In my last post, I wrote about the high risk of potential conflicts of interests in a PRPP, especially given the provider is associated with a financial institution offering related products and services. The problem is that there is little in the legislation to minimize the risk. In this post, I discuss how to minimize the risks – the key is using passive investment products. A passive approach also simpler to understand and easier to administer.
The case for limiting investments
Index Funds representing broad classes of securities are allowed under the regulations. Most academic research indicates that over a longer term passive investments, after fees, out-perform most actively managed investments (the retail investment industry, as you would expect, disagrees). Nevertheless the advantages of passive management are significant and include
- significantly lower fees;
- comparable or better long term returns, after fees;
- reduced volatility (vs. benchmarks);
Allowing only a passive investment approach would minimize the potential conflicts of interest and facilitates the purpose of PRPPs: to achieve lower costs in relation to investment management and plan administration.[1]
New low cost products are also available such as ETFs which increase the choice and flexibility of passive investments. The majority of CAP members however will be disengaged investors but committed to long-term investing. Having only passive investments in PRPPs would be a simpler low cost approach with little downside for all stakeholders.
Defining an investment option
While the regulations limit the number of PRPP investments including the default fund to six choices, the term “investment option” is not defined.[2] The lack of a definition is a potential problem. From a diversification perspective each investment option should have a specific risk and return profile for diversification purposes. Are life cycle funds such as a series of target date funds (TDFs), asset allocation funds or one-,three- and five-year GICs considered to be one investment option or individual investments?
This is also important for TDFs since the Act states that any change of a member’s investments must be requested by the member.[3] The limit of six investment options will become meaningless if each financial institution is allowed to decide what constitutes an investment option. The term “Investment option” needs to be defined in the regulations.
Allowing only six investments options supports the argument that a limited number of choices can be sufficient to provide a diversified and prudent set of investments. A suite of six broadly-based index funds would appear to be ideal in this situation. For example, the options might include a balanced (default) fund, Canadian, U.S., EAFE and global equity funds and a bond fund. A choice of investment product within each of the asset class does leave room for some risk and return customization. A passive approach with a limited number of investment options would provide a simple, low cost approach that is easier to understand and administer.
To properly assess a PRPP program the sponsor’s roles and responsibilities need to be clearly understood. This information has yet to be provided.
A passive approach would minimize many areas of potential conflict of interest as well as providing a reasonably prudent investment approach. Passive investing is also ideally suited to many of the unsophisticated, reluctant and long term type of investors likely to be in PRPPs.
In Part 3 of this series, I’ll discuss fee disclosure, the requirement to provide a PRPP at a low cost and the responsibility for education and communication.
[1] PRPPA S3.
[2] PRPP Regs SS 17(a)
[3] PRPP Act S25