by Tom Slee
Comments on venture capital investing cause concern
It now seems almost certain that Paul Martin is going to become our next Prime Minister, and here at IWB we wish him well. Of course, being completely apolitical, we have no opinions one way or the other about his appointment. However, one thing we have been doing is carefully monitoring Mr. Martins formal statements in order to get a handle on how his policies may affect small Canadian investors. The news is mixed.
On the plus side, our next Prime Minister promises to facilitate investment, particularly in the high tech, medical services, and bio-pharmaceutical sectors, the wave of the future. Who can argue with that? The trouble is that Mr. Martin believes that pension funds should provide a lot of this very high risk capital. He recently said: Canadian pension plans provide 20% of the venture capital in Canada, while in the United States they provide roughly 50%. . .how can we build an economy in the 21st century if we rely on a concept of risk that dates back to the 19th century?
You get the message. The Canada Pension Plan is going to assume more risk and government will encourage corporate pension fund managers, perhaps even RRSP owners, to speculate. It is a frightening prospect.
I realize that I sound like a broken record, but let me say once more that the sole purpose of pension funds and RRSPs is to provide people with regular, reliable income throughout their retirement years. The best way to do that is to invest the money safely, build a portfolio steadily, and above all safeguard the capital. Pensions are not performance-driven funds and they are certainly not vehicles for implementing government policy. Just ask the managers at the once proud Caisse de Depot. Quebec's giant pension plan has run off the rails because politicians started making the investment decisions and redirecting capital to fund their agendas. Future pensioners are going to pay for that.
My concern, however, is not only about government intervention but also the cavalier use of equities to build public and corporate pension plans and RRSPs. Jeremy Gold, a distinguished U.S. actuary and author, has recently published papers arguing that stocks have no place at all in pension plans. He gives several reasons. First, the stocks may not perform; second, if corporations are forced to fund shortfalls their own shares will come under pressure, driving markets even lower; and third, and most important, equities allow actuaries and managers to gamble.
For example, let us say that a corporate pension plan needs to have about $1.6 million on hand in 10 years to pay benefits. The managers can invest $1 million in a 5% strip government bond today and be fairly sure of reaching the target. Alternatively, the same managers could assume that stocks are going to earn 10% per annum over the next 10 years and invest approximately $625,000 in equities to earn the $1.6 million. There is an immediate saving of $375,000 for the company, the plan is apparently funded, and the CEO is a hero. Of course, its a mirage. The 5% is real but the 10% is wishful thinking to at least some extent.
Is that an unfair example? Unfortunately no. The average assumed return on pension assets owned by the S&P 500 companies last year was an optimistic 9.5% at a time when independent actuaries maintained that 6.5% was realistic. Companies have fallen into the habit of reducing costs by underfunding their pension plans and offsetting the shortfall by assuming higher rates of return. It is an easy way to cook the books but it creates two problems. There is a stored-up pension liability and an increasing overweighting in stocks. As a result, when we run into a prolonged bear market, as we just did, many corporations find themselves in serious trouble. Ford Motor, with a $3 billion pension shortfall, is a typical situation. General Motors expects to pay as much as $12 billion in additional contributions to its pension plans before 2007.
Now we have Mr. Martin proposing to use pension money as venture capital. Even more alarming, the people in Ottawa are not waiting for his arrival at Sussex Drive. The CPP Investment Board is already allocating the entire cash flow of over $7 billion per annum from its $160 billion portfolio to equities. The idea is try to meet the Plans goal of a 7% annual return after inflation. Its not working. Last year, the CPP earned a negative 1.5%. That is an appalling performance by a pension fund that should be growing steadily, with market downturns cushioned by the fixed-income flow.
All of this is more reason for us to be as defensive as possible in our own RRSPs. Have some equities, of course, but make sure that they are dividend-paying blue chips. Never mind the high-tech issues. You have plenty of exposure to those through the CPP. Overweight your portfolio in bonds and consider using conservative income trusts instead of stocks. Of course, the distributions are not guaranteed but at least you will be able to see your cash flow. Then, by reinvesting the bond interest and distributions, you can build your portfolio gradually and predict its value at your retirement date. In the case of equities, project a growth rate of about 8%, or better still 7%.
We seem to have come full circle with pensions. At one time, people had to take care of themselves in their golden years. Forty years ago, however, with the advent of the CPP and handsome corporate pensions, there was no longer any need. We were going to enjoy a comfortable retirement. Unfortunately, the corporations have failed to deliver, the OAS is being clawed back, and the CPP is something of a question mark, although the government always has the power to keep raising premiums if necessary.
Except for people with guaranteed public service pensions, we are on our own once more for the most part. So nurture your RRSP and safeguard the capital. It may be all that is left at the end of the day.
This article originally appeared in the Internet Wealth Builder, a weekly e-mail newsletter that provides timely financial advice from some of Canada's top money experts. For more information about becoming an Internet Wealth Builder member, Click Here