Can the Canada Pension Fund save the American Social Security system?

LUIZA CH. SAVAGE June 18 2007


Can the Canada Pension Fund save the American Social Security system?

LUIZA CH. SAVAGE June 18 2007



Can the Canada Pension Fund save the American Social Security system?


It was a quintessentially Canadian soft sell. “Do we recommend our model for you? We wouldn’t be so bold as to do that. It’s not for us to say. After all, good neighbours know when to mind their own business.”

The Canadian product in question was not a new BlackBerry, nor Albertan oil. It was not another comedian or female vocalist. It was policy wonkery. David Denison, the president and CEO of the Canada Pension Plan Investment Board, was explaining to a gathering of congressional staff and scholars in Washington how Ottawa had fixed a pesky little problem that now perplexes the American ruling class: a public pension system that will be unable to pay full benefits by the time today’s youngest workers retire.

Less than a decade ago, Canada was in the same sinking boat. Like the U.S. and many other countries, Canada had a “pay-as-you-go” system in which contributions of current workers were used by the government to pay current retirees, rather than being tucked away for the future. Workers relied on a government promise that there would be money to cover their CPP cheques when they retired, but as baby boomers headed toward retirement that promise was looking like wishful thinking.

Today, the Canadian system has been put

on solid financial footing for at least the next 75 years. But the U.S. pension system, called Social Security, has a long-term problem. As the American population ages, there are fewer workers paying for the benefits of retirees. Ten years from now the system will begin spending more in benefits than it gets in contributions. In theory, Social Security has a trust fund that will help make up the difference. The problem is, there is no pot of cash sitting in a vault awaiting that rainy day. The trust fund is made up of federal government bonds—a giant US$2-trillion IOU from the Treasury to today’s workers that will have to be paid back with interest by the government from elsewhere in its budget, beginning in 2017. And by 2041, when workers born after start retiring, the trust fund will be exhausted, forcing either large tax hikes or cuts to the benefits younger workers were promised. Washington is now looking for a way out of the same politically untouchable time bomb that Canada found a way to defuse. “It’s an exact parallel,” says John Rother, one of the most influential


policy minds in Washington and the man who invited Denison to speak. Rother is the policy director of a seniors’ group, the AARP, formerly known as the American Association of Retired Persons, whose membership of 38 million is greater than the entire Canadian population. Two years ago his organization laid waste to a proposed reform proposal that

was supposed to be the signature achievement of George W. Bush’s second term: allowing workers to send their Social Security contributions into individual accounts that they could invest in the financial markets (without any guarantee of what will be waiting for them when they retire). Democrats and labour unions denounced Bush’s agenda as “privatization,” a risky gamble, and a gift to Wall Street. But it was the white-bearded, softspoken Rother, a former policy aide to two Republican senators, and his aging activists who dealt the fatal blows, spending tens of millions of dollars on lobbying and ads attacking the Bush plan, which they compared to casino gambling. When seniors from around the country dialled their congressmen en masse, Congress couldn’t drop the issue fast enough, and hasn’t touched it since.

But the demographics are not changing. In 1950, there were 16 U.S. workers for every retiree; by 2032, there will be only 2.1 paying in for each beneficiary. When a future president takes an inevitable second look at the issue, Rother wants to be ready. He has looked around the world for a model to follow and he has settled on Canada’s. The only problem is, well, it’s Canada’s.

“It was the usual American reaction to things Canadian,” recalls Kent Weaver, a Georgetown University professor of public policy, about the reaction to Denison’s speech. “Which is to say massive ignorance on the part of Americans because they don’t know much about Canada, and a skepticism—that I think was deliberately increased by business groups during the debate on Clinton’s health care reform proposal—that Canada is different and what may work there won’t work here.”

The Canadian solution was simple, yet a

leap of faith. In February 1997, then-finance minister Paul Martin and his provincial counterparts reached a deal that involved trimming benefits, hiking CPP contribution rates (by a whopping 80 per cent), and pumping the money into a pooled fund that was invested in the financial markets. They hoped the broader investments would earn higher rates than the provincial government bonds that the pension plan had traditionally held.

There was one little snag: such national funds were the laughingstock of the financial world. In country after country, industrialized and not, they were used for “social investing” or even political slush funds, in either case bilking pensioners. Run by governments, sometimes with unions and industry on the boards, they put money into well-intentioned but rarely profitable projects such as public housing and hospitals, as well as the less well-intentioned, such as a third residence for a Tanzanian prime minister. A1999 World Bank study found that, on average, the money would have earned almost two percentage points more in interest if retirees had simply left it in a savings account. In some countries, the recordkeeping was so poor that the researchers had had trouble identifying whether the pension funds had made any money at all.

When Bill Clinton suggested setting up an investment fund with Social Security in his 1999 State of the Union address, he was immediately slapped down by no less an authority than Alan Greenspan, the chairman of the U.S. Federal Reserve. “I find it very difficult to believe that it is feasible,” Greenspan testified in 1999 to Congress, suggesting that politicians would not be able to refrain from raiding the kitty. “I guess I’ve just seen too many presidents in my lifetime who, when confronted with a problem in the federal budget—meaning lack of resources— and a huge pot of money sitting out there, would be able to resist moving in that direction. I just don’t believe they would.”

Greenspan’s words were the kiss of death for Clinton’s proposal. But in Canada the experiment forged ahead. To break with the failed funds of the past, the money was separated by law from the general federal revenues, taken off the government books and put into the hands of an independent board of directors that hired professional managers. Their one and only job was explicitly spelled out: to “maximize investment returns without undue risk of loss.” No politically motivated pet projects. As well, appointments to the board were made through a convoluted multi-step process that involved the finance minister, provinces, and a professional search firm—in an effort to keep the overseers as independent

and arm’s-length from politics as possible.

Not only did it work, it worked really well. The fund quietly grew from $44-5 billion in 2000 to $116.6 billion today, and saw an annualized real rate return of 13.6 per cent over the past four years—almost three times the rate needed to sustain the CPR About twothirds of the fund is now invested in equities, and it owns a small slice of every major company in Canada. Since initial restrictions on investing abroad were lifted, it has invested nearly half the money offshore, in everything

from Microsoft and Exxon to Japanese cars and rice crackers, from Swiss chocolate to a Gibraltar-based online gambling outfit founded by a phone-sex mogul.

Attempts by politicians and interest groups to meddle with the money have failed—even when they involved pouring extra money into the fund from government surpluses, as Finance Minister Jim Flaherty proposed in his March 2006 budget, drawing reminders that the separation between CPP and government ledgers is supposed to remain sacrosanct. The Canadian blueprint has been borrowed by Ireland and New Zealand. South Korea has sent a delegation to study it. Smaller-

scale funds have worked successfully in Scandinavian countries, but other industrialized countries are still struggling to put their public pension plans on a sure footing. Half the countries in the European Union have looming retirement crises. In Italy and France alone, the gap between public pension promises and their ability to pay is twice the size of their GDPs. Japan’s pension system is reeling amid revelations of massive corruption and incompetence. Britain is in the process of raising its retirement age to 68.

The CPP’s success has changed minds among former skeptics in Canada such as Bill Robson, the head of the C.D. Howe Institute economic think tank, who had previously favoured an individual-accounts system in Canada. “But for now I would advertise what we did in Canada as a state-of-the-art approach to securing your social security system.” Adds Rother: “The Canadian experience has been quite successful on two levels. One, it has generated very nice earnings, which will be available in the future to help pay benefits. Secondly, it’s been successful politically, in that there has been no attempt whatsoever to influence decision-making regarding investments.”

Rother wants Social Security to harness the power of the financial markets through a Canadian-style independently managed fund without transferring the risk of stockmarket losses from the government to seniors. As in Canada, an investment fund will not solve the whole problem. He says that a combination of contribution increases as well as cuts in benefits will be necessary. “We think this kind of [investment fund] approach could well work in the U.S. as part of a bigger solvency solution,” he said. There’s another reason he likes the Canadian model. It could redirect the public conversation away from individual accounts, and enable the kind of bipartisan compromise that is necessary to reform Social Security. “In part what we hope to accomplish is to say there is this other way to use the power of the market—by making the success of the Canadian system more visible to [lawmakers],” he says.

The CPP’s Denison, a former president of Fidelity Investments Canada Ltd., told his American audiences that the Canadian plan was a “third option,” and a “hybrid” between a public and private system. But the American skeptics remain focused on the risks of political interference. They fear that every company, every cause, would want to influence the investments. “When Enron failed they were trying to get the Treasury Department to prop up their stock, arguing that it was essential to the infrastructure of the U.S.,” says David John, a social security specialist at the conservative Heritage Foundation, and an advocate of individual accounts. “You

would see efforts like that, and similar responses from labour groups. If [the investment fund] started selling off a company that is in bankruptcy, someone could argue that a government agency was destroying jobs.”

The danger would be especially acute if the appointment of pension-fund board members followed the traditional process of appointment by the president and confirmation by the Senate, he says. “It wouldn’t take much for a senator to call them up and say, you only need to take $300 million of these funds and purchase stocks in my district, and I’ll have the secretary of the Treasury call you and indicate why this is a great investment,” he adds.

Complicating Rother’s case is that one key factor protecting the Canadian system from

political tampering is very difficult to imitate: namely, the Canadian constitutional structure under which the provinces share responsibility for the CPR Martin and the provincial ministers deliberately made the pension law to be as difficult to trifle with as is the Constitution. They required the consent of twothirds of the provinces with two-thirds of the population to change the fund’s set-up, such as any move to strip the CPP Investment Board of its independence. If Ottawa tried to raid the fund, it would have nine provincial finance ministers down its throat. (Quebec has its own pension plan.) The problem for Washington is that Social Security laws are written by Congress. “In the U.S., I can’t think of the equivalent set-up they could come up with. That’s a bit of a hurdle they have to get over,” said Robson. Another challenge will be raising the Social Security contribution, which at 12.4 per cent is already more than double what the Canadian one was when Martin increased it.

But Georgetown’s Weaver says a similar approach in the U.S. “is doable,” through some combination of legislated independence, lengthy terms for board members, and the American political system itself, which has checks and balances that make it more difficult to change legislation once it’s passed.

“It’s easier to block something in Congress than to enact something. The fact that the U.S. has multiple veto points should allow the structure to stay.”

Others doubt it. “We can look to other countries for guidance,” says John. “But we are fooling ourselves if we think we can import the circumstances of another country’s political structure and graft them on the U.S.” But while many Republicans will continue to demand individual accounts, Democrats aren’t exactly lining up to embrace the Canadian model either. Some even see a risk in the approach: it could legitimize the idea of investing Social Security contributions in the markets, which could ultimately be a boon to the advocates of individual accounts. “The

next question would be, ‘Who do you trust to do it, the government or you?’ ” said one influential Democratic congressional staffer who asked not to be named. “And that’s a losing formulation for our side.”

And the Canadian experiment is far from over. Already, the fund is taking a more aggressive stance in the markets, with, for example, its bid to play a leading role in the $31-billion attempted buyout of BCE, Canada’s largest telephone company, a move that was not emphasized to the Washington audience. The image of a government fund taking such an active role in financial markets would not sit well with free marketeers in Washington. Nor is the fight for political independence over, given perennial demands that the CPP fund invest or divest for reasons unrelated to profit. “One day it will be tobacco, then guns, then trans fats, then Chinese investments in Darfur,” says the C.D. Howe’s Robson. “Our struggle to prevent that sort of thing has only begun and will never end.”

The AARP’s Rother acknowledges it’s an uphill battle to get American politicians to change their attitudes about borrowing policy ideas from abroad. “It’s not just Canada,” he says. “It’s called American exceptionalism and the fundamental premise is that we are different.” M