Proceedings of the Standing Senate Committee on
Banking, Trade and
Commerce
Issue 8 - Evidence - Morning meeting
TORONTO, Tuesday, February 17, 1998
The Standing Senate Committee on Banking, Trade and Commerce met this day at 8:00 a.m. to begin its study of the governance provisions contained in the Canada Pension Plan Investment Board Act (previously Bill C-2).
Senator Michael Kirby (Chairman) in the Chair.
[English]
The Chairman: Our first witness today is Mr. Bob Hamilton.
Please proceed, Mr. Hamilton.
Mr. Bob Hamilton, Assistant Deputy Minister, Financial Sector Policy Branch, Department of Finance: Mr. Chairman, I hope everyone received a copy of my handout. Also, I trust that everyone has received a preliminary version of the regulations which we sent out on Friday afternoon.
I wish to begin by giving you an overview of the CPP investment policy, the new policy. I will spend about 15 minutes to walk you through the handout, at which time we would be pleased to answer any questions you might have.
The first page of the handout is a road map of what I would like to cover in the next 15 minutes or so. First, to give you an overview of the new investment policy I will talk a little bit about the size of the fund and how it is projected to grow over the next number of years. Next, I will talk about independence and accountability and some of the features of the framework that are, on the one hand, designed to make this board independent, which was a key message that we heard through the consultations, and on the other hand to make sure that it is accountable to Parliament and to Canadians, which is another message that came to us through the extensive consultations leading up to designing this policy. Then I will talk a little bit about the investment board structure, highlighting various features of the independence and accountability there. Finally, I will turn to the regulations which, just to be clear, are presently in preliminary form. We are hoping to release them publicly soon. In the meantime, for the purposes of this and subsequent meetings, we have provided you with an advance copy.
In looking at the new investment policy on the slide in front of us, slide three, the key element is that the CPP Investment Board has been set up to invest the new CPP funds prudently and professionally in a diversified portfolio of securities, in the best interests of the plan members. That is what we have tried to achieve in setting up the governance structure and other features of this board.
As we move away from a system where these funds were simply lent out to provinces at the federal government market rate, with the growth of this fund we must put in place an investment policy that operates in the best interest of the plan members, an investment policy that follows many of the same rules and guidelines that are in place for many of the other large pension funds in the country.
We have studied many of the existing models, with a view to learning from them and taking what is good. In a couple of places, we have made changes to those models to fit the particular circumstances of this fund.
Senator St. Germain: You say that under the previous plan you made loans to the provinces at the federal government rate. Is there an amount outstanding, that we know of?
Mr. Bob Hamilton: Yes, about $35 billion is outstanding.
Senator St. Germain: And when you say the "government rate", do you mean the Bank of Canada rate?
Mr. Bob Hamilton: If the federal government were to borrow in the marketplace at a rate of, say, 6 per cent, for a 20-year term, that would be the rate that would be charged, as opposed to the rate that the province would have to pay.
Senator St. Germain: You did not charge the provinces?
Mr. Bob Hamilton: No. However, part of the new regime will be that all loans to the provinces will be made at their market rates. We will come to that later in our discussion.
Senator Callbeck: What percentage is lent out to the provinces?
Mr. Bob Hamilton: All of it.
Mr. Wayne Foster, Chief, Financial Sector Policy Branch, Department of Finance: Virtually all it. If a province turns down moneys that it has a right to borrow, the federal government must take them up at the same rate. So of that $35 billion, roughly $3 billion is with the federal government.
Mr. Bob Hamilton: The investment board will be set up at arm's length from the government to invest these funds in the best interests of the plan members.
Moving from the old regime to the new, a couple of features in the regulation determine how much access the provinces will have to the funds in the new regime, again at market rates -- and we will talk about those later.
The Chairman: Just to be clear, in case some senators are not totally familiar with the way the program has historically operated -- which is that the federal government allowed the provinces to borrow CPP funds at preferred interest rates; in a sense, instead of going to the market to borrow millions of dollars by issuing bonds, historically provinces borrowed from the federal government at a significant premium, certainly for the poorer provinces, over what they would have had to pay for the same amount of money on the open market -- this new system will take away from provinces the ability to source loans at a cheaper rate than they have historically done.
Senator Tkachuk: That is because they had no choice.
Mr. Bob Hamilton: Who had no choice?
Senator Tkachuk: The provinces. They would either have had to roll over the funds or pay them back. That is an option they choose.
Mr. Bob Hamilton: Yes, the provinces can refuse the funds. As Wayne said, they can say that they do not want them, and the federal government would take up part of those funds. But if the provinces took the funds, it was at our market rate, if you like.
Senator Tkachuk: When the funds were there; but the funds are no longer there.
Mr. Bob Hamilton: Yes, for the last several years there have not been any funds available.
The Chairman: I can remember when I was in the Cabinet office in Nova Scotia in the early 1970s, when the Nova Scotia credit rating was very low relative to the AAA credit rating of the federal government, when we borrowed from the CPP, we borrowed at a rate significantly less than the rate we would have been charged on the open market.
Mr. Bob Hamilton: Turning to the next slide, I have outlined the framework for the new investment policy. You are probably familiar with most of this. Many of the rules that will apply in the new investment policy are set out in the Investment Board Act, which is the framework legislation that sets up this arm's length corporation to invest the funds.
The second element of the framework is the investment board regulations -- and we will talk about those towards the end. Those regulations are contained in the preliminary copy that we sent you on Friday. What the regulations do is apply the relevant PBSA rules to this -- the PBSA rules being the rules that all pension funds in Canada abide by. It takes those regulations and applies them to this board, with a couple of changes along the way, which I will talk about later. Provincial access is specified in the regulations -- and again, we will talk about that in a moment. The regulations also set out additional reporting requirements -- which I will go over in a few minutes.
The final piece of the framework will be the board itself, which will set its own policies, procedures and by-laws, all of which will be written and public, so therefore transparent.
Those are the three main elements of the framework.
The fifth slide contains a quote which answers the question: What is the object of the new investment board? The quote is there for you to see. The key words in it are: "...in the best interest of the contributors and beneficiaries to maximize the rate of return without undue risk of loss."
And again, that object was set out on the basis of consultations with a number of Canadians, in general, and with pension experts, and on the basis of discussions with the provinces, some of whom are responsible for their own funds. The object of the board is set out in section 5 of the act.
You will note that no mention is made of a secondary objective; in other words, economic development or an alternative objective to the best interest of the plan members. Again, when we were setting up this fund, we received a clear message about the importance of independent investment, at arm's length and solely in the best interest of the plan members.
The next slide shows how the fund is projected to grow over the next ten years. As you can see, it is projected to grow slowly over the first few years, followed by a period of more rapid growth. I will explain each of the columns in that table to you.
The first column is total CPP assets. As such, it includes the old amount, the $35 billion that is already loaned to the provinces. So you can see that that actually starts at $36 billion in 1998, and grows over the term. The next two columns talk about the assets that will be under the management of the board because the board will not be responsible for those loans to the provinces. It will take the new funds that come in, or any funds that the provinces decide not to roll over when they mature. For example, if in next year one of the loans that a province has comes due and the province decides not to renew it at market rates for another term, those funds flow to the board.
So what we have are two columns that show two scenarios. The first is that if the provinces fully take this roll-over option -- and maybe I should just take a second to explain what we have done in a transitional sense there. In the present situation, the provinces are borrowing from the CPP fund. We have told them that they can roll that over for one more term. So when that borrowing comes due, a province can opt to have one more borrowing at market rates, for another 20-year period, and thereafter the funds go into the board's management.
Provinces can choose to take that roll-over, or not, and that is really what these last two columns show.
Senator Oliver: What if they refuse?
Mr. Bob Hamilton: Well, it is at market rates. It is no longer, as we talked about earlier, at the federal government's rate as opposed to the province's rate. So it is a 20-year borrowing at market rates. A province may decide that in its own best financial interests that is not what it wants at this particular time. A province will also be able to borrow directly from the fund itself. If a province has reasons for wanting to roll it over, we have left that option open. On the other hand, for financial reasons a province may decide that it does not want to roll over a loan at current market rates.
Senator Callbeck: To what extent do you think the provinces will make use of that roll-over?
Mr. Bob Hamilton: I am really not sure. It will very much depend on the circumstances that come up over the next number of years -- how the markets look; their financing options; their needs. I find it difficult to predict where they are going to line up in there. It is going to be somewhere in between the two extremes: I do not think that the provinces will want to roll over all of it; but I also think they are going to want to roll over some of it. It will vary by province, as well.
So it is difficult to predict. What we have done in setting up the regime is offer the provinces the option either to roll over their loans or not to roll over their loans.
Senator Oliver: Which province was it that asked you to extend it for another 20 years? Where did the initiative come from?
Mr. Bob Hamilton: It was very broad-based. As part of the agreement that we worked out, I do not recall one province pushing more aggressively than another. I think they all felt that this would be an important transitional measure as we move to the new regime. Everybody appeared to be comfortable with the new investment policy regime, but we have put in place a couple of transitional measures, to help us better manage the transition to the new regime.
Senator Oliver: When a province goes to the market, in addition to having to pay rates they also have to pay fees? Do they have to pay fees to the federal government, and will they under the new proposal? If they roll it over, will there be any fees?
Mr. Bob Hamilton: I do not think there is any fee.
Mr. Foster: They may actually save a bit because there are no underwriting fees as such.
Mr. Bob Hamilton: So you can see, if we take the end-year to be 2007, we have said that the total CPP assets, including the existing borrowing, would amount to about $94 billion. The assets under the board's management, if the provinces roll over everything they have the option to, would be $57 billion. If the provinces decide to take none of the rolled over funds, then the board's assets would be $76 billion -- the difference being whether they have decided to roll over, or not.
By way of comparison -- although it is always difficult to project how big these and other funds will grow -- our estimate of the size of the Ontario Teachers' fund in the year 2007 is $91 billion. That is a rough estimate at this stage; no one knows precisely how that will turn out, but it gives you an order of magnitude. And the Caisse de dépôt in Quebec is projected to be about $120 billion at that stage.
That gives you some order of magnitude of how big this fund will grow, how quickly, in comparison to some of the other large funds in the country.
Senator Callbeck: When you say they can roll over at market rates, would that be a better deal for a province like Prince Edward Island? Can Prince Edward Island go into the market and get the market rate?
Mr. Bob Hamilton: Yes, except for the fee that was mentioned earlier, which would be the only differential.
Senator Callbeck: And is the fee large?
Mr. Bob Hamilton: No; I would not expect it to be very large. We are talking about major borrowers, who can get very good fees.
The next slide highlights that in setting up the rules for this fund we have had to look at the independence of the fund, because there was a very strong view that it needed to be at arm's length and invested in the best interest of the beneficiaries as I mentioned, and as well as to make sure that it is accountable to both federal and provincial governments and to Canadians.
In some cases, a policy decision is taken that is more in favour of independence but one that may reduce accountability, or the other way around. We have tried to highlight in a couple of these slides how we have struck that balance to achieve, hopefully, the best of both worlds in terms of having an independent board, but one that is still accountable.
We looked at a number of other models. This is not the first large pension fund in the country, so we have some models to look at. We have adapted many of their good features; we have also made a few changes along the way, recognizing the particular feature of this fund.
This next slide highlights what I have been talking about here. We set up two columns: independence and accountability. On the independence side, the object of the board is clear. It will have independent directors and full discretion to set its own management structure and operating and investment policies.
Senator Oliver: Before you leave independence, it seems to me that the essence of independence means independent of government influence. What is there here in your column to indicate that that would be the case, or is that your plan?
Mr. Bob Hamilton: Independent of government influence. For example, in setting its investment policy the board will have to determine what is in the best interests of the plan and its members as opposed to what a particular government might think would be a good investment.
Senator Oliver: Has your department had some suggestions as to what that might be? What shelters them? What protects their independence?
Mr. Bob Hamilton: To me, the clear statement of the object in the legislation, that this board is responsible to invest in the best interests of the plan; that if it decides to invest in something that is not in the best interests of the plan, because the Department of Finance or some government thinks that that is the right to do for a particular reason, then it is not carrying out its fiduciary duty.
I think the clear statement in the legislation is very good protection that this board will be making its investment policies in the best interests of the plan members as opposed to a secondary or an alternative objective.
Senator St. Germain: Mr. Hamilton, if I may, you agree, I hope, that this is still a regular GIC appointment, no different than any other GIC appointment, in that I would say that 99 per cent through all administrations are totally partisan.
Mr. Bob Hamilton: For the appointment of the directors?
Senator St. Germain: Yes.
Mr. Bob Hamilton: I was going to talk about that in a second. There are some differences in how these those directors are appointed, but can I just hold that for a moment because the next slide talks about that?
Senator St. Germain: Sure.
Mr. Bob Hamilton: Just to finish on this one, on the accountability side, an effort was made to make this as transparent as possible and to ensure that there were good reporting requirements so that it would be well known what the board was doing and how it was handling these investments. You can see that we have set in place a requirement that there be transparent investment policy standards and procedures. The board is required to table an annual report in Parliament and to hold biannual meetings in participating provinces.
Thus, a number of features are present in the legislation to make sure that there is a window into what this board is doing and to ensure that the board is accountable.
Now let me come to your question on the directors.
The manner in which the directors of this board will be selected is different from anything I have seen, although there may be similar examples. A federal-provincial nominating committee, which has been set up, will come up with a list of qualified candidates. One of the features of the list of candidates is that there has to be a core group with proven financial ability or relevant work experience. The nominating committee, comprised of one person from each participating province and someone from the federal government, will present a list of names to present to the ministers. From that list, the 12 board members will be selected. The appointment will be made on the recommendation of the Minister of Finance, after consulting with the provincial finance ministers.
So the process is as follows: the nominating committee provides the list; the federal and provincial ministers consult on the choice of the 12 directors; and then appointments are made on the recommendation of the Minister of Finance.
Senator Hervieux-Payette: How do we make sure that women get on the list?
Mr. Bob Hamilton: When choosing the board of directors, regional balance and gender balance must be kept in mind; as well, consideration will have to be given to a core group of people who have proven financial experience. A number of factors will be taken into consideration, in selecting the directors. There will have to be a balance.
In terms of balance, some have argued that it should be just 12 finance experts. In fact, I do not think that that should be the makeup of the board. It needs a core of financial experience; but I think it will also draw from experiences in other areas.
I am confident that through this process the board will be balanced, regionally, gender-wise, financial experience, and perhaps other factors.
Senator Tkachuk: So will it be like picking a cabinet, rather than you having the best board? Are they going to look at other ethnic groups or colour groups? How is this going to be done?
You said that considerations will be given to gender balance, regional balance, maybe some financial expertise. How will anybody else get into the act?
Mr. Bob Hamilton: The act sets out -- and perhaps Wayne can correct me if I am wrong. The regional balance and the financial experience is laid out in the legislation, if I am not mistaken. The other aspects of the balance will just be part of the process of picking a good board.
Senator Austin: What does the legislation say about regional balance?
Mr. Bob Hamilton: I do not have the exact words.
Mr. Foster: In general, it says that the minister, in making his recommendations to the Governor in Council, must have regard to this desirability of having regional balance and to having a sufficient number of directors with prudent financial ability, relevant work experience -- words to that effect.
Mr. Doug Wyatt, Acting Director, General Legal Services Division, Department of Finance: I can read it to you:
The Minister shall have regard to the desirability...
Senator Austin: Could you please give us the section number first?
Mr. Wyatt: It is section 10(4):
...the Minister shall have regard to the desirability of having directors who are representative of the various regions of Canada and having on the board of directors a sufficient number of directors with proven financial ability or relevant work experience such that the Board will be able to effectively achieve its objects.
Senator Austin: So essentially, in terms of a legal test, it is in the sole discretion of the minister to define those terms; would you agree?
Mr. Wyatt: Yes, that is right.
Mr. Bob Hamilton: And just to finish that thought, the directors will have the same fiduciary duties as other pension fund trustees. They will be appointed initially for staggered terms. A third of them will be appointed for one year, a third for two years, and a third for three years; thereafter, for terms of three years. As well, they will hold office on good behaviour; they can be removed for just cause.
Senator Callbeck: As it relates to the nominating committee, did you say that there was one on that committee from every province?
Mr. Bob Hamilton: Participating province; that is right.
Senator St. Germain: With respect to the selection of directors, it is clearly stated in the act, if I recall, that the minister "may consult", instead of "must" or "shall" consult. Am I correct?
Mr. Wyatt: The acts says: "The Minister may establish a committee$" Referring to consultation, it says "shall consult". So it is "may establish a (nominating) committee" but "shall consult with the appropriate province".
Senator St. Germain: The minister does not necessarily have to adhere to consultation?
Mr. Wyatt: Consultation is exactly that.
Senator St. Germain: In other words, it is a normal GIC appointment, other than the fact that the minister "shall consult".
Mr. Wyatt: It does not mean that the minister's decision or the Governor in Council's decision is bound by what the provinces say.
Senator Kelleher: What about remuneration?
Mr. Bob Hamilton: They will be remunerated in line with people who have comparable responsibilities. So, I expect that they would look at what other large pension funds are doing, at other comparable circumstances, and compensate in line with those.
Senator Kelleher: What would the benchmark be?
Mr. Bob Hamilton: I expect that a starting point would be to look at the other large pension funds that are operating in Canada. There is an obligation in the act to establish comparables when deciding on the appropriate remuneration.
Senator Kelleher: Will the incumbent board or its human resources committee have full discretion as to remuneration?
Mr. Bob Hamilton: It will be within the guidelines that I described.
Mr. Wyatt: I just want to point out, aside from the guideline of comparability, that the remuneration will be public information. It will be part of the by-laws.
Senator Kelleher: The chair of the board of directors will be a full-time employee; is that right? He will more or less be the CEO.
Mr. Bob Hamilton: No, there will be a separate CEO.
Mr. Wyatt: A non-executive chairman.
Mr. Bob Hamilton: Yes, non-executive chairman.
Senator Kelleher: So the non-executive chair would receive the same remuneration as other board members, with perhaps a slight --
Mr. Bob Hamilton: I would have thought that it would be slightly different than that of the rest of the board members, looking at comparable circumstances.
Senator Kelleher: Is there any restriction on the CEO's remuneration?
Mr. Bob Hamilton: There are no restrictions in the act. We did say that the salaries of the top five executives will be disclosed.
Senator Kelleher: In other words, if it were considered necessary to pay a base salary of $750,000 to the CEO to attract a person with the proper qualifications, there would be no limitation; correct?
Mr. Bob Hamilton: There is no specific limit.
Senator St. Germain: Mr. Hamilton, will there be a bonus structure or stock options, or the equivalent thereof? Will there be a performance bonus?
Mr. Bob Hamilton: I would have to say that there very well could be, yes. If you look at the remuneration models of CEOs of other pension funds, I believe there would be a bonus aspect in most of those.
Mr. Foster: Mr. Lamoureux will be here this afternoon; you can ask him what his salary is comprised of.
Senator Tkachuk: Who will set the salary for the board members?
Mr. Bob Hamilton: The board will set the salaries of its members.
Senator Tkachuk: That is convenient.
Mr. Bob Hamilton: Keeping in mind those guidelines.
Senator Tkachuk: So when someone who is asked to sit on the board asks about the remuneration, he is told that a board members gets to set his own salary; is that right?
Mr. Bob Hamilton: He is told what the act provides for, including having regard to persons having similar responsibilities and engaged in similar activities.
Senator Tkachuk: So there will be no starting fee, such as that of a director of the Bank of Canada or something like that?
Mr. Wyatt: There are lots of checks and balances.
Senator Austin: Is there any provision in the act for ministerial direction?
Mr. Bob Hamilton: No; there is none.
Senator Austin: So once the Minister of Finance appoints someone to the board of directors, that person serves a fixed term under the Order-in-Council, and all of the powers to run the corporation vested in the board without any further role played by the Minister of Finance?
Mr. Bob Hamilton: They operate on good behaviour, so a board member could be removed for just cause in what will generally be a three-year term.
Mr. Wyatt: As well, the minister has the power for special examinations and special audits, but he has no power to direct anything.
Senator St. Germain: There is nothing in government today, in any Crown corporation or anything, that compares with the investment possibilities and the magnitude of the CPP fund that is going to be developed; is that not correct?
Mr. Bob Hamilton: There are certainly a number of important Crown corporations, but I guess there is no direct comparable within government.
Mr. Wyatt: The closest comparable Crown corporation model is the Bank of Canada, which probably has the same degree of independence in its operation -- there is no power except in economic policy; there is no power to direct the bank to do things.
If you are relating it to the size of the fund, I would say, no, I do not know of any Crown corporation that sits on this much money.
Senator St. Germain: And there is no organization, in theory, where there is such a possibility of conflict as a result of directors' activities, and what have you. I am sure that that has to be taken into consideration because, first, if you are going to get the most qualified people in the world, they are almost going to have to divest of everything. I believe that it is going to be a real challenge to find people who will not be conflicted, because the investments that they make, everything they do -- the magnitude of this fund, because of the 20-per-cent-foreign-investment rule, will practically guarantee conflict.
Mr. Bob Hamilton: We spent a fair amount of time on the conflict of interest provisions. You are correct to say that, with a large fund like this, as with other large funds, it is important to be aware of the potential for conflict of interest and to make sure that the appropriate guidelines are in place; that the board has the responsibility to come up with appropriate conflict guidelines, as well as to adhere to them and to make them public.
The next slide talks about conflict of interest; I can walk you through that, if you would like.
Senator St. Germain: We will get there.
Mr. Bob Hamilton: Conflict of interest is dealt with on the next slide; let us turn to that now. It says that the board must establish conflict of interest procedures; it must also establish a committee to monitor the application of those procedures.
In setting out the legislation and the regulations, we have gone further than the standard CBCA rules on conflict of interest. We have said that directors must disclose any transactions in which they have a material interest.
Senator Oliver: How is "material" defined?
Mr. Bob Hamilton: That is a good legal question.
Mr. Wyatt: It is not defined. In some of these respects, we have borrowed provisions from the CBCA. However, the word "material" is used quite frequently in legal terminology. A court would have to define it in these circumstances, should that ever be necessary.
Mr. Bob Hamilton: We have taken the CBCA model and added an extra provision that it must be "any" transaction in which they have a material interest. As well, directors cannot vote on transactions wherein they have a material interest; nor can they participate in discussions related to those. Again, that last part, of not participating in discussions, is stronger than was found elsewhere.
We have not tried to re-invent corporate governance here, but we have tried to take the good features that are out there and add to them as necessary.
In the next slide, we talk about audits, and this is an issue that has been the subject of some discussion. The board will appoint its own qualified auditor. The Auditor General has and will have responsibility to audit the CPP as a whole, and this includes looking at the financial statements of the investment board.
A feature of the legislation that was changed late in the day was to clarify that the Auditor General will have access to any information required to carry that out. That was always our intention. The Auditor General voiced some concern that it was not clear in the legislation that he would have complete access to any information, so we added that feature, amended that part of the legislation towards the end of the process to be absolutely clear about that.
As Doug said earlier, the minister can order special audits and special examinations; in fact, there will have to be a special examination at least once every six years.
Senator Tkachuk: When you say that the Auditor General audits the CPP as a whole, are you talking about the actual fund or are you talking about the expenses of the board? What are we talking about here?
Mr. Foster: It is the contributions, the benefit payments, all the administration that is done by Human Resources Canada, Revenue Canada, et cetera.
Senator Tkachuk: Can you repeat that, please.
Mr. Foster: The cash in-flow/out-flow, benefit payments, disability administration.
Senator Tkachuk: So it will audit the board.
Mr. Foster: No, the overall Canada Pension Plan.
Senator Tkachuk: And the board and its expenses.
Mr. Foster: The board will have its own financial statements, which will be audited. They will form a part of the overall annual report of the CPP.
Senator Tkachuk: I am asking you to clarify how this audit system works. You have said that the Auditor General will audit the CPP as a whole.
Mr. Foster: Right.
Senator Tkachuk: You said that the board will appoint its own qualified auditor. You are then going to have the Auditor General audit the auditor, is what it reads here.
Mr. Foster: The Auditor General will audit the annual report of the Canada Pension Plan, one component of which will be the annual financial statements of the investment board. The investment board does not administer the benefits; it does not collect the contributions.
The Auditor General will have access to whatever information he needs from the board in order to ascertain that the audited financial statements of the board are accurate, and they will form a part of the annual report of the CPP.
Mr. Bob Hamilton: Perhaps it is helpful to think of it as a parent company and subsidiary, if you like. If I can use that analogy, think of the subsidiary as the investment board, which is one part of the CPP. The investment board would have its own audited financial statements, but that would feed into the bigger picture, when the Auditor General audits the CPP more generally.
Senator Tkachuk: Let me put this in layman's terms. The investment board is a Crown corporation. They spend money. They pay directors; they pay presidents. The board has expenses, to be paid out of the cash that is coming in, called "the fund".
The expenses of that Crown corporation are going to be audited by whom?
Mr. Bob Hamilton: By the auditor that they choose.
Senator Tkachuk: So they are not going to be audited by the Auditor General?
Mr. Bob Hamilton: No, they will be audited by their own auditor.
Senator Tkachuk: By their own auditor; let us put that aside.
Now we have the fund, the invested cash that came in from Canadians, the beneficiaries. Who names the auditors to that?
Mr. Foster: The assets of the board are audited by its own auditor, which could be the Auditor General, but it does not have to be. Then you have the old fund, which is, as Bob described, the loans to the province that could be rolled over. The Auditor General will be auditing that, as part of his audit of CPP. And then the contributions and benefit payments, which flow in and out, will also be audited by the Auditor General.
Senator Tkachuk: Which he has always audited.
Mr. Foster: Which he has always audited, exactly.
Senator Tkachuk: So the assets of the board and the board are each audited by the their own auditor; right?
Mr. Foster: That is right.
Senator Hervieux-Payette: Sometimes cheques are sent to people who should not receive them, or to people who do not exist. Will the Auditor General report on these mistakes?
Mr. Bob Hamilton: I would have thought that that would be covered by the board's appointed auditor.
Senator Hervieux-Payette: So the Auditor General will not report on whether or not the fund is well administered.
In the case of the Caisse de dépôt, I have seen circumstances where people who should not receive a payment are sent cheques.
Mr. Bob Hamilton: Are you talking about the benefit payments, because that would be covered by the Auditor General?
Senator Hervieux-Payette: That is what I was wondering. So the administration of that is still with the Auditor General.
Mr. Bob Hamilton: Yes. It is still with the Auditor General; it has not changed.
Senator Tkachuk: Once the audit has been completed by the auditor who has been hired by the board, what happens to that audit? Is that audit sent anywhere?
Mr. Bob Hamilton: I believe they are tabled in Parliament.
Mr. Foster: It is part of their annual report. It is sent to the Minister of Finance and all the other provincial finance ministers. The Minister of Finance and the Minister of HRD must prepare a consolidated financial statement of the CPP, and then that is audited.
Senator Tkachuk: So the auditor reports to the board of this Crown corporation?
Mr. Foster: Its own auditor does, yes.
Senator Tkachuk: And then according to the legislation, the Crown corporation mails it to the Minister of Finance; correct?
Mr. Foster: They release it publicly.
Senator Tkachuk: Yes, that is it. For example, what formal process is there for the beneficiaries or their representatives to question the auditor about the report?
Mr. Bob Hamilton: To question the auditor?
Senator Tkachuk: Yes, similar to what shareholders do at an annual meeting or a private corporation.
Mr. Foster: There is the opportunity for plan members to attend a meeting of the board, at which directors must be present, once every two years to discuss the annual report. The board, I suppose, could choose to the bring the auditor with them.
Senator Tkachuk: But there is no formal process built into the legislation for the beneficiaries or their representatives.
The Chairman: What the honourable senator is asking is: What is the process by which accountability takes place? For example, in the private sector, an annual shareholders' meeting is the forum where one might ask questions. What Senator Tkachuk is asking is: What is the analogous process here, the equivalent accountability step?
Mr. Wyatt: I understand the question, but a Crown corporation does not have a process similar to that of the shareholders' annual public meeting of a private corporation. However, the annual report of a Crown corporation is tabled in the House of Commons and in the Senate. That is probably that analogous stage because the annual report will contain the financial statements, the auditor's report, and so on; it will contain a lot of information. At that point, the process kicks into the public arena, if there are problems -- letters to the minister and things of that sort.
Senator Tkachuk: Consider the CBC, for example. The CBC's budget is included in the Estimates. The Estimates are tabled in the House of Commons. They come to the Senate. The Estimates are subject to committee review in the Senate.
My concern is that the process I have just alluded will not be extended to the fund in question; correct?
Mr. Wyatt: These funds are similar to a revenue-dependent Crown corporation that does not have an appropriation.
The Chairman: An example would be Air Canada and CN, who, in their last few years, never tabled a budget in Parliament because they were a self-financing corporation.
Mr. Wyatt: The Bank of Canada, for example, does not have a budget; the CDIC does not work off of appropriations. Therefore, the only toe-hold that Parliament gets is the annual report, at which point it must be kicked over to a committee, if there are questions.
The Chairman: Does the legislation require the annual report to be tabled in both Houses?
Mr. Wyatt: Yes.
The Chairman: I have a follow-up question, as well. This is not meant to be a reflection on the Auditor General, but it may be read that way. Essentially, we have a situation in which the board's auditor is either auditing the auditor, who is the Auditor General, or the Auditor General is auditing the board's auditor, or we have two auditors doing the same job -- which strikes me as being modestly redundant, to put it mildly. Why? There is no private-sector analogy to having two auditors do the same job.
Mr. Wyatt: Perhaps this will help to clarify things. When Crown corporations were more numerous than they now are, there were different classes of them, as defined by the Financial Administration Act. Some of them were under the auspices of both the Auditor General and a private-sector auditor. They worked out their functions amongst themselves.
In terms of a comprehensive auditor or a special examination, that is a separate process.
The Chairman: I understand that.
Mr. Wyatt: In the private sector, all of the chartered banks have two auditors, by statute, under the Bank Act.
Is that not right, Mr. Hamilton?
Mr. Bob Hamilton: I believe that is right.
Mr. Wyatt: I am sorry, I do not want to confuse matters, but I think there is a lot of precedent for this.
Senator Angus: Let us do this one more time. There is the board's auditor, there is the fund's auditor; that is private. And then there is the Canada Pension Fund, as it is today, with cash coming in and cash going out, which is under the auspices of the Auditor General; right?
Mr. Bob Hamilton: That is right. And the Auditor General, in looking at the CPP, will have access to all of the records.
The Chairman: Yes. The Auditor General has both parts.
Mr. Hamilton: Yes. That is why I used the subsidiary concept.
The Chairman: Thank you. I understand.
Mr. Bob Hamilton: Let me now turn to slide 12, where I will give you an overview of what is covered in the regulations.
The key elements of the regulations are to take the Pension Benefits Standard Act provisions that exist for all pension funds and to adapt them to this particular circumstance. In many cases, it is a simple matter of taking those rules and putting them into our regulations. In other cases, it means tweaking those rules slightly, to recognize the special circumstances. The basic thrust is to take the PBSA rules that apply to all pension funds and make sure that this pension fund also is subject to those rules.
A couple of additional features that are in the regulations -- and we have talked briefly about these. The first is that the fund will have to make its domestic equity investments on a passive basis; that is, they will have to mirror a broad index -- and I will come back to that in a moment on a separate slide. How the board will do that is laid out in the regulations.
The third element is provincial access at market rates. The rules governing that are in the regulations -- and again I will talk about that in a bit more detail in a moment.
And finally, the regulations set out additional disclosure requirements for the board in its annual report.
Before I turn to those elements individually, the other thing I should note is that the regulations require the approval of two-thirds of the participating provinces representing two-thirds of the population; in other words, before the regulations can come into effect, they need that degree of approval -- a similar process to that found on the legislative side. Therefore, as we move toward finalizing the regulations, we are required to talk to the provinces and make sure that we have sufficient support.
If we look first at the PBSA provisions, in general terms I would say that we have taken those PBSA regulations and applied them here. An example is the 10 per cent rule, where a maximum of 10 per cent of the fund can be invested in one investment vehicle; and the fund may not own more than 30 per cent of the common shares of a company. Those kinds of rules, which are also found in the PBSA, are present in our regulations, which you will see in the version we sent you.
In some cases, we have adapted or enhanced the PBSA rules. For example, we put a prohibition on the use of derivatives for leveraging purposes.
However, I think the over-riding point is that the rules that apply to other pension funds in Canada have been applied here.
Passive equity, which is part of the agreement that was struck by the federal and province governments, provides that at least for the first three years the fund's domestic equity investments will be made on a passive basis. The purpose of that provision is to ensure a smooth transition from the old regime to the new. One of the concerns was: What would be the effect of the fund as it goes out and invests in domestic corporations, perhaps targeting one particular stock or another?
The Chairman: Just so I am clear, what that says is that they will operate an index fund for three years; correct?
Mr. Bob Hamilton: Yes.
The Chairman: Right away I can tell you that they do not need a big staff. If you think about it, operating an index fund is a pretty simple operation. You know the mix that makes up the index. So it is probably not an exaggeration to say that you can run it with five people, if you have absolutely no flexibility but you have got to buy the index; right?
Mr. Bob Hamilton: It is probably modestly more complex than that, in the sense of whether you actually buy an index or whether you replicate an index, but the substance of your point is right, that it is a much simpler process and it ensures that this fund will invest broadly across the economy.
The Chairman: I do not mean to be argumentative, but it is only as broad as the index is broad. We all know that there are geographic areas of the country and industries that are not as included in the index, in the sense that they do not totally reflect the Canadian economy, that they reflect the index.
Mr. Bob Hamilton: That is fair.
The Chairman: There has always been a debate about whether or not the index is a true reflection of the Canadian economy as a whole. And that is why there are a whole bunch of indices, because it is not.
Senator St. Germain: Consider a situation like Bre-X: Are there any special investigative provisions in place, say, for the directors of the fund to investigate an investment such as Bre-X prior to investing in that company, regardless of the percentages that exist? Would that be permitted?
Mr. Bob Hamilton: I do not think there is a specific provision, no.
Senator St. Germain: Would it be permitted?
Mr. Bob Hamilton: Could the directors investigate it? I do not think there is a specific prohibition.
Senator St. Germain: Is this a grey area?
Mr. Bob Hamilton: There is no specific rule on that, one way or the other.
The Chairman: I have two other questions, senators, with respect to the index. It is in the regulations that it has to be an index fund; right?
Mr. Bob Hamilton: That is in the regulation, yes.
The Chairman: So that regulation can be changed. If it is a regulatory change, is there any requirement in the regulations that that be discussed? If you start off saying it has to be an index fund, for whatever reason, any switch away from that is such a fundamental change that it ought to be the element of some parliamentary debate; that it cannot simply be made by a regulatory change because that represents a dramatic difference in the way in which the fund operates.
Mr. Bob Hamilton: The way it is set out now, for a 3-year period they will have to invest in this passive manner. After three years it will be reviewed. Wayne may wish to correct me, but my sense is that if the federal government and enough of the provinces agree on changing that it can be done through the regulations.
The Chairman: I understand the process. What I am saying is that it seems to me that it might be helpful if there were a regulation which required some element of debate of that particular policy change, because it is so fundamental, either before this committee or elsewhere.That is all I am asking.
My second question is: I assume that if they are purely an index fund they are also purely a passive investor in the sense that they do not do the CalPERS kind of thing; they do not do the kind of thing that we have been talking to as part of our institutional investors study -- with which you people are familiar.
What is your leverage in talking to someone if the person knows that you have to buy the index? You have to stick with the index, right, so your leverage is zero? You are the ultimate passive investor; right?
Mr. Foster: There is nothing in the act or the regulations that suggests that the board cannot exercise its right as a shareholder. Some might argue -- and you might ask your witnesses this afternoon this question -- that if you are an index investor it is more important that you be vigilant in exercising your shareholder voter rights because there is nothing else you can do; you cannot sell.
The Chairman: Right. Your current regulations place no restriction on the degree of shareholder activism that this fund can use; is that correct?
Mr. Foster: That is right.
The Chairman: So that when this committee reports -- as it will before we rise for the summer -- its views on the whole issue of shareholder activism, we are perfectly within our rights to comment on the CPP level of activism at the same time because at that point you are becoming such a fund; right?
Senator Tkachuk: Will your American funds or international funds be turned over to someone who deals in that market, or will that be done in-house?
Mr. Bob Hamilton: The board will have to decide whether it wants to do that in-house or turn it over.
The Chairman: Is this fund subject to the same 80/20 rule as all other pension funds?
Mr. Bob Hamilton: That is right, yes. The foreign property rule applies to this fund as well.
The Chairman: Which you can either say is a constraint or you can say, in a sense, these public funds can be invested outside the country, up to 20 per cent?
Mr. Bob Hamilton: That is right.
Senator Callbeck: It says in the last sentence that this provision will be reviewed. Who is it going to be reviewed by?
Mr. Bob Hamilton: It is part of the federal/provincial agreement, so the federal/provincial finance ministers will review this. For example, if the board lives with this policy for three years and decides that it does not want to passively invest any more, then the decision as to whether it is a good idea or a bad would come before the federal and provincial finance ministers.
Senator Oliver: What about parliamentary oversight?
Mr. Bob Hamilton: Right now, my understanding of the process would be that if the federal and provincial finance ministers decided that it was a good idea to change it, the change would be made through the normal regulatory process.
Senator Hervieux-Payette: It is not in the legislation so it will not come before Parliament, per se. It requires a regulatory change only.
Mr. Bob Hamilton: Yes, regulatory change; that is correct.
I will move on to provincial access. To define what this means -- we have talked about the old system -- in moving to the new system, we have put a couple of special features into the regulations. Basically, it boils down to how much access the provinces will have to this fund. In other words, could the fund decide not to invest at all in provincial bonds, or will there be some guaranteed access?
We believe that the asset allocation decision is the board's, in terms of equity versus bonds broadly; however, of the amount that the board decides to invest in bonds, a certain percentage must be invested in provincial bonds. For the first three years, the amount will be 50 per cent. For example, if the board's decision is 60 per cent equity, 40 per cent bonds, of that 40 per cent, half, or 20 per cent of the total, has to be offered to the provinces. The provinces may choose, for other reasons, not to take that financing option, but the board is under an obligation to provide that level of access. That is for the first three years.
After the first three years, the percentage of investment in provincial bonds will be determined by what other pension funds in the economy are doing. For example, if other pension funds are allocating 40 per cent of their bond portfolio to the provinces, this fund will have to offer that to the provinces.
Senator Callbeck: With all those regulations, in order to change them, did you say that the board makes a recommendation to the federal and provincial finance ministers and that they make the decision?
Mr. Bob Hamilton: No. For any change in the regulations, the support of the federal Minister of Finance and two-thirds of the provinces is required.
Senator Tkachuk: When you say that the provinces will be renegotiating their loans at market rates, is that federal market rates?
Mr. Bob Hamilton: No, their own market rates; the province's market rate.
Senator Tkachuk: If a province that was revolving its funds had a B rating rather than AAA rating, that province would pay a higher interest rate; correct?
Mr. Bob Hamilton: That is right.
Senator Tkachuk: So the interest that each province will pay will depend on its credit rating.
Mr. Bob Hamilton: That is right.
Mr. Foster: On new borrowings.
Senator Tkachuk: On the revolving borrowings?
Mr. Foster: Yes. When they roll it over, it is repriced; but not until they roll it over.
Mr. Bob Hamilton: I will just touch on the last element of the regulations. There are some additional disclosure requirements set out in the regulations -- what the board has to provide in its annual report. We have talked about the executive compensation, a description of the board's committees, conflict of interest procedures, and again we picked up on TSE requirements and other requirements of securities exchanges. Again, there is nothing new and exciting in there; those are additional requirements that are set out in the regulations.
Senator Angus: In order to get the main bill by the end of 1997, the minister undertook to arrange for the suspension of coming into force of the first 57 sections. Circumstances being what they were, neither the House of Commons nor the Senate had an opportunity to study the proposed legislation to the degree that they would have liked. To that end, we are now holding these hearings, beginning today, and we appreciate your attendance before our committee.
Suppose that at end of our deliberations we recommend that a change be made to, say, sections 2(b) and 7(a), what process will follow? In other words, can you give us some assurance on the record that this exercise is not futile and a waste of money?
Mr. Bob Hamilton: If your committee recommended a change to a regulation, we would have a look at that recommendation, but, ultimately, any change must be approved not only by ourselves but also by two-thirds of the participating provinces. We consider those recommendations valuable as we go through the process of finalizing the regulations; but again, that process is done in conjunction with the provinces. So that part is clear.
The legislation has passed but it has not yet come into force. It will come into force on April 1, 1998. Any changes that require legislative change would be rolled in as part of our tri-annual review, which is under way now. There is a three-year review period on all of the CPP legislation. Recommended legislative changes would form a part of that review.
So there are the two components: regulations and the legislation.
Senator Angus: In other words, it is illusory to expect that there will be changes made to the act, before April 1, 1998; correct?
Mr. Bob Hamilton: Changes to the act, no; to the regulations, yes.
Senator Angus: What steps will you follow if this committee issues a unanimous report that is adopted in the chamber? I know you told us that proposed amendments would be considered in the tri-annual review; but beyond that, what assurance can you give us?
Mr. Bob Hamilton: I am not sure how much assurance I can give you. Obviously, the views of the committee are valuable; I cannot imagine that they would not be given serious review by ourselves in that context.
As I said, we have not re-invented corporate governance here. We have tried to take the best of what is out there and adapt it as necessary. The fund will grow over time and these issues are going to become even more important over time. The first number of years will be an evolutionary process whereby we will look at the provisions and see how they are operating. The input that we receive from forums such as this will be helpful.
Senator Angus: Prior to these hearings, the committee was involved in a study on the corporate governance of institutional investors. That study, which has been somewhat delayed but not struck from our agenda, will culminate in a committee report, wherein the committee will recommend guidelines on accountability and corporate governance, et cetera, as it relates to institutional investors.
May I assume that you will take that report into consideration as well?
Mr. Bob Hamilton: Yes, absolutely.
Senator Angus: What we are talking about here will be the largest Canadian institutional investor, once it gets up and running.
The Chairman: Within a decade.
Mr. Bob Hamilton: Over time, yes.
Senator St. German: I cannot recall the minister say that only regulations would be subject. You are telling us now that any recommended changes that this committee would make to the legislation would be part of the three-year review; is that right?
Mr. Bob Hamilton: Yes.
Senator St. Germain: Was that clearly stated?
The Chairman: Yes, it was.
Senator St. Germain: I disagree with it; but what really matters in these hearings is the legislation. Personally I think there is only one issue, and that is the selection process of the board. If we get the right people, we will have an effective arm's length board in which the public will have confidence.
For example, the Governor of the Bank of Canada -- I think we used that as an analogy -- is not selected by the board.
Mr. Wyatt: The governor is selected by the board with the approval of the Governor in Council.
Senator St. Germain: With the approval.
Mr. Wyatt: Selected by the board of directors, yes. The outside directors pick the governor, the senior deputy governor, with the approval of the Governor in Council.
Senator St. Germain: Thirty years ago, we were told that the best pension was being put in place. And today they are broke. We are now asking businesses and individuals to carry the load. What guarantee do we have that, in 30 years from now, your replacements will not be sitting here saying: "Too bad. Bad investment; bad move"?
In any case, it is not your fault.
Senator Angus: I would remind the honourable senator that terms of the nominating committee, we know the names of the members of the nominating committee, and I think there is only one federal appointee on there.
Senator St. Germain: I am not worried about the first go-around. The first go-around I am sure will be better than Caesar's wife. It is the next two to three boards that come out of this system that will be pure patronage.
The Chairman: Let me thank the officials for their presentation. I understand that they will be staying for the remainder of the hearing.
Our next witnesses are Keith Ambachtsheer, John Por, and Malcolm Hamilton. Mr. Ambachtsheer and Mr. Por have been before our committee previously. Mr. Hamilton was not able to participate in our previous discussions on institutional investors.
Welcome, Mr. Hamilton. Some of us have known you in other capacities in the past.
I will ask each of you to make an ten-minute opening statement. Following those opening statements, we will have a question-and-answer session on the broad issue of the governance provisions of CPP.
Senator Angus: Mr. Chairman, have you determined, in advance, that none of these gentlemen is a candidate for chair?
The Chairman: No, I did not, but I would hope that the board would take their advice on what the appropriate governance provisions are to be.
Senator Angus: They heard about the $750,000.
The Chairman: Before I ask you to begin, Mr. Ambachtsheer, I wish to thank all of you for giving so generously of your time.
Please proceed, Mr. Ambachtsheer.
Mr. Keith P. Ambachtsheer, President, Keith P. Ambachtsheer & Associates Inc.: What I thought I might do with my ten minutes is continue the conversation we started last November. You may recall that at that time I described an organizational design study, in which I was involved, that was sponsored by eight major pension funds from around the world: two Canadian, Ontario Teachers and OMERS; in the U.S., AT&T, IBM, CalPERS, Wisconsin and Florida; and the big Dutch civil service pension fund, ABP. Those eight pension funds sponsored this study, which looked into issues of corporate governance and organizational design of pension funds.
The Chairman: That is right. As I recall, the study was still under way at the time.
Mr. Ambachtsheer: Actually, it had been completed but the eight top teams had not yet come together, which happened in early December. So, what I thought I might focus on today is: How did that December discussion inform us about how to run pension funds; and as a practical matter, how did it inform the eight top teams in terms of what they might do differently when they returned to their offices?
By way of background, we discovered two key things in our research, even before this organizational design study took place, looking at the drivers of pension fund performance: First, we found that, generally, large funds do better than small funds; second, we found that relatively high proportions of assets passively managed seem to correlate positively with positive performance for the total fund.
What we discovered through this study was that, indeed, the quality of organizational design of a fund does impact performance in a measurably quantitative way. We were able to get at organizational design quality in a number of ways: one, through a survey method of handing out a questionnaire to all of the pension fund executives of funds that are involved in our data base where we have their performance. That was a quantitative approach. Basically we were asking them some judgmental questions about how they felt about certain aspects of their organization. We found that their scores correlated positively with performance.
We were able to do some other work which focused on a more objective way of assessing the quality of organizational design. It also correlated positively with performance.
So we wrote this up -- and this paper, which was not available then, is available now. It is entitled: "Good Governance Matters Most", which is, I think, appropriate for this hearing.
We looked at three dimensions of how pension funds are run. We said that you need three things going for you: you need governance; you need management; and you need operations. We got some statistical measures on all three.
I will pass those statistical measures around to committee members.
We got some measures on all three dimensions of running pension funds: governance dimensions; management dimensions; and operational dimensions. What we found was that statistically the responses of 80 pension funds -- this was a sample of 80 pension funds -- as to how they felt about their governance process correlated more highly than either management or operations of the pension fund. Hence the title of the study, "Good Governance Matter Most", in terms of how it correlates with performance.
Senator Angus: Some people tend to confuse the terms "governance" and "management". What would you say is the key distinguishing characteristic between the two?
Mr. Ambachtsheer: By governance, we define the process through which the fund determines its mission; the process through which it determines its key policies -- asset mix; and through which it decides how to run the fund. And we found that part of how to run the fund is to put in place a qualified executive team to delegate the day-to-day management of the fund. We found that the clearer that delegation and the clearer the distinction between governance-type of activities and management-type of activities -- which would get into things like the resource plan, compensation scheme, what to manage internally and externally; those will be management type decisions -- the better.
Senator Angus: And is there not a grey area between management and operations?
Mr. Ambachtsheer:Yes. It is somewhat arbitrary where one stops and the other starts.
A typical operations-type activity would be managing a particular portfolio. That would be an operations-type activity, okay. So that those are the three levels of activities that we looked at.
What I would like to do, by opening the discussion, is to highlight some of the key things that came out of the top team meeting, when the eight groups got together and talked about these findings. They it in the context of their own eight situations.
Please know that the paper I am about to refer to is not yet formal; it is still under construction. I will refer to section entitled, "Improving Pension Fund Performance". That section talks about some of the key conclusions that were reached in this December 9th meeting.
There were three areas that turned out to be key. The first related to clarity about the mission: Why is this fund here? The better the organization can articulate the purpose of the fund, and why it is there, the better the performance of the fund.
The second area is in fact this question of pension fund governance and making it more effective. Two areas were identified by this group as being key: one, devising strategies which would produce higher quality candidates for the board of governing fiduciaries would have a high pay-off -- but this is usually difficult to implement. Keep in mind that these are the top executives of the pension funds. These were not the board of trustee candidates making these judgments.
The second key area identified was: devising strategies which improved the performance of the actual governing fiduciaries also has a high pay-off. One such strategy is to get the board to evaluate its own effectiveness, which will help them focus on doing the right things rather than just on doing things right. These right things include deciding the fund's mission, selecting the pension fund's CEO, clearly delegating management authority, and monitoring outcomes against plans.
The third area where they felt that the research could make a significant difference in terms of how well the fund was run is improving organization design: specifically, achieve a clear distinction between management work -- business planning, resource planning, et cetera -- and professional work -- portfolio operations -- in the pension fund organization and focus especially on building strong management skills within the organization.
They also said that it was important to try to understand the right number of layers within the organization, in establishing appropriate positions, and to delegate authority to the proper layers in the organization.
And finally, be clear about organization goals and determine how compensation can be related to their achievement. Aligning the economic interests of the people in the pension fund organization with those of plan members and the sponsor is critical to getting the desired outcomes.
Those were some of the major conclusions reached by this group based on research and their discussions during the day as to what are some of the critical drivers of achieving good pension fund performance over the long term.
I will just stop there.
The Chairman: Thank you, Mr. Ambachtsheer.
Mr. Malcolm Hamilton, please.
Mr. Malcolm Hamilton, Principal, William M. Mercer Limited: It was kind of Senator Kirby to describe me earlier as an expert in the governance of pension funds, but unlike my co-panelists I am actually a pension actuary. My area of expertise is not the governance of pension plans; it is the funding and management of pension plans.
For 18 years, I have advised many of the largest pension plans in this country: the Ontario Teachers Plan, Ontario Hydro, Bank of Montreal, Abitibi Consolidated. I have for ten years been a very vocal critic of the Canada Pension Plan, but one who is fairly comfortable with the reforms that are now been undertaken. In essence, I believe that we are making the best of a bad situation, and that is a lot better than what we were doing five years ago.
My comments are not going to be about plan governance, per se, but about what kind of a pension fund we are talking about here and how I think that should affect the way we manage the fund and what we expect of the people who are managing the fund.
The Canada Pension Plan never was a real pension plan -- I think everybody knows that now. I think confusion exists because many Canadians think it is about to become a real pension fund, and it is not. It is still going to be different than other pension funds.
The funding proposal that is now being implemented will make the fund a lot bigger. We are now talking about the equivalent, in today's dollar terms, of $100 billion. At that level, it is still going to cover 20 per cent of the plan's liabilities.
If you compare it to a corporate pension fund or a fund covering public servants, you will discover a far lower asset base relative to what you would normally see in a real pension plan. I am not saying that that is bad; I am just saying that that is the way it is, and I do not think that is appreciated
You are also looking at a funding mechanism whereby, if the fund makes or loses money, if it performs better than expected or worse than expected, the feedback is into the steady state contribution rate, which is the contribution rate that is to be paid not only by current members of the plans but also by all future generations. So that is an awful long amortization period for gains and losses. To get a sense of proportion, you are talking about $100 billion pension fund. If you compared that to the present value of the future payrolls that are subject to the payroll tax I suspect that you are looking at about $10 trillion of future payrolls.
What that means is that if the fund did very badly in the year -- let us say we lost 10 per cent of the fund through some very poor market result -- the consequence of that will be, in the long-term, a 0.1 per cent increase in the contribution rate. Conversely, if we had a blockbuster year, somehow managed to make 10 per cent better than we expected, the long-term consequence of that will be a 0.1 per cent decrease in that contribution rate. So there is a 100:1 demagnification here between the fund and the contribution rate.
I have a concern that this is dismally understood by the Canadian public. I have a concern that people will think that if you appoint the right panel of wizards, and if they go out and invest as effectively as Warren Buffet, all this nation's pension problems are behind it. And that is just not the case. This is not a big enough fund to create that kind of potential.
The investment objective that would make me comfortable, as it relates to this fund, is one that says that this is the longest term investor in Canada. Because there is so little linkage between how the fund performs and what is happening in the real world, it has the luxury of being a very long-term investor. And as a very long-term investor, it should be, in my view, predominantly invested in equities, and foreign to the extent that it is permitted.
The objective should be to do no better and no worse than the market. It is probably obvious to everybody why we would want to be no worse than the market -- we should at least expect the fund to do that well. But I do not think there is any gain in trying to be better than the market. Experience teaches me that it is very hard work beating the markets, even for professional investors.
I was looking at mutual fund statistics the other day. For the last five years, the average Canadian mutual fund that invested in the Canadian stock market earned a return that was about 2 per cent under what the TSE 300 produced. That 2 per cent is almost spot on the measure of the investment expenses of mutual funds. So the average mutual fund gets the market return, minus investment expense.
For large funds, it is very hard to do much better than the market. And no matter how hard this fund tries, I am pessimistic that it will be able to beat market by very much. I also do not see a very big gain for the Canadian people. Beating markets is a zero-sum gain. For example, consider a market out there that produces a return. The question becomes: How do you divide that return among the participants? For everyone who beats the market, someone else will beat the market. The more one beats the market, the further back others trail the market.
Therefore, even if you find this magical group that can generate incredibly good returns, you must ask yourself: Who is going to get the worst of market returns? The answer is: Canadians who hold RRSPs, mutual funds and pension funds that are invested in the same market, trying to get a good return.
So I do not see a big advantage to us beating the market. And although this may sound facetious and ridiculous, I am not sure that I would not dismiss those responsible for investing the fund, if they beat market by very much, because that is not what they should be trying to do, in my opinion.
In my opinion, what the Canadian public would define as the goal of this fund is quite different from what a Canadian economist would define as the goal of this fund. In my view, the Canadian people think that the objective of this fund is to have it do a lot better than market and have it either improve benefits or bring down the cost of the Canada Pension Plan. And I said earlier, I think that is not on.
The real purpose of this fund is to generate $100 billion of savings that will then turn into, in essence, a lower cost of capital for Canadian business. We are taking the supply of savings up, or we are trying to take the supply of savings up. If economics works the way it is supposed to, that should take the return on savings down; it should take interest rates down; it should take price-earnings ratios down; it should make it cheaper for Canadian companies and companies around the world to invest.
This is the return on that strategy: take the cost of capital down, create an environment where it is easier for companies to invest, and then let that go. Let them invest it, let the market decide where the investments go, and that will create jobs and a better economy, and all of the things that, in long-run, this plan relies on. This plan does not rely on that $100 billion fund. This plan relies on that $7 trillion of present value of future earnings that is going to be taxed to pay for it.
You have to get that earnings base up. Investing and bringing the cost of capital down, and creating jobs and employment growth, real wage growth, all of those things will feed positively into the future contribution stream of the plan.
That covers what I have to say. What I am advocating is no heroic action, no heroic expectations. We want a competent group getting market returns, a group that is going to be very challenged to try to get the Canadian public to understand just what this is about, what is reasonable to expect and what is not reasonable to expect.
The Chairman: Thank you, Malcolm; a lot of provocative statement, good food for questions.
We will now turn to John Por for his opening statement.
Please proceed, Mr. Por.
Mr. John Por, President, Cortex Applied Research Inc.: The last time we met, in November, the following challenge was offered to the group sitting around this table: Come up with some thoughts as to the necessary characteristics of the group of people who would form an effective public sector pension fund board, the characteristics of that group who form an institution we call "pension boards".
In response to that challenge, I wrote a position paper -- which I see in front of you. It is entitled: "Briefing Notes on Effective Pension Boards". Because it would take me about 25 minutes to go through that paper, I will jump over some parts. Instead, what I would like to do is to elaborate certain points which I consider to be very important.
First, let me review my credentials. We work with large institutional investors, mainly pension funds, and look at their governance practices, to evaluate what are the best practices.
We have 35 clients. Overall, we have found that everybody agrees on principle that -- over the years, Mr. Ambachtsheer has quantitatively proved that there is a quantitative link between good governance and investment performance. The issue is never principle; the issue is how to implement those. Because of the political nature of such an institution, there are huge implementation obstacles. For example, we have worked with more than 35 boards, and I have never met a board that would say that it is not a good board. It is as simple as that.
In the case of a corporate board, there is a well-proven way of telling whether or not it is doing a good job: A market reaction will take place, one way or the other. So after a few years, or months, one will be able to discern whether or not anything is wrong.
In case of a pension fund, it can take 20 or 25 years, as was the case with the CPP, to find out that, for whatever reason, the scheme is not working. It is open to question as to whether it was poorly designed or implemented, or whether it was that the assumptions have changed, because 30 years is a long, long time.
Given the fact that these institutions cannot rely on effective market feedbacks, short-term, it is important that the governance issues be looked at right at the beginning.
Whenever we say that there is a difference between good boards and bad board, say 80 to 100 basis points, we have found that most people take that to mean that a good board can create an additional 100 basis points, over and above market performance. We have found that it is true that there is a difference of about 100 basis points between good governance and bad governance, but the 100 basis points are the leakages. You can actually lose because you do not have good governance structures.
So please consider what Mr. Hamilton was saying, that if, through a good board, we believe that we are going to have an incredible investment performance, far better than anything else in the market, we are probably not being very realistic.
In order to determine what kind of board we need, let us look first at what activities a typical pension board should undertake. What are those activities?
First, they have to understand the pension system, the inherent risks and the participating financial interests. You just heard a very interesting point: that is, if we have a good investment performance, over one or two or three years, in the long-term that will affect the contribution to a very marginal degree. We have to understand that. For the board to actually govern the system, it must understand how the system works in totality.
This board's job will be interesting job because it is not being asked to manage liabilities, administration and assets, so there will be a tendency to just look at the investment function as is. They will probably look at relative performance against other pension funds. This fund will be fundamentally different from all other pension funds in existence, as far as we know.
The second task of the board is to set an actual governance-come-decision-making structure -- that is, there has to be distinct, clear and understandable accountabilities for all fiduciary decision-making bodies with a system of delegated authorities. Usually a pension fund consists of a board, board committees, executives, portfolio managers, governing fiduciaries, managing fiduciaries, operating fiduciaries. Only the board can delegate. So that is their second task.
The third task -- which goes without saying but it is a very important point -- is selection and evaluation of key senior staff to ensure that staff capability is commensurate with the size and/or complexity of the operations.
We are at the threshold of creating the largest pension organization this country has ever seen. What kind of staffing do we have to put in place in order to manage $90 billion? That is an important consideration. It may be a slam-dunk type of situation, where everything will be invested in an index fund -- come up with an asset mix and ride with it; or the organization may consist of many layers of decision-makers, many professionals, which could result in a huge investment organization.
Take OMERS, for example. If I am not mistaken -- and you can ask them this afternoon -- the investment staff itself consists of about 40 to 45 professionals. OMERS has assets of about $30 billion, I think.
Fourth, the board has to identify all of the major risk areas they want to manage and they have to set the risk parameters within which the delegated authorities can operate without interference from above. At the end of the day, the board has to set those risk parameters in a manner consistent with delegating decision-making authority to lower levels, such as the CEO and the investment staff.
The next task is to ensure that sound processes are put in place to develop the proper combination of expertise among board members to enable them to discharge their fiduciary duties. Again, that is easier said than done. I think it was about 8:30 this morning when you actually began to look into the issue of how the board will select its members. That is a huge issue -- one I will expound on that later -- because once you have a bad board, for all intent and purposes bad boards beget bad boards, always. And bad boards beget bad staff. The selection process of the first board is, therefore, key, because this is the time when you actually set the quality of the board for many years to come.
Sixth -- and in this case I am not sure that it is relevant -- a typical public-sector pension board has to ensure that the constituency pressure is contained. Because a huge fund is being created, everybody and his brother in this country, professionals, money managers, constituency groups, will go after this fund with a vengeance. These constituency pressures should be contained. The competing interests in the pension plan and fund operations have to be understood; a proper balance must be struck between the complexity of operation and the availability of organizational resources.
Usually what happens is that somebody says to the board, "If you give me these resources, I can deliver you incredible investment results." The costs are real; the investment results are only a possibility. And by the time you realize that the possibility was not lived up to, about five to ten years has past.
Seventh, the role of board members is to set an overall measurement system to evaluate the success of the administration and the investment operations, including implementation of board decisions, board policies, the board's own performance and compliance with the governance and decision-making structure.
One of the key issues for any board, especially in public-service service pension fund boards, is: If for whatever reason the fund is not performing, how would the board know that? As I said before, the market will not provide short-term information. So one of the things that a board has to do right up front is to make sure that suitable processes are in place to enable it to evaluate the fund's performance. To discover six or seven down the road that it should have been something else is too late for a board.
In my practice <#0107> and as I mentioned I have 35 to 40 clients -- I have yet to see a situation where a board undertakes a third-party evaluation of its governance operations.
Eighth, the board must vigorously monitor and evaluate the performance of its fund; and if the fund is not performing up to par, the board and staff must take appropriate actions.
Ninth, the board must undertake periodic evaluation of its system of governance, including delegated authority and risk posture. Usually what happens is that when something is set up, it is left to operate, and it is a given that that is the way it should be done. Thus, it becomes very difficult to change. So unless there are landmarks or milestones set ahead of time that we are going to look at, these evaluations will probably never happen.
And finally, it is the very important that there be strong communication of the inherent risks and their financial impact on the sponsoring organization, in this case the Canadian public, and regular reporting on the performance of the pension scheme.
By and large, that summarizes the role the board.
In that light, if you go to page 5 of my position paper, you will see the following ideas about how a board should be created. First, the board should be able to make decisions independent of the specific interests of any constituency. The board composition should reflect the nature of trusteeship -- that is at least a strong minority of the trustees should have no vested interest, career or political, in demonstrating to any constituency that their specific interest is being furthered.
Second, at least some of the trustees should have work experience that entails overseeing large, sophisticated organizations because whenever a policy is set the board must understand the organization or ramifications of that policy.
Third, the majority of the trustees should possess senior decision-making experience to ensure that the distinction between management and governance is maintained. Mr. Ambachtsheer clearly explained the difference between management and governance. The most common problem that is encountered is that boards start making managerial decisions. Why? The distinction is very difficult to draw.
Fourth, at least some of the trustees should come from a background that entails an understanding of recent professional development and the consequences of the related disciplines. In this case, the board is not responsible for pension administration and liabilities, therefore they can concentrate on investment discipline. The only point that I would like to make is that the experience with other large funds may not necessarily be that relevant for this fund, for reasons which Mr. Hamilton explained previously.
Fifth, at least some trustees should have a background in arriving at and formulating long-term policies and the need for periodic evaluation in light of actual experience to avoid significant damage. So although policy-making is difficult, unless we know that policy-making will eventually result in a long-term situation which may indicate that we have to change those policies, we are actually in the process of creating new policies without going back and evaluating the experience in light of what happened.
Sixth, the board composition should enable informed discussions on the various risks inherent in the pension system, and they have to represent considerable credibility to enable communications with the sponsor, the public and various constituencies. This board will eventually have to explain to two or three constituencies why things happened as they did.
Seventh, the board composition should reflect the need for withstanding outside pressure, especially constituency group pressures. I think it is important for the board to establish up-front an evaluation process that will provide feed-back on how well they do.
We believe that all trustees, irrespective of their background, should accept the need for extensive fiduciary orientation, usually on liability, pension administration and investment matters, and be willing to expend the effort necessary to build and maintain requisite and shared fiduciary knowledge and the often tedious process of policy-setting.
What we are trying to say here -- and this is my last point -- is that most board members will get on board because of their experience, and usually they do not see any need for learning new things about the pension system. Given the complexity of the pension system, and how fast it is changing, it is important that, regardless of the final make-up of the board, the members of the board develop a process whereby they can create shared knowledge.
The Chairman: Thank you, gentlemen.
Let me just ask all three to address the following question, which relates to an issue that was raised earlier with respect to the regulations: Given the fact that Mr. Hamilton says that the board should be able to do as well as the market, but no better, or if it does better that creates a different set of problems, do the three of you favour requiring the fund being an indexed fund, as the regulation will require it to be for the first three years?
And if you all agree with that, does that mean that (a) it needs a lot smaller staff and (b) you are much less concerned about the quality of staff if in the fact the investment policy is essentially mechanistic by virtue of it simply trying to match the index?
Mr. Ambachtsheer: I think one of the issues -- and I do disagree with Malcolm; he predicted that I would, and I do, disagree with what he said earlier about taking a passive, hands-off approach with this money.
If you look at capital market efficiency from an economics point of view, what that means is that there is out there some right proportion of active and passive management, so that at the margin an extra unit of active management cannot pay for itself. It is the classic case of using market principles to try to allocate resources. It is no different in this areas than in any other area.
The question becomes: Is there some disciplined process which gets you to that right proportion of active and passive management in an economy?
And I think what the CPP investment board properly constructed has an opportunity to do is to help find that right balance between active and passive. You achieve that by incenting the best professionals to find investments which have a bigger expected return than the informational cost and the risk associated with acquiring it. That is the mandate you give to any investment professional with an active management mandate.
A lot of bad investing is taking place out there, in the sense that a lot of the investing taking place out there is not incented to create that right balance to do enough active management so that pays for itself.
A lot of the bad investing that is happening out there is because of what I have mentioned, what John has mentioned, and what Malcolm, in his own way, has mentioned: that is, a lot of investing institutions are not properly organized today to articulate their mission, to get clarity in terms of organizational design, and to develop a selection process whereby professionals will look at those areas which have the greatest opportunity to create incremental value, and then reward them with an incentive bonus. Our research shows us that the development of those types of organizations results in a comparative advantage over organizations that are not as well organized.
Therefore, my question to Malcolm <#0107> although I do not know whether or not I am allowed to pose a question to him -- is: Why would we want to take away from the CPP investment board that opportunity, to create an excellent investment organization? You are right -- it only takes the contribution rate down from 9.9 to 9.8, if it does well.
Our research shows that if an investment organization is operating on all cylinders, it can produce about 50 basis points a year of risk-adjusted net value added. When you look at the Ontario Teachers' Annual Report, that is about what they have produced over the last four years.
Let use the example of $100 billion again: 50 basis points on that represents $500 million a year. My question is: Why we want to leave $500 million a year on the table if we have an opportunity to create an organization to take that off the table.
The Chairman: Malcolm, did you want to reply?
Mr. Hamilton: Notwithstanding that very eloquent answer I would index the whole thing. It is not a matter of quality of staff; it is a matter of number of staff and what the staff do. Trying to reproduce an index return at the lowest possible cost is not easy. You do not want idiots trying to do that. You need competent, technical people.
What they do not need is this sort of excellent judgment about where the market is mispriced, but they have to know how to efficiently execute the strategy that they have been given.
On Keith's point, I just do not think it is in the cards that you are going to beat the markets by 50 basis points. If you look at Teachers' returns, or look at funds that do beat markets, it is important to ask how they are doing it. I suspect that in the Teachers' case there is a fair bit of asset mix.
So one way you can beat the index is if you say that your boggy is 50 per cent equity, 50 per cent stock, and then hold 60 per cent, then you beat the markets over the long-term because you have changed the asset mix from the benchmark that you are comparing to.
Referring to the fund under discussion, if the board does its job properly, it is going to be predominantly equities. I do not think there will be a big position in fixed income, other than the one that the provinces insist that you have. I think it will be internationally diversified. I do not think there will be a lot of room to add value on asset mix. You are then into the much tougher job of trying to add value on security selection and market timing, and I just do not think you are going to get 50 basis points out of it.
Now there are places in the market where managers have been able to add value. Almost all global funds add value, and they do it by underweighting Japan. They have underweighted Japan for seven or eight years, which is why many of them have beaten the markets by a lot.
If I were a betting person, in the long-run beating the markets is not as easy as people think. There is a reason why those guys who really do it make a lot of money, and the reason is that it is awful hard to do. I do not know whether the CPP, which has its own governance problems -- for example, how do you keep it at arm's length from government? I like passivity. I think the incentive for politicians or the political process to try to meddle in a passive strategy is much less than the incentive or possible interest in meddling in an active strategy. So I am comfortable with passive.
Mr. Por: Financial theory supports Keith's comments. A number of articles have been written to the effect that the best strategy is to immunize your pension funds from your financial liabilities. One reason you would do that is, because liabilities are not stationary, you have to use the fund as you would a defined contribution type of plan, so you actually share the benefits with the beneficiaries.
Another reason is, because you can deviate from that minimum risk policy, then you start applying knowledge to management, and that creates additional value. That should be the main reason. In that sense, Keith's position is crystal clear and understandable: We should do this because we would leave $500 million on the table.
Yet another reason for doing that is based on the successes of actual experience. I must reiterate that it is horrendously difficult to come up with a governance structure which will do this consistently. Over the last eight to nine years, most of the value added to the Ontario teachers' fund is as a result of the asset mix held. Compared to the majority of pension funds, they chose a very aggressive asset mix and, in the last five to six years, the markets have been unbelievably good to them.
In the case of a large, visible, public sector pension fund, it will be very difficult to create a governance structure which will withstand the meddling that will inevitably happen.
Of course, the promise has been made, but the promise can work against you because, if you want to add 50 basis points you have to risk losing 50 basis points, plus the expenses. If you want to add 50 basis points through internal excellence that would have to be done by a tremendously sophisticated financial organization, and public sector pension funds are not known to be able to do that consistently, across the board. Financial theory suggests that you may want to do that, but usually that applies to corporations, not necessarily public sector pension funds. Our experience suggests that it takes tremendous great effort, and you have to protect it so well that it is almost impossible to do.
Are we going to gear up for an organization which will add that 50 basis points? If the answer is yes, then you will have to hire some very knowledgeable staff. That is one way of doing it.
The other way is Malcolm's way, which I happen to support, and that would keep the costs down.
Senator St. Germain: You have spoken of governance and the quality of the organization design. My major concern relates to transparency and the confidence that Canadians will have in this board. Some of you gentlemen have worked with the Ontario Teachers Pension Fund. I believe they have a process whereby half of their board members are provincial appointments, and half are chosen from their own sector. I understand they pick a neutral chair.
A lot of political horse-trading will most likely go on in this instance. The officials who appeared before us this morning used the analogy of the Bank of Canada. Those of us who have been involved in the political process know how the Bank of Canada's selection is made. It is based on regional representation. It is strictly a GIC partisan appointment to the board.
If this board is to operate efficiently, it matters not whether all the members are from Newfoundland or whether they are all women, just as long as they are the best people to do the job. The appointments should be non-partisan, as much as possible. If not non-partisan, one suggestion I would make, and it is not original, is that the Federal Government could chose half the board and provincial governments could chose the other half. Then they would select a neutral chair. That would at least give it the transparency it deserves. As one of you has pointed out, this is a long-term commitment. Thirty years down the road, if it fails, it will be a disaster.
Some people in this country figure that the people that are there now cannot make mistakes. Believe me, they can.
Do you have any comment on that?
Mr. Ambachtsheer: The concerns about governance management mechanisms that are being expressed are no different from concerns related to any large retirement system in terms of creating governance, management mechanisms that do the job. This is a societal challenge. What bothers me is the notion that we should not do this because it will be difficult.
I would suggest that we are moving to a society of pension fund capitalism. We now live in a world where a large chunk of corporate Canada, America, and increasingly other countries, is held by institutional investors. If we do not create mechanisms where these institutional investors hold the management and boards of the investor corporation accountable for creating value for retirement system members, then we will become disconnected.
My view is that we must be a player, and we must do that in a responsible, transparent way. To say that we cannot play because it is too difficult is the wrong approach to take.
Senator St. Germain: I do not think I am saying that it is too difficult. I am asking you whether the transparency is there in the method that is being advocated by the government. I did not suggest that we should not go ahead.
Mr. Ambachtsheer:This was one of the discussions that we had at our meeting in December with the eight top teams of the eight pension funds. There was in that group -- and I will not single out individual funds -- a general concern expressed by the senior executives with respect to selection processes for their boards. There was a general dissatisfaction, not just with what we are talking about here, but generally, with how it is done.
The Chairman: Even in private-sector boards?
Mr. Ambachtsheer: Yes, because in the private sector, the choice tends to be a person who is a senior executive. You may pick the person running from Human Resources and, say, the chief financial officer and two or three others and appoint them to the pension committee. That is not necessarily a good way of doing it.
It is a real challenge to choose the proper selection process. I think, collectively, we have an opportunity here to choose the right process. I would suggest that the involvement of a professional executive search firm might be appropriate. You could specify the kind of people you are looking for and they would go out and find them.
Senator Angus: Now you are talking.
Mr. Por: There is no impending disaster. Let us suppose this board, for whatever reason, is poorly constituted and all the concerns voiced around this table are justified. Even in that situation there would not be a disaster.
At worst they would not get their expected market returns and they would have to pay some managerial fees.This would not signal disaster.
The issue is actually somewhat different. The issue is: If there are good governance practices -- and they do exist as many of us around this table have said -- under the circumstances, can we ensure that these good governance practices are put in place in this particular fund which will be huge? Do we have the right circumstances in place to create that? There is no question in our minds that, with an appropriate governance structure, you can add 50 basis points. However, that will be very difficult.
As well, given current circumstances, is this the moment to create that? As a matter of fact, for a public sector pension fund, this is the moment because this is the only fund that can start from scratch.
One of the biggest problems for teachers relates to the board composition. Each and every time somebody retires from the board, it is an agonizing task to ensure that the appointees to that board are the right people for the job. The talent required is a very scarce talent, and it is difficult to find.
If you really want to set an example about how to do it properly, this is the time to do it. The question should be asked: Can we do it now?
Senator St. Germain: Do you gentlemen have confidence in the Governor-in-Council method of appointment which means that the appointees would be chosen by the Minister of Finance and ratified by cabinet?
I realize how complicated and how trying it must be to find the most competent people to serve on these board. In your professional opinions, is the system that is put forward in the legislation the best system, or should we recommend a different methodology to the Minister of Finance?
A nominating committee has been set up and, looking at it, I see the majority on that list are bureaucrats from various provinces. One of you recommended hiring a professional firm of head hunters to select these people. As I look down this list I cannot comment on the competent of these bureaucrats. That they are bureaucrats from the system may not necessarily be a bad thing, but they may not be the best people to recommend members of a board as important as this, because the initial board will set the guidelines that will guide this particular fund for decades.
Mr. Malcolm Hamilton: I have a difficult time responding to these questions because I have a different vision of this board and what it will be doing. I see a structure where the board is in an environment where it cannot do harm, as opposed to can do good.
My requirement of board members is that they would be humble people who would get up every morning and say, "I am not Warren Buffet; I was not yesterday; I am not today; and I will not be tomorrow."
There is a select group that I think would be dangerous to have on the board, but there is a large group that, I think, would do a commendable job.
Senator Angus: Gentlemen, could you comment on whether the rate of return is dependent on the market, which is a reasonable benchmark, or would the extra 50 basis points that you might get be a bonus for exceptionally good management and governance? What are your assumptions as to the real rate of return after all the usual adjustments? When you project that it will be worth a certain amount in 20 years, you must be basing that on an assumed rate of return.
Mr. Por: The question was: Do I, personally, believe that a good selection process could be created for the CPP? That is an important question. My answer is: No, I do not. I do not believe that we can put together a governance process for any public sector pension fund that has the kind of clarity and the kind of quality we are looking for.
That is not to say that other funds could not do it. However, quite frankly, in the private sector you have a much better chance of doing it than for the large public sector pension funds. It is not because they are inferior, it is just that different political processes are in place, and there is a huge temptation to be politically correct.
Senator Angus: You say we should forget the 50 basis points; is that right?
Mr. Por: That is right.
Senator Angus: I would like to get a sense of what the rate of return would be. That was my question.
Mr. Malcolm Hamilton: Many long-term consequences are not particularly dependent on the real rate of return. The actuary of the plan assumes a 3.8 per cent real return. However, I think most economists and actuaries would view that as being low today. From reading the "KPMG Survey of Economic Expectations" for this kind of fund you should probably expect 5 per cent to 6 per cent. In fact my estimate would be 5 per cent and I think would share that opinion.
Senator Angus: Would that be so within the restriction of the 20 per cent rule?
Mr. Malcolm Hamilton: Yes. I would not draw a major distinction. I think the 20 per cent rule is more about managing risk than boosting return. If 80 per cent of your fund is in Canada, your ups and downs will be a little more profound than if the fund is broadly diversified. However, I have no reason to think you will get better returns in the long-run by going outside the country. However, the fact is that nobody knows. The returns over the last 20 years have been nothing like anybody predicted 20 years ago, and in the next 20 years they will probably not be like anybody predicts today. It will be what it will be. The important thing is to get the savings into the economy, try to turn it into productive investment, and use the markets to do that, because that is one thing the markets do pretty well.
Senator Angus: I thought the Ernst & Young study found that, by removing the 20-per-cent rule and by going to, say, 30 per cent, you could get as much as another 160 basis points.
Mr. Por: If we accept the past as a guide.
Mr. Malcolm Hamilton: I think they said that would be the case if it had been done a long time ago. It is a little different.
Senator Angus: That is retrospective.
Mr. Ambachtsheer: Yes. It is not a good study because it is retrospective. If we could predict that the next 20 years would be like the last 20 years, it would help.
There are some relatively simple economic rules of thumb that you can use to gauge prospective returns which, as Malcolm points out, never completely work, but they do give you some reasonable expectations in the sense of indicating a baseline.
Senator Angus: Are you referring to 4 per cent to 6 per cent?
Mr. Ambachtsheer:The nice thing about the bond market is that you can look it up in the paper every morning and know whether 6 per cent is what long-term term bonds are doing, and then you know what is the expected long-term return on bonds.
Historically, stocks have done 3 per cent to 4 per cent better. However, based on the numbers, that is not in the cards. It looks more like 2 per cent better now, prospectively, so we are living in an 8 per cent, 6 per cent world, in terms of gross returns. If you subtract 2 per cent for inflation you are down to a 6 per cent or 4 per cent world, and 50-50, brings you to 5 per cent. It is that simple. I mean there is no amount of incredibly detailed analysis that you can do to get a better number. What looks like a reasonably balanced portfolio prospective return today is 5 per cent real.
Senator Angus: Personally, I would tend to you agree with you.
I believe you were all here when the officials were giving us their briefing this morning. You have had an opportunity to look at the draft regulations, I believe, have you not?
Mr. Malcolm Hamilton: Even if I looked at them I would not understand them.
The Chairman: I should point out these three gentleman have the tremendous advantage of not being lawyers.
Senator Angus: Knowing what you do about the framework of the legislation and the concept we are examining, particularly the governance structure and the first 57 sections of the act which was passed before Christmas, are there any particular criticisms that any of you might want to highlight? I am referring to instances where you think the government has got it wrong and where we might be able to recommend some improvements?
Mr. Ambachtsheer: I think quite the contrary. I think an extraordinarily amount of work has gone into creating at set of rules that are probably as good as you can realistically expect to get.
As was said earlier, the real key is the composition of the first board. If the first 12 appointees are good people then good work will continue for a long time. The good work will continue. However, as John pointed out, if poor choices are made at the outset, bad work will continue. Getting it right the first time is very important.
Senator Angus: The mechanism is there. As I understand it, you folks have no major concerns in terms of the ability to provide good governance to set up a structure that will function well.
Mr. Por:. Actually I have no concern in terms of the wording of the legislation. I personally hoped it would be a little longer than three years before going into the markets actively, but that is a side issue.
The key issue is: Who will be the first chair? One of the keys to the success of the Ontario teachers fund is that they had an excellent first chair. You may want to consider their obviously very good model. The key is the selection of the board.
I know only one or two individuals on the list I have. I do not know whether this is a good list from which to select members. I think it is important that this Senate committee should outline the qualifications that are necessary before anyone is chosen from any list of candidates. I spent a great deal of energy trying to figure out what kind of people should be on any such list.
Mr. Malcolm Hamilton: I will comment on the teachers' board because I have experience with them. The teachers' board is not a board of experts, it is a board of individuals with sound judgment.
Senator Austin: They have a proven track record.
Mr. Malcolm Hamilton: They are not at all partisan. There are hardly ever any split votes in the Ontario Teachers Pension Plan Board. They turn up; they know what their mission is; and they know they are not the experts. They hired good people, followed good advice and got good results. There was nothing more magical to it than that.
Senator Angus: We are talking about sound judgment. There is no magical person out there who should be the first chairman, I suppose.
Mr. Ambachtsheer: The important way in which the whole process is self-reinforcing is that the good board will pick good senior management. Good senior management can help a board tremendously in terms of coaching and filling in knowledge gaps. It needs to be synergistic process.
Senator Angus: It is really the main duty of the board, is it not, to get that management in place?
Mr. Por: That is correct. However, our experience is that boards tend to pick senior executives who are weaker, and who will not stand up to them. Do no forget, the CEO is beholden to the board. The 50 basis points Keith is suggesting is attainable, but you would have to work at it. Usually experts are hired to achieve your goal, and by the time you realize that the 50 basis point is not being achieved, you have hired about 60 people and it is five or six years down the road.
Mr. Malcolm Hamilton: If I had to put my finger on one positive situation in respect of the teachers' board, it was that those who were appointed to the board quickly forgot who had appointed them. They were instructed upon arrival that it must make no difference who had appointed them. They were told their mission was to do their best for the members of the pension fund.
If this board gets that same message, that is, that they do not represent a province, political party, region or gender, and that they have been chosen to do a job for the people who participate in the Canada Pension Plan, then that will do a lot of good.
Senator Austin: On this issue, I have a comparative table which shows that, in respect of the board of the Ontario Teachers Pension Plan, four members are appointed by the Minister of Education, four by the Ontario Teachers' Federation, and then a chairperson is selected. It states that either partner may remove its appointees and appoint a new member. The term is for two years, limited to four consecutive terms. In theory there is a lot of leash on the members; far more leash than is proposed for the Canada Pension Plan investment board. That will be a complicated process in that members will be appointed by the Governor-in-Council on the recommendation of the Minister of Finance who must consult appropriate provincial ministers prior to recommending appointments. The Minister has to take into account the desirability of having directors who represent regions, and people with proven financial ability or relevant work experience. The term is three years, and there is no limit to the number of times a person can be appointed. A person can only only be removed during a term for cause.
I suggest that there is a good deal more formal independence, although the reality may be no different if the way in which the two corporations are organized is along the lines of good governance.
I know my colleague, Senator St. Germain, is concerned about political interference of some kind. We heard from Professor MacIntosh that that is a far greater problem in the private pension fund sector than in the public pension fund sector.
I do not mean political interference with a capital "P"; I mean the problems associated with a convergence of interests. The problems of private sector managers seeking to have additional funds to manage, being more susceptible, if you like, to the concerns of corporate managers than is likely to be the case in a public pension fund where there is no competition for additional funds to manage. There is a designated stream of funds.
You can comment on my editorial statement when you answer my other questions, but I am curious to know, particularly from you, Mr. Hamilton, how the framework you gave us with respect to the long-term scenario of the public pension fund would apply to the mutual fund concept. Would you give us a different matrix for the management of a mutual fund from the management of a public pension fund?
Mr. Malcolm Hamilton: I do not see very much similarity at all between the management of a mutual fund and the management of the Canada Pension Plan.
The business reality of a mutual fund is you have to do something to distinguish yourself over a hoard of seemingly identical products. It is a very different business dynamic. How you manage a mutual fund to succeed in the mutual fund business has a lot to do with marketing and promotion and percolating to the top of the performance charts every few years.
The Canada Pension Fund is completely different from that. The money flows in. You do not have to compete for it. It is very long-term. In the mutual fund business you have a bunch of people who read the paper every day to see what happened to their money.
The Canada Pension Plan fund will be different from that. There will be some sense of ownership and attachment, but it will be far more remote. You will have the luxury of concentrating on doing a capable of job of investing.
Senator Austin: I am asking the question because I believe a lot of Canadians do not distinguish between how a public pension fund, which has a long scenario, is managed and how mutual funds are managed. In fact when the revisions to the Canada Pension Plan were being proposed, arguments were put forward to abolish the Canada Pension Plan and simply give Canadians the opportunity to manage their own funds in a different kind of scenario. What I am trying to establish is whether there is a viable long-term pension plan system that produces a stable financial product.
Mr. Malcolm Hamilton: Yes, but you have to overcome a major hurdle because Canadians misunderstand this completely. They should view the Canada Pension Plan as being 80 per cent pay-as-you go, and 20 per cent funded. For every dollar of interest they have in the fund they have a $4 claim on the taxes of future generations. That $4 claim on the taxes of future generations is mostly what the Canada Pension Plan is about. If we get to the point where the Canadian public views this as their mutual fund, we will be completely off track, because that is not what it is.
Mr. Ambachtsheer: The irony is that it is very likely that that asset pool will do much better, on a net return basis, than a comparable asset pool of mutual funds, for the very simple reason that mutual funds charge 2 per cent per year in fees, and this asset pool will run at one or two basis points. There is a rule of thumb in pension economics that, for every incremental 1 per cent of long-term net returns, your ability to pay your pensions goes up by about 20 per cent. Therefore, when you have an almost 2 per cent cost advantage, you should be able to produce 40 per cent more in terms of terminal pension.
Mr. Malcolm Hamilton: Except that 80 per cent of the money is not there.
Mr. Ambachtsheer: That is right, except that 80 per cent of the money is not there. However, for the money that is there, if you were to run a horse race with $100 billion of CPP assets, against an equivalent investment policy pool of mutual funds of $100 billion, I would predict that the CPP investment pool would do 2 per cent per year better, on average, over the long-term.
Senator Austin: I do not disagree with that, but the irony of that is found in the metaphor of our society: If some fund produces a 43 per cent gain, how good are the managers who are operating according to standard norms and performing extremely well against those standard norms? Perception is sometimes reality, and it is very important to fight the misconceptions.
Mr. Por: The pension industry is doing a very reasonable job internally. None of the pension funds we know of would expect to beat the markets by 5 per cent, 10 per cent, and so on. I think the economic considerations that Keith mentioned are well known in the pension industry.
As to your editorial comments regarding conflict of interest, I do not believe that private sector pension funds suffer from this syndrome more than public sector pension funds. It is not a major problem in private sector pension funds.
Senator Austin: That point was made in evidence given to us by Professor MacIntosh.
Mr. Por: I think his evidence was that, when it comes to corporate governance issues, private sector pension fund investment officers have more difficulties taking the other company's management to task because of that issue.
Senator Austin: Professor MacIntosh told us that a study from the U.S. shows that, on average, public pension funds earn about one and-a-half points less than a broad market index. He told us that the main reason was that many of the public funds in the sample were pressured by local politicians to invest in local enterprises that turned out to be not very profitable; and that public fund managers often like to avoid publicity for fear that this will attract political interference in their investment program. He was talking about U.S. funds.
Mr. Por: This is anecdotal evidence. I have still to see a large public sector pension fund with a huge portion of its fund being managed like this.
Mr. Ambachtsheer: I have the numbers. It is unfortunate that Professor MacIntosh is not here. He was quoting a fairly obscure source. We have the best database in the world, and we do very professional research.
As I mentioned earlier, the two factors that we discovered relative to distinguishing between good and bad performance, were fund size, portion passively managed, and now this third dimension, the quality of organizational design.
If you try to include public versus corporate funds as an additional explanatory variable, you get nothing.
Senator Austin: I am glad we are exploring it because it is a matter of some concern to me. Professor MacIntosh also stated that public pension fund managers cannot be coopted in the same way as private sector managers, that is, corporate pension fund managers. If a private sector pension fund manager holds a large block of stock in a company, he might legitimately fear that adopting an activist stance, vis-a-vis corporate management will cause it to lose pension fund business. Public pension funds are not susceptible to this pressure since public pension funds do no business with companies in which they hold stock. That was his evidence.
I believe the industry acknowledges that is a problem.
Mr. Ambachtsheer: To clarify that, it is important to distinguish between an internally managed fund and where the money is out-sourced to third party money managers, which tends to be the case for funds less than $1 billion in size. It is virtually all out-sourced to third party money managers.
For example, in Canada, you have Canadian Pacific Investment Management, which manages all of the CP pension assets which, I think, runs close to $10 billion. That is an internally managed fund, largely. You have to keep the matrix in mind as to how the money is being managed.
Mr. Por: Both Keith and I tried to make the point that it is incorrect to assume that, if you invest just a little bit in corporate governance, all of a sudden the market will react wonderfully. This corporate governance debate has going on since the late 1980s, early 1990s, and there is still no definite study showing that activist management has outstanding results.
You will hear all sorts of evidence from the big funds but, at the end of the day, I think you will conclude that their efforts are meek. At the end of the day this corporate governance action, quite frankly is marginal in effect from what we found.
Senator Austin: Could I ask you then, is there any large public pension fund that is fully indexed and that is their strategy; or are they mainly indexed but with variations?
Mr. Ambachtsheer: The only one that I am aware of that is a large and growing public sector fund is actually the U.S. Federal Government Employees Fund. They have the traditional defined benefit plan but, some number of years ago, they started the U.S. Government Employees Thrift Plan. That was set up with completely, 100 per cent, passive rules. I think it is now up to $30 billion to $50 billion in assets which, by U.S. standards, is still relatively small, but it is growing quite rapidly. There are "automatic-pilot" rules in place which apply to any investment, and personal judgment does not come into it.
Senator Austin: Three years from now when the federal government and the provinces are asking themselves whether a fully indexed Canada Pension Plan Fund is the right way to go or whether they should vary the rules, what advice would the three of you be prepared to offer?
Mr. Por: It depends on what they do. Now, value judgment is involved. The promise has been made there regarding the $500 million and, if they start managing that actively now, three years hence it would be too early to measure progress. However, after six or seven years Keith, who would be measuring these things, may find that you are actually losing value. The question is: What will the board do once it acknowledge that it did not chose the right manager and take steps to achieve those 50 basis points?
These issues will never go away because the promise is there. The experience is new. The board may be unwilling to accept that it is not doing a good job and may decide to wait for another five or 10 years before it makes a change. We find it is very difficult to change.
Mr. Ambachtsheer: I have a lot of difficulty with a large proportion of the Canadian market being "passively" managed. It is a whole separate discussion as to how you actually run an indexed fund.It is not at all clear to me how it is done. I do not think you can be 100 per cent passive because you are always interacting with other players in the marketplace to try to pick up positions. Interestingly, if you look at the really good passive managers, there is an active dimension to how they actually run the assets.
On top of that you have the whole corporate governance issue that has already been raised: How passive are you with respect to corporate governance issues?
Frankly, I think the passive issue is a bit of a red herring.
The Chairman: I am puzzled by your comment that you have to be active to run a passive fund. I know that is exaggerating what you said, but maybe it reflects the fact that Malcolm and I are mathematicians. If a percentage of various stocks goes into the TSE 300, to take an index, what huge degree of judgment is involved? For example, if you pick a number that works, usually $100 million, and if 15 per cent of the TSE is in Noranda and then I have got to own 15 per cent of $100 billion in Noranda. That strikes me as purely mechanistic and not judgmental.
Mr. Ambachtsheer: I think it is mechanistic when you are small, that is, you have a small piece in relation to a large totality. The larger the supposedly passive pool becomes, the more difficulty you will have actually trying to find the securities. People then realize that they have to be in the market for a certain amount of a particular stock.
The Chairman: That implies to me that the size of the fund operating as an index fund is, in fact, going to cause impacts on the index.
Mr. Ambachtsheer: Exactly. Everything is relative.
The Chairman: It is not, in effect, a neutral index player because, by adopting an index strategy, it is, by definition, changing the index.
Mr. Ambachtsheer: Think about the TSE committee that has to revise. Let us say they run off the TSE 300, which may or may not be a good example, but think about the index committee that has to do the revisions two months from now, as to what stocks they kick out of the index and what will comes in and the value of that information. Do you see the problem?
The Chairman: Yes. Malcolm, as my fellow mathematician, do you want to reply?
Mr. Malcolm Hamilton: I think it is a different issue. We are not talking here about 100 basis points; we are talking about little, slim margins.
If someone wants to go out and actively chase those slim margins, I have no objection at all. I just do not want a group that is out there saying: We are going to stick huge amounts in this one and small amounts in that one because we have got a vision of the future that is clearer than that of normal Canadians.
The Chairman: Tinkering around the edges is one thing, attempting to be hugely strategic is another.
Mr. Malcolm Hamilton: Yes.
Senator Austin: Mr. Hamilton, you gave us a scenario in which, operating according to index norms, can generally bring down the cost base in the economy and encourage higher productivity. Did I understand you correctly?
Mr. Malcolm Hamilton: It is not so much operating on index norms. The economic justification for funding the Canada Pension Plan is to boost savings and boost investment.
Senator Austin: Which allows lower cost capital to be available.
Mr. Malcolm Hamilton: That is right. If you boost savings, and if everybody decides to buy bonds with the result that there are no more bonds available, then the price of bonds will go up and interest rates will drop. That is supposed to send a signal to all Canadian entrepreneurs and companies that they can raise capital less expensively than they would otherwise.
At the margin, some may decide that the factory that was not viable when capital was expensive is now viable. They are to make those decisions that the capital is to be deployed there. That will create job and boost productivity. That is how it is supposed to work.
Frankly, that would happen whether it was actively or passively managed. There is no magic about passive. However, I am not optimistic that any body of this sort will be able to generate enough of the gains from active management to make it worthwhile.
Senator Austin: I understand.
By buying an index, presumably you are buying the most established companies in the country with presumably the best balance sheets; is that correct?
Mr. Malcolm Hamilton: No, that is not so. You need a very broad index for this plan. You do not want this plan chasing the TSE 35 because, as Keith points out, all they will do is drive the shares of the TSE 35 to ridiculous levels. Then we will have great investment, and a low cost of capital for the TSE 35 and no change in the cost of capital for anybody else.
Senator Austin: Yes, exactly.
Mr. Malcolm Hamilton: You need a broad index, and a broadly represented index. How do you do that in Canada? You have got the VSE, Alberta, Montreal, Toronto, what is this sort of universal Canadian equity index, and what would you do in a worldwide index?
There are challenges, but I think those are second-level challenges. I would suggest that you just do something sensible. Have the capital broadly dispersed. Pick a broad index, and just go for it.
Mr. Ambachtsheer: I must have one more go at Malcolm because he is arguing for a lower broad cost of capital across all companies, and I am asking: Why don't we go the next step and have some experts figure out which companies within that broad spectre deserve the lower cost of capital relative to other ones?
Mr. Malcolm Hamilton: This plan will not have those experts.
Mr. Por: May I just comment because I believe that there is no right answer to this. The problem we are facing is that, on the one hand, you have a promise, and we say that there are well established governance principles so this can be done and, given the risk and rewards, it should be done. That is one way of going.
The other one is to say: given what we know, yes, it can be done but it has never been done for a number of reasons which have nothing to do with theory and the brilliance of the experts. In the future we will know whether we were right or wrong. When we sit down five years from now we will have exactly the same argument. It is a matter of faith.
There are technologies to set up the right board. The question is, do we believe in our ability, societal ability, to put that in place. There is no right and there is no wrong. There is a promise and there is a risk. Eventually, that is what you have to decide.
Senator Austin: I have the impression that choosing the right methodology is more important. Everything is important, but choosing the right methodology is little more important than the people chosen to be on the board.
Mr. Malcolm Hamilton: You can get mired in the technicalities. The question is: What is the objective? Is this board to be told to go out and beat the markets, or to get the run that the markets provide at the lowest possible cost? Those two objectives are a world apart.
Senator Austin: I think that message is clear.
That leads me to the last point I want to ask you, Mr. Hamilton, because you are an actuary. I am looking at remarks of the Minister of Finance before this commitment on December 17, 1997. He has established a 9.9-per-cent rate as being sufficient, actuarially, to fund all of the liability.
The Chairman: That is the contribution rate.
Senator Austin: Yes, to fund all the liability. Are you comfortable with that?
Mr. Malcolm Hamilton: It is not sufficient to fund the liabilities. What he is saying is that that contribution rate, continued indefinitely, will support the plan. At no point do the liabilities ever get funded in the sense that the money is in the fund cover them. He is saying that will, if continued indefinitely, support the plan. I think that is as good and as responsible an estimate as we can have right now. Any adult in Canada should know that no number picked by even the most visionary Minister of Finance will endure for centuries. If birth rates drop or rise, if real wage growth goes up or down, all of those things will move that rate. I have no reason to believe, ab initio, that that is biased and that it is more likely to go up than down.
Senator St. Germain: Did you concur with his statement that the selection of methodology is more important than the board? The methodology has to be set by the board.
Mr. Por: What is most important is the quality of the first board you pick, especially the chair.
Senator Austin: The implied premise of that is that you have a highly experienced leader of this plan who understands the methodological choices that need to be made.
Mr. Por: That leader will outline the choices to the board. They will argue for the alternatives they favour, but the board has to make a final judgment: Will we try to live up to the promise or not? Are we going to build that organization or not? A quality board is essential; in other words, those in charge must have an understanding of their responsibilities.
Senator Tkachuk: My view is that this fund will do better than the other fund did. It cannot be any worse. Then we have the question of accountability. To whom is the the board of directors accountable?Whose money is it? Even though it is not their money, they play with it as if it were their money. Political decisions were made when the board was set up. The pension was set up fund in 1967, and they have made political decisions as to what should happen to that cash ever since. They even made political decisions knowing the problems that existed with the Canada Pension Plan when they decided to revolve the debt once again at market rate so the provinces would be able to revolve their debt. Another political decision was that 50 per cent of the money ought to be invested in provincial bonds. That was a political decision. They, in fact, directed the fund.
When we talk about public pension funds we should remember that we are not talking about government, we are talking about the public at large, people who have, as beneficiaries, a role to play in the selection of the board of directors. We do not have that here. This is, in effect, a Crown corporation, and that, to me, is a strange, ugly vehicle. I do not like Crown corporations. They are responsible to no one.
How do we set this up so that the money is seen to be the people's money? It is extracted from the people by law. There is no choice. How can we be sure it will be treated as the people's money, and how can the people have a say in how this money will be treated? I will tell you, if there is the opportunity, the politicians will use it.
Mr. Por: You have touched on the most difficult issue respecting the nature of a public sector board. It is public money, but how can those responsible for it be held accountable in practical terms?
The CPP could have been set up so that the government would have control of this money. They are accountable to the voters every four years.
However, as a society, we made a decision that that was not a good idea. Therefore, we set up what is, in fact a trust managed by a board. We chose people to sit on this board to act on our behalf and we, as beneficiaries, can do little to influence their decisions. Once they are appointed, unless they cheat and lie, we will be unable to remove those people.
I think there should be term limit. Perhaps after eight years a member of the board should not be reappointed. However, experience suggests that, once an appointment is made, it is very difficult to terminate a member. Therefore, there should be some automatic mechanism.
You have to trust the process. Once you have set up a financial institution, so to speak, with independent people governing it, they are accountable to society in broad terms, but they accountable to themselves in practical terms. In setting this up, it is important that there be some mechanisms to provide periodic evaluation.
Therein lies the problem of every public sector pension fund by and large, and that is you are accountable to constituency groups, such as the unions, but the same problems exist.
Senator Tkachuk: Do you think that there should be a statutory review section in the act itself?
Mr. Por: Yes, I think it would help. A term limit would also help. However, in legislation you cannot specify what kind of review will take place. You can say that every four years there will be an independent board evaluation process but the legislation is not the vehicle to actually set out the mechanism.
If the board has some sort of evaluation every five years it will give them an opportunity to step back and assess their own performance.
Mr. Ambachtsheer: There is an adage in business: What gets measured gets managed. One of the absolute keys in this whole process is to have a clear understanding of the mandate of this organization and how results are measured. What is it trying do? Then you need some objective measures. That helps focus the mind as to how you organize to produce what you want.
The Chairman: I totally agree with your comment that what gets measured gets managed and, by implication, what does not get measured does not get managed. What things ought to be measured, other than rate of return?
Mr. Ambachtsheer: The problem with a raw rate of return measure is it is very difficult to directly infer quality of management from that.
One of the key drivers of a rate of run is the chosen investment policy. For example, Malcolm here is recommending that the board seriously consider a virtually all equity type investment policy. Clearly, whatever benchmark you use should recognize that policy.
For example this notion, which is becoming now fairly broadly accepted, of risk adjusted net value added would reflect the choice of a policy. It would reflect the cost of running the operation. It would also reflect the cost of risk capital, so that if risks were taken through active management, that would imply a certain hurdle rate would have to be met.
It is the same idea that is now gaining broad acceptance in the corporate sector called "EVA", economic value added, which basically says an organization is producing value for shareholders when it produces results net of its cost of operation and net of paying back some costs of equity capital. You can develop a similar matrix for an investment business.
If we could be clear that the business of the CPP investment board is either to produce zero risk adjusted net value added, which is a purely passive approach, or to produce a positive number within some risk constraints, then immediately we would have set the guidelines for how the business will be evaluated.
Mr. Por: Once you start measuring, you have to measure whose contribution was what portion of the value added because boards have a mixed policy. If they decided to be 100 per cent in equity as opposed to 50 per cent in equity, that would really be the board's decision. Periodically, the board has to measure how well it is doing given the organizational objective set forth. They must ask themselves: Did we follow our policy? Did we actually interfere with management responsibility? Are we really spending the time the way we should? Are we really clear about our communications with our constituency group?
Apart from the actual product, which is investment returns, the technology of which has already been established, there is another dimension in that you look at the organization from the board down and make sure that these interactions between the different decision-making levels, that is, governing fiduciaries, managing fiduciaries and operating fiduciaries, are actually followed as well.
Mr. Malcolm Hamilton: The mechanism usually used to accomplish what you want to accomplish will not be available to this plan. With the Ontario Teachers' Plan, what disciplines them to focus on member interest, is the fact that statements go out every year and, among other things, which demonstrate how the Ontario Teachers Pension Fund performed versus its objectives, and other kinds of funds.
If there are headlines in the paper every year about how the Canada Pension Plan did vis-a-vis some comparable other plan, that will get people focused.
There is a danger here, though, that is not in the Ontario Teachers' Plan. If the Ontario Teachers' fund fund does better than expected for a period of time, there is a real dividend. There is real, tangible benefit for the members. Either their contributions will drop noticeably or there be a lot of money available to improve benefits.
The Canada Pension Plan, by virtue of the arithmetic, by virtue of the fact that it is only 20 per cent funded, will not have that link. There is the danger, if you get everybody to focus very much on the return, and if the fund does better, the expectation of the beneficiaries will be that they will get a bigger pension or that they will be able to retire at 60 with no reduction in CPP benefit. They will expect to be rewarded for that performance. I think we will come up short on the rewards because we do not have enough money to generate it.
The Chairman: Which means there is a role for the board in managing public expectations.
Mr. Por: The one problem you will always find in a public sector pension is that you cannot manage the expectation along those lines. At the end of the road the measure is always that how well we did against other funds. Even if the fund is significantly different from other funds, which this fund will be, it will not avoid the analyses and comparisons with other funds. Therein lies the problem, because there will be all kinds of articles stating that the board is mismanaging the fund because these comparisons will have been made.
Senator Tkachuk: You have hit the nail on the head, because this is a political instrument and, as such, it is exposed to all the vagaries of politics. How we choose the board of directors, how this board reports to Parliament, and how the audit is done, is not only important from the point of view of the fund, but it is also important to the public in general, because this exposes the public to what is happening within the fund. Frankly, if all of this information is buried in private audits as a report sent to the Minister of Finance, and the appointees to this board are a bunch of provincial ministers with no exposure to Parliament so that people can see who is on the board, then what you have is a situation where it will be used for political purposes. Opposition parties will say, and why not: Gee, on my mutual file fund I made 18 per cent last year, this fund only made 4 per cent.
This is what will happen, gentlemen. We are setting up an instrument for 30, 40 or 50 years and we have to get it right. As I see it, this fund will be in trouble in five or six years, not only from the point of view of it being political, but from the point of view of those who will perceive it.
Mr. Por: I do not share that concern. Basically, this fund, no matter what you do, will perform reasonably well because, first of all it is well set up. They will be following a reasonably well established tradition. I think the objectives can be explained to the public.
Mr. Ambachtsheer: As a counterpoint, let me ask: What do you think about the disclosure level of the mutual fund industry in terms of its ability to explain to its customers whether they are creating value for their customers?
Senator Tkachuk: You see a report in the paper every day.
Mr. Ambachtsheer: Yes, that that's not information.
Senator Tkachuk: That is all people care about. That is my point.
Mr. Por: We should not shrink from setting up an actively managed program because of public perception.
Senator Tkachuk: I am not against this. We do not disagree, and I certainly do not disagree with the principle of the bill. I disagree with points of substance in the bill, not the principle of the bill. It is not that we are against doing this or anything like that. All I am asking is: To whom are the board members responsible?
Mr. Por: Once you set up a fund and a board, and the fund's purpose is to the good of the public, the board, for all practical purposes, is accountable to itself.
Senator Tkachuk: Are you saying it should not have to report to Parliament?
Mr. Por: In what sense?
Senator Tkachuk: By reporting to Parliament, like any other Crown corporation, and being questioned by Members of Parliament?
Mr. Por: They should be compelled to explain why they are taking certain decisions. However, I do not believe we want individual members to be removed from the board.
Senator Tkachuk: I did not say that.
Mr. Ambachtsheer: There is a three-year review process of the whole CPP deal. This is being created as a joint partnership between the federal government and the provinces. I would see that, as part of the three-year review process where all aspects of the CPP deal are reviewed between the partners, this would be an important new dimension to evaluate how well the CPP investment board is operating, and if it is not meeting certain standards, I would see that review process picking that up and something being done about it.
Mr. Por: Periodically, the board should go to Parliament and explain why they are doing what they are doing.
Senator Oliver: My question goes back to good governance matters.
At the outset of your evidence when you were going through the organizational design study that you did, you told us that it is very important that the first principles must be the right people. You went on to say that you start with a vision, and then you must have a mission statement which you must carry out with good governance.
Since you know what the government is trying do here with the CPP, and since you know what their objects are, can you suggest what language they ought to use in this mission statement so that, at least, they will have the right language at the outset?
At our briefing this morning we were told that, the objective of the board is to manage any amounts that are transferred to it in the best interest of the contributors and beneficiaries, and to invest its assets with a view to achieving maximum rate of return without undue risk of loss.
Mr. Por: That would not be it.
Senator Oliver: I would like to have your suggestions.
Mr. Ambachtsheer: One of the responsibilities of the board is a fiduciary responsibility. That is a very powerful type of position where someone is willing to be accountable for achieving certain results on behalf of other parties.
The "fiduciaries", and that is what the members of that first board will be, should take that very broad statement and give it a specific content and to say, "We believe that, in the context of the CPP investment board in 1998, given the realities of everything we know, this is how we interpret that broad statement." I think they have to give it very specific content.
One of the issues they will have to deal with quite quickly is this whole issue of active/passive. As you have already discussed this morning, if it is a completely passive shop that just tries to represent some broad market exposure, then that leads you down a very different path from the one you would follow if, there were active management content. Then you need to get into the whole issue of what is that active management dimension; what should it be able to produce; and how are we to go about actualizing that?
That is the specific content that has not been filled in yet.
Senator Oliver: If you were on that first board, what are some of the words and concepts that you would want to see included in the language of the legislation?
Mr. Ambachtsheer: The first issue they would have to deal with is what Malcolm Hamilton talked about this morning as the "broad asset allocation policy."
Senator Oliver: Yes, that is whether it will be more equities than bonds, and so on.
Mr. Ambachtsheer: The record and research show that which track you decide to run on is a major determinate as to where you end up between that nominal 8 per cent and 6 per cent.
I see that as being one of the major agenda items that the board would have to deal with. Will they have a heavy equity orientation, or will they take a much more balanced approach? I see that as being a major issue on which they should seek good advice. They will have to debate it.
Senator Oliver: What would your advice be?
Mr. Ambachtsheer: I am with Malcolm on this one.
Senator Oliver: Is that because it is so long-term?
Mr. Ambachtsheer: It is so long-term that I think there is an opportunity to create maximum return over the long-term. The downside of that is that the board has to manage, as we were saying earlier, public opinion. To the degree that they run an asset mix policy, which is different from many other pension funds, immediately they have got that potential exposure where their policy difference could lead to different returns over a three-year period, let us say, and the question they are going to have to ask themselves is: Can we manage public opinion through that? If equities had, relatively, a bad three-year spell so that they ended up with a relatively lower rate of return than a lot of other funds, the public will conclude that that is because they have a different policy.
Those are the kind of discussions the board must have.
Mr. Por: The motherhood statement is the best one can produce at this point in time. You have basically decided to have a board. There will be a process of selection of 10 people, if I remember well. Then there will be a process whereby all the pros and cons will be presented to the board and, at the end of the day, you have a mission statement for the plan, which is not to provide the highest return with the risk assumed, because if you do not define the risk assumed the statement does not make any sense. The board has to produce a series of investment principles and beliefs based on the presentations by different experts. They must define the risks and, given these risks, they must decide, for example, whether to go for active management by asset cost and be willing to take the risk of active management in return for the extra return, 50 basis points, over the next 10 year.
The motherhood statement must be translated into measurable and actionable items, which could be audited after five or six years. To come up with an overall mission statement at this point in time, is not relevant because we have not yet appointed the group of people who will actually assume the risk, or assume the risk on our behalf.
Mr. Ambachtsheer: I have discovered that it is the process that develops mission statements. You cannot do it before the fact. It is the interaction between those 12 people, given the broad mandate and given the specifics, that will lead to a mission statement that they will have to go public with.
Senator Oliver: It really goes back to your first statement, which is to get the very best board possible who can visualize and help put real teeth in this mission statement. That is what will determine the success of this board.
Mr. Por: That is correct, but you also have to educate them about the system. We cannot just ask them: What do you think we should manage? We have to itemize the risks they can manage, including public perception, relative rate of return, political risk, management risk, and any others, and they have to make an informed opinion on that. They should then write it up in a statement.
Senator Callbeck: Mr. Chairman, I had questions on accountability which have pretty well been answered.
If you were responsible for setting this up are there extra provisions that you would want included regarding the whole accountability issue, or are you comfortable with what is there?
Mr. Ambachtsheer: A lot is included there, and it covers a lot of eventualities. There is, though, the 90/10 rule about everything. It is that the first 10 per cent of the effort gets you to 90 per cent of where you want to go, so you should try to attain that next level. I am not sure there is a lot of value in that.
Mr. Por: I think the first board has to decide what it wants to achieve, but it also has to address accountability. However, to include everything in legislation in other than quasi terms, I do not think is in the cards. I do not think it could be achieved at this point.
The Chairman: I want to pick up on a question asked by Senator Tkachuk which, in a sense, is related to accountability and to auditing.
As you know, there is to be a tri-annual review of the CPP so, presumably, at the end of the third year of the operation of the plan the training review will be completed. Does it make sense to you that, in that third year there would be a process audit or a governance audit, or something which looks backs at the criteria which both of you in your presentations today have laid out? It would not be done by the board on itself, but by an outside third party and it would point out that in certain areas the governance process has worked. They might use a ten-point scale or something so that those of us who feel that we ought to be part of the accountability process in the way that Senator Tkachuk suggested, actually have a measure against which we can say, on the governance issue, this fund is performing well or badly or whatever.
As well, am I right in assuming that the fund would have to operate for a couple of years -- that is why I suggested a tri-annual review -- in order to be able to make that measurement?
Would you comment on that general principle?
Mr. Por: Yes. At the outset I should state that I have a huge conflict of interest because that is our bread and butter. That is what we do.
Of course, you must have a review, because I have never seen a board admitting that the decisions made by the board are the problem. Most often the issue is related to excellency in management or organizational design. I call it "pension governance." It is an absolute must.
The problem is related to how you will select the individuals because there are consultants out there who would want to apply. It will be a difficult selection process. However that is a technical difficulty that you can overcome. I think you should do it.
Mr. Ambachtsheer: You do need some way of assessing how well that organization is functioning. It is no different from what, in many cases, pension funds are increasingly requiring of corporate boards. If it is good for corporate boards, surely it is good for pension fund boards.
You are, right. You have to let three years go by because it will take them that long to create any kind of track record and process that is repeatable.
Mr. Por: The technology is there. Keith can tell you exactly how to measure performance. As well, the governance audit technology is there. You just have to apply it.
The Chairman: Would you agree that, if such a governance process audit were done, that ought to be a public document? Simply giving it to the board, with Canadians not knowing what level of performance was achieved, will not have a huge impact on the performance of the board. The pressure will come from the fact that the people whose pension funds are being managed understand the results of the audit.
Mr. Por: There is one professional problem. Let us suppose you ask us to conduct the audit, and we find that certain things did not work too well. Our name would be all over the newspapers and, probably, other pension funds would be less keen to obtain our services.
You have to measure what kind of balance you want to achieve.
Mr. Ambachtsheer: I would have no trouble doing it.
Mr. Por: It would have to be done by a a panel of known experts with good credentials.
The Chairman: It seems to me that, unless that audit is made public, then you take away a huge element of the leverage that goes with having done the audit in the first place. Why do shareholders get auditors' annual financial statements? It is precisely so they can understand the performance.
Mr. Por: The mechanism should be such that not one firm should be selected because there is a business risk involved for that firm.
The Chairman: On the points raised by Senator Tkachuk and the concerns expressed by Senator St. Germain, which I happen to agree with, it seems to me that, having this added element of pressure for the right process would have some real impact on the system.
Mr. Ambachtsheer: I think it is an education process, both inside the organization and outside.
The Chairman:I agree. Corporate culture requires it.
Senator Oliver: Earlier, when we talked about the eight conditions that should be met by a person who would be appointed to the board, my concern was that there may not be many people in Canada with these exceptionally high qualifications.The structure of this board is one-third, one-third, one-third, so that one-third of the members will stay on for a year, so the membership will be revolving for the first three years.
The Chairman: That is not my understanding of the revolving aspect of this membership. The purpose of starting from scratch is to ensure that one-third of the board memberships' terms come up each time. Typically, the people who are appointed at the beginning of year one, whose terms expired at the end of year one, would be re-appointed. When you start an organization and you want revolving boards you do it that way. It does not mean that a third of the people are new each of the three years.
The officials may want to correct me, but my understanding is that you would start off by appointing the board, and the membership of one-third of the board would expire at the end of one year and they would then be re-appointed; one-third of the membership would expire at the end of the second year and they would be re-appointed; and one-third of the membership of the board would expire at the end of the third year, and at that point you can switch to new people.
It has nothing to do with politics. That is typically the way private sector boards handle board memberships, which is, if they are three-year board appointments, which many private sector companies are, a third of the board is up any given year.
Senator Oliver: Is that three-year term too short, in the circumstances? Does that give people enough time to get up to speed, to become expert, to understand the mission, and to do the job that you would like to see them do?
Mr. Por: I think the legislation does not limit that term to three years.
The Chairman: It is three years, subject to reappointment.
Mr. Por: You could have a three-year appoint eight times.
There are a lot of people in Canada who could qualify for board membership. There are a lot of ex-bank presidents and financial people out there. However, you want to avoid having active professionals there. You do not want to create tunnel vision. There are many well prepared, understanding men and women who could serve. I presume there will be a tremendous amount of training, priming, and orientation involved. This has been done before. There is no magic to it. The magic is how to get those people out of the political process. However, there is enough material to do it.
The Chairman: Gentlemen, thank you very much. It has been a most instructive morning.
The committee adjourned.