Proceedings of the Standing Senate Committee on
Banking, Trade and
Commerce
Issue 13 - Evidence
OTTAWA, Tuesday, March 17, 1998
The Standing Senate Committee on Banking, Trade and Commerce met this day at 9:35 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: Senators, welcome to our continuation of a discussion of the CPP Investment Board and its regulations, and the legislation governing it.
Our first witness this morning is Professor Michael Goldberg, who previously appeared before this committee on the corporate governance hearings.
Professor Michael A. Goldberg, Dean, Faculty of Commerce, University of British Columbia: Honourable senators, I appreciate the opportunity to share some of my ideas with you. I have become interested in this area, even though my background is not in finance. I am an economist by training; specifically, an urban economist, looking at cities. In that regard, I focus on real estate at some points in my brief.
I have had experience over the last decade looking at how financial markets globalize, as well as being involved in the UBC endowment committee and now the Workers Compensation Board Investment Committee. We manage $7.4 billion.
Many of the issues facing this committee are issues that I worry about in my own personal responsibilities. I wanted to share those worries with you in the hope that we can make good public policy with them.
I mention seven areas. I will skim over some of them because you have had ample testimony on a number of them and I do not want to spend time on areas where I add only my agreement.
Let me start with the issue of governance and selection. A great deal of attention in the hearings has been placed legitimately on the selection of CPP Investment Board directors. I do think that it would be useful to set out some criteria such as those that are listed in section II 3(a) where I talk about the need to draw from a pool of people to create a portfolio of skills on the boards. It is not important that each of the 12 people has the desired set of skills, but that the board itself, comprised of all 12 people, must represent these skills.
The skills that I think are important are general business knowledge and experience, international business knowledge and experience, financial knowledge, economic knowledge, strong analytical skills, either qualitative or quantitative, and team skills. In a committee of 12 working together, those team skills need to come to the fore because ideally they will make decisions by consensus and not by going to a vote.
Integrity, honesty and reliability are binding constraints which are much more ephemeral and difficult to achieve. The surest measure of success is being able to draw on people who have been in situations where they have had to prove their integrity and honour.
I am not suggesting that these other criteria which have received significant attention, such as regional representation, ethnic and gender diversity are unimportant, but I deem them to be secondary criteria.
Given that the primary criteria of substantive knowledge can be met, then a much stronger committee would exist which would be able to have more regional diversity and consider issues of gender and ethnicity. However, it is imperative that the substantive skills be there.
I wish to spend some time on the important issue of governance of owned companies. For lack a better word, I call them "investees". I strongly favour the CalPERS approach in its idealized state; that is, where the fund would take an active interest in the quality of management and the performance of the company that is owned. I do not favour the TIAA kind of activist stance.
The CalPERS approach of being a prudent, active investor adds value for all shareholders. To the extent that a fund on the scale of CPP would be able to do that helps to make the market more efficient and adds value to Canadian capital markets, not only to the owners of CPP.
As a result of the scale of CPP, it will have the research resources to help the companies that need help and also to be quite active in voting its proxies.
Social activism, as practised by TIAA and others, is a much more problematic approach because it is difficult, as many people have said, to discern who the average CPP beneficiary is and what are the exact set of values we are trying to promote. Staying with the narrow, prudent person rule as a fiduciary to earn the best returns possible at a given risk level should be the mandate of the board. The CalPERS approach, to the extent it adds value to shareholders, serves that purpose admirably.
There is one issue which is extremely important. An enormous amount has been written recently in the press and in some of the more popular management books about the need for corporate decision-makers to take a longer-term rather than a shorter-term world view. I wish to reinforce my bias that taking a longer-term world view is extraordinarily important.
As the assets of CPP can be long-term, to match its long-term liabilities, and because of its scale, it will be forced to hold assets for significant periods of time. If it moves the assets -- even indexed funds would move the market -- the CPP will not be doing a benefit for other shareholders and for other market participants.
CPP could add an important long-term dimension to the way management thinks. In the end, it could lead management to invest much more in research and development, in their people, and to build shareholder value and wealth rather than to build impressive quarterly returns.
CPP does not have any interest in quarterly returns; liabilities are not going to be quarterly liabilities. Therefore, this presents a significant opportunity to change the culture of corporate Canada to take a longer term view, which will have significant benefits for individual companies and for the Canadian economy.
The independence of CPP directors will aid in this. To the extent that CPP directors will be broadly selected and independent, they should be able to act as honest brokers, in the CalPERS kind of model, where CPP does deal with companies with lacklustre performance, with the benefit of improving the performance, not leading a witch hunt against management. Having respected independent directors will facilitate that and, in the process, will facilitate a longer-term world view.
I do mention proxies. It is important to vote proxies. However, given the scale of the proxy that CPP will have, some experiments must be performed to see how those can best be voted without being destabilizing and while moving the companies in the right direction.
The fourth area I touch on is clear investment objectives and performance measures. This is particularly important for the CPP investment board so it knows what it is expected to do. My colleagues, Stan Hamilton and Rob Henkel, have spent some time on that. However, I wish to add to their excellent presentation to you by stressing the long-term. I should like to see long-term measures of performance developed, and this is not something that we have done.
If one were to look at most investment managers, they report quarterly. We do not seem to have the needed long-term measures. Long-term investment objectives need to be set out to match the long-term liabilities, and some new kinds of measures to measure that performance over the long run is important.
The fifth area that I talk about is flexible investment policies. I was delighted to see that derivatives will be allowed under the regulations as proposed. It seems that certain kinds of risk-reducing derivatives will be allowed. There is a great deal of flexibility.
The huge stumbling block here is clearly the 20 per foreign rule. I know from reading the testimony here that there has been an enormous amount of discussion about that. I sense a strong sentiment to eliminate it or to raise it dramatically. I wish to lend my voice to doing that.
I wish to relate the experience of investment bankers in the U.K. The U.K. basically took the lid off its foreign content rule in the 1980s. They found two things: First, there was a net inflow of funds at the end of the day, because as U.K.nvestment managers went over to the continent and elsewhere to buy assets, they also made the security dealers in those countries aware of what was available in the U.K.second, it wound up being an enormous source of employment creation. If you look at the international investment management business in London, it is a huge business.
I would see the 20 per cent rule being lifted to do two things: First, to allow us to get higher, more stable returns through global diversification for the CPP fund; and second, to provide us with a significant opportunity to add to our already strong investment management business, create jobs and add an important export line to the Canadian financial services industry, that being exporting international investment product.
When I look at the specific classes, I see that nothing is really precluded in the regulations. The whole range of real estate venture capital is allowed. I would argue strongly for the greatest possible flexibility to allow the CPP investment board to put together the broadest and most diversified portfolio possible.
The point I wanted to focus on is the sixth point. As I have been preparing for these hearings -- and the delay of a week gave me a chance to read much more in the area -- it has become clear to me that most of your discussion quite legitimately is focused on the demand side of the capital market.
There is a legitimate fear that a pool of $150 billion Canadian, squeezing its way into Canada's equity markets, would be highly destabilizing and would more or less force the investments into some form of an indexed product that would be passively managed.
I should like to spend a few minutes asking you to consider the other side of the market, and that is to consider ways in which we can expand the supply of investment instruments. On the fixed income side, mostly through asset-backed instruments, we have an enormous opportunity to create new instruments, not just for the CPP, but for the other large pools of money that exist in Canada today. I think raising the 20 per cent rule will be helpful, but we have to do much more than that. When you look at OMERS, the Ontario teachers, the B.C. government and other funds in Canada, you see a huge pool of capital chasing a limited supply of stocks. I think that will get more severe in the future.
Countries such as China, for example, are terribly worried about the consequences of their one-child policy when they will have a rapidly aging population in the future. They are terrified that they will wind up where the Japanese are in the sense that they will have an enormous, old population being funded by a relatively small, younger population. The Chinese are already looking to put in place legislation very similar to the CPP legislation. This is being replicated all around the world as people look at the demography of their citizens. They are saying that they will have to fund this out of a carefully crafted national retirement fund.
As those funds start to grow, the amount of liquidity that will be available for investment around the world will be quite staggering. It will be important for us to develop new investment instruments so that we can compete for some of those funds and so that we can moderate the impact these funds will have on our capital market.
Compared to the United States, for example, why do we have a more limited number of instruments? Part of that I think relates to the way the banks make loans. The banks in Canada tend not to price loans. They do not ration by price; they tend to ration by risk. Canadian lenders are given check sheets. They fill out the check sheet, and it goes back to some central loans centre. If you have a risk profile below the threshold, you get the loan but, if you have a risk profile above the threshold, you do not.
Let us say the threshold is prime plus 2 per cent. There is no incentive for banks to package their loans of prime plus 2 and less and put them in the marketplace because those loans are quickly exhausted.
In the U.S., lending tends to be different; it tends to be done on the basis of price. They put together loan portfolios with an array of prices. From time to time the banks need liquidity. It is more difficult for them to match assets, liabilities and duration. They are continually putting packages of loans and other assets on to the market, creating a huge source of securities while, at the same time, continually renewing their liquidity.
I think we need to some expansion in Canada. The specific suggestions I make below deal with the whole area of asset-backed securities -- bank loans and mortgages.
Federal agencies present some interesting opportunities -- for example, the Business Development Bank of Canada, the Export Development Corporation, Canada Mortgage and Housing, and even the Asian Development Bank, where we are one of the largest contributors. All have assets that could easily be packaged and put on the market for sale by pools such as the CPP and other large pools of capital. I believe this would do a great deal to broaden Canadian capital markets, and it would help avoid the Tsunami effect of shoving $150 billion of CPP funds into the Canadian marketplace. That is the principal point I wish to raise. It is one that I have not heard others raise, but I believe it is something we should think about.
On the equity side in Canada, the situation has worsened. Only roughly 50 per cent of the leading manufacturing companies actually trade because they are wholly owned foreign subsidiaries. The breadth of the Canadian equity market is already quite limited. Someone mentioned to me the other day that the S&P has twice the number of industrial categories as does the TSE 300, which would be consistent with the foreign ownership here.
To summarize, I think the governance and selection of the CPP investment board members should be based on their excellence and demonstrated impeccable integrity, as well as their ability to add value to the beneficiaries of the fund. In that vein, I am for full accountability. I think the people of Canada deserve to get the most information about how their money is being invested. I would argue strongly not just for an annual audited statement, but also for a fairly innovative information strategy that helps get the information out so it is understandable to the holders of the CPP.
I would like to see fairly active governance of the owned companies, not micromanaging, but doing it at a more strategic level when substandard performance is evident.
I would like to see very flexible long-term investment policies by the board.
Last, I would like to see a broadening and deepening of Canadian capital markets, not just so we can absorb the CPP funds, but so that we can strengthen our capital markets and add a significant export sector by creating assets that are of interest globally.
The Chairman: For your information, you should know that this committee has for some time been exactly where you are and where several other witnesses have been with respect to the foreign investment rule. We have argued in speeches and reports that the 80-20 foreign investment rule ought to be substantially changed, if not eliminated entirely.
In your comments on CalPERS, which you used as an illustrative example of what you would call good pension fund management, I assume you were specifically referring to their policy of identifying companies that are performing in a substandard way and then suggesting to those companies ways they could improve their performance. Having understood that, I was surprised by your comment that you were not sure whether the CPP should vote its proxies in the sense that it is not an inconsiderable lever that a firm would have. You might explain why there appears to be that difference in position.
As well, CalPERS is also either notorious or famous, depending on your point of view, for the public way in which it has historically pursued many of its goals by using well-organized campaigns and ads, et cetera, to put pressure on people. Would you comment on that aspect of the CalPERS modus operandi, given the fact that you like some other aspects of the way it operates.
Mr. Goldberg: I was careful to use the phrase the "idealized CalPERS model".
The reason I would go slowly on proxies is not that I am being inconsistent, but we do not have an experience in Canada with a fund this size. I think it is important to vote proxies.
The Chairman: The teachers' situation is fairly close. I do not remember the exact number for them, but I believe it is 80 to 85. We have not had one much over 100, but the reality is we have had at least one experience with a large fund, and they absolutely do vote proxies.
Mr. Goldberg: I know the province of B.C. votes its proxies. It has about $47 billion.
Given the scale of the CPP and its prominence, I am in favour of voting the proxies. I should like to find a number of models to do that in order to add value to the company and the market and to avoid destabilizing. That was my point. I am certainly encouraging them to be much more activist.
Several of the people who testified before you earlier were advocating a Canadian approach to dealing with management. I think there is some significant value to that. However, I still like the old model we used to teach in monetary policy, where the governor could invite the six banks for lunch and have a little chat and explain what he would like to see. There is still some virtue in that, but there is also some virtue in letting the people know that there will be opportunities to go public if those discussions are not helpful.
My sense of CalPERS is that it is not functioning in the idealized state that it would prefer; it has become rather more vocal. When you get vocal consistently, it is like the boy who cried wolf; people stop listening after a while. That is an option you always have. If you are really smart, you never need use it.
The Chairman: So they should make them an offer they cannot refuse but do it quietly.
Mr. Goldberg: Yes. Then they can save face and they can actually work on it.
The Chairman: We should not call it the godfather approach, but rather, more carefully, the Canadian approach.
Senator Hervieux-Payette: First, I compliment you; so many bright ideas come out of B.C. You and your colleagues have given us many excellent suggestions.
You talk about long term and not quarterly, knowing that it is not a tradition of the stock market. Also, we have no pundit, in English, that would say it is crazy. What kind of standard should we use there for the long term?
We will not go to $150 billion in the first year. It will take some time to get there. Do you prioritize? Would you say that the foreign investment limit should be removed at an early stage in order to allow more flexibility? Or should we go with flexibility by developing different options here in Canada?
Of course, I understand you are suggesting both but, at the same time, one may be easier. How do we explain the fact that the banks are not putting these packages of loans on the market? I do not see any barrier in our system that would not allow them to do that. Is it because they are conservative or because they want to compete in the rest of the world? There are things that they can do but which they do not do right now. What is your feeling? Can you explain why they are not doing these things?
Mr. Goldberg: My hypothesis was that banks do not do those things because they have no incentive. They have no need for liquidity. They can almost perfectly match assets and liabilities and the duration of assets and liabilities, so they do not find themselves in the periodic liquidity crunch experienced by U.S. banks. As a result, for them to change their behaviour, they would need a very different kind of lending system. They would need a lending system which was not centralized and where each branch manager basically ran a business. The branch manager would be familiar with good business practice and know that the job that he or she faced was to help the bank assemble a fully diversified pool of loans by industry, region, and risk.
That is not the way the banks make loans. The banks, having taken risk rationing as the way, really have no incentive to sell the loans off because they will not replace them with loans of an equivalent risk since they have worked down the risk profile and settled with a risk profile that satisfies them.
That is why I suggested we have other financial institutions in Canada, for example, credit unions, treasury branches in Alberta, the co-ops in Saskatchewan, the Caisse de dépôt. All of these have more local asset bases. This is not a good time to talk about creating a new federal institution but I am not ideologically opposed to Crown corporations when Crown corporations act like businesses, look like businesses, and return a hefty return to the shareholder.
I would not be opposed, for example, to a federal financial institution that was made up of an amalgamation of EDC, BDC, CMHC and some others, which was able to afford the data systems and the like that could be sold at a reasonable price to these regional institutions. It could help the regional institutions package their assets and so get a nice healthy supply of assets on the market from the federal agencies that have this paper. That would start to put some pressure on the banks to say that they should get out there, too, because other people are beating them in this market.
Your first question was about the long term. We do not have good measures of long term. I was careful in my notes to say that it is important to develop long-term measures. Everything has been focused on the quarter. It is terribly important that we step back and assess our liabilities, which are long term in nature. We need to develop some interesting measures that would allow us to govern and match the liabilities.
It should be a high priority to develop those kinds of long-term measures. They may sound just like the measures we use today, but instead of looking at cash flow earnings per share this quarter, we may want to look at returns over a five-year period or cash flow over a five-year period. That is an interesting research project, and it is one that needs some serious thought. We have been so driven to the short term in the last decade.
Senator Meighen: Regarding longer-term thinking and outlook, would you subscribe to the views of some witnesses who feel the terms of the board members should be longer than three years?
Mr. Goldberg: I was a bit surprised at that. Just going from my own experience, I know that three years barely gives you enough time to understand what the issues are. I know, again, my colleagues are advocating terms somewhere in the range of four to five years, with a possibility of one renewal. I think that makes sense. It gives people the opportunity to be on a board like this for six to eight years where they can develop not just knowledge but maybe even a smidgen of wisdom, then you roll the members over enough so that that culture can be transmitted to the next generation. You then get new ideas over time, but you also get experience in being able to make those decisions. That is important.
Senator Angus: In the private sector, in public corporations, the directors are always elected for a year by the shareholders. If they are performing well, they are invariably appointed over and over again, but there is always a mechanism for removing someone if there is a problem.
Having a four- or five-year fixed term will work against that principle. That fits in with Senator Meighen's question on the term. What is your view on that? Why do we need to lock them in for a longer term?
Mr. Goldberg: My feeling is that people who take on this job will be making an enormous investment in learning about how to do this well.
This involves an enormous moral responsibility. These people need to know that they have a suitable amount of time to understand the issues and to develop some understanding of how to make good decisions in this kind of environment.
The corporate model is well suited to the corporation. Regrettably, in a corporation there is little turnover in boards, as we have seen in the paper in the last few weeks, and shareholders want to see more frequent turnovers in boards, particularly bank boards. However, it is important to know that there is some term.
I think it is also important to have some vehicle for removal. I notice that the Governor in Council can remove for cause, and I think that is enough for the time being. However, in three or four years, if it turns out that this is not working, then I would hope the investment board would recommend that there be some vehicle by which we can remove some of these people.
Senator Meighen: I say this somewhat tongue in cheek. You dealt quite properly with the questions of conflict of interest and what sort of people should be named to the investment board. You dealt with integrity, and experience was high on your list. You suggest turning to the academic community, which might possibly raise the conflict issue itself, but who knows. We will have to wait and see.
How do you see the board being comprised? I appreciate that conflict has to be minimized. At the very least it has to be disclosed. However, that might lead to an absence of experience and a proven track record in the members of the board. I am not referring here to academia. Would you err on the side of a proven track record, thereby setting up a conflict situation in the minds of some, or would you err of the side of purity and little experience, therefore bringing a completely fresh mind to the problem?
Mr. Goldberg: It would be tough to make a choice between someone with great experience, which would possibly result in there being a conflict, and a naïve individual who knows little about the board, but who is absolutely pure. You would go with the person who can add substantive knowledge. My suspicion is most of these decisions will involve some grey area, as most good decisions do, and you will have people with highly relevant experience and differing degrees of conflict of interest.
In the end, conflict of interest does not worry me nearly as much as it has to worry you. I have been around these kinds of activities. Honourable people will excuse themselves from discussions where they see a conflict. Integrity is the one quality that cannot be sacrificed. The greatest safeguard against conflict of interest being an embarrassment is to appoint people who have demonstrated their integrity and their ability to work beyond their private good for the public good.
Senator Meighen: I agree.
How involved do you believe the investment board will be in actually choosing investment vehicles? Do you see them hiring managers? If so, should they hire managers by asset class, region or track record?
Mr. Goldberg: With this much money, you can do it all. Going by our experience in B.C., it is very inexpensive to manage a passive indexed product in-house. I think we manage that for 11 or 12 basis points. It is really a mechanical chore, so it is silly to hire an external manager.
However, when you are into more specialized products, such as buying emerging market equities, you may want to have some people like that. If they do not work out, you can fire them. I have spent a fair amount of time compiling clear firing rules for managers. That is important.
I see the board providing broad strategic direction, meeting quarterly at least, reviewing investment guidelines, and looking at the prospective trajectory of investments. They must consider whether the portfolio is being built along lines that will accommodate the long-term view and match the long-term liabilities. However, there should definitely be no micromanaging and worrying about individual stocks. That would be dysfunctional.
Senator Meighen: You noted with approval that the regulations provide for the use of derivatives. It was suggested to us by a witness in Vancouver that perhaps 1 per cent to 2 per cent of the asset base be allocated to venture capital investment. What is your view on that?
Mr. Goldberg: I had that noted as a class. I have not seen the Vancouver transcripts, so I put that down independently.
It will provide good diversification. It makes sense to be in that asset class. I do not see this as public policy investment; I see this as pure fiduciary investing. Having a highly volatile, high-risk class at the 1 per cent or 2 per cent level in a portfolio this size is good portfolio selection.
Senator Meighen: Your suggestion about increasing and expanding the supply of investment products is most interesting. It troubles us very much to think of all this money going to a small market, particularly when we still have the foreign investment limitation. Are companies such as Newcourt Credit Group and GE Capital not filling a void that you alluded to with respect to the banks?
Mr. Goldberg: I think that is a start. On a scale, it is reasonably small compared to the demand for capital. Huge pools are now being built up in Canada. I think we have to speed up the rate at which we package these new securities.
Senator Meighen: Do we do that through legislation? How do we speed it up?
Mr. Goldberg: You people have enormous moral suasion. Were you to look into this and raise its importance on the national agenda, that would attract attention. You have done these kinds of exploratory hearings before. They are very helpful in getting people to think about an issue differently. That was my primary suggestion.
I also think that creating a market-based federal financial institution that hires the best people it can, builds the best systems, and makes a profit for the people of Canada is a very effective way to keep innovation in the system.
If one looks at Canada Mortgage and Housing, before they were of a scale where they could do something, there was no innovation in the mortgage market. The private sector did not come out with mortgage-backed securities -- it was the CMHC. They came out with mortgage insurance.
I know it is very popular to bash government institutions today, but we also have a pretty good record in Canada of government institutions making progress in markets and moving the markets ahead in the way a competitive market would work. On the financial side, it is worth considering.
This is not an idea that I have spent a lifetime studying. It is an idea that occurred to me, and I thought I would share it with you. We can worry about it later.
Senator Meighen: I think the bashing traditionally occurred because of a perceived inefficiency. Now the bashing seems to be because of perceived competitive arguments. That is always a question to be considered.
Senator Angus: Either last year or the year before, this committee, when studying the various lending institutions such as the Farm Credit Corporation, the BDC and so forth, recommended the concept of bringing them all together under one roof and one minister. I think they are spread out over several different departments. Would that be compatible with your suggestion?
Mr. Goldberg: Yes, I think it would be absolutely consistent.
It could develop the kinds of information systems needed by a modern financial institution but which very efficient, smaller institutions cannot. The credit unions in British Columbia and the treasury branches in Alberta have access to first-rate information systems. They can be much more effective. If they also had access to ways to diversify their loan portfolios, they could be much more effective.
The federal government could create this large institution, develop some first-rate information systems, and sell or rent those information systems to these smaller groups. The federal government could also act as a packager of, let us say, Treasury Branch paper and let B.C. credit unions buy some Alberta paper, and that starts to diversify their asset base, stabilizes the economy, and gets more paper and more product out into the countryside. Everyone benefits.
Senator Angus: I was thinking in terms of the potentially negative perception of creating a new agency. At the same time, you would be doing away with a big phalanx of bureaucracy, or at least putting it into the one house.
Mr. Goldberg: I support that. That is fully consistent.
Senator Angus: That enhances the development of your idea. I am really becoming a liberal.
Senator Callbeck: Professor, I noticed your comments on accountability on page 3. You said that you wanted full accountability. Are you comfortable with what is laid down in the legislation and the regulations with regard to statements and public meetings, et cetera? I know that you said that it was important for the information to be put out in a manner or language that the public can understand. Are there things you would like to see added here?
Mr. Goldberg: I am very comfortable with what I have seen. I was suggesting that accountability be almost a spiritual value inculcated in the 12 directors, that they see this as part of their moral obligation to serve, and that they are enthusiastic about developing an information strategy, not just printing a piece of paper and submitting it to Parliament but really looking at the best ways possible to get this information into the hands of the beneficiaries so they understand what is going on. I think that does take professionals. I was actually taking this and going beyond the letter, trying to get at the spirit of accountability. I should like to see a much more robust kind of accountability than we usually have in these kinds of things, one that is really aimed at, "These people are going to depend on us, and we better let them know what we are doing with their money."
Senator Oliver: It is refreshing to have a professor come before the committee.You have moved the yardstick and made us all think about many new refreshing ideas.
My first question flows from something that Senator Meighen asked you about these new instruments. As I heard you give your evidence, you said that one of the things you would like to see done is the creation of some new investment instruments. You went on to talk about asset-backed securities that would be "securitized" in the market, put into a trust, and sold off perhaps to institutions. That has been done by Newcourt and others quite successfully for a fairly long time now. What apart from asset-backed securities did you have in mind by way of new instruments?
Mr. Goldberg: I mentioned federal agencies that have a lot of paper such as EDC and Business Development Bank.
Senator Oliver: Would those not be asset-backed securities?
Mr. Goldberg: Those are other places that could put money out as well. It has always been curious to me that we do not have Canadian depository receipts the way Americans have American repository receipts. These are shares held in trust in the U.S. which trade and create a new derivative instrument. It opens access to foreign equities which are registered in the U.S. It would seem to me that that would be another way to expand the supply of equities.
I also talked about being invested fully in the whole range of assets such as real estate and venture capital, and I think all of those would be able to bring forth more investments than we have seen. Real estate trusts can either be asset-backed or not, depending how you look at it. The growth of real estate investment trusts has been reasonably steady in Canada, not explosive as it has been in the U.S. There has been a lot of use of trusts recently, mostly for tax purposes as income trusts. I should like to see that continue, and I should like to see us use some of our intellect to develop new instruments at a pace that is being done in other places, London and New York. We have been badly lagging in the development of new financial instruments in Canada, and I think that has not served us well.
Senator Oliver: My second question relates to the board. When you were talking about the criteria and what they should be and what they should do, you mentioned that a director should have the ability to add value to the beneficiaries. This is fairly reminiscent of the language used in companies about enhancing shareholder value. What did you have in mind when you talked about these directors adding values to the beneficiaries? You meant to the funds, but in what way?
Mr. Goldberg: When they make decisions, I think the decision is not very different from the decision you would make in a private pension plan or mutual fund. Is this going to be good for the people who own us, or bad? One adds values through making prudent investments, by having a fully diversified portfolio, by trying to take advantage of new instruments and new asset classes as they come on the market. By acting as a prudent investor acts in the 21st century, or will, knowing that the array of assets that he will face is much broader than the array he will face today, the 21st century investor therefore will be conversant with what those assets can and cannot do for his portfolio, hiring the best people possible to advise on whether or not to include them, and in what size tranche, and then building a fully diversified portfolio which is as stable as it can be and earning the highest return possible. That is what I meant by adding value.
Senator Oliver: You would expect any director doing their due diligence would do just that.
Mr. Goldberg: I was not thinking of policy loans. I do not see policy loans as we have seen in Asia as being a particularly fruitful way to go. A part of the issue underlying this whole CPP exercise is that there will be this enormous source of funds and we in a province or industry or region now can have access to this to finally get our industry on track. That is not adding value.
Senator Angus: Is it fair for us who will be making a report back to the Senate in terms of how we might perhaps improve the board to say that you do not feel that, as presently structured, there are sufficient processes to satisfy your requirements for accountability, that there are not sufficient criteria, and that the so-called nominating committee that has been set up is too much in a vacuum and so forth? Is it fair that your comments, while they have been put in a very tempered way, are really constructive criticisms?
Mr. Goldberg: If you have to err on the side of being more transparent or less in this case, always err on the side of being more transparent. I do not think meeting the letter of the law for accountability here is good enough. There must be a spirit of accountability and an attempt to find innovative ways to get information out into the hands of the beneficiaries.
Senator Angus: On the issue of conflict of interest which you touched on with Senator Meighen, you are familiar with the policy that is in place at OMERS. We had some witnesses either in these hearings or in hearings on corporate governance tell us about the policy that OMERS has in place. Are you familiar with that?
Mr. Goldberg: I read that, yes.
Senator Angus: Is that, in your opinion, the best one out there? It seems to me to be the more comprehensive.
Mr. Goldberg: It seems to cover most of the bases that need covering. It did not seem to me that OMERS had an enormously long experience with that. It is something that you will want to cast about for the best models. Having a Canadian model close at hand is great, but it is worth looking at how it performs over time.
Senator Angus: Is it something that should be in the regulations, in your view, or is it a directive that would be organic and subject to change?
Mr. Goldberg: I should like to see language such as best efforts, prudent person kind of language, rather than sledge hammers in the directives.
Senator Kelleher: Professor, you have been emphasizing to us this morning the long-term view, upon which many of us would agree. If I can ask you to continue to look into the future, concerns have been expressed about the size of this fund, how it will continue to grow over the next number of years.
A number of people have suggested or advocated that as this fund grows perhaps we should investigate splitting the fund up, so that there are two or three funds rather than just one gigantic one. This will then give a sense of competition and a chance to measure one off against the other. What are your views on that for the long term?
Mr. Goldberg: I have not seen those suggestions, however, my sense is that competition is not what is needed in the marketplace today. Most of the discussion has suggested that injecting that much money into the market could be disruptive. If you split it among three funds that are competing for a scarce supply of equities, that would probably be destabilizing.
When I was talking about the long term, I was talking about developing measures and cultures that looked into the long term in corporate Canada as well as on the CPP board. If, in the future, it turns out that the CPP does start bumping up against itself in the market place, then clearly something must be done about that. With the supply of new instruments, perhaps with a new federal financial institution of some sort, with the private market responding with new instruments, with dropping the 20 per cent foreign content rule, there should be room over the next decade as CPP develops and gets a sense of what it needs to do that those kinds of questions will be reasonably apparent when they come to the fore.
Senator Tkachuk: Having read some of the minutes and the testimony of some of the witnesses who have made presentations, you would know that one of our major concerns is the question of accountability.
When you speak about a conflict of interest of the board of directors, as the board is set up now, if there is a conflict of interest, how would anyone know?
Mr. Goldberg: Again, taking my rule, if we need more information rather than less, let us obtain more.
I would hope, for example, that the broad decisions that are made are ultimately on the public record in a meeting. That is fair. There should be enormous peer pressure to ensure this these conflicts are disclosed, as well as having legislation.
I always become suspicious when I see codes of ethics in organizations. Once there is a code of ethics, people feel that they have been given a licence to cheat because they can stay within each element of the code and be thoroughly scandalous. What you really want is the spirit of who the beneficiary is and what the beneficiary needs from you as a director. To the extent you codify it, you make it easier to get around the specifics. Tight specifics can be written, however they may well get in the way of the board's ability to do its job.
By choosing carefully and by making clear the kinds of behaviours that are expected, perhaps in a preamble to the appointment letter, that should provide enough of a culture at the outset that those kinds of issues will not arise.
Senator Tkachuk: I agree with you on the code of ethics. I was trying to find out if you had a suggestion. My particular view -- although it may not be the view of the committee -- is that some formal process must be put in place for the board to report to the beneficiaries through Parliament, which is the representative of the beneficiaries, which we do not have now. If the board is appointed, by the time you find out what is happening, the way it is set up now, it is too late. In other words, how do you examine conflict of interest or issues of performance unless people are examining the board?
Mr. Goldberg: I was advocating that there be open reporting, not just to Parliament, but to all beneficiaries. The advice of an excellent communications consultant should also be obtained to help put this information in a form to which people can have access, including summaries of meetings.
I would assume that the minutes of the board would be carefully kept because of the magnitude of the money being invested. Those minutes would provide a clear idea of whether the conflict of interest was being handled.
When I talk about full, fair and understandable disclosure, I mean providing this information in an form that is attractive and understandable, so that people will say, "Yes, they have done a reasonable job." Prudent people do not make the best investment decisions. What they do is do the best worrying before they make the investment decision. You must be able to demonstrate to the beneficiaries that you struggled with some very tough issues and this must appear in the annual reports or more frequent reports. This board must also be accessible.
Senator Stewart: We have been told that the board should take a fairly active interest in the companies in which it invests. We have been told that it should have a long-term strategy.
My first question relates to what is to be achieved by that strategy. Are we concerned primarily with the investment of the money in the fund, or would attention also be given, as we were told at another meeting it should be given, to creating prosperity in Canada so that the money coming in by premiums from employers and employees would be great and thus enhancing the size of the fund?
Are we concentrating simply on the investment part, or are you interested also in the premiums which might be enhanced by reason of a good long-term fairly active investment strategy?
Mr. Goldberg: You put it very succinctly. That would be the outcome. I would be interested in both. I was very disturbed by the Industry Canada report which came out about a month ago which showed we badly lagged behind the United States in productivity, research and development, and investing in our people. Those are all long-term behaviours. To the extent that CPP would take a long-term view and encourage its companies to take a long-term view, the outcome would be exactly the outcome that you mention, that the fund and Canada would be more prosperous in the long term.
Senator Stewart: This board must be politically acceptable, in the broad sense of the word "political". So we will have regional representation. Four or five slots are already committed: British Columbia, the old west, Ontario, Quebec, and certainly someone from Atlantic Canada. As well, women will have to be on the board. Labour will certainly have to be well represented, as will industry and the financial sector. Will such a board be competent to develop the kind of long-term strategy you suggest?
Mr. Goldberg: Those criteria were secondary criteria in my presentation.
Senator Stewart: I know, but let us be realistic. Is that not what will happen?
Mr. Goldberg: I hope not.
As I read through the transcripts of your meetings, I saw a schizophrenia that exists between accountability, which sometimes smacks very close to control, and independence. You cannot have people who are independent while at the same time doing your bidding.
I sense the weight of evidence is for independence. I hope that the government, if it does have to accommodate regional concerns and the concerns that you note, will be able to do so within the context of appointing people who are knowledgeable and who will contribute to the beneficiary and not use this as a rallying point for their own particular ideology or region.
Senator Stewart: You are a highly knowledgeable and extraordinarily successful professor at a university in British Columbia. In view of what has happened in the Far East in the last few months, do you have any generalized guidance to give, especially in view of the possibility of an increased amount of foreign involvement? Do you have any suggestions, guidance, warnings or salutary advice for members of the board with regard to foreign investment?
Mr. Goldberg: I would chose well, but I would be fully invested.
Senator Stewart: In Indonesia?
Mr. Goldberg: That is probably an extreme example.
Senator Stewart: A year ago, the Standing Senate Committee on Foreign Affairs issued a report in which we were very bullish on the Far East. We never raised the problems of the financial sector in the Far East. We were oblivious to it. Now we are told that of course every knowledgeable person knew how bad things were. Will our board fall into the same trap?
Mr. Goldberg: Maybe I can reframe this issue, not to dodge the question, but to answer it.
Being fully diversified or as diversified as you can be overcomes that problem. In 1989 or 1990, if we could have found a way to be outside Canada and into Asian markets, we would have earned vastly superior returns to what we would have been able to earn inside the country. The beauty of being invested wisely in diverse circumstances -- and there are still companies in Asia that are doing very well -- is that a good portfolio will give you that stability. You can have both high return and lower risk through diversification.
With respect to the short-term blips, in the early 1990s we would never, ever have invested in real estate because we knew it was a terrible asset class then, but it is certainly not a terrible asset class now. However, if you have a balanced portfolio, then you do not have to worry as much. That is my argument.
Senator Austin: Professor Goldberg, we could spend all day dealing with your paper. I am sure that the board, when it is finally constituted, will find your checklist very useful. In fact, I am sure, had it been necessary, they would have paid for it. We thank you for your help.
I would like to cherry-pick some of your positions. There is a proposal in your paper that the board pursue long-term objectives that have a public policy characteristic, but not short-term public policy issues. If I have stated that correctly, you raise the question of how one can measure performance in the long-term.
When you deal with long-term versus short-run investments, you look at what I would call major structural questions through intervention by the board in terms of the investments it makes. It may provide long-term financial support for firms going through cyclical experiences -- such as the B.C. forestry industry -- to avoid large-scale layoffs, to avoid asset fire-sales under short-term market pressures, and to enable firms to plan and act over a long-term horizon. While these are desirable public policy goals, the question is: How do you see these issues being traded off by the board in terms of its need to be judged as equally competent to other large-scale funds with regard to return on its investment portfolio? In the short term these may require a lesser performance in order to get a better longer-term performance. What you are proposing here involves a rather novel set of criteria by current standards. Yet, you feel that this additional test should be put on these directors.
Mr. Goldberg: Because the liabilities are long-term.
Senator Austin: The liabilities are about the same as the liabilities of any other pension fund. People die in about the same actuarial order.
This is my point. The fund will continue for a long time, but I am not sure how the directors would achieve these goals. That is one question.
Second, even if they could be achieved, at certain times in the investment cycle they will be underperforming by industry standards. Do you think that is a desirable public policy conclusion?
Mr. Goldberg: The liabilities are long term, so matching asset liability targets make sense.
As well, being very practical, given the position that the CPP will actively manage money, realistically they are in for the long-term because they cannot get out. They do not have liquidity given the size of the tranche.
We receive a benefit from those two facts. We can start to change the culture of Canadian business so that it reinvests more, takes a longer-term view, and adds value, so that it does not act as if each business decision is an isolated transaction. I am not talking about micromanaging companies or micromanaging the economy. I am suggesting that we have a unique opportunity here to consider changing the corporate culture in an effort to build long-term value.
Warren Buffett is an example of a successful money manager who does this. He operates out of Omaha, Nebraska. He builds huge long-term value. Everyone cites Warren Buffett legitimately as an investment guru. He buys for the long term and works with companies to build long-term value. The Berkshire Hathaway shareholders are delighted that he has done so. It is not as if we are venturing out into totally virgin territory. This field has been ploughed before. We are saying let us learn from the best and let us do this because, first, it makes fiduciary sense, and second, we get a kicker for the Canadian economy. We can start to change the culture to build long-term value, to invest in ideas and people and make us competitive for the future.
Senator Austin: I appreciate the answer.
Let us take that process and then bring it into the accountability sphere. A report is to be tabled with Parliament. As you know, this pension fund is as a result of an agreement among most of the provinces and the federal government, so there is accountability to provinces and there is intervention by provinces in the composition of the board, as well as some regional diversity. There are a number of small "p" political pressures. You would then expect, I suppose, that the leadership of the board would come before Parliament and explain how they intend to or are actually creating long-term value. Would it be fair to say that this is on the cutting edge of managing an investment system? They would actually be educating Parliament and the Canadian people in a whole new perspective.
Mr. Goldberg: There is no question of that. On the accountability side, we would be at the cutting edge in seeing this as being a moral obligation to fully disclose, in a comprehensible way, so that people can understand why the board did what it did and how it did it.
Senator Austin: I appreciate that.
Mr. Chairman, in Calgary, Professor Goldberg's two colleagues from the business school at the University of British Columbia gave us a very interesting presentation. We in turn offered them the draft regulations we are considering, for their comment. Have we received their comments as yet?
The Chairman: Not as yet.
Mr. Goldberg: They did tell me that they had prepared them and that you should receive them in the next day or two.
The Chairman: Thank you. I have one last question. In your written document, you make the observation that banks in Canada ration by risk rather than by price. They basically set an informal ceiling of prime plus 2 and, if you are above that, you do not get money, so they are using risk rather than price to do rationing. You then go on to talk in the same section of your report about the innovative financial instruments which we have discussed here today. You do not say, although it is a well-known fact, that at many banks in the United States there is a relationship between the price you pay for a loan and its riskiness. Some banks in Florida are prepared to go up to prime plus 8, for example. You clearly would favour that as an expansion of the market now.
Do you see any way in which the CPP investment fund can, in fact, be the catalyst to allow that kind of access to capital in Canada? I ask the question because I can imagine the headline if CPP were responsible for someone being told that, yes, they could have a loan but it was going to be at prime plus 7. I am sure the Canadian banks would love to have that shelter to hide under while all the guns were turned on the CPP.
I happen to share your view that rationing by risk and not by price is not desirable and therefore if we could do something to change that strategy, it would be highly desirable, but how do you do that when the instrument is, in fact, a government instrument?
Mr. Goldberg: I think having a pool of capital that is willing to buy packages of paper from institutions, say credit unions and treasury branches, that may be willing to make those kinds of loans, starts to change the perception, and says there is a market for this. That means we can get liquidity if we are in that end of the market and perhaps we should be more aggressive at packaging it.
The Chairman: The government's role becomes essentially indirect. It is not making loans at that rate. It is simply buying instruments and the CPP fund indicates it is prepared to buy instruments which are structured to include high-interest-rate loans.
Mr. Goldberg: The great irony to me about the Canadian banks is that, because they are national, they could all along have been lending at prime plus 7 or 8. If they put together a package of 40,000 or 50,000 loans at prime plus 7 or 8, the pool of such loans probably has a risk rating of prime plus 2 or 3, because of diversification. Because they are national and can diversify by region and by industry, they can actually put together fully diversified loan packages and probably charge prime plus 5 on a prime plus 7 loan and still put 200 basis points away. They can diversify the way other deposit takers cannot. It has always been curious to me that they have not taken advantage of their national scale to do precisely that kind of lending, and then in the process make that money available to the market.
Senator Austin: That is the type of lending that has been done by the investment banking community in the U.S. or organized by the investment banking community in the U.S.
Mr. Goldberg: They have been packaging local loans.
The Chairman: The point you are making is that a number of banks in the United States do that at a local loans level rather than the Goldman Sachs level, which is essentially much bigger.
Mr. Goldberg: They put them together and the pool is quite stable, made up of high-yielding paper which is diversified by region and industry.
The Chairman: Thank you very much.
Our last witness this morning is Mr. William Robson. Welcome and please proceed.
Mr. William B.P. Robson, Senior Policy Analyst, C.D. Howe Institute: I hope it will not be regarded as a frivolous use of my time if I start by thanking you for the invitation to be here today, and remarking that you are doing Canadians an enormous service by conducting these hearings. I am flattered to be a part of them.
I am going to argue in my presentation that the make-up and conduct of the CPP Investment Board are going to be determinative of public confidence in the Canada Pension Plan. That matters politically in the future but it also matters economically in the present because, as I will argue, the state of confidence that people have in the plan and in it is durability is going to affect the amount of job loss that we will see as a result of the contribution hike that is in prospect.
That said, appearing here is also a bit daunting because you have heard from a number of people who have much greater knowledge of the pension business than I do. What I think offers the best chance for me to provide something useful to this discussion is to talk a bit about the concerns that I had about the Canada Pension Plan as it stood prior to Bill C-2, to talk a bit about the reform package in light of those concerns, and then to draw out the key implications of that for the board.
I think it bears repeating that we are here today because, 30 years ago, federal and provincial governments established a mandatory, work-related pension plan on a pay-as-you-go basis. Those plans have been compared to Ponzi games, reminiscent of a spectacular practitioner of financial scams who actually spent a bit of time in jail in Canada before he went on to bigger and better things in the U.S.
That comparison, I think, is a fair one. They do not have real investments or they have negligible real investments from which to pay pensions. Therefore, they depend on a perpetual inflow of new money, and that money has to come in in quantities large enough that participants can be given pay-outs greater than those that are available on alternative investments backed by real assets.
That sounds a bit like a multilevel marketing scheme or chain letter. Those schemes ultimately collapse because the supply of new participants who are willing and able to contribute to these ever larger amounts of new money will eventually dry up. The realization that the Canada Pension Plan was headed for that kind of trouble at some point in the future is why we are here today.
The prospect of a future collapse is a concern not only because of the pain and dislocation that we would go through if we did have some kind of radical wind-up, but also because the benefit that people expect as a result of their participation in the plan affects the consequences of their contributions on employment in the here and now.
To the extent that people paying contributions see them as being equivalent to a fringe benefit, we can expect them to regard those contributions as being the same as contributions to a life insurance plan or pension plan through their employer. It is a fringe benefit. To the extent that they look forward and see no benefit from the contributions they are making, those contributions are a tax. Like all taxes of this kind, they drive a wedge between what the employer pays and what the employee gets. That cuts purchasing power, discourages work, and increases the attractiveness of the underground economy. The worse those destructive effects on the job market are, the more they undermine the Canada Pension Plan's contribution base, and you can get into a vicious circle.
The key thing that the reform package did was to fund the CPP more fully. That marginally improves the deal that the Canada Pension Plan is offering younger participants on paper but, more important, it gives the potential to raise the confidence that people have that those benefits will actually be there when it is their turn to collect. The difficulty we continue to face is, because the adjustment that would have been necessary to completely undo Ponzi's legacy here and completely fund the plan would have been enormous, the reform stopped well short of fully funding the plan, and we now are looking at a fund that will never amount to more than about one-fifth of the present value of the plan's obligations. That low-funding ratio will continue to stand as a warning to CPP participants that they may not actually see the benefits they are promised.
Because of the destructive effects of that fear on the job market, we must be concerned, because we are looking at a substantial contribution hike. If it is seen as a pure payroll tax increase, it will have dismal consequences for us. Rightly or wrongly, the Canada Pension Plan Investment Board will be a key focus of the fears and hopes that people have when it comes to the future of their benefits, and so allaying those fears will be one of the board's principal challenges.
With that key criterion set out, let me discuss a few pertinent features of the reform package. When it comes to the overall mandate of the board, the section of the act that puts the best interests of contributors and beneficiaries and the objective of achieving a maximum rate of return front and centre has it exactly right. Since the Canada Pension Plan's funding ratio will always be quite low, the payment of benefits each day will depend mainly on the collection of premiums the day before. Unlike some of your witnesses from the pension industry who have spoken about various liability related issues, I see only one as being central to what the board does. The liability of the Canada Pension Plan will be massive compared to the fund. Their job is to make the fund grow and to try to shrink that gap. In this light, there are some provisions in the draft regulations that may not turn out to mean much. I do not think the liquidity of investments will be a material issue for years to come because the fund will not be tapped to meet the CPP's obligations.
The main message I would leave with you as a result of this observation is that the job of the fund managers is a simple one. Their job, and it should be reflected in the benchmarks that are used to compare the fund's performance, is to invest for growth, high returns over the long term, and to fund the plan as completely as they can. In my view, that is the core of the board's job when it comes to building and maintaining public confidence in the CPP.
When looking at the board itself, the question is clearly how you deliver on that objective. Experts in governance have made some important observations about the board's ability to draw clear lines between its functions and those of management, and also its ability to regularly evaluate its own performance. Because there will be no formal institutional representation of participants at the table, those are important observations.
I will mention one presenter's concern about the lack of an explicit mention of directors' fiduciary responsibility to participants. I know that came up in the testimony. It is fixable, but it is something that should be in the legislation. In my written remarks, I have made one amateurish attempt to suggest how that might be done.
I turn to the practice in other areas such as central banking, where you have a task to do in terms of setting a long-term goal and trying to ensure that it is achieved in spite of some shorter term pressures that may come to bear. Looking at that situation, I concur with those who have expressed concern about the three-year, indefinitely renewable term for directors. I would weigh in on the side of those who have argued for longer terms, perhaps with more limited opportunity for renewal. That may produce directors who are more able and who will be seen to be more able to focus on their long-run duties to CPP participants.
The question of remuneration has arisen. Clearly, high quality requires you to offer attractive remuneration. I do not know that this will be a tremendously difficult issue to manage at the board level because, although the members should be compensated well in relation to the time that they put in, I do not see it as a full-time job. Claude Lamoureux referred to the problem of full-time board members starting to look for things to do with their time and encroaching on management's responsibilities. That is a point well taken.
Accountability is critical in terms of building and maintaining confidence. I think that the provisions for audits of the board by its own auditors and then audits of the CPP by the Auditor General are, when put alongside the chief actuary's periodic reports, likely to be quite adequate, especially because this is a fund that will come under enormous scrutiny on a regular basis around the country, and many people will make it their job to translate its performance into terms that people who are familiar with their own investments and pensions will be able to understand.
I noted the absence of any mechanism for formal reporting to the legislatures of the participating provinces. I mention this because I suspect that continuing dissatisfaction with the Canada Pension Plan will spur more debate in the future than we have heard to date about whether some provinces should follow Quebec's lead in establishing their own separate plans. If I were in charge of preserving the CPP in its current form, I would try to defuse that pressure by increasing its visibility and accountability to provincial legislatures.
My last topic is investment practices, and I would close on the issue of accountability by recalling, as many witnesses have, that the CPP will be under constant pressure to violate its fiduciary duties for the sake of regional or other types of development. I would observe in that connection that some board members, certainly the CEO and the chair of the board, will need to be able to communicate effectively their devotion to the interests of participants and the key importance of that. I make the observation that you need showmen and women who have a deft political touch to fulfil that function, because it will be very important.
Finally, on investment practices, I would mention two familiar issues that have not, to my knowledge, in this committee been linked before -- the question of indexing passivity and the question of dividing the CPP fund among different managers.
The requirement to replicate indexes looks sensible. It responds clearly to concerns about politically driven or otherwise imprudent investments. As well, it reflects a realistic assessment of how able active management is to consistently get better returns. Looking at the draft regulations, the provision in there seems to give enough flexibility to avoid the problems of small or illiquid floats, especially during the initial period when the amount of new money that the CPP will be putting into the market is not that large. If those problems look likely to become acute later, then the question of farming the money out to different managers seems to me to obviously warrant consideration since individual decisions made by managers of smaller pools will be less disruptive to markets and will offer less opportunity for shrewd trading by others at their expense than would be the decisions of one big fund.
This line of inquiry leads naturally to consideration of the foreign investment limit. I know you have discussed that extensively. For the record, I also agree with raising or eliminating it.
The draft provision in the regulations allowing the board to use derivatives opens the door to using derivatives in a way that would provide effective foreign exposure, and I am encouraged by that. It seems to me incongruous that an act that purports to put the best interests of participants first and foremost would contain such limits. I hope the board will do what it can to maximize returns, despite that restriction.
I would offer one footnote on the foreign investment limit, I know this is a topic you have discussed. I am not sure if this has been put forward. What bothers me about the foreign investment limit is that for large, sophisticated funds and for the members of those funds, it is not a serious obstacle to obtaining better investment returns; they can get around it and do so cheaply. For the small investor, it is a significant obstacle. They will pay dearly for the privilege of getting around it if it is possible. The differential impact of that limit on different types of investors and pension plan members is something to which we should pay more attention.
Finally, in the area of investment practices, I have concerns about provincial financing. Looking at the regulations, I am not clear what some of them mean or why they are there. An example is the requirement that provincial debt issued to the plan should be non-negotiable. I do not know what "substantially the same interest rate as a public issue" means; and I do not know what the provision allowing certain terms and rates as spelled out there to be set aside by agreement between the board and the province might mean.
I mention these simply because it is my observation that the Canada Pension Plan's role as a source of subsidized finances for the provinces has helped to undermine confidence in the plan. Therefore, the regulations in that area may need some special scrutiny.
Let me close by emphasizing my sense that the CPP Investment Board will, rightly or wrongly, be a key focus for Canadians who are looking ahead and wondering about the plan's durability.
Confidence in the CPP's promises matters enormously because, among other things, it may mitigate the job losses we will face as a result of the premium hikes. For that reason, the stakes are quite high as we try to design a board that will bolster confidence and put the ghost of Ponzi behind us. I hope that my comments are helpful in that task.
The Chairman: On the issue of separate managers, do you mean separate managers or essentially complete and distinct separate pools? If you had $100 billion, would you divide it into two or three separate funds, each of which would have its own board; or, would you say that you might, within the same board and the same institution, have four managers each responsible for $25 billion?
I am trying to understand if you mean "managers" in the way I would interpret "managers", or whether you would mean it in the context of actually separate institutions and separate boards.
Mr. Robson: I was any thinking more of the latter. I see the activity of all those funds as being overseen by the one board.
The Chairman: A single board but different managers managing different blocks of it; is that right?
Mr. Robson: Yes.
Senator Stewart: You recommend modification of the foreign investment limit. You do not say how far you would go. However that is not the important point.
You went on to say in your testimony that it is easy for the big investor to get around this limit, but difficult or certainly very expensive for the small investor. You did not explain how the big investor does get around it and it would support your argument if you would explain how that is done.
Mr. Robson: When Claude Lamoureaux appeared in front of you, he spoke about the way the Teachers' Pension Plan, through derivatives, provides effective exposure to an international market that is more in the order of one-third.
That is the sort of ability that is difficult for a small investor who has an RRSP or is in a group RRSP to match. It is true that you can buy mutual funds that do the same thing, but the fees on those funds are high compared to the low administrative costs that a member of the Teachers' Pension Plan effectively pays for the same kind of diversification.
Senator Stewart: My other question is political. You say that if you were charged with preserving the Canada Pension Plan, you would try to diffuse the pressure caused by the fact that almost all the provinces have gone into the plan by increasing the plan's visibility and accountability to provincial legislatures. That is all well and good. However, let us suppose the plan is reporting to a provincial legislature, let's say the assembly of the Province of Nova Scotia, and it is ascertained that the plan has been investing a significant amount of money in industries far removed from Nova Scotia. Are you not creating problems for the Canada Pension Plan? Will the opposition not be up in arms, whichever party it is? Are you not putting the plan out among the lions?
Mr. Robson: Clearly, the sort of pressure you are speaking of will be out there and we will hear of it when the plan does its regional presentations as well. The other obvious type of thing to worry about is that the plan, because of the nature of its objectives, long-term growth, will, from time to time, under-perform other types of mutual funds that have different investment objectives and may have more cash that protects them from a temporary decline in the market.
Both of those circumstances are going to put pressure on the plan. I am speculating that in some provinces, particularly, that pressure may take the form of suggestions that the province should assume its share of the liability, step aside and do something different.
My expectation is that, to the extent that the plan is in contact with the parliamentarians and members of the legislatures, it will be possible for them to communicate more directly what it is that they are trying to do with the money and increase the understanding of the elected representatives of the importance of their pursuit of that core mandate to grow the fund and to act in the best interests of the beneficiaries.
I hope I do not appear naïve in suggesting that that would increase the level of understanding and comfort provincial legislators would have with the way the fund was performing its duties and, to some extent, help those legislators cope with the type of pressure that may be applied by many of their constituents.
Senator Meighen: Mr. Robson, in your conclusion you make reference to the job losses we face as a result of the premium hikes and how confidence in the CPP promises could mitigate that. Is there anything else in your view that could be done? Are you just holding back from saying that there should also be some tax reduction such as in the Employment Insurance premiums?
Mr. Robson: The tax cut that I favour is a cut in the bottom personal income tax rate. This would be very helpful to mitigate the increase in CPP premiums. However, looking only at the Canada Pension Plan, one can make a solid case that the effect of the premium hike will be much less if it is accompanied by some equivalent increase in the minds of the contributors in the value of the promise that has been made to them.
Jim Pesando, at the University of Toronto, wrote a good piece for us where he recommended that the extra money that will be raised as a result of higher premiums ought to go into earmarked individual accounts. His motivation was that, by doing that, you would create a direct link in participants' minds between the money they were putting in today and the benefit that they expected to receive down the road. He thought that would be a good way of reducing the negative impact of this rate hike on jobs.
I do not see that option as being actively considered so I did not address it. However, it is motivated by the same idea, that if you can create that stronger sense of a link, you will mitigate the damage. Therefore, the need for you to try to do anything elsewhere, as in EI premiums or a cut in personal income tax, is a little bit less in respect of what is happening in the CPP, not that it the might not be desirable for other reasons.
Senator Meighen: Referring to the second paragraph under "Investment Practices" and the requirement that the board substantially replicate the composition of one or more widely recognized broad market indexes, we have had a lot of testimony expressing real concern about the rigidity of that passive investing approach. You say it seems flexible enough to avoid the problems of smaller liquid floats, especially during the three-year period. Well, it might during the three-year period, but what about after the three-year period? Are you not concerned?
Mr. Robson: I do not think it is a concern over the initial period. As we go further out, it becomes gradually more of a concern. If it is true that the availability of this fund helps to lower the cost of capital in Canada, the opportunities to invest may also expand.
Part of the concern there has to do with the technical difficulties of moving your portfolio when you are such a large player in the market. That is why I suggested that dividing up the fund among different managers, even though some of those managers may have substantially the same mandate -- not necessarily the people whose job it is to look at specific sectors, but even managers whose job is quite similar -- can help to alleviate some of the difficulty that arises as you get down to the 299th stock in the TSE 300. I do not claim that is the entire answer, but I think it is an appropriate thing to bear in mind. As I say, the motivation behind that instruction to replicate indexes is very sound.
Senator Meighen: I do not mean this in a caustic way, but what is the skill in investing in the index? Is it not a mechanical procedure?
Mr. Robson: In some sense it is. My understanding about the objections that have been raised, though, is that the requirement to replicate the TSE 300 may require you to take positions in shares that you cannot buy easily, except by paying a large premium and giving someone else an opportunity to take advantage of the constraint you are under.
As I read the regulation, it seemed to provide enough flexibility that the fund could avoid putting itself in that situation.
Senator Meighen: It seems to me that you do not need to hire high-priced managers to replicate the index.
Mr. Robson: To reflect the point raised earlier, the ability of active management to consistently get better returns than indexing is one that has been researched and researched. Although there is some evidence suggesting that you can, it is not tremendously compelling.
Particularly in view of the very high profile that this fund will have and its key importance coming from people's confidence in it going forward, I think the fund would be well advised to stick to the index for reasons of protection and avoiding the kind of mistakes that might otherwise cause major problems in people's confidence.
Senator Meighen: You could well be right. It would be an awfully boring job, though, being responsible for the investment policy or practices on that board if all you had to do was invest in the index.
Mr. Robson: That is true, but a lot of the smartest money in the world does exactly that.
Senator Meighen: I do not deny that one would have done very well if one had invested in the U.S. indexes in the last few years.
Senator Stewart: I have a question arising from an answer given to Senator Meighen.
Reference was made to the size of the contribution hike and the potentially destructive effects of that on the job market. If I heard correctly, your response was that this might be mitigated somewhat by a tax reduction on the bottom brackets; is that correct?
Mr. Robson: Yes.
Senator Stewart: All right, then re-educate me. I was taught -- and this is old stuff and probably obsolete -- that it was desirable for sound political policy not to exclude large numbers of people from taxation when those people would be expecting to be the beneficiaries of services afforded by the government. One did not want to divide one's population into the taxed and the recipients of the benefits on the other hand. I gather that what is taught nowadays is different from what I was taught; is that correct?
Mr. Robson: This is a topic on which we can profitably spend many hours.
In suggesting that the bottom personal income tax rate be lowered, I am certainly not suggesting that it be eliminated.
Senator Stewart: If you lower it, you will drop more people off.
Mr. Robson: I am talking about cutting the bottom rate. The current federal rate is 17 per cent. If that rate were lowered, people would still be paying tax, but they would simply be paying less tax.
I am suggesting that, in addition to lowering EI premiums in order to offset the impact of the Canada Pension Plan premium hike, it might be sensible to look at personal income tax.
As a footnote to that, according to the label that is attached to them, EI premiums are supposed to be providing a certain type of social insurance. We have now twisted that system very badly out of shape. I am concerned about further twisting it by suggesting that EI premiums are something that you manipulate in order to deal with the problem in the Canada Pension Plan. It seems to me that there is virtue in putting these things in individual boxes and dealing with them on their merits. Therefore, I would like to put something else on the table in addition to the EI premium hike. I suggest that the bottom personal income tax rate is a logical alternative place to look if you wish to balance this impact on the tax burden.
Senator Stewart: You would not go beyond the bottom rates.
Mr. Robson: Not for this particular reason. For all kinds of other reasons, yes, but in terms of the Canada Pension Plan, I would look most hard at the bottom personal income tax rate.
Canada Pension Plan premiums are capped at the level at which your earnings are no longer covered by the pension. In a sense, you are rather imprecisely looking at the same population when you look at those two taxes.
Senator Oliver: You began your remarks, finished your remarks, and even referred to them again in response to Senator Meighen by saying that when Canadians look at this investment board, they will use the investment board as their standard and test for the reliability of the fund. Therefore, my questions to you relate to the appearance of political interference or control of this board.
When you look at the way in which the board was struck by the Minister of Finance, appointing a group to produce some names, and the provinces are involved in that process as well, is this nomination process intrinsically political? Since you stressed throughout your presentation and even to Senator Meighen that the public's sense of reliability will be judged on the performance of this board, what do you recommend can be done to remove some apparent political interference or positioning in this appointment process? What can be done in the future, and should changes be made now?
One person who appeared before us suggested many private sector agencies out there are very good at recruiting and picking good people. Should we not use that as a route?
Mr. Robson: I do not see political involvement as intrinsically positive or negative. The implication is that it is necessarily negative, but it depends on the motivation of the politicians as they look at these people.
I know there is an argument that says the fund is only a small part of the story and that the ability to tax is the key thing in terms of making sure that the benefits will be there. Rightly or wrongly, though, I think people will watch this organization like a hawk and treat the performance of its investments as a key indicator of their sense of the health or sickness of the Canada Pension Plan.
If the process that picks the board members is motivated by a sense that this is really a key factor, then the political influence need not be negative at all -- it can be positive. It is simply a question of ensuring that the political process bears in mind the enormous weight that will rest on the shoulders of these people and, therefore, choose people who look as though they will be able to discharge their responsibilities in a proper fiduciary way.
The comment has been made before in front of this committee that Canada is full of such people. I would re-emphasize that point. I think they can be found. It is simply a matter of being motivated to look for them.
Senator Oliver: Many Canadians are suspect of anything political. They feel that if politicians have any part, directly or indirectly, in the appointment of someone to a $100 billion fund that they will appoint their political cronies and people without a lot of knowledge in investment. That is the concern. If this board is so important, I want to know if you have any other suggestions for ongoing appointments.
I know that in your paper you concur with Senator Angus' point today that a three-year turnaround for these boards is too short. You go up to eight years. You also agree with Senator Angus' view that perhaps they should be appointed for one year, as in a regular corporation, and if their performance has been good, they will likely have their name come up again for up to eight years. Is that what you are suggesting?
Mr. Robson: I suggested longer terms because of the contradiction between a longer-term goal that you sincerely wish to achieve, but then there are all the shorter-term deviations that cause you to deviate from it.
I cannot answer your question entirely satisfactorily, but the proof of the pudding obviously is in the eating. When you look around the world at the performance of this kind of provident fund, in general it is terrible. These things have an awful record around the world. I am not simply playing to the gallery when I say that I think Canada can do better than what we see around the world. I think with the right motivation, we can set a new standard in terms of how these things work.
I would return to my observation that the political appointment process need not produce something bad or suspicious looking. If we get people who are respected in the investment community, people with integrity, people who can mange, and people who have experience, I think we will be all right.
Senator Oliver: Is the current process for choosing directors one with which you concur?
Mr. Robson: I know the skeleton of the process. I do not know enough about the details to comment with a lot of confidence. However, nothing in it makes me worried that we will end up with something destructive. I am at the moment optimistic that we will see a board in which we can have confidence.
The Chairman: Thank you very much for appearing today, Mr. Robson. We appreciate your time.
The committee adjourned.