Category: Market Action

Some illuminating charts from a Statistics Canada study:

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Meanwhile, PrefBlog’s Department Studying Artificial Intelligence Because There’s Not Bloody Much Of The Real Kind has learned something of interest to insurers:

The predictions of early death that were made by AI algorithms were “significantly more accurate” than predictions delivered by a model that did not use machine learning, lead study author Dr. Stephen Weng, an assistant professor of epidemiology and data science at the University of Nottingham (UN) in the U.K., said in a statement.

It was an interesting day for the Canadian preferred share market, which steadily fell until 2:15pm, down 45bp, when the cavalry arrived and the index finished with a gain of 8bp on the day.

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PerpetualDiscounts now yield 5.40%, equivalent to 7.02% interest at the standard equivalency factor of 1.3x. Long corporates now yield 3.66%, so the pre-tax interest-equivalent spread (in this context, the “Seniority Spread”) is now about 335bp, a sharp narrowing from the 350bp reported March 20.

PerpetualDiscounts now yield 5.58%, equivalent to 7.25% interest at the standard equivalency factor of 1.3x. Long corporates now yield a little over 3.85%, so the pre-tax interest-equivalent spread (in this context, the “Seniority Spread”) is now about 340bp, a sharp narrowing from the 355bp reported February 20.

Rob Carrick of the Globe published an article last week titled Critics of the overhauled CPP say it’s a bad deal – here’s why they’re wrong which contained the following puzzling statements:

Critics say the CPP pay outs offer a poor rate of return on contributions…
…
The Fraser Institute think tank critiqued this column, partly for not deploring the rate of return people will get on money contributed to the expanded CPP. The institute quotes a study saying the overall return is 2.5 per cent, which is described as “meagre.”

Based on numbers only, maybe so. Guidelines for financial planners set out after-fee returns of 3.2 per cent for conservative portfolios (25 per cent stocks, 75 per cent bonds and cash), 3.9 per cent for balanced portfolios (50 per cent stocks, 50 per cent bonds/cash) and 4.7 per cent for aggressive (75 per cent stocks, 25 per cent bonds/cash.

This puzzled me because the last time I reviewed it, I figured the CPP was doing a pretty good job. The primary reason for this is that they have a captive market; therefore they have no salesmen; and therefore they don’t have to come up with interesting stories and ensure their portfolios are aligned with that story. All they have to do is choose good investments. This is an extremely important determinant of investment management results, as I have stated in this blog to the point of weariness when discussing outfits like OMERS, Teachers and HOOPP. It also helps that they can fire people without having to worry about clients’ reactions.

So I did a little checking and a little digging and, after the Fraser Institute came out with another volley in their debate, had an eMail exchange with one of the Fraser Institute honchos which included the following, taken from my side of the exchange:

Aren’t the figures quoted by Carrick (which appear to be from the FPSC Projection Assumption Guidelines, published online at [LINK] ) nominal returns, gross of 2.0% inflation, as opposed to your figures, which are net of inflation?

It makes quite a difference to the comparison!

…
As you are doubtless aware, the CPP was only 6% funded in 1996 (see [LINK] ) as the CPP was conceived as having a pay-as-you-go basis.

This was changed in 1997 to a requirement for steady-state funding and full funding (see [LINK] ).

It is clear that a transition from 6% funding to 100% funding must be paid for somehow, and I see only three avenues for accomplishing this task:
– reduce benefits for the ‘early benefiticiaries’ [sic], some of whom achieved staggering rates of return on their contributions, as discussed in [LINK]
– increase contributions for ‘late beneficiaries’
– make up the difference through government general revenue, i.e., taxpayers in general irrespective of CPP status.

The solution reached was to adjust the contribution and benefit rates with the effect that current contributors are over-funding their benefits. Right or wrong, that was a political decision that people seem happy with, although it leads to the gap you deprecate between the fund’s required rate of return and the rate of return realized in benefits to current contributors.

Thus, the existence of this gap is irrelevant to any discussion of CPP expansion, as the gap that existed in 1996 is slowly being erased through increased contribution rates. Any changes to the level of expected benefits must be fully funded; this implies that the gap, expressed in terms of fund- and contributor-returns will actually narrow as the plan is expanded (or, conversely, widen if the fund should become less ambitious; I note that as per the 16th Actuarial report referenced above, the contribution rate was projected to rise to 10.1% in 2016 and 14.2% in 2030.

Even after accounting for the gap in returns, contributors are expected to achieve a 2.5% real rate of return on their contributions according to your figures, a rate that can hardly be described as meagre. This is equivalent to a 4.5% nominal rate given generally accepted estimates of future inflation, handsomely exceeding the ‘conservative’ (3.2%) and ‘balanced’ (3.9%) portfolios of the FPSC Projection Assumption Guidelines quoted by Carrick. The projected contributor rate of return is exceeded only slightly by the ‘aggressive’ projection (4.7%). It is my experience in the investment management business that there are far more investors who will demand ‘conservative’ or ‘balanced’ investment portfolios – particularly among those who hold less than the median non-pension financial assets of a mere $11,600 in 2016 (see [LINK] ).

You claim that “the CPP has to earn a 4% ROR over time in order to sustainably provide a 2.5% ROR to retirees. No worker would likely make that deal voluntarily” This is absurd. There exist a huge number of Canadian equity mutual funds with MERs in excess of 1.5%, and (according to the OSC in 2013 (see [LINK] : “According to analysis from Strategic Insight on advisory fees charged by client asset size under U.S. fee-based programs (2011), 70% of U.S. investors with account sizes of $100,000 are charged advisory fees higher than 1.25% and 31% are charged over 1.50%”. Note also that, as discussed above, elimination of this gap with respect to current contributors would only move the requirement for increasing the CPP funded ratio onto other shoulders; this is in distinction to the extortionate levels of fees in the Canadian financial services industry which are paid very happily by investors.

I will also note that my analysis of annuity rates indicates that the expected rate of return on annuities offered to retail investors is 0% – the profits due to investment returns during the lives of the annuities are captured entirely by the sponsoring company – and are well in excess of 1.5% (the value of annuities lies not in their value as investments, but as insurance against unexpected longevity). Additionally, the Net Interest Margins achieved by Canadian banks are grossly in excess of the 1.5% that “no worker would likely make … voluntarily”. (see [LINK] ). It is also clear that almost every investor in Canada bonds for the past ten-plus years has voluntarily accepted a rate of return far below 2.5% real.

I remain perplexed by your statement that “please note that the CPP doesn’t offer any inheritable asset other than the death benefit. That issue isn’t included in the comparison.” Surely your analysis included all cash-flows from the CPP to beneficiaries; therefore your claim of a 2.5% expected rate of return will – under the “full funding” regime – be unaffected by whether any given outflow is labelled as a death benefit or otherwise.

Sincerely,

For the record, I don’t consider the Fraser Institute to be a think-tank at all. It’s just another murky mouthpiece for the vested interests … their funding is unusually opaque.

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TXPR closed at 629.97, up 0.53% on the day. Volume of 2.22-million was painlessly average in the context of the past thirty days.

CPD closed at 12.59, up 0.24% on the day. Volume of 89,873 was low in the context of the past thirty days.

ZPR closed at 10.26, up 0.39% on the day. Volume of 108,534 was low in the context of the past thirty days.

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TXPR closed at 626.64, up 0.67% on the day. Volume of 2.08-million was roughly average in the context of the past thirty days. The TXPR Total Return index turned positive for the year-to-date!

CPD closed at 12.56, up 0.72% on the day. Volume of 143,910 was mid-range in the context of the past thirty days.

ZPR closed at 10.22, up 1.19% on the day. Volume of 304,367 was fourth-highest of the past thirty days.

Here’s a graph that helps explain the past four months:

Bank of Canada – Five Year Canada Yield
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GOC-5 was up 8bp to 1.86% today, according to TMXMoney citing CanDeal.

The Fed issued its FOMC Statement:

Information received since the Federal Open Market Committee met in December indicates that the labor market has continued to strengthen and that economic activity has been rising at a solid rate. Job gains have been strong, on average, in recent months, and the unemployment rate has remained low. Household spending has continued to grow strongly, while growth of business fixed investment has moderated from its rapid pace earlier last year. On a 12-month basis, both overall inflation and inflation for items other than food and energy remain near 2 percent. Although market-based measures of inflation compensation have moved lower in recent months, survey-based measures of longer-term inflation expectations are little changed.

Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability. In support of these goals, the Committee decided to maintain the target range for the federal funds rate at 2-1/4 to 2-1/2 percent. The Committee continues to view sustained expansion of economic activity, strong labor market conditions, and inflation near the Committee’s symmetric 2 percent objective as the most likely outcomes. In light of global economic and financial developments and muted inflation pressures, the Committee will be patient as it determines what future adjustments to the target range for the federal funds rate may be appropriate to support these outcomes.

In determining the timing and size of future adjustments to the target range for the federal funds rate, the Committee will assess realized and expected economic conditions relative to its maximum employment objective and its symmetric 2 percent inflation objective. This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial and international developments.

Voting for the FOMC monetary policy action were: Jerome H. Powell, Chairman; John C. Williams, Vice Chairman; Michelle W. Bowman; Lael Brainard; James Bullard; Richard H. Clarida; Charles L. Evans; Esther L. George; Randal K. Quarles; and Eric S. Rosengren.

No changes were expected, so no surprises there – but notably:

While the Fed said continued U.S. economic and job growth were still “the most likely outcomes,” it removed language from its December policy statement that risks to the outlook were “roughly balanced” and struck language that projected “some further” rate hikes would be appropriate in 2019.

They also issued a Statement Regarding Monetary Policy Implementation and Balance Sheet Normalization:

After extensive deliberations and thorough review of experience to date, the Committee judges that it is appropriate at this time to provide additional information regarding its plans to implement monetary policy over the longer run. Additionally, the Committee is revising its earlier guidance regarding the conditions under which it could adjust the details of its balance sheet normalization program. Accordingly, all participants agreed to the following:

•The Committee intends to continue to implement monetary policy in a regime in which an ample supply of reserves ensures that control over the level of the federal funds rate and other short-term interest rates is exercised primarily through the setting of the Federal Reserve’s administered rates, and in which active management of the supply of reserves is not required.

•The Committee continues to view changes in the target range for the federal funds rate as its primary means of adjusting the stance of monetary policy. The Committee is prepared to adjust any of the details for completing balance sheet normalization in light of economic and financial developments. Moreover, the Committee would be prepared to use its full range of tools, including altering the size and composition of its balance sheet, if future economic conditions were to warrant a more accommodative monetary policy than can be achieved solely by reducing the federal funds rate.

Finally, they updated their Statement on Longer-Run Goals and Monetary Policy Strategy, reaffirming the 2% symmetrical inflation target and stating that their current estimates of the longer-run normal rate of unemployment is 4.4%, down from last year’s figure of 4.6%.

The IAIS (International Association of Insurance Supervisors) issued its January 2019 newsletter today, with a reminder that:

The IAIS is hosting an ICS stakeholder event. The meeting will provide Members and stakeholders with the opportunity to provide feedback on the ICS prior to the finalisation of ICS Version 2.0 for the monitoring period. The IAIS published the ICS Version 2.0 consultation document on 31 July 2018. The event will take place between 09.00 and 15.00 CET (Basel time) on 1 February 2019, at the BIS Tower in Basel, Switzerland.

Assiduous Readers will rememeber that the Comment Period Expired 2018-10-30 for IAIS Public Consultation on ICS 2.0; ICS 2.0 is the set of global insurance guidelines that, we hope, will include tighter rules on the going-concern loss-absorption ability of insurance company preferred shares … even if OSFI takes the lowest-trigger-possible approach with NVCC rules similar to banks.

I also note there is an “ICS Task Force” meeting in Basel on February 26.

PerpetualDiscounts now yield 5.72%, equivalent to 7.44% interest at the standard equivalency factor of 1.3x. Long corporates now yield a little over 3.95%, so the pre-tax interest-equivalent spread is now about 345bp, a slight (and perhaps spurious) narrowing from the 350bp reported January 23.