canada.’
Compare this to our case study investor. They have 3% US and 5% International stock exposure with zero US or International bonds. A more prudent strategy would be to spread investments across many different global sources of income, growth and potential gain.
Third, to meet its pension obligations to current and future beneficiaries, the CPP has determined it must earn an average of 4.2% (plus inflation). With 3% inflation, say, the required return for the CPP seems a reasonable 7.2%.
Our case study investor (until recently) had been realizing double digit returns and expects this to continue. Given the 60% stocks / 40% bonds asset mix and with bonds yielding 4%, stocks, then, have to return 14%. Is this a realistic expectation? (see BTO, March 2007 ‘All we want is 10%’).
Granted, if the individual is counting on the CPP for retirement income then their retirement portfolio should compliment rather than duplicate the CPP. The point however, is that if the two portfolios have vastly different risk characteristics, then the investor can expect very different return and volatility patterns.
Don’t have a plan? The CPP is as good a guide as any.
Originally published in the Business Thompson Okanagan news, January 2009.
Doug Cronk CFA is Manager, Investments for a Canadian Pension Fund.