Proceedings of the Standing Senate Committee on
Banking, Trade and Commerce
Issue 16 - Evidence of March 27, 2003
OTTAWA, Thursday, March 27, 2003
The Standing Senate Committee on Banking, Trade and Commerce, to which was referred Bill C-3, to amend the Canada Pension Plan and the Canada Pension Plan Investment Board Act, met this day at 11:05 a.m. to give consideration to the bill.
Senator E. Leo Kolber (Chairman) in the Chair.
[English]
The Chairman: We are here to study Bill C-3, to amend the Canada Pension Plan and the Canada Pension Plan Investment Board Act.
It will be done in two parts. First, there will be witnesses from the Department of Finance. Heading up our list of luminaries is Mr. Bryon Wilfert, Parliamentary Secretary to the Minister of Finance.
Mr. Wilfert, do you have an opening statement?
Mr. Bryon Wilfert, M.P., Parliamentary Secretary to the Minister of Finance: Mr. Chairman and members of the committee, I appreciate the opportunity to appear before your committee today to discuss Bill C-3, which amends the Canada Pension Plan and the Canada Pension Plan Investment Board Act. My opening remarks will be brief so that we can have time for questions.
Bill C-3 completes the final stage of the 1997 reforms to the Canada Pension Plan, CPP, that were initiated by the federal and provincial governments as joint stewards of the plan. This bill will transfer all CPP assets currently being managed by the government to the independent Canada Pension Plan Investment Board, the CPPIB.
The 1997 reforms to the Canada Pension Plan were a direct result of a warning in the early 1990s by the Chief Actuary of Canada that unless something was done, not only would the CPP assets be exhausted by 2015, contribution rates would have to increase to more than 14 per cent by 2030 to pay plan beneficiaries. This was unsustainable.
As honourable senators know, the Canada Pension Plan was set up jointly in 1966 by the federal and provincial governments, and provides everyone who has worked in Canada and contributed to the plan with retirement income. The plan can also provide financial assistance to contributors and their families in the event of disability or death.
A compulsory earnings-based national plan to which all working Canadians contribute, the CPP was designed to complement personal savings and employment pension plans, not replace them. It worked well for 30 years.
However, with the sustainability of the plan at risk, the federal and provincial governments undertook a complete review of the plan in the mid-1990s. In 1997, following extensive cross-Canada public consultation, the federal and provincial governments adopted a balanced approach to CPP reform so that the plan would be able, at reasonable cost, to meet the demand of the coming years when the baby boomers would be retiring.
This balanced approach included an increase in CPP contribution rates to 9.9 per cent by 2003, instead of by 2015, as originally scheduled. It also included the buildup of a larger asset pool while baby boomers are still in the workforce and the investment of this fund in the markets at arm's length from government for the best possible rates of return, and administrative, and expenditure measures to slow the growing costs of benefits. A key part of the reforms was a new market investment policy of the CPP.
The CPPIB was established to develop and implement this market investment policy. It was set up in 1998 and began operations in 1999 with a mandate to invest for CPP contributors and beneficiaries and to maximize investment returns without undue risk of loss.
Prior to 1999, all funds not immediately required to pay benefits were invested in provincial government bonds at the federal government's borrowing rate. This investment policy resulted in an undiversified portfolio of securities and provided an interest rate subsidy to the provinces.
Under the new market investment policy, all CPP funds that are not immediately needed to pay benefits and expenses are transferred to the CPPIB and prudently invested in a diversified portfolio of market securities in the best interests of contributors and beneficiaries.
The CPPIB prudently manages billions of dollars of retirement funds belonging to Canadians to the highest professional standards, at arm's length from governments and with highly qualified professional managers making the investment decisions. The CPPIB has a strong independent board of directors with investment and financial experience. Directors are chosen through a rigorous process from a list of candidates identified by a nominating committee. In addition, the board is fully accountable to CPP members and the federal and provincial governments. It keeps Canadians well informed of its policies, operations and investment activities.
Under Bill C-3, all CPP assets that still remain with the federal government will be transferred to the CPPIB over a three-year period. The assets, which are valued at about $37 billion, include a cash reserve and a large portfolio of mostly provincial government bonds. This move has several advantages.
First, studies undertaken by the Chief Actuary of Canada indicate that investing all CPP assets in the market will produce a benefit of about $85 billion over 50 years for the Canada Pension Plan.
Second, consolidating all assets under one organization ensures an optimum investment and risk management strategy for all CPP assets, and will put the CPP on the same footing as other major public sector plans, which will help ensure the sustainability of the plan.
Third, transferring the bonds to CPPIB over three years will provide a smooth transition for capital markets, provincial borrowing programs and the CPPIB.
I am pleased to report the provincial and territorial governments unanimously support these transfers. With the passage of this bill, all CPP assets will now be managed by one independent professional organization.
I urge members of the committee to keep in mind that the money the CPPIB invests today, and the returns earned, will be used by the CPP to help pay the pensions of working Canadians who will begin retiring 20 years from now.
In light of this, it is imperative that the CPPIB be fully independent of governments in making investment decisions. This independence is critical to the board's success and for the public confidence in the CPP investment policy.
In conclusion, Bill C-3 completes the process began in 1997 by the federal and provincial governments of investing CPP assets in the market by an independent professional investment board. Together with these reforms, the measures in Bill C-3 will help to ensure that the CPP remains on sound financial footing for future generations.
That concludes my prepared remarks, and, as you have indicated, I am here with officials who will be more than happy to help with any questions that the committee members have.
Senator Tkachuk: You mentioned that the CPPIB opposes stock options and supports directors and management receiving performance-based stock grants that will be held during their tenure.
Is that the position of the CPPIB and is that the way you are exercising your votes — against stock options? This question is for the government representative.
Mr. Larry Weatherley, Chief, Government Financing, Financial Markets Division, Financial Sector Policy Branch, Department of Finance: The CPPIB operates independently and is fully responsible for its own investment policy. It recently came out with proxy voting guidelines that indicate how they intend to vote on certain corporate governance issues. The decision is theirs.
The Chairman: May I suggest that you put that question to the board members when they appear?
Senator Tkachuk: I want to know if the government has a position on this as well.
Mr. Wilfert: It is an independent board of directors. On their Web site, they have posted a clear presentation in terms of what their charged responsibilities are.
However, in terms of some of the more technical, specific questions that the senator has, I respectfully suggest that the next group of witnesses would probably be in a position to respond.
The government essentially wants to ensure that the funds are prudently invested and that the risk is minimized. The board of directors comprises a very impressive list. The members are recommended by the provinces and through the federal government. They all have extensive experience and, therefore, are very clear in their mandate. They want to maximize investment returns without undue risks.
Senator Tkachuk: What about government pension plans?
Mr. Wilfert: Again, this change will put us on the same footing as other major plans, including the Ontario Teachers' Pension Plan and the Ontario Municipal Employees Retirement System, OMERS, for example. The previous format did not return much interest in terms of benefits for the beneficiaries so we expanded the options. They also have a governance code in terms of what they may invest in.
Senator Tkachuk: As far as the government pension plans are concerned, it is not a policy of the government to vote against management that gives itself options. Is that what you are saying? I am not quite sure what you said.
Mr. Weatherley: The government has set up another public sector pension investment board to manage the funds from the public service superannuation account and a couple of other ones. They operate on much the same basis as the CPP Investment Board. They are fully responsible for their own investment policy. I am not sure whether they have proxy-voting guidelines. I believe they do, and they are similar to what the Investment Board has. It is managed separately.
Senator Tkachuk: I understand that. The reason I am asking these questions is that you say the CPP is accountable, but the shareholder is the Government of Canada. I would think it is accountable to the shareholder.
How does the government exercise its right, as the owner of the Crown corporation, to ensure that its views are apparent to the board of directors? Otherwise, the board is not accountable to anybody. What relationship do they have to the shareholder? How do they work together? How do they organize themselves? What does the minister do to ensure that the shareholders are being protected?
Mr. Wilfert: There is accountability through annual reports to Parliament. There are also consultations with stakeholders throughout, I believe, a three-year period, and those consultations are with all stakeholders.
Mr. Weatherley: The stakeholders here are the CPP plan members.
Senator Tkachuk: Yet they do not have a vote.
Mr. Weatherley: The CPP Investment Board prepares annual reports and submits them to Parliament through the Minister of Finance. The governments are the joint stewards of the plan. As Mr. Wilfert said, there are mechanisms in place. There is a requirement that the investment board have meetings every couple of years with the participating provinces where people are invited to comment on their investment policy. I believe the board does presentations.
The board also puts all its policies and its financial results on its Web site, so it tries to make them as publicly available as possible, and people are free to write in to the investment board and ask questions.
Senator Tkachuk: I am just trying to see how the board fulfils its fiduciary responsibilities to the major shareholder, which is the Government of Canada. They have meetings with plan members — CPP people — who have no say over their pension plan whatsoever. They cannot take it out when they want. It is not really their pension plan. It is the government's pension plan; money comes in and money goes out. Just having meetings with people does not really mean anything. What relationship do you have to the owner of the CPP — the Government of Canada and the minister? I know you send in a report, but where do you get cross-examined? How does this happen on an annual basis?
Mr. Wilfert: In fact, the standing committee of the House of Commons, for example, can have the chair of the board before them at any time if there are issues or questions. I would point out to you that because of the role of Deloitte Touche in terms of an internal audit, and the Auditor General, the fact is that if there are any questions on these reports, parliamentarians, in the end, will be in ones in the final analysis be able to ask the questions. If you have any issues in regard to anything in the reports that are tabled, in a very public, transparent and accountable process, then it would be incumbent upon Members of Parliament to act.
Senator Tkachuk: Deloitte Touche conducts your audit. What is the role of the Auditor General of Canada?
Mr. Wilfert: They review the audited statements of the investment board.
Senator Tkachuk: Why do they not do the audit?
Mr. Weatherley: When the investment board was set up, it was decided that it would be independent. This is part of the independence.
Going back to your question, the Auditor General audits the financial statements of the Canada Pension Plan. When the CPP Investment Board was being set up, the Auditor General signed off on a plan that the OAG would have access to the information from the investment board when it was auditing the CPP plan.
Senator Tkachuk: Explain this to me. Does Deloitte Touche audit the investments or the management group that is running it and spending money on salaries and so forth? Who does that, and how does the Auditor General fit into that, exactly?
Mr. Wilfert: Deloitte Touche does the internal audit of the investment board. The Auditor General's role is to review the audited financial statements of the board. The Auditor General has the ability to ask for any relevant information which he or she determines is necessary for fulfilling, in this case, her responsibilities.
I would also point out, Mr. Chairman, that the Minister of Finance and HRDC, both prepare an annual report with regard to CPP as well. This report includes the board's audited financial statements and the Auditor General's report. It is tabled in Parliament. It is also sent to all the provincial finance ministers.
Therefore, in terms of transparency before the members of Parliament and before the public, if there are any questions or issues, they can be dealt with at that time.
Senator Tkachuk: Who chooses the auditor?
Mr. Wilfert: Their internal auditor?
Senator Tkachuk: The CPP auditor. Is it the board or the audit committee?
Mr. Weatherley: It is the audit committee of the board.
Senator Tkachuk: Do they make a recommendation, or do they just choose? You would think that the major shareholder would know how this is done.
Mr. Wilfert: It is very technical.
Senator Tkachuk: It is not that technical. Either the audit committee chooses it or the board chooses it, or the board chooses it on the recommendation of the audit committee.
Mr. Doug Wyatt, General Counsel, Central Agencies Portfolio, Department of Finance, General Legal Services, Department of Justice: The board chooses the auditor.
Mr. Wilfert: Then they sign off.
The Chairman: I am happy that you asked the question, but it is a little beyond the scope of the bill. You should repeat those questions when we have the CPPIB people here.
Senator Tkachuk: They are the major shareholder and they should be able to answer some questions. They are the Government of Canada.
The Chairman: The only purpose of the bill, as I read it, is to transfer these funds to the CPPIB.
Mr. Wilfert: That is correct. The thrust of the bill is simply to transfer. We are obviously familiar with the internal operations of the board and we try to make sure we can answer questions about it. However, for some of the more technical questions, in the other place we ask for the members to come before us and ask those questions. Obviously, members of the board are in a much better position to questions pertaining to internal operations. These questions are beyond the scope of the bill and the specific responsibilities that I have.
Senator Kroft: I would like to clarify one thing that I think is fundamental. I understand the process; I understand the inherent efficiencies; and I understand the concept of management.
In your brief, you say that the Chief Actuary of Canada has indicated that investing the assets in the market will produce a benefit of about $85 billion over 50 years to the Canada Pension Plan.
Mr. Wilfert: That is correct.
Senator Kroft: I would like to understand where this enhanced return is coming from. Some of it, presumably, will come from efficiencies of operation.
Mr. Wilfert: Yes.
Senator Kroft: Some of it will come from a change of eligibility of investment.
Mr. Wilfert: That is correct, senator.
Senator Kroft: Can you give me some idea of what will produce this? I have some skepticism about anyone who projects anything over 50 years. Yet, that is what actuaries do, and I respect that.
Can you be specific on terms, so I understand exactly what is happening? I do not know if you can put a finger on what will come from efficiencies or a more focused or professional — if that is the right word — management, but I would like to know what the portfolio will look like and what will be an eligible investment and whether it creates more balance in the portfolio. I would like an idea of what the portfolio will look like under the new regime.
Mr. Wilfert: I will make a brief comment. Mr. Ménard is very familiar with the breakdown, but I would point out that the rates are going up, and they are going up very quickly. They are not going up as high as they would have because of the situation that we faced.
In terms of the bond issue, they were going by federal government borrowing rates, which were not high interest rates. I would point out the performance of the plan has been, in the main, significantly higher than others, such as the OMERS or the Ontario Teachers Pension Plan, notwithstanding their recent purchase of some sports franchise.
The plan is doing very well. I believe it is because, from everything I have read, of the quality of the managers involved. Part of it will be through cost efficiencies and internal savings. Part of it is because of the changeover, but perhaps Mr. Ménard will be able to provide you with some figures.
Mr. Claude Ménard, Chief Actuary, Office of the Superintendent of Financial Institutions, Department of Finance: The higher assets result from the current operating balance account of $5 billion. This current account earns the T-bill rate of around 2 per cent or 2.5 per cent. The $5 billion represents almost 8 per cent to 9 per cent of the total CPP assets; this is a much higher amount than in any other pension plan in Canada. Transferring this operating balance into a diversified portfolio of bonds and equities will earn a higher return and this is the main result of the higher assets.
Senator Kroft: It is a better deployment of that component?
Mr. Ménard: Yes.
Senator Kroft: Can you clarify as to how the rest of the funds are currently invested in a non-cash component?
Mr. Ménard: Our assumption is for a 75-year period. The assets that are invested and will be invested by the CPPIB include 50 per cent in bonds, 25 per cent in Canadian equities and 25 per cent in foreign equities.
Under this bill, the transfer of the $5-billion operating balance to the CPPIB, the assumption of this rate of return of all the CPP assets is approximately 4.25 per cent on top of inflation. Therefore, if we have inflation of 2 per cent, it means 6.25 per cent. Instead of having a rate of return of 2.5 per cent for the operating balance, you have about 6.25 per cent for a diversified portfolio. This is the main impact.
Senator Kroft: You are saying that the move to a 4.5 per cent real rate what projects through to provide this number?
Mr. Ménard: Exactly.
The Chairman: That is an estimate, is it?
Mr. Ménard: Yes. Everything in this actual report is an estimate.
The Chairman: It could be dead wrong, could it not?
Mr. Ménard: If I look at the historical figures for a long period of time, every diversified portfolio of assets earned much higher returns than T-bills.
The Chairman: Okay.
Mr. Wilfert: In order to put it in context, I will give you the figures that I have at the present time. I will provide you with two different examples of annual returns for selected public sector pension plans. For the year ending December 31, 2001, OMERS was minus 3.4 per cent; Ontario Teachers was minus 2.3 per cent; Caisse des dépôts was minus 5 per cent; and CPP at the end of December 31, 2001 was plus 6.2 per cent.
The last annual report of the CPPIB indicated that an overall return for CPP assets for the year ending March 31, 2002 was 5.7 per cent. Unfortunately, we cannot directly compare it with other large public sector funds at this time because they were on a calendar-year basis. However, this gives you a sense of the types of operations that the CPPIB has been conducting.
The Chairman: I know. However, if you went back nine or ten years, when the markets were good, would you not get a reverse result?
Mr. Wilfert: Yes, you would. That is why projections are over a long period of time.
The Chairman: I am not arguing with you. I am saying that you can pick any period at any one time and get the result that you want. Are you saying that what you are trying to do now is get more into equities?
Mr. Wilfert: Absolutely.
The Chairman: We will have to see how that works out.
Mr. Wilfert: We hope, obviously, and the Chief Actuary has indicated that, given the bumps and mountains that often occur in these times, we will in fact project it — I agree with your comment — certainly over 50 years, but it is based on some sound trends.
Senator Kroft: We are getting into the same place. Given the time span that you are dealing with here, you are saying — and I think it is quite correct — that you are prepared to accept the greater short- and mid-term volatility that comes with this exposure in favour of the historically based projection of a greater rate of return.
Mr. Ménard: We looked at the historical returns of the last 60 years in Canada. We set the same asset mix as the one projected in our report: 50 per cent bonds, 25 per cent Canadian equities and 25 per cent foreign equities. The real rate of return on top of the inflation was 5 per cent — despite the fact that in the 1980s the inflation was quite high. That is much higher than our assumption of 4.25 per cent.
However, we also see that there are volatilities in the market. In fact, if you look at this portfolio for the last 60 years you can see that one year over three delivered a negative rate of return in real terms. The volatility is there, but the expectation of higher returns is also there.
[Translation]
Senator Bolduc: If I am not mistaken, foreign content is currently restricted to 30 per cent. If there were no restriction at all, do you think that it would promote foreign investment?
Mr. Ménard: The actuarial report tabled in the House of Commons set out a very long-term, prudent portfolio. Fifty per cent of the envelope in fixed income securities and the remaining 50 per cent in variable income securities, divided up into 25 per cent Canadian and 25 per cent foreign shares. Inflation forecasts, in real terms, for the performance rates of each of these types of assets are 3.8 per cent for bonds, including federal, provincial and municipal ones. Canadian corporate stocks stand at 4.5 per cent and foreign stock at 5 per cent.
A higher foreign content would give a higher performance rate.
Senator Bolduc: When did you do these calculations?
Mr. Ménard: We developed these forecasts two years ago now.
Senator Bolduc: Given the markets' performance over the past two years, do you think that your calculations remain valid?
Mr. Ménard: Indeed, we believe our figures are still valid. The actuarial report was reviewed at the time by three independent actuaries, including two former presidents of the Canadian Institute of Actuaries. The actuaries, on the issue of performance rates, looked at each of our theories from a demographic point of view. They considered issues such as fertility rates, immigration, death rates, employment rates, inflation and salary increases. The issue of rate of return was the area which was most criticized. I was told that I had been too prudent. It goes without saying of course that the longer the horizon, the more difficult it is to forecast accurately.
Senator Bolduc: We are all aware of the volatility that has existed over the past 10 years. We saw this in the period between 1994 and 2000, and now, since the year 2000 we have been experiencing a new downward trend. This is why I am somewhat concerned. Do you intend, therefore, to ask the Minister of Finance to amend the foreign content ceiling?
Mr. Ménard: That is not my role. However, Canada's population will be an aging one over the next 10 or 15 years. Several studies have revealed that an aging population requires a less aggressive stock portfolio. As a result, if half of one's portfolio is in bonds, then, the foreign content rule becomes less important.
Senator Bolduc: Why do you say that? Well, the Canadian economy represents 2.5 per cent of the overall world economy. Do you think that it is reasonable, therefore, to have 25 per cent Canadian stock?
Mr. Ménard: Yes.
Senator Bolduc: That seems to you to be reasonable? So what you are saying is that this is a safe investment, are you not?
Mr. Ménard: I think that 25 per cent of a portfolio in Canadian stock is quite reasonable. It is true, however, that, as you have said, Canadian stock represents approximately 2.5 per cent of the world economy.
[English]
The Chairman: I wonder if there is an arithmetic problem here. I happen to agree with you, but the rule, as I understand it, is you cannot invest more than 30 per cent of your assets in foreign equity. However, if 50 per cent is already tied up, then it is a moot point. It does not apply here, if that is their basic concept.
Mr. Wilfert: The foreign content rule, Mr. Chairman, is not changing, so you are absolutely correct.
The Chairman: I believe it is a valid question to be asked but, frankly, not just about this plan but about the whole topic. That is kind of extra-territorial today.
Mr. Wilfert: It is, although the government, as you now, has looked at that in the past.
The Chairman: That is to help out Canadian companies, I guess. I do not happen to agree with it, but that is a whole other problem.
Senator Moore: I should like to thank Mr. Wilfert and the other witnesses for being here this morning.
On page 3 of your brief, you mention that the balanced approach included administrative and expenditure measures to slow the growing costs of benefits. What are ``the growing costs'' and what has been the experience?
Mr. Wilfert: The growing costs relate to the aging population and increasing demands on the system. When the system first started, we were estimated that for every person who was collecting, five were working. Now we are down to three people collecting for every one that is working.
Senator Moore: I understand that part.
Mr. Wilfert: That is why the government took those actions.
Senator Moore: This talks about administrative and expenditure measures to slow down the growing costs.
Mr. Wilfert: Are you talking about the internal costs?
Senator Moore: Yes.
Mr. Weatherley: I believe they were administrative changes to reduce the costs of delivering the benefits. I do not know if anyone from HRDC is aware of them, however.
Mr. Del Carrothers, Director General, Seniors and OAS/CPP Programs, Human Resources and Development Canada: I do not know what they are, and I am trying to find them.
Senator Moore: I understand the increase in the aging population but I was wondering if there was something else there in terms of administration costs. Is it substantial or what is it?
Mr. Wilfert: If HRDC is able to find that for you we will pass it along.
Senator Moore: All right. Thank you.
The Chairman: Thank you gentleman.
The Chairman: Our next witnesses are from the CPP Investment Board, Ms. Gail Cook-Bennett, Mr. John MacNaughton and Mr. Ian Dale.
Ms. Gail Cook-Bennett, Chairperson of the Board of Directors, CPP Investment Board: We are delighted to have the opportunity to participate in your discussion of Bill C-3. When appropriate, we are pleased to facilitate the process of transferring the remaining CPP assets to our care. We have the governance and the operational structures in place to receive and handle them.
This morning I will comment on the CPP Investment Board's governance model. I would be happy afterward to pursue some of the questions that the senator raised earlier. Mr. MacNaughton will then have the opportunity to deal with the investment strategy, performance, and external corporate governance policy.
The CPP Investment Board's governance model balances two objectives. First, the investment professionals must be able to make their decisions independently of governments as long as these decisions are consistent with our legislation and regulations. Second, there must be full accountability and reporting to Parliament, the provinces and the people of Canada.
I will quickly remind you of the underlying features of our governance model. Our legislation requires us to have a board with ``a sufficient number of directors with proven financial ability or relevant work experience''; in other words, a knowledgeable board.
How the directors are appointed is a departure from the traditional practice for most Crown corporations. In our case, a committee appointed by federal and provincial finance ministers and chaired by an individual from the private sector nominates candidates. The federal minister then selects candidates from the committee's list in consultation with the provinces.
The resulting board consists of professionals with accounting, actuarial, economic, and investment credentials. Collectively, they are experienced in the public and private sectors. They have informed opinions on public and private sector governance, and they are not only independent but they are independently minded.
Legislation gives the board powers that reinforce this buffer zone between governments and the investment professionals. These powers include the board's responsibility to appoint the chief executive officer, as well as to approve policies that frame management's discretion in making decisions. The board appoints the external and internal auditors who report directly to the audit committee of the board. The board of directors reviews and approves management selection of external investment managers.
Despite these powers, governments can check on what is being done with CPP money. The federal Finance Minister must authorize a special examination of the CPP Investment Board's books, record, systems and practices every six years. This will occur, in consultation with the provinces, before the end of next year. The federal Finance Minister also has the authority to appoint a firm of auditors to conduct a special audit at his or her discretion.
Let me now turn to the second governance objective, our political and public accountability. We are accountable to Parliament through the federal Minister of Finance; the federal and provincial finance ministers through the filing of quarterly and annual financial statements; and, to the public through quarterly and annual reports and public meetings. To date, we have had two series of public meetings from coast to coast.
Those are the legislative requirements. The board of directors of the CPP Investment Board has chosen to go further. The disclosure policy approved by the board of directors states:
Canadians have the right to know why, how and where we invest their Canada Pension Plan money, who makes the investment decisions, what assets are owned on their behalf, and how the investments are performing.
Extensive information is published on our Web site, including the investment strategy, quarterly results and current assets under management. No pension fund in Canada reveals as much as we do and as often.
In summary, the federal and provincial governments were innovative in creating a study governance model, which we have strengthened. Based on the public opinion research that we have conducted, this model has the support of our key stakeholder groups.
Mr. MacNaughton will discuss strategy, performance and investment-related corporate governance matters.
Mr. John A. MacNaughton, President and CEO, CPP Investment Board: Honourable senators, I will go through those topics that were just mentioned.
I will first speak about the factors that shape our investment strategy. We expect between $6 and $8 billion annually in new cash for many years to come. No other investor in Canada is in such a position.
We have at least 18 years before we are expected to pay income into the Canada Pension Plan to help pay pensions. That means that we can invest quite differently from other funds that must generate current income to pay benefits today.
When we began in October 1998, the Canada Pension Plan had a large bond portfolio; it still does. We have been investing cash flow in equities to diversify the asset base. History tells us, as the chief actuary mentioned, that equities pay a premium over the long term for the extra risk assumed compared with bonds. Investing in equities makes sense in its own right, although earning at a risk-adjusted premium means weathering a good deal of volatility in the markets in the short term.
We are also diversifying beyond government bonds and public equities. In June 2001, we moved into private equities, including venture capital. Last January, we acquired ownership interests in community shopping centres and have committed funds to real estate investment firms. Ultimately, we expect we will own office, industrial, retail and multi-residential properties.
We are currently considering investments in infrastructure. These assets fit within our mandate as a long-term investor. They require large amounts of capital and patience and they should produce the level of returns that we need. These assets are also a good hedge against inflation and Canada Pension Plan benefits are indexed for inflation.
We will also be exploring investments and diversification into natural resource assets and real return bonds. Real return bonds are a good match for indexed pensions as they guarantee rates of return that are attached to inflation.
The chief actuary has assumed, as he mentioned, that the assets should earn 4.25 per cent real return over the long term to support the policy approved by the federal and provincial governments.
Government bond yields fall short of that target. Equities will, on average, earn returns higher than 4.25 per cent over the long term. Real estate and infrastructure returns fall somewhere between bonds and equities.
What this all means is that the future security of the Canada Pension Plan increasingly rests on diversifying the asset base. As of December 31, 2002, bonds represented approximately 58 per cent of CPP assets, at $32 billion. Equities were approximately $18 billion for 32 per cent of the portfolio; and the cash reserve, at $5 billion was 9 per cent. We will decide the appropriate long-term asset mix later this year after further discussion with our board of directors.
How have the CPP assets grown since the CPP Investment Board was created? Total assets have increased by $10 billion to almost $55 billion through the combination of increased contributions and investment income. Overall, they have earned an annualized nominal return, averaging 3.8 per cent since 2000. Of course, those returns have been volatile, ranging from a high of 7 per cent in 2001, to a low of 0.8 per cent in the first nine months of the current fiscal year.
The Chairman: As a matter of clarification, did you say that you will get new money each year, amounting to $6 to $8 billion?
Mr. MacNaughton: Yes, that is correct.
The Chairman: Are you including that in what you are saying?
Mr. MacNaughton: These are the numbers as of December 31.
The Chairman: The return does not include that, does it?
Mr. MacNaughton: No, these are historic returns, not expected returns.
Senator Tkachuk: This is 3.8 per cent return on the cash available to invest; is that right?
Mr. MacNaughton: This is the historic return on all of the assets of the Canada Pension Plan — those managed by us and those still in the care of the Department of Finance, in Ottawa. This is the return on the consolidated assets of the CPP.
The Chairman: Please carry on.
Mr. MacNaughton: These results compare favourably with other public sector funds, which, like the CPP, have experienced declining equity markets for three consecutive years, offset by fixed income gains.
While our equity values have declined by about $3 billion over the past four years, we have been in a position to build our equity portfolio at what we believe are advantageous prices. Bonds, on the other hand, have enjoyed improved valuations during the period of declining interest rates. In the next few years, we might well see the reverse happen. It is our hope that equities will produce offsetting value growth — although no doubt at modest levels compared with the 1990s, which was a high decade by any historic comparison.
In closing, I should like to make a few comments on our proxy voting and corporate governance guidelines. Through the CPP Investment Board, the Canada Pension Plan is the beneficial owner of shares in approximately 2,000 publicly traded companies, principally in Canada and the United States, and to a lesser extent in other countries.
The voting rights that come with these shares have potential economic value if they are exercised to encourage companies to enhance their performance.
We do not seek to manage the companies in which the CPP Investment Board owns shares. What we want to do is to underscore shareholder ownership rights by focusing management on serving our best interests. After all, management works for the shareholders, not the other way around.
Consequently, we support resolutions that empower boards of directors on behalf of the shareholders and reaffirm management accountability. We also support performance-based incentive programs that require executives to put their own capital at risk, just like the shareholders. We do this by requiring or expecting executives and directors to own a minimum value of shares while they are with the company. For us, this is better achieved through stock grants at market value than through stock options that have no downside risk for management.
Most of all, we want boards and management teams to take a long-term view of the company's best interests and those of its shareholders. The CPP Investment Board is a long-term investor, consistent with the long-term needs of the Canada Pension Plan. With billions of dollars committed to equity ownership we cannot, nor do we choose to walk away from the companies by selling our shares every time we feel that those corporations are not acting in our best interests.
Therefore, we will support boards and management teams through difficult periods as long as their long-term visions and strategies are clear and compelling, and focused on the enhancement of long-term shareholder value.
We oppose resolutions that are likely to diminish long-term shareholder value, even though they might create long- term gains. It is profit growth, over the long-term, that ultimately drives return on equities. Management's priority should be to enhance sustainable, long-term profitability.
Many Canadians believe that there is more to share ownership than supporting profit making to improve share price. We agree. Employees, customers, suppliers, governments and the community all have a vested interest in good corporate conduct that can positively influence future value.
Consequently, we support reasonable shareholder resolutions that ask companies to make full disclosure on issues that relate to social responsibility, ethical behaviour, sustainable development and corporate citizenship. There is ample scope for companies to demonstrate leadership on disclosure, to build and sustain investor and public confidence in the free market system.
There is much more we could share with you on this and other topics. I hope our comments have been helpful in putting various things in context. We look forward to your questions.
Senator Tkachuk: When you spoke about the asset growth of 10 to $55 billion and you mentioned a 3.8 per cent return, you said that was a consolidated return of the money that was in the corporation and the money outside the corporation.
Do you have a split on what the returns were within CPP and what they were outside of CPP on the CPP funds?
Mr. MacNaughton: Those numbers are on our Web site on a quarterly basis. I cannot recall the specifics, but the equity portfolio lost money in that period and the fixed-income portfolio gained money because interest rates were declining throughout that period. Obviously, the bond portfolio did well.
Historically, the last decade has been one of the best for fixed-income investments. Therefore, it has been a good period to accumulate an equity portfolio but a bad period to own a big one.
Senator Tkachuk: I think you said the 3.8 per cent was a consolidated return on monies that you managed and monies the Department of Finance managed. Did I get that wrong? What was the split? What was the return on the Department of Finance, and what was the return on the CPP?
Mr. MacNaughton: I mentioned the equity portfolio, which represents the assets we have been building in the equity portfolio. It had a loss of $3 million. The bond portfolio had a gain that offset that and had a positive contribution. I cannot recall the specific numbers, but they are published on our Web site.
Senator Tkachuk: You mentioned venture capital. What percentage of your portfolio will be devoted to venture capital?
Mr. MacNaughton: At the present time, we have an allocation of up to 10 per cent to what we call ``private equity''; of that, we would envisage maybe 3 percentage points being in venture capital. Therefore, I would say, at the maximum, it is 3 per cent of the total portfolio.
Senator Tkachuk: Who will make those decisions? Will it all be the CPP board or distributed around the country to venture capital companies?
Mr. MacNaughton: Our team is working successfully to develop a core competence to identify the best private equity managers around the world and to enter into limited partnership arrangements with those firms.
We have thus far committed to approximately 35 different funds with about 30 different managers that we have assessed to be best in class in Canada, the United States and in Western Europe.
Those 35 funds would probably have 10 investments each, or, on average, 10 to 12 investments each. It is broadly diversified, and we have negotiated attractive relationships with each of those 35 limited partnership managers.
Senator Tkachuk: That does not matter much to the people who receive the pensions because, if you get a great return, their pension does not go up. Their pension stays the same no matter what happens. It could be a disaster, but it is not their pension plan; it is the government's pension plan.
We have a problem with the CPP because of a decreasing birth rate. The actuarial results of the 1960s were incorrect in this respect. Therefore, it will not be as cheap as we thought. We have larded up a couple of extra benefits and decreased the age from 68 to 65, and then decided to charge 5 and 5, almost 10 per cent.
That is a huge policy decision. For example, would a person age 25, having finished college and starting at a salary of about $28,000 to $34,000 per year be better off not being in the pension plan having kicked in 9.9 per cent at the end of 30 or 35 years?
Mr. MacNaughton: I would like to address a few premises. First, the question of how to fund a nation state pension plan is a question with which every country around the world wrestles — countries with maturing populations. If pay- as-you-go plans are sustained, as the workforce declines relative to the population, the contribution rates must go up. There is no alternative in a pay-as-you-go plan. That would happen year after year, decade after decade, as the working population declines as a percentage of the whole.
The question is this: Should these funds, in part, be pre-funded? Canada is one of the leaders in concluding that the nation-state pension plan should be a partially pre-funded plan, and that as the workforce declines, the current workers should be putting extra money aside to fund their own retirement as opposed to relying on progressively increasing contribution rates for subsequent generations.
The mathematics of this and the principles of it were very much discussed during the public consultations in the 1990s. The conclusion was to increase contribution rates before the boomers were all on the pension plan, and to invest the assets in capital markets for higher returns. Therefore, those two things in combination are what we are addressing here.
In answer to your final question, I believe that, for the vast majority of Canadians, being a part of this plan is better than not being a part of this plan. There may be some people who have the ability to save and manage investments on their own, but I do not believe it represents the vast majority of working Canadians.
Senator Tkachuk: It might be cheaper.
New Speaker: In aggregate, it will not be cheaper. In aggregate, it will be more expensive. That is a certainty.
The Chairman: One of the problems with self-insuring is that you need a lot of discipline. It is like life insurance. You are probably ahead if you do it yourself.
Senator Tkachuk: You are compelled to do it, so you could be compelled to put it into your own pension plan. You are compelled to do it because it is taken off your paycheque. You have no choice. It is matter of where it goes. It can go into my own pension plan or the CPP pension plan.
The Chairman: Your own pension plan needs to be managed, however. I am not arguing. I am simply saying you need to be a highly disciplined person to do that.
Senator Tkachuk: The state extracts it from you now. If they compelled you to do it, you could put it in your own pension plan.
The Chairman: Who manages your pension plan?
Senator Tkachuk: Some people manage their own; some people belong to pension plans. We pay the CPP whether we have a pension plan or not. Everybody pays it except self-employed people. At the end of the year, they can write a cheque for 10 per cent and put it into their own pension plan.
Senator Fitzpatrick: I was interested in your remarks on corporate governance. This committee is interested in that topic, as we have been studying this subject in the aftermath of the Enron situation.
I realize you referred or alluded to how you would approach this, but I am referring to an article that was in The Toronto Star, which states, ``Because it has previously invested in stock market indices, the CPP investment board currently owns a stake in virtually every major publicly traded corporation in Canada.'' The article goes on to name some of the companies in which you have invested.
I realize you have indicated that you will be scrutinizing the board's corporate governance procedures. I think you stated that the guidelines are expected to influence where new money will be invested and, over time, the portfolio will reflect your views.
I am just wondering if this is not a hard problem to manage. Although I agree with your corporate governance recommendations, I am wondering if this will not have an adverse impact on your ability to have flexibility to make good, money-making investments.
Would you give this committee your view as to how you can manage this, how long this might take, and whether you think it will have any impact on your ability to get the kinds of returns that you hope to get?
Mr. MacNaughton: I would say the corporate governance movement is very robust in Canada right now — in part for the issues you have mentioned and the work being done by this committee. We are, in this regard, but one of many motivated institutional shareholders right now. We have published our proxy voting guidelines that inform how we will vote. In some cases, we are consistent with others, and in some instances, we are, I would say, a little bit ahead.
We cast our proxies through a proxy voting agency service that has global capabilities. As the various proxies come in, this service reviews them against our guidelines and makes recommendations on how we should vote. We can modify those suggestions if we do not agree.
This is a manageable process. I believe that we, along with other institutional shareholders, primarily pension funds, but also, in some cases, mutual funds, are starting to positively influence boards of directors and management teams on a variety of topics. We are already seeing some significant changes in this regard, in response to this movement, and, also, I would say, changes to the Business Corporations Act about a year ago, which permitted shareholders to talk to each other. Bizarre as it sounds, shareholders were not permitted to talk to each other on governance matters related to the companies in which they were invested until those changes to the Canada Business Corporations Act were made.
Senator Fitzpatrick: How are you making out on the stock options issue?
Mr. MacNaughton: We took a position that we would vote against stock option plans as a matter of principle, because we do not believe that they are as effective as was hoped in aligning the interests of employees and directors with shareholders. I would say we have received some affirming comments for our position. We have received some negative comments. However, we are holding to our view; we think it is the right one.
We have noted, even in recent days, some major companies announcing that they are abandoning their option program, largely for the reasons that we have identified. They have concluded that they are not worth the bother and they do not need them for competitive reasons, even though they thought for a while they did.
The Chairman: This is not the place, but some day I would like to have a debate with you on that.
Senator Hervieux-Payette: In Quebec, we have our own organization that is hosted in a nice ``palace'' in Quebec. What is the size of your organization? You mentioned the 35 different funds that you are using. What is the structure in terms of managing these assets? Do you have a zillion employees in a nice big building, or do you have a strategy so that your administrative costs are kept at a decent level?
Mr. MacNaughton: We have 35 employees and 12,000 square feet of office space. We will expand our team in the coming year and years. Our strategy is to be a highly focused professional management team that addresses the big questions, gets the right answers, and implements those strategies through external expertise that is available in the competitive marketplace in Canada and internationally.
Senator Hervieux-Payette: How does it compare with the teachers' plan and Caisse des dépôts?
Mr. MacNaughton: In payroll, we are substantially smaller, obviously. I do not know specific number, but I know at its peak, the Caisse was close to 1,000 people, and the teachers', on the investment side, was approximately 200. We will grow and migrate functions internally if we conclude that we have reached a scale where we can do it more economically internally or for better returns.
These are ongoing judgments. Right now, we believe that being focussed on the critical issues is more important than building the implementation machine.
Ms. Cook-Bennett: There are a number of different models and approaches in the various pension plans — none of which is right or wrong. They have been moulded to their own situation. I do not think necessarily that one will produce great results and the other not great results. How each individual model is managed is critical.
Senator Hervieux-Payette: The cost, the percentage of the fund, is important.
Ms. Cook-Bennett: Some would argue that in certain areas, if the pension fund happens to be investing in a certain asset class, that it is cheaper to do it inside with your own personnel, which adds to your own head count, as opposed to doing it outside. It is a judgment that each fund makes.
Senator Hervieux-Payette: You are talking about considering investment in infrastructure. Does that mean provincial, municipal, federal infrastructure, a harbour, airport, road, bridge or whatever? We have some good projects in Quebec.
Mr. MacNaughton: We would consider all of those things.
[Translation]
Senator Prud'homme: In light of your presentation and the expertise that you have shown in your answers to our questions, I am very pleased to see that you are at the helm of this issue. My question is for Mr. McNaughton. I would just like to get some quick clarification on what you said in the second-last paragraph.
[English]
Consequently, we support the resolutions ... that relate to social and ethical behaviour...
[Translation]
What you are saying is that you might take into account what individuals want. For example, someone might say to you that he or she did not want to invest in Talisman. Is that what you are saying? Is this the way I should be interpreting this paragraph? I think it is quite regrettable, of course, that we have drawn a link between politics and Talisman. I think it would have been much better to leave Talisman out of it.
[English]
I would have preferred that no one touch Talisman and that we let business take its course. Is that what you mean by this paragraph?
Ms. Cook-Bennett: There are a number of aspects. You used the Talisman example. It could be tobacco. It could be any other.
The approach the CPP Investment Board takes is threefold. Basically, we vote in favour of resolutions that permit the shareholder to know exactly what is going on. That is a ``soft'' answer to your question.
We also take the position that, when it comes to actual active investment decisions, corporations that act in the best interests of the environment and human interactions and that sort of thing tend to be, in the long run, the companies that will be more profitable.
Having said that, by our legislation, we are required only to operate in the interests of the beneficiaries and contributors to the plan. We are required to maximize returns. Indeed, right in the legislation, we are not permitted to do anything with the portfolio that does not meet those two objectives. I am giving you a nuanced response.
Senator Prud'homme: It is very nuanced. I was expecting just a yes or no. What about the example of Talisman?
Ms. Cook-Bennett: We are operating against an index right now. We are invested in Talisman and, under the legislation, we would not be permitted to rule out Talisman on the grounds that it was in the Sudan alone, and so forth.
Senator Moore: I am interested in the infrastructure possibilities as a source of investment for you.
Last year, our committee on national finance conducted a study. We learned that there was a matter of $3 billion in accumulated deferred maintenance in our post-secondary institutions. These institutions need a fix-up. Are you looking at new infrastructure, or would you entertain universities making application for funding for such projects?
Mr. MacNaughton: Various corporations and governments at different levels sometimes decide to sell assets that, broadly defined, might be called infrastructure. We do not make the decision as to what would be offered. It is made by the owners of the assets that either exist, or are wanted to exist.
Senator Moore: Is it strictly equity positions, or would you enter into a loan arrangement?
Mr. MacNaughton: I would say our primary interest would be in the equity component of the transaction. We would also be interested in inflation-linked bonds attached to some of the projects. Nominal fixed income would not be particularly attractive to us.
Senator Moore: If your idea is to invest so that you are doing so with a minimum amount of risk — and I cannot think of a better risk than learning institutions — why would you not entertain that possibility?
Mr. MacNaughton: I am saying we would entertain it.
Senator Moore: You would want to own the building, for example, or a residence on the campus.
Mr. MacNaughton: We would want to own an interest in the income stream related to the project, and also to have a return that is indexed to inflation. That is really what would motivate us.
Senator Moore: Is your answer no, in terms of lending to a university?
Mr. MacNaughton: Nominal fixed income, except during periods of declining interest rates, is not a particularly good asset for a pension fund.
Senator Moore: They would probably pay more than 3.8 per cent.
Mr. MacNaughton: Over the long term, fixed income assets do not produce returns that exceed the required return of the Canada Pension Plan. Historically, they have not; and our expectation is that they will not in the future.
Senator Kroft: Since you have entered into the role of some advocacy on certain issues, can I suggest two more? One is to try to encourage those with whom you associate, in the management of other large funds, to be active and aggressive in the field of private equity.
This committee has learned, over a long period of time, that there is a real deficiency in the Canadian entrepreneurial structure and business development structure as compared with the U.S. There is, for example, a low level of participation in private equity by large pension funds. Any leadership you could provide in that area would be welcome.
Second, you talk about a partially prepaid system. It is a huge policy discussion, and we only have to go to the other side of the border — or Chile or all sorts of places — to see how they are coming to grips with their investment of provision. I presume that you have an interest in seeing that the eligibility levels for other components — particularly RRSPs — are maintained at an ongoing competitive level. I recognize there is a political element to this and another element. However, you are part of a package, and the RRSP is another part of the package by which Canadians save for retirement.
I hope that, while you are filling one piece, that you will continue with your willingness to be advocates for those things that complete the picture.
Mr. MacNaughton: Thank you. We will.
Senator Bolduc: You have money coming in from the premiums at 9.9 per cent. The stock market has been in a meltdown for the last three years. People say we will be out of it in a few months but in my opinion, it will take a long time because the drop has been huge all over the world. Do you feel comfortable with that 9.9 per cent? I know it is not your responsibility — it is the responsibility of the ministry — but I am asking the question because you are an expert in funds performance.
Mr. MacNaughton: We are looking at this question by examining what is the portfolio that we could construct that would earn returns that are sufficient to sustain the contribution rate at 9.9 per cent? Based on our expectation of returns, we look at two periods: one is the next 10 years, and the other is the next 75 years. Our view is that over the long term expected returns should be sufficient to sustain that contribution.
Senator Bolduc: Over the long term?
Mr. MacNaughton: Yes.
The Chairman: Senator Tkachuk has a request to make. Following that, we will go clause by clause and then we will have the teleconference.
Senator Tkachuk: I have a question, but I do not want you to answer it now because of our time constraints.
The social responsibility aspect of investment always intrigues me. Could you send us a letter as to how you make those decisions? Could you give us some of the parameters, and expand on them a little bit? Could you also tell us whether you would apply this same rigorous social responsibility test to municipalities? Will you invest in bonds with municipalities that do not have sewage treatment plants, proper disposal of tires and all of those other items? That would be quite interesting to know.
Senator Bolduc: Also, will you use nationalistic arguments like the Caisse des dépôts does in Quebec?
The Chairman: Thank you for your presence and your cooperation. Senators, is it agreed that we go to clause-by- clause consideration of Bill C-3?
Hon. Senators: Agreed.
The Chairman: Regarding Bill C-3, an act to amend the Canada Pension Plan of the Canadian Pension Plan Investment Board Act, is it the intention of any honourable senator to propose an amendment?
Hon. Senators: No.
The Chairman: Shall the title stand postponed?
Hon. Senators: Agreed.
The Chairman: Shall clauses 1 to 20 carry?
Hon. Senators: Agreed.
The Chairman: Shall the title carry?
Hon. Senators: Agreed.
The Chairman: Shall the bill carry?
Hon. Senators: Agreed.
The Chairman: Shall I report the bill?
Hon. Senators: Agreed.
The Chairman: The bill is to be reported.
We will continue with our next witness. Mr. Higgs, please proceed with your perspective on the collapse of Enron.
Mr. Derek Higgs, Author, Report entitled ``Review of the role and effectiveness of non-executive directors'': I would be happy to do so however, I do not regard myself as an expert on Canadian or U.S. matters. I presume that you asked me to appear before you because I was asked by the U.K. government one year or so ago to conduct what was described as a short, independent review of the role and effectiveness of non-executive directors in U.K. corporate boardrooms.
The Chairman: Yes, we have that review in front of us.
Mr. Higgs: I talked to researchers to an extent and considered developments in the U.S, in particular, and, to a lesser extent, elsewhere in Europe and outside Europe. I would hate for you to think that I regard myself as an expert on U.S. matters.
The Chairman: Mr. Higgs, you could ignore the Canadian context and highlight for us what you think are the important aspects of the discussion.
Mr. Higgs: If I may suggest, I will compare and contrast, from a United Kingdom perspective, the approach to corporate governance taken in the U.K. with what I understand to be the U.S. approach by the Sarbanes-Oxley Act. Would that help you?
The Chairman: That is perfect.
Mr. Higgs: I would describe the approach taken in the U.S. as the ``hard law'' approach to corporate governance compared with what we would regard in the United Kingdom — and increasingly in Europe — as a ``soft law'' approach. By that, I mean legislative approach to regulating corporate governance in the U.S. compared with a principles-based approach in the U.K. and increasingly in Europe. This approach relies on the concept of describing best or acceptable practice and leaving companies either to comply with that practice or explain why they have chosen to depart from it. Shareholders, rather than legislators decide whether that divergence is acceptable.
The Sarbanes-Oxley Act has no equivalent in the U.K. We have something called the ``Combined Code on Corporate Governance,'' which is a document that does not have any force of law, other than the remote, ultimate sanction of removing listing of companies on stock exchanges. It is a game that is played between boards and shareholders, between managers and owners, and between principles and agents. It does not, in the ordinary course, involve the force of law.
The combined code as it stands in the U.K. currently is probably about 12 pages long. It does deal with the same things as Sarbanes-Oxley. It deals with the composition of audit committees, nomination committees, and remuneration committees. It deals with the typical shape of boardrooms and with the fundamental separation of the roles of shareholders and the chief executive.
It represents guidance on best practice and what companies do in reporting whether their practice is in line with that guidance. If the company departs, the departure is explained. If the shareholders are happy with that departure, that is the end of the matter.
It is a fundamentally different approach. There are those in the U.K., and I suspect elsewhere, who think that if you set up a series of rigorous rules backed by the law the exercise becomes one of finding your way around the rules. If you set up a series of principles and this flexible framework of ``comply or explain,'' you then encourage responsible behaviour and intelligent judgment and discussion.
Of course, it is not always black and white and perfectly formed in every tiny detail as that. Yet, by and large in our country, the concept of the combined code and its influence on corporate governance has been regarded as very satisfactory and positive.
The review I was encouraged to do has put forward some evolutionary changes to that template of best practice. As has happened with other evolutionary moves in corporate governance, there has been some resistance to it from corporate boardrooms. I suspect that as before, you should anticipate finding some resistance if you are raising the bar to the standard of behaviour in boardrooms.
The Financial Reporting Council, FRC, in the U.K, which has the responsibility at the moment for both supervision of the code and of accounting standards and parts of the accounting and auditing professions, is considering the recommendations that were made in my review. The period for receiving consultation is coming to an end on April 14, 2003. Thereafter, the council will consider what it heard. It is expected to produce a revised combined code within a matter of two or three months. That will become effective sometime in the early summer this year. The accounting periods it will cover remain to be determined.
After some of the corporate problems incurred, particularly in the U.S. a year or so back, there was a sense that a legislative approach might be required in the U.K. because of loss of public confidence in corporate responsibility and corporate governance. The passing of the Sarbanes-Oxley Act, for most people in the U.K., had the effect of reinforcing the value of the flexible framework rather than the legislative one.
Have I chosen my words carefully enough, I ask myself?
The Chairman: Yes, you have.
If the principle approach works as well as you seem to think, how did we end up with all these problems?
Mr. Higgs: We have had problems in the U.K.
The Chairman: How did we end up with that problem?
Mr. Higgs: How did you end up with those problems? I fear I cannot answer that.
The Chairman: How did the U.S. end up with such problems?
Mr. Higgs: I would refer to the earlier comments about the fact that bright people tend to see rules as things to be found a way round rather than necessarily to be respected in all regards.
The Chairman: To debate that for a second, by that standard, why would you have a Criminal Code? I do not suggest you are wrong, I. do not know the answer.
Mr. Higgs: There is a difference between the civil and the criminal. It sits oddly from my side of the Atlantic to see section 907 of Sarbanes-Oxley resulting in a revision to the U.S. federal criminal code. That does not seem to us to sit easily with the more important matter of the ``moral compass in the boardroom,'' which is a phrase originating on your side of the Atlantic. That is absolutely critical to the way that corporate entities behave.
The Chairman: You are saying essentially that you cannot legislate proper behaviour?
Mr. Higgs: You can foster responsible behaviour. There is some description of the conditions for effective behaviour and how that can be fostered in this review.
However, you would be pushing a piece of string; you cannot mandate, legislate or dictate it. You can encourage and foster it. You can try to find the conditions in boardrooms that result in mutual trust, confidence, openness and constructive debate leading to better economic performance, hopefully.
Senator Tkachuk: Did the scandals that took place in the United States with Enron hurt investor confidence in Europe, particularly in England? We had a few scandals here as well, but we are not a big dog so, it did not have the same effect.
Mr. Higgs: Absolutely, yes. I was asked to conduct this review partly in response to the perceived and relatively extensive problems in the U.S. corporate scene. To be fair, it was timely because it had been about four or five years since this combined code had last been reviewed. There was an element of having a look to see if the practices needed to be changed and updated.
However, it was absolutely in the post-Enron era and there was a loss of public confidence and trust in corporate leadership to an extent in the U.K. There was not that much fraud or deliberate misstatement of corporate results, but there were some failures of strategy.
Boards are responsible for the strategy of companies. Questions were understandable asked about whether better governance in boardrooms and stronger contributions to strategic development from non-executive directors could have prevented some of those misjudgements and failures of strategy that clearly resulted in substantial losses in shareholder value.
Senator Tkachuk: I gather from what you said that investor confidence was shaken, but not as much as it had been in North America. Did your report and the actions of the government and the corporations themselves solve that problem? Is it a situation where you believe that investor confidence will be restored?
Mr. Higgs: I am not a member of the government so I do not speak on its behalf. I am in the independent private sector so I describe what I perceive to be the government's approach in the U.K.
In the autumn of 2001 when some of the problems began in the U.S., the government put in hand a review of auditing and accounting structures, practices and standards. It also commissioned, through a private sector firm, a review of aspects of institutional investment and pension fund governance and so forth in the U.K. This review also spoke to aspects of boardroom behaviour and, in particular, the behaviour of non-executive directors.
This review covers a large part of the territory that affects whether companies conduct themselves properly. In parallel with my review, there was a specific review of audit committee structures and conduct that was published at exactly the same time.
The combined code is to be incorporated into a revised code. One way or another, the government did look at — directly and indirectly — many of the aspects of corporate organization that had been perceived as going wrong, certainly in the U.S.
The same issues about auditor rotation, auditor independence and the role and function of the audit committee were examined in the U.K. context as they were looked at closely in the U.S. as well. Will that result in investor and public confidence being restored? One would hope so, to an extent, but this is not the transformation time.
Senator Kroft: Mr. Higgs, I am interested in your introductory comment in which you explained to us the hard-law approach versus the soft-law approach and what underlies your thinking. We are fundamentally talking about investor confidence in all of these issues. I should like to know whether the actions in the U.S. — be they the Sarbanes-Oxley, the stock exchange or the securities commission — have given comfort to the U.K. investor even you are not proposing to do this in the U.K. Is the fact that the U.S. has done it had a salutary effect on investor confidence in the U.K.?
Mr. Higgs: The greater impact, unfortunately, has been on U.K. corporate businesses with a listing on the stock exchange in the U.S, where the imperial approach of Sarbanes-Oxley has scared many people in the U.K. That has resulted, as you have seen, in many representations, from the U.K. and from Europe, about not being forced to do things precisely to fit the American mould simply by virtue of an additional listing.
It has focused minds, which is helpful. If it has deterred people from taking advantage of global capital markets —U.S. markets in particular — I do not think that is helpful. Seeking to impose American standards on British, French or German companies that do things differently and in accordance with their own is a form of imperial progress, which is not always welcomed by those on the receiving end of it.
Senator Kroft: As a small country sitting next to the U.S., we are not indifferent to that type of consideration. At the same time, we may come to different conclusions about what works best for our investors and our capital markets.
I should like to speak to a couple of specific issues that arose out of your report, having moved on from a general question. These issues are in respect of the board of directors.
In your system, although the roles of the chief executive officers, directors and chairmen are different, is the chairman an executive position?
Mr. Higgs: Normally, it is not. The characterization of the chairman is as the chairman. He or she is not an executive in the usual sense of the word and not a non-executive because of the significance and importance of the role in relationship to and with the chief executive. He or she sits in a category of one on the board called ``the chairman.'' In my review, you saw the comment that it is not, in my personal opinion, helpful to describe a chairman as executive or a non-executive unless it is a situation where the roles of chairman and chief executive are combined, in which case the chairman is clearly an executive chairman.
However, in the ordinary course, with the separation of roles, the logic in this country is that you have both a chairman and a chief executive. Again, the review says that, although it is desirable that the chairman be independent by the definition on appointment, it is not relevant or appropriate to consider questions of independence after the appointment has been made. The chairman is in a category of one, with the other members of the board being non- executive directors or executive directors.
Senator Kroft: You have explained it clearly. It had not been clear about whether the independence would be lost by virtue of becoming a chairman.
Mr. Higgs: The answer is ``yes.'' However, that does not make them non-independent; it makes them the chairmen.
Senator Kroft: I would like your comments on term limits in respect of directorships. Could you expand your thinking, both specifically and philosophically? You are generally suggesting that periods of directorships be limited.
Mr. Higgs: The drafting may need a bit of tidying up. The logic is that there is no time limit if the shareholders are happy and the board is accepting of an individual continuing. However, there is encouragement, to the degree of refreshing and manage demography on boards, which suggests that two- to three-year terms will ordinarily be enough for any single non-executive director. That is backed up by annual re-election, if any non-executive director goes beyond nine years, and the presumption of independence being lost if they go beyond 10 years. It does not amount to a cap on their tenure; they can stay for 20 years or however long. They would just change their re-election process and the concept of independence. There are strong encouragements to keep refreshing the board so that it does not become a static group. However, but there is no obligation on anybody to leave after any given period. Certainly, with regard to the chairman, it very specifically says there is no guidance for tenure on chairman, recognizing the importance of continuity and the fact that the chairman is the chairman.
Now, some of the press reporting and commentary about this has inferred from the text — which therefore is obviously not clear enough — that there is a cap or term limit on that tenure. That is neither what is intended nor what is said. I believe this is one of the drafting issues that further consideration of this review would address.
Senator Kroft: It would be consistent with your approach not to be rigid on this. As I listen to you, the suggestion is interesting, although obviously nothing applies in every case, of the risk that long-term periods of directorship have a way of compromising independence.
Mr. Higgs: There is a phrase about going native somewhere in this, I think.
Senator Kroft: Great. Now, in light of U.K. practice, is it sort of a shocker to suggest to the boards of London that, perhaps, they are hanging around too long?
Mr. Higgs: Those people who are clearly hanging around too long think it is outrageous to make any comments in this direction. It may be a self-proving point.
Senator Kroft: Thank you.
The Chairman: Thank you very much for being with us, sir. It has been very illuminating and helpful. We wish you luck in all your endeavours.
Mr. Higgs: Thank you. I hope that in some small way, I have at least given you a little bit of personal flavour beyond this, even if I have not told you much you did not know already about Sarbanes-Oxley.
The Chairman: I am afraid that we are a lot more wedded to it than you are.
Mr. Higgs: You are closer to it; that is true.
The committee adjourned.