How Peter Drucker Revolutionized Canada’s Public Sector Pension System: Lessons for Americans

“They own assets all over the world, including property in Manhattan, utilities in Chile, international airports, and the high-speed railway connecting London to the Channel tunnel. They have taken part in six of the top 100 levered buy-outs in history. They have won the attention of Wall Street, which considers them rivals, and institutional investors, which aspire to be like them.”

From “Maple Revolutionaries”

THE ECONOMIST, March 3, 2012

Who are these “Maple Revolutionaries”, why did they warrant a feature article in THE ECONOMIST ten years ago, what lessons are there in this story for American public sector pension plans, and what does the great management philosopher Peter Drucker have to do with all this? This article addresses all four of these questions.

The Maple Revolutionaries

The “Maple Revolutionaries” are Canada’s large public sector pension plans and the investment organizations that manage their assets. The eight largest, “The Maple 8”, manage the assets of the Canada Pension Plan (CPP Investments), the Quebec Pension Plan and other Quebec public sector pension plans (CDPQ), the British Columbia public sector pension plans (BCI), the Alberta public sector pension plans (AIMCO), the Ontario Teachers’ Pension Plan (OTPP), the Ontario Municipal Employees Retirement System (OMERS), the Hospitals of Ontario Pension Plan (HOOP), and of other Ontario pension entities (IMCO). Collectively, these eight organizations manage retirement savings amounting to some US$1.4 trillion today.

Why did these Maple Revolutionaries warrant a feature article in THE ECONOMIST ten years ago? In short because, as the article points out, by then these funds had developed a unique, effective style of ‘value for money’ management that was revolutionizing the pensions world, and continues to do so to this day.

Revolution Origins

This Canadian pension revolution started with the publication of Peter Drucker’s 1976 book “The Unseen Revolution”. Out of the 39 books he wrote over the course of his illustrious career, he would remark in a 1996 reprint of the book “it was my most prescient, and least read”. When I met with Prof. Drucker in 2005, I assured him that some of us did read his 1976 book, and that over the course of the 30 years since its publication, his imagined pension revolution had taken hold….at least in Canada.

What was so compelling about Drucker’s 1976 advice that made it worth taking seriously? There were two things:

1. Demographics: While the outsized Boomer generation was still young in the 1970s, it would eventually become an outsized retiree generation. We should think about the social and financial implications of that reality now. One of those implications is that through their retirement savings, the Boomer generation will become material owners of the means of production. This in turn implies that careful thought should be given to how we design the organizations that will manage Boomers’ retirement savings.
2. Business Model: these organization designs should encompass intergenerationally-fair pension ‘deals’, as well as the creation of effective arms-length pension organizations. Their sole purposes should be the cost-effective execution of the pension ‘deal’, and the fiduciary, expert management of the accumulated pools of retirement savings.

However, saying is one thing, doing another….

A Taskforce to Improve Public Sector Pension Management in Ontario

In 1986, Robert Nixon, Treasurer of Ontario, announced that he was creating a taskforce to study how public sector pension management could be improved in Canada’s largest province. This provided an opportunity for me to share Drucker’s thinking on pension design and management as set out in his “Unseen Revolution” with the Taskforce. To their credit they were receptive, as evidenced by the title of their Report “In Whose Interest?”, submitted in November 1987. Its two key recommendations were to ensure pension deals were intergenerationally fair, and that arms-length pension organizations should be governed and managed as effective financial intermediaries with fiduciary mindsets.

Often, taskforce reports die slow deaths once they are submitted. However, sometimes their recommendations are accepted, as was the case with the “In Whose Interest?” Report. Treasurer Nixon liked the Report as did Margaret Wilson, head of the Ontario Teachers’ Federation. Together, they persuaded the Ontario Government and the key union leaders in the province to come on board. Leading the way, the new Teachers’ Pension Act reflecting the Taskforce recommendations was passed in 1990, followed by further legislation covering the rest of Ontario’s public sector workforce, and eventually public sector workforces across Canada.

Building the First Drucker Pension Organization

With the 1990 Teachers’ Pension Act in place, the stage was set to build the world’s first Drucker pension organization. Immediately, the meaning of ‘arms length’ surfaced. It was understood that as ‘partners’ who had created the Ontario Teachers’ Pension Plan (OTPP), the Ontario Government and the Ontario Teachers’ Federation (OTF) would be responsible for negotiating an intergenerationally fair ‘pension deal’ and be involved in the OTPP Board of Directors appointment process. However, they also agreed that the nine Board members would have diverse skill sets, strategic mindsets, and be free of any conflicts of interest. Further, the ‘partners’ would delegate full organizational oversight to the Board, and agreed not to meddle in OTPP strategies, or their implementation.

Who would be the first Board Chair of this new pension organization? Fortuitously, the term of office of the Governor of the Bank of Canada, Gerald Bouey, has just ended. Highly respected as a person who had successfully managed Canada’s central bank and its relationships with both the federal government and the business community, he was ideally positioned to become OTPP’s first Board Chair. He was offered the position. Reading the intentions of the Teachers’ Pension Act and receiving assurances that both the Government of Ontario and the Ontario Teachers’ Federation would take their role as OTPP ‘partners’ seriously, he agreed to become OTPP’s inaugural Board Chair. This in turn greatly facilitated the job of attracting highly-qualified, but also public service-minded individuals to take the other seven Board positions.

With the OTPP Board in place, its first major task was to attract a CEO who would not only understand the Drucker pension vision, but would be capable of implementing it. The search led to Claude Lamoureux, a qualified actuary with extensive international business experience in the insurance industry. He too asked for, and received, assurances that he would not be constrained in implementing the Drucker pension model. With these assurances, he agreed to become OTPP’s inaugural CEO, leaving Chief Investment Officer (CIO) the final key position to be filled. This search led to recruiting Bob Bertram, a well-known senior finance executive in the telecommunications sector.

Implementing the Drucker Pension Model

The Lamoureux-Bertram team wasted no time designing a strategic plan to implement the Drucker pension model at OTPP:

• Upgrade the OTPP benefit administration model and IT capabilities.
• Swap the US$15 billion OTPP asset portfolio made up of 100% non-marketable Ontario debentures into a diversified global asset mix.
• Develop an ‘owner’ investment philosophy to towards buying cashflows at reasonable prices, and holding the leaderships of investee corporations accountable for devising and executing ‘value-creating’ strategies.
• Build a substantial in-house investment function, focusing especially on private markets in the equity, real estate, and infrastructure areas. This in turn requires gaining Board approval to raise OTPP pay-scales to attract and retain the requisite talent to compete globally in these spaces.
• Manage public discourse resulting from OTPP acting as a ‘pension revolutionary’ on corporate ownership and governance matters. For example, while traditional pension funds would build real estate exposure through allocations to external real estate fund managers, OTPP did so by privatizing Cadillac Fairview (CF), Canada’s largest publicly-traded real estate company in the late 1990s. CF continues to be OTPP’s wholly-owned real estate arm to this day.
• Advise OTPP’s ‘partners’ that they needed to change the OTPP ‘pension deal’ to make it fairer, and more sustainable by making inflation protection conditional on the health of the Plan’s funded status. The ‘partners’ took the advice.

These actions did not go unnoticed in Canada’s public sector pension community. As just one example, when the national Canada Pension Plan was reformed in the 1990s to make more sustainable through higher contribution rates, the CPP Investment Board was created. Not surprisingly, the 1997 CPP Investment Board Act looks a lot like the 1990 Teachers’ Pension Act, with its key organizational ‘arms-length’ and good-governance features. Today, 25 years later, CPP Investments is one of the most respected ‘asset-owner’ organizations in the world. So over time, the Drucker pension model evolved to the Canadian pension model.

Value-Creation with the Canadian Pension Model

All this is all well and good, but does the Model work in practice? “Yes it does” answers my 2021 JPM article titled “The Canadian Pension Model: Past, Present, and Future”. It cites five separate studies with similar findings: in large international samples of pension fund performance, Canadian funds are better funded, and have historically produced higher investment returns at lower risk levels. One of the studies is especially interesting, as it was conducted by Americans Clive Lipshitz and Ingo Walter (“Seeking Sustainability in American Public Sector Pension Systems”, 2020 JPM). They compared the average financial performance of the 25 largest US pension funds against that of the 10 largest Canadian pension funds. Key fundings:

• The Canadian funds were 100% funded versus an average funded ratio of 78% for the US funds.
• However, the US funds used aggressive discount rates to arrive at the 78% funded ratio. Had they used the more conservative discount rates used by the Canadians, the average US funded ratio drops to 62% funded. This places future plan members and tax payers in a precarious financial position, as such a ratio signals some combination of materially higher contribution rates and lower pensions in the future.
• The Canadian funds were materially better diversified through less exposure to public equities and greater exposure to inflation hedges such as real estate and infrastructure.
• The average Canadian fund net return over the last 10 years was 9% vs. 7% for the US funds, despite the Canadian funds exhibiting lower return volatility.

These findings lead Lipshitz and Walter to conclude: “Canadian political leaders came to realize that failure to reform their public sector pension systems would hurt future beneficiaries and taxpayers alike….the time has come for US politicians to follow”. Key required changes they note are creating ‘arms-length’ legal structures for pension organizations, and board selection processes that focus on independence and competence. No doubt, were he still with us, the Austrian-American Peter Drucker would agree.

A Final Word on Board Selection Processes

Two recent studies throw considerable light on the impact of board selection processes on the finances of US public sector pension organizations: a 2017 study by Andonov, Bauer, and Cremers titled “Pension Fund Asset Allocation and Discount Rates” published in The Review of Financial Studies, and a 2018 study by Andonov, Hochberg, and Rauh titled “Political Representation and Governance: Evidence from the Investment Decisions of Public Pension Funds” published in the Journal of Finance. These studies found:

• 55% of the board members of US public sector pension funds are either appointed through some kind of election process or through ‘ex officio’ status requiring board membership by state or local officials (e.g., Treasurer, Comptroller, etc.) versus 0% in Canada and Europe.
• There was a statistically significant positive correlation between the proportion of board members elected or ‘ex officio’ and the degree to which the pension plan was underfunded.
• These was a statistically significant negative correlation between the proportion of board members elected or ‘ex officio’ and realized pension fund investment returns.

In short, the findings of these two studies confirm the logic and power of the Drucker ‘legitimacy’ requirement in the governance of pension organizations. When short-term political considerations become part of the pension governance mix, future generations of plan members and taxpayers are likely left holding the short end of the stick in the forms of higher contribution rates and lower pension benefits.