Proceedings of the Standing Senate Committee on Banking, Trade and
Issue 5 - Evidence - November 18 meeting
OTTAWA, Tuesday, November 18, 1997
The Standing Senate Committee on Banking, Trade and Commerce met this day at
9:35 a.m. to examine the state of the financial system in Canada (institutional
Senator Michael Kirby (Chairman) in the Chair.
The Chairman: Honourable senators, this is the first of a series of hearings,
which will take place over the next three days and when Parliament returns
after the Christmas break, on the subject of institutional investors.
You will recall that this issue arose when we were holding hearings
approximately one year ago on the corporate governance provisions which should
apply to the Canada Business Corporations Act. Issues about the role of
institutional investors in the Canadian economy in general, their
accountability procedures and the impact they had on the companies in which they
invested were raised by a number of the witnesses. As a result, the committee
decided -- with the active encouragement of a number of senior executives in
Canada, non-executive chairmen of the board of major corporations and some
large pension funds -- to undertake a study designed to look at the various
issues related to the role of institutional investors, their governance
practices internally, and their impact on the governance of the firms in which
We begin today with three experts who will give us an overview of the issues we
ought to be exploring with future witnesses.
Mr. Jeffrey G. MacIntosh, Faculty of Law, University of Toronto: Honourable
senators, I am pleased to be here this morning to present my views to you.
These hearings will explore two not uncomplicated issues -- the involvement of
institutional investors in corporate governance, as well as the governance of
Let me begin by telling you what a noted corporate law scholar named Theodore
Geisel wrote about these problems many years ago. He said:
Oh, the jobs people work at! Out west, near Hawtch-Hawtch, there's a
Hawtch-Hawtcher-Bee-Watcher. His job is to watch... to keep both his eyes on the
lazy town bee. A bee that is watched will work harder, you see.
Well... he watched and he watched. But, in spite of his watch, that bee didn't
work any harder. Not mawtch.
So then somebody said, "Our old bee-watching man just isn't bee-watching as
hard as he can. He ought to be watched by another Hawtch-Hawtcher. The thing
that we need is a Bee-Watcher-Watcher."
Well... the Bee-Watcher-Watcher watched the Bee-Watcher. He didn't watch well.
So another Hawtch-Hawtcher had to come in as a Watch-Watcher-Watcher! And today
all the Hawtchers who live in Hawtch-Hawtch are watching on
Watch-Watcher-Watchering-Watch, Watch-Watching the Watcher who's watching that
bee. You're not a Hawtch-Hawtcher. You're lucky, you see!
You may have guessed, of course, that Theodore Geisel is also known at Dr.
Seuss. I think Dr. Seuss's passage nicely encapsulates the issues that we have
to deal with today.
Senators, you are Hawtch-Hawtchers. Actually, by my account, you are
Watch-Watchers, which is to say that the town bee, hopefully not too lazy, is
Canadian corporations, and the bee watchers are Canadian institutions. I
suppose the Watch-Watcher-Watchers are the people who benefit from the
institutions, and I guess the committee is one level above that.
Now that I have thoroughly confused everyone, let me start to make some sense
about Canadian institutional investors.
First, I wish to address the issue of institutional investors and corporate
governance. The threshold question is: Do we want institutional investors to be
involved at all in the question of corporate governance? I think many corporate
managers would tell you that the answer is no, that they do not want
institutional investors playing a role in corporate governance. The corporate
managers will tell you that those particular watchers know nothing about what
it is that bees do, and they want the bees to do some very silly things.
The evidence, in fact, is to the contrary. Institutional investors do have a
useful role to play in supervising Canadian corporations. To support this view,
we have both theory and evidence.
On the theoretical side, we would expect institutional investors to be better
overseers than retail investors, simply because they have much larger interests
at stake and, therefore, are likely to take a much keener interest in who is
running the corporations in which they have invested.
On the empirical side, there is a lot of support for the view that the
involvement of institutional investors does indeed better corporate
performance. For example, the fund in the United States that has been most
active in corporate governance is CALPERS, the California Public Employee
Retirement System. I would like to refer to one study done on CALPERS.
They picked 10 of the worst performers in their portfolio every year. After they
became involved in straightening things out at those 10 companies, performance
improved over the next few years in the order of approximately 50 per cent;
that is, an abnormal return over the market of 50 per cent. So if you had
invested in those firms in which CALPERS became involved, you would have done
extraordinarily well. The corporate governance program of CALPERS seems to be
I, along with an economist, did a study on Canadian institutions. We found that
where there was high institutional ownership, there tended to be a higher
return on assets and equity. There is plenty of other empirical evidence, which
I will not take the time to discuss now but which might come out during
There is much anecdotal evidence that institutions have made a positive
difference in corporate governance in Canada, beginning in approximately 1986
with the recapitalization of Crownx, where institutional investors stepped in
to oppose a dual class recapitalization and actually succeeded in getting the
corporation to abandon its proposal, as well as the Canadian Tire transaction,
also in 1986-1987, up to the present where hardly a week goes by without a
newspaper story about how some institutional investor or group of institutional
investors has made a difference in corporate governance somewhere, whether in
relation to a poison pill, an executive compensation plan, or some such thing.
There is much evidence now that institutional investors do good things in
corporate governance and that we ought to be encouraging them to do this.
What kind of role does this leave for this committee? It strikes me that there
are various legal restraints that make institutional investors somewhat less
active than they might be. I will refer to three legal restraints, which will
sound familiar to senators since these are things that were touched on a year
ago in the broader corporate governance proceedings. I will mention them because
they do impact on the way institutional investors carry out their business.
One is the absence of confidential voting, a key issue in the sense that many
institutions are not active in corporate governance because of conflicts of
interest. Banks and life insurance companies are virtually completely absent
from matters of corporate governance. It has been the pension funds that have
been active, in particular the public pension funds. The banks are not big
equity holders, but the life insurance companies are. One of the reasons for
this inactivity in corporate governance is conflict of interest; that is, they
do not want to be involved in matters of governance where the result might be
to get on the wrong side of people who are either current clients or potential
clients, corporations for whom the company might be writing insurance policies
or might wish to write insurance policies. This conflict-of-interest problem is
absolutely essential to the role of institutional investors in Canadian capital
If confidential voting were instituted, management would not be able to punish
them for voting in a way that appeared uncongenial to management.
Another legal restraint relates to proxy rules. This matter has been under
discussion in Canada for a few years and would ensure that shareholders can
engage in effective, informal communications without triggering the requirement
for a distance proxy circular.
The last matter is the takeover bid threshold, which is now, in the Canada
Business Corporations Act, 10 per cent. It ought to be raised to at least 20
per cent, to conform to the provincial legislation.
I will make a few very brief remarks about the governance of institutions,
focusing on the governance of pension funds. That is perhaps the most pressing
governance problem that we face in the institutional arena.
Obviously, pension fund governance is an important issue. With the Canada
Pension Plan beginning to fray and tatter around the edges, it is obviously
important that private pension plans be there to provide a safety net to
Canadians when they retire.
The problem of pension governance is, in many ways, more difficult than the
problem of corporate governance, in the sense that you do not have the same
market controls that are controlling the activity of managers. For example, if
a corporate management team performs badly, there might be a hostile takeover
in which the managers are displaced from without and a new management team put
in. You simply do not have the same kind of market mechanism in the case of a
badly performing pension; nor do you have the kind of direct oversight by the
people who are the beneficial owners of pensions that you have in a private
corporation where shareholders can directly replace the managers. The problem
of governance is a very difficult nut to crack.
The committee may find it beneficial to focus on the issue of who ought to
control the board of the pension fund. This is one of the crucial issues. One
ought to be asking: Who is in a position most analogous to the shareholders of
a private corporation? Who has the interest most analogous to the residual
claim in a corporation? There are good reasons for believing that those who hold
the claim that corresponds most closely to the residual claim have the best
incentives to run the pension fund. In a defined benefit plan, it is the
corporation itself. The corporation, as sponsor, has to make up any shortfall
in the defined benefit plan and typically these days, at least in newer plans,
will have made arrangements to capture the surplus, if any, and therefore looks
a lot more like the residual taker than the beneficiaries of the plan.
However, in a defined contribution plan, it is the beneficiaries of the plan who
are the residual risk-takers. Therefore, they ought perhaps to take a much more
active role in the governance of the fund, subject to the consideration that
employees need a considerable amount of expert guidance in setting up the
structure of a defined contribution plan so that employees will be knowledgeable
enough to select options that suit their risk preferences and time horizons.
I will stop there. I am sure there are many questions that will arise as a
result of my remarks. I will let my confreres get in on the action.
The Chairman: Thank you, Professor MacIntosh.
Dr. Por, would you like to proceed.
Mr. John Por, President, Cortex Applied Research Inc.: I wish to restrict my
comments to the governance of large public sector pension funds, for a number
of reasons. One of those is that these funds are huge and the degree of
potential influence they can exert over the Canadian economy is enormous. To
give you some scope of this influence, in 1996 in Canada the 15 largest public
sector pension funds had joint assets of over $150 billion. One should compare
this with the $50 billion of the 15 largest private sector pension funds. That
is probably now about 30 per cent more due to market movement.
The Chairman: So the 15 largest public-sector funds are collectively three times
larger than the corresponding number of private-sector funds.
Mr. Por: That is a good way of putting it. Another way of putting it is to say
that while the private-sector funds are not growing other than by asset growth,
public-sector funds are growing through a tremendous amount of contribution as
While the private-sector pension funds come under managerial oversight of boards
and executives accustomed to the scope of decisions involved, public-sector
pension funds are usually governed by boards whose members may only
infrequently encounter decisions of a similar nature in their day jobs. People
sitting on the investment committees of private-sector funds regularly make big
financial decisions, while the board members of public-sector pension funds very
infrequently do so.
The difficulty of this task is compounded by the fact that the principles of
group decision-making, delegation, governance, workings of effective financial
reporting and monitoring systems, the broad nature of capital markets, the
risks involved in asset-liability mismatch, et cetera, are not concepts which
can be easily acquired through general readings.
The third comment is that while public-sector plans were originally set up 25 or
30 years ago to provide oversight of pension administration, they have
gradually evolved into organizations which invest a significant portion of
Canada's capital and, as a matter of fact, of North America's capital. It is
important to note that since they were set up by legislation, no significant
attempts were made to make them adapt to their new role. In order to change,
legislation must be changed and that is not an easy feat.
These funds, at the same time, are under tremendous pressure to satisfy the
understandable but specific and usually not impartial interests of a very
diverse stakeholder group without any agreed-upon, objective yardsticks of
success. Many articles have been written and many theories abound concerning
how to judge the success of large public-sector pension funds. The debate is
still ongoing without any specific resolution to that issue.
Who are the stakeholders? They are the membership who always have an interest in
low contribution and ever-improving benefits; the unions -- more control,
better pensions, lower contribution; employer groups -- more influence, lower
contribution; governments -- potential source of revenues; the fund's own staff
-- higher income, career growth. Then there are the service providers, the
money managers, the actuaries, the consultants, the lawyers, the accountants,
the custodians, for whom these funds provide a very decent source of income.
Private-sector funds must also consider competing interests. Usually these
interests are just not sitting right there on the board and participating
directly in the decision-making.
We have found that pension boards, once established, have no clear-cut transfer
and selection processes to ensure that their members are experienced,
knowledgeable and fit for fiduciary duties. Usually, appointments are effected
by the stakeholder groups, which could be governments, employers, unions.
Hence, the selection process is heavily influenced by agendas outside the
paradigm of good governance and fiduciary duties. A good case could be made that
a cycle of weak boards begetting weaker boards and even weaker executive staff
may set in, due to the nature of the defined benefit plans, and the public
purse will suffer.
In light of the above issues, the governance practices, at least in our view, of
large public-sector pensions should be examined with the purpose of building
guidelines for improvements. Here are some questions to consider.
How can we ensure that accountability exists? The board may fail to effectively
govern and the general taxpaying public is penalized through increased taxes.
Governments at least must be elected periodically. Pension boards -- one can
say this with some trepidation -- are not really accountable to anyone, once
they are set in.
How can boards ensure that a significant number of their members have the
necessary scope, experience, knowledge and, essentially, the time to oversee
the complex operations involved, which would include investments management,
information systems, administration, communications, risk management, et
What are the mechanisms in place and what kind of mechanisms can one put in
place to keep constituency pressure from dominating fiduciary considerations?
Given that the boards appoint the chief executive officer of a pension fund and
that board members are appointed by their constituencies, how can the
independence of the CEO be maintained in dealing with constituency pressures?
Where is the clear delineation of duties between board and executive staff? How
can we ensure that boards are not micro-managing the business?
What are the measures of success of a public-sector pension plan and fund? What
mechanisms are in place to ensure that pension funds follow the best governance
practices -- which are dubious because who knows what the best practices are?
How do boards ensure that, as an entity, they possess and will continue to
possess direct knowledge and information for discharging their fiduciary
Mr. Keith P. Ambachtsheer, President of Keith P. Ambachtsheer & Associates
Inc.: Honourable senators, I also have no poem with which to begin. In a moment
of reflection, my chosen word would be "convergence." I testified to
the House of Commons Finance Committee yesterday morning on Bill C-2. The
session yesterday morning specifically focused on the CPP Investment Board.
I have taken the liberty of simply changing the name at the top of my
presentation; essentially, the words are the same. I do that partly as a
manifestation of the thought that we do live in a world of convergence and some
of these issues are coming together in interesting ways with the general topic
of governance and the specific meaty issues in front of the House of Commons.
I have been involved in advising large pension systems around the world on
issues of governance, finance and investments for some 20 years now. One of my
more interesting experiences over the years was to work with the CPP Working
Committee on Investment Policy to put together some thoughts on the structure
of the CPP Investment Board.
It is in that context that I will share some opening thoughts with you and we
will see where it takes us.
Just as the three things which matter most in real estate are "location,
location, location," so the three things which matter most in the
management of large retirement systems are "governance, governance,
Second, this is no longer just an opinion. A major study which we have just
completed involved 79 major U.S. and Canadian pension funds and one Dutch
pension fund. We were able to find a statistically significant link between
organizational performance and organizational design. Interestingly, and more
specifically, we found the most important driver of organizational performance,
based on a standardized metric over the last few years, to be the quality of the
board of governing fiduciaries.
As additional background, this study was sponsored by eight major pension funds
around the world, two of which were Canadian -- OMERS and the Ontario Teachers'
Federation. There were three large U.S. retirement systems -- CALPERS, as
mentioned by Professor MacIntosh, Wisconsin and Florida. There were two major
U.S. corporate funds, AT&T and IBM; and finally, the big Dutch civil
service pension fund. The aggregate value of these eight funds is over $500
billion. We can talk more about the analysis later if you would like to pursue
This very new research actually has not yet been published. One of the
businesses with which I am involved develops these standardized metrics with
respect to organizational performance. That is much more difficult to do,
generally, in the publicly traded corporate world.
They are still struggling with a measure called EVA, something which does
develop a standardized metric economic value added. A firm with which I am
associated developed a measure called RANVAD, risk adjusted net value added,
and the organizational performance measure of which I spoke is that particular
Before this research, we had already established that there was a statistically
significant relationship between pension fund performance and size -- assets
under management. That relationship was positive. In other words, we find that,
on average, bigger pension funds have better performance than smaller pension
funds. Therein lies an important dimension we should all keep in mind. Obviously
the question is: Why should this be so?
One direct answer is simply economies of scale. The fund management business is
a business where economies of scale are tremendously important. You can
visualize that. As the assets increase, the costs of management do not increase
at the same rate. Unit costs decrease significantly for large funds.
Another factor which may not be quite as obvious relates to the ability of large
pension funds to organize themselves as businesses, complete with boards of
governing fiduciaries and expert management teams which are given clear
mandates as to how to run the business and what kind of goals to achieve. They
in turn can hire a staff that is expert in their respective fields and can carry
out their responsibility.
A subtle idea in this institutional investing business is the question that was
actually the name of a report which came out of the Ontario public sector task
force in 1987 titled In Whose Interest? A tremendously important thing to keep
in mind with respect to retirement systems is that they need governance
mechanisms where there is a clear mandate to act in the best interest of the
stakeholders of that retirement system as opposed to the interest of various
kinds of suppliers, the investment dealers, and the investment management
community, all of which are anxious to offer services to retirement systems. It
is tremendously important to create what economists would call informational
symmetry between buyers and sellers. You need buyers that have the same amount
of knowledge about their business and how financial markets work as do the
sellers. That is the more subtle reason why we find that larger pension funds
have better organizational performance than smaller pension funds.
The organizational design quality factor and the size factor are obviously
highly material for the CPP Investment Board, which will become a large
institutional investor within six or seven years. The latest number I have seen
is somewhere between $75 billion to $100 billion in terms of assets, which does
not make it any larger than Caisse de dépôt et placement du Québec
or Ontario Teachers', which is currently at $50 billion. It is of that order of
magnitude. You cannot think about the system strictly in domestic terms. You
must think about the system in a global context, where pension funds of $50
billion to $100 billion are not at all uncommon.
The other point I would make is that this is now a green light on moving ahead
with the public service retirement system in Ottawa, which has been basically
managed on a cash-flow basis where the net positive cash-flow purchases
non-marketable, government debentures which then accumulate. That whole system
is now in the process of reorganizing itself as yet another major stand-alone
retirement system, with details to follow -- they have not been worked out.
That is another $60-billion system which is potentially not that far away from
playing a market-type role in our financial markets.
To develop a language about the different kinds of players involved with pension
funds, there are governing fiduciaries, which are effectively the board. There
are managing fiduciaries, which are generally the people accountable for
managing the business; and then there are operating fiduciaries, people to whom
individual tasks have been delegated.
The point that I would make -- and this is certainly relevant with respect to
the CPP Investment Board which is in the process of being formulated -- is that
how well that system performs will be largely determined by the quality of the
12 appointed people, with the delegated power to create a management structure
to create a vision for that organization and to report out to Canadians as to
how well that system is performing.
The final point that I would make -- and people who know me know that I do not
miss any chance to make this point. I saw this 10 years ago, but most people
now recognize that we live in a global world with global financial markets.
With the 20-per-cent rule, trying to manage the proportion of assets that
Canadian funds must keep investing in Canada is becoming increasingly
inappropriate. This is a good forum to place that view. I believe -- and
hopefully Mr. Martin will agree -- that we must be close to letting that rule
go so that Canadian pension funds do not operate under any handicap. We live in
a global world, and we must accept that reality.
The Chairman: Thank you very much.
I wish to ask the first question. You have talked about institutional investors
and pension funds and the difference between public- and private-sector
financial pension funds. There are many individual Canadians who are investing
their own money in the market, either through mutual funds or on their own.
Should those individual investors care about the outcome of this kind of study
or the governance of institutional investors, or should the only people who
really care about this be people who run major corporations in which funds are
invested and the institutional investors themselves?
Mr. Ambachtsheer: I was involved in the creation -- and it was just released
last Thursday -- of a paper by ACPM, the Association of Canadian Pension
Management, which looks at Canada's national retirement income system as a
whole. It talks about three pillars: minimum income support; CPP/QPP; and the
voluntary sector, which then divides into employment-based pension plans and a
whole myriad of RRSP-based investing opportunities that are group RRSPs or in
many cases individuals investing into the financial market through the mutual
We point out in this paper that we should all have a concern about the current
system relating to this idea of unbalanced information between buyers and
sellers. An interesting statistic was published a few weeks ago in a Canadian
business magazine. A survey was done whereby 2,000 Canadians were asked whether
they knew what level of mutual fund fees they were paying. An astounding 45 per
cent of them did not know they were paying any fees at all. We argue in this
ACPN paper that is a major informational problem, because while the markets
earn 20 per cent per year, you can pay 2 per cent in fees and it does not
matter very much. However, in the future world, when we look realistically at
single digits, 7 or 8 per cent in the long term, nominal returns, the rule in
pension economics is that for every 1 per cent of return you give up, you loose
20 per cent of your final pension. Consider a 2 per cent fee versus that of the
Ontario Teachers' Federation which runs at one-tenth of 1 per cent. The
differential in fees is huge, and that is just not generally known. That factor
is important in terms of understanding the third pillar and the economics of
Mr. MacIntosh: My comment is of a slightly different nature.
Institutional investors play a vital role, as I have suggested, in making sure
that corporate managers manage in a disciplined kind of way. That benefits not
only institutional investors but also small, retail investors, especially as
markets become more efficient and it becomes much more difficult for a small,
retail investor, or indeed institutional investors, to beat the market on the
basis of information they might find in the newspaper in the morning.
Institutional investors protect not only their interests but also the interests
of other investors who, if you will, are free riders, in the sense that if
corporations are generally better run in our economy, then all investors will
benefit from that.
In addition, institutional investors now do the bulk of the trading in Canadian
The pricing efficiency of the portion of the market in which you find active
institutional investors is a lot greater than the pricing efficiency in that
segment of the market in which you find only retail investors.
Here is another case in which retail traders are, in a sense, free riders. That
is, institutional investors, by virtue of protecting their own interests and
engaging in a lot of trading and making sure that stock prices reflect all
currently publicly available information, are doing a favour to anyone who
trades in the securities markets.
Mr. Por: I want to add to what Mr. Ambachtsheer said. If, for whatever reason,
these large public-sector public pension funds do not perform as well as they
could or should, the tax-paying public will have to cough up the money because
the actual benefits are defined. That is the nature of defined benefit pension
plans. It is not only the private-sector investor who should be eagerly looking
at this issue. All of us who are, one way or another, taxpayers in this country
should be looking at it because we must pay the price of the difference.
Senator Kolber: First, I, too, am a fan of Dr. Seuss and I enjoyed what you
On the question of confidentiality, are you talking about when you send in your
Mr. MacIntosh: The idea that lies behind confidential voting is that management
at no time gets to see how people are voting; management never gets to see the
proxies. Most voting is, of course, done by proxy. My understanding now is that
managements are able to figure out who votes in which way.
If we design mechanisms to prevent them from doing that and protect the
confidentiality of institutions or other investors voting one way or another,
then that might make some inroads into this problem of conflicts of interest.
Senator Kolber: I do not see how you can do that, but that is an idea.
There seems to be a wide range of subjects that we are talking about here.
First, there is the question of institutional investors vis-à-vis
corporations. How does that manifest itself in any sort of legislation or
regulating body? Why should an institutional investor be treated differently
from any other shareholder who wants to make himself heard? I do not quite
understand what we are getting at here.
Mr. MacIntosh: I was not arguing that institutional investors should be treated
differently. In talking, for example, about the shape of the proxy rules, the
argument is that the proxy rules ought to be crafted in such a way as to make
informal communications between investors feasible without having to go through
the whole apparatus of putting together a distance proxy circular, and so on. I
would certainly extend that to any other shareholder. I was not trying to
distinguish between institutional and other shareholders.
Senator Kolber: From a governmental point of view, what would you do that is not
Mr. MacIntosh: Perhaps I should give you a copy of a paper that I wrote and
brought with me. It examines the various legal aspects -- both provincial and
federal -- that impinge on the activities of institutions that want to get
involved in corporate governance. There are approximately 10 or 15 different
legal dimensions to the problem. I talked today only about three of them.
There are various legal barriers that tend to have an impact on the activity of
institutions getting involved in corporate governance, such as the proxy rules
or the insider-trading rules. I do not want to launch into a long discussion of
all those problems but perhaps I should give the committee a copy of this
Senator Kolber: I was fascinated that you brought up the question of the
efficacy of large pension funds as opposed to small pension funds.
I have been involved in my lifetime with some large pension funds, such as
Dupont, Seagram, TD Bank, and so on, and they are all run in different ways. I
am not sure we could do anything about it. The problem with small pension funds
is they just cannot afford to hire the best managers as in-house managers.
When you look at the great successes of running money, they have been by the
people who have given them out to managers. I think the idea that a pension
fund has to have its own staff all the time is probably wrong.
Mr. Ambachtsheer: If you look at the issue from an organizational design point
of view, I think it is a reasonable proposition to say that any business that
is going to operate to achieve certain goals needs to have proper governance
and an organizational design structure to achieve those goals.
By the way, my cut-off point between large and small is at about $1 billion. To
me, anything below $1 billion is small. The reason I say that is, as per your
point, below that number it becomes difficult to support the economic
proposition that that smaller fund has a management team dedicated to achieving
positive risk adjusted net value added in the kind of financial markets in which
they must operate. There is a long-standing rule in game theory which states
that you do not play games you cannot win. I would argue that most funds under
$1 billion should follow the passive management route.
Senator Kolber: I wish to ask you a question on fees. You said that the Ontario
Teachers' pension fund only pays one-tenth of 1 per cent in fees.
Mr. Por: It is the cost, not necessarily the fees.
Mr. Ambachtsheer: It is the all-in costs. Their money is managed 90 per cent
internally and 10 per cent externally. When I quote 10 basis points, it is the
aggregation of all of the costs, both internal and external.
The Chairman: That is not trading costs. That is operating costs of the fund
itself. Salary is an overhead.
Mr. Ambachtsheer: That is right. The risk adjusted net value added metric would
be net of transaction costs, and the fees and internal costs would be specified
Senator Kolber: The last point I want to make is a hearty endorsement of your
globalization theory. I think this 20-per-cent rule is idiotic. It is
absolutely imperative that it be changed. I do not know how a plan such as CPP,
with $100 billion worth of assets, can be run if it is restricted to the
Canadian market. It will compound our problems. I hope the committee will see
fit to advise the government that this is something that should be rectified.
The Chairman: For the record, I should point out that at least twice in the last
four or five years, including about one year ago, this committee unanimously
urged the government to get rid of the 20-per-cent rule, for the same reasons
that Senator Kolber has just mentioned.
Mr. MacIntosh: I would like to support Senator Kolber's point. Canada is about 3
per cent of the world financial market. Many Canadians do not understand that
by forcing Canadian pension funds to invest in Canada, we are forcing people
who have pensions to receive a sub-optimal risk-return trade-off. Clearly, you
can enhance your risk-return trade-off by buying into financial markets. If
many Canadians realized that, there would be more pressure on the government to
get rid of the 20-per-cent limit.
Senator Angus: Welcome to the committee and thank you for setting the stage for
what I think is already becoming an interesting discussion.
For some time, we have been faced with these challenges about corporate
governance. Your poetry at the outset was interesting because our challenge is
to watch the clock-watching clock watchers, and it is not always easy. The
study which this committee did on corporate governance focused on the basic
governance rules of Canadian public corporations. Therefore, my question is
fairly elementary, and I should like to have any one or all of you elaborate on
Professor MacIntosh, you seem to be saying that the governance of publicly
traded Canadian corporations can be enhanced by the role of institutional
investors, if you will, whereas in our earlier deliberations we heard that this
was rather a difficult area. I submit that it is the smaller retail investor,
perhaps, who needs the protection more than the big boys, since he is often
disadvantaged. That can be by privileged information, the innuendo of briefings
that go on, similar to briefings that go on with analysts which are, perhaps,
more intimate, or lunch with the president of the institution or the CEO of the
We decided to have this fact-finding study to see what kind of governance the
institutions themselves should have, given that there seemed to be a
difference. You all seem to agree that there is need for some strong governance
rules for institutional investors. Could you delineate the differences, if there
are any in your minds, between the institutional investor and the publicly
Mr. Por: I tried to highlight some of these differences in my opening remarks. I
see two or three major differences, which is why I have come to believe, after
five years of haggling, that, quite frankly, corporate governance may not be as
big an issue as people, including myself, originally thought in the late 1980s
and early 1990s. First, to a fairly large degree, we can read every day in the
newspapers about how bad a company is doing. Therefore, eventually, after three
to five years, the directors, whether they like it or not -- and usually they
do not -- are forced to do something because the results are not sufficient.
If something happens, we know about it fast. However, with a large public-sector
pension fund, on which I am concentrating my efforts, you can go on for years
without actually knowing how it is doing. One of the ongoing debates in the
industry is that something can be set up and start to work and you will not
know before 15 or 20 years whether or not it is working out. And that is the
other problem -- namely, that public-sector pension funds are not working in
what we would call a market economy, per se. Therefore, one has to find
measures -- and Mr. Ambachtsheer is working on this diligently -- we can use in
lieu of the market which will tell us what is going on.
Third, in terms of publicly traded corporations, the rules for selecting
directors are reasonably clear. There are generally accepted criteria with
regard to who should serve as a director. We can get into a lot of arguments,
which happened in the last couple of years, concerning who should serve as
directors. There is a reasonable consensus that these are the people we should
In the public-sector pension funds, we came up with the notion that good
governance is such that we invite the people who are affected by these
decisions. These people could be employer groups, from the government, union
groups, et cetera. From there on, there is no mechanism to pick these people,
other than a very political process. I must suggest that in Canada we have less
of a problem than in the U.S. My company worked with one of the largest U.S.
pension funds. It is even worse there.
Once the governance process is not working, there is nothing much to date that
you can do. We asked the question: If you feel that your representative on
these boards is not doing the job well, or another representative of another
constituency group is not doing the job well, then what can you do? The answer
is: Practically nothing.
The selection of board members, the definition of what kind of knowledge should
be there and non-performance identification, which is almost non-existent in
large public-sector pension funds, are factors to be considered. It is a very
different kind of environment in which to make governance decisions.
Mr. MacIntosh: I agree with everything that my friend John Por has said.
However, I should like to put it in legal-academic terms.
The current thinking about corporations is that there are a variety of market
and legal controls which constrain managers. Typically, we talk about four
different kinds of market controls. I mentioned one, which is the hostile
takeover. You cannot have that in a pension fund.
You also talked about the constraints put in place by the product market. That
is, corporations sell products; if the product fails, the corporation fails and
the managers are out of work. Again, that is not in place with a pension fund.
We talked about a market for managers in which managers compete for jobs either
within the corporation or outside the corporation. That market does not really
work in the case of pension funds.
Finally, corporations are subject to a cost of capital every time they go into a
capital market. Again, pension funds are not.
You basically take away those four market controls. You then look at the legal
side and ask: What are the controls on the legal side? There are fiduciary
duties and duties of care and skill. If you look at the pension benefits
legislation in Ontario, you will find that there are these duties that apply to
trustees, just as they apply to corporate fiduciaries. However, the question
here is: Who will bell the cat?
In the context of the corporation, you may have an institution with a large
stake which is willing, if push comes to shove, to sue management.
Beneficiaries of pension funds simply do not have the same incentive. Each
beneficiary has a small interest. It becomes a question of who will pay the
costs of the action, which may be considerable. On paper, the duties look very
much the same, but they do not mean the same thing in terms of enforcement.
Finally, there is the question of oversight. In direct oversight in a
corporation, shareholders elect directors. Mr. Por mentioned in the context of
pension funds that that does not happen.
If you look at the whole array of controls that exist to discipline corporate
managers, you take away almost all of them in the case of pension funds. That
is why I say that pension fund governance is a much more difficult problem than
Senator Angus: First, I thank you both for those answers. What I understand you
to be saying is that there are inherent checks and balances which naturally
pertain to public companies trading on the stock exchange. Therefore, the need
for some stricter accountability and controls on the institutional investor is
I am assuming you more or less agree with that summary. If you do not agree,
then I hope you will say so.
Largely, you have confined your comments to the pension funds, be they private
or public. I am left wondering about investment counsellors. Do you consider
them to be institutional investors? Small mutual funds, some open-ended and
some closed, seem not to be interested at all in even discussing this subject.
Could you comment on that, please? As far as I can see, there are no laws which
Mr. Ambachtsheer: My friends in Australia use the word "contestability"
in relation to this aspect. The whole notion of contestability is where you
have fairly natural monopolies, in the sense that if you have a retirement
system that covers these 200,000 members, it is not like you can start a
competing one and get a market kind of outcome. However, you can do some things,
such as the notion of how transparency can be simulated and motivation
incentives can be created, so that similar outcomes are achieved as in a market
kind of environment.
The key to success is benchmarking. Metrics must be developed which truly
represent the kinds of outcomes that the stakeholders would value. That is
where one must start. If one has no metrics to measure whether the system is
doing what it is supposed to be doing, one has nothing.
The interesting thing about the institutional investing field is that there is a
tremendous amount of data produced in this field, and that as such, there is an
interesting hierarchy that we should remind ourselves of which is that data
should become information, should become knowledge, should become wisdom. The
challenge in the area of pension funds, the institutional investing area,
generally, is exactly that; namely, to turn lots of data into information that
truly informs and then creates knowledge about how to do things better.
That process has begun and it needs to continue. There is a long way to go.
There is no other answer other than to create contestability for these systems
and to simulate some of these disciplines in this area which do not naturally
occur because they need to be different from the ones that exist in publicly
traded corporations. I believe we can do that.
Senator Kolber: Could we get an example of that?
Senator Angus: Is it possible to have a specific example of your last point on
benchmarking and setting up a performance-based hedge or hurdle?
Mr. Ambachtsheer: Let us take a defined benefit pension plan. The idea is that
its members are promised a benefit. At any particular point in time, the
accrued obligations can be estimated. In other words, on the debt side of that
balance sheet, if we put a present value on these future promises, it is, for
example, $10 million using today's market rates.
The question on the asset side of that balance sheet is: "If you have $10
billion worth of assets, how do you invest the assets?" You have a couple
of basic choices. One is that you can make the assets look as much as you can
like the liabilities -- the same duration, the inflation sensitivity, and make
them government guaranteed. Then you have what is technically known as an
immunized balance sheet.
Senator Angus: Is that like a conservative portfolio?
Mr. Ambachtsheer: Exactly. The business of a pension fund is basically to manage
that balance sheet. In that sense, it is not much different than any other
business, insurance company or bank that is also trying to manage a balance
sheet. The choices are the same. You can try to minimize risk on the balance
sheet, but the problem is that that outcome is costly because if you can earn an
extra 1 or 2 per cent on the assets, it reduces the cost of the pensions. One
can put equity risk on the balance sheet. A typical ratio for pension funds is
60/40 equity debt. That is done to assume that you can earn an equity risk
premium which then reduces the cost of the pensions. There is an asset-mixed
policy decision. It is a fundamental decision that needs to be monitored.
The other kind of decision is how you implement your asset-mixed policy. You
could do it passively, through an index passive-type program. Or you can do it
more actively and take what is called active management risk, which is
basically to participate in the market, to try to earn additional return,
usually at additional cost and additional risk.
If those are the key decisions that are made, you need to measure the outcome of
Senator Angus: You need to find a fairly foolproof way to monitor the situation;
is that correct?
Mr. Ambachtsheer: The impact of the asset-mixed policy decision and the impact
of the implementation strategy is what you must measure.
Mr. Por: There is one thing I should like to add to our previous comments. We
may have said that there is an impending disaster and that unless we do
something radical... That is not the case. That is the first point.
We are not facing an impending crisis in the management or governance of large
public-sector pension funds. We face a future whereby these public-sector
pension funds will grow and grow. Eventually, according to our calculations --
even now, they own 50 per cent of the outstanding shares of the largest
corporations. They did not know, and the corporations did not know, what to do
with that power.
Mr. Ambachtsheer is describing metrics which are available and are continually
being refined. Unfortunately -- and I have been working with groups of
decision-makers like boards -- this debate is between corporate financial
experts, theorists, whatever, and it is a very slow process whereby we could
get the boards to actually accept these metrics. Some of them accept these
metrics more readily than others.
We find, in working with boards, that in order to follow these metrics, board
members must give up significant individual power and they are unwilling to do
We are working on a pension fund in California, and we are looking at these
metrics. It is easy to say: "We are screwing up. Why do not just do
something else; we will not get involved." That is not a realistic answer.
Your task is to find a method -- you have the metrics, which are developed, and
the financial theory, which is emerging reasonably clearly -- and get the
boards to act upon this wisdom and commit themselves to a learning curve. I am
referring to existing boards.
Senator Angus: I wanted to get an answer on my point on investment counsellors
because they have so much power.
Senator Kolber: The idea about the omnipotence of a board of directors always
comes through to me. As a director of large corporations for about 25 years, I
feel that boards of directors, in large corporations, anyhow, are fairly
Mr. Por: That would be a sad commentary of how our system works.
Senator Kolber: I should like to hear from you learned gentlemen, because it
seems to be the crux of everything you are talking about. It is something that
we have not come close to solving.
In the final analysis, the mandate of a board of directors of a large
corporation is nothing more than hiring or firing the CEO. If you could
convince me it is more, then I will feel enlightened, believe me.
Mr. MacIntosh: Your question goes back to the Berle and Means theory of 1932
which is that the management of public corporations were, in fact,
self-perpetuating entities because shareholders either threw the proxy material
in the garbage or just endorsed management's nominees.
That view stood unchallenged for about 50 years.
Senator Kolber: We are now at 1982.
Mr. MacIntosh: About that time, or a little later, institutional investors
started to become active and financial markets started to get a bit more
efficient. Scholars were beginning to wake up to the view that there were these
other controls on managerial behaviour that we talked about before.
Nonetheless, many corporate scholars have suggested that outside directors,
independent directors, who are supposed to play an important oversight role,
are very often not terribly independent because they have been historically
nominated by the CEO. They have office at the pleasure of the CEO. If they
disagree or ask difficult questions, they will not stand for election next time
There are many who would take a sceptical view of what a board of a large public
corporation is capable of doing.
On the other hand, with enhanced oversight from investors, like institutional
investors, in particular, we are getting more oversight than was ever the case
before. Hence, large boards of public corporations are better policed, perhaps
not well-policed at this point in time, but better policed than they once were.
Mr. Ambachtsheer: If I can relate back to the study of 80 pension funds, the
organizational design was based on CEO or equivalent ratings in the pension
fund about certain statements. One that correlated most highly with
organizational performance was the clarity of the delegation between the board
role and the management role. This is directly related to what Mr. Por was
In a lot of pension funds, you get micro-management at the board level where
clarity requires delegation to a CEO. They might say, "Now that we are
clear about the mission, the vision and what we are attempting to achieve, just
do it." There is a lot of fuzziness in many pension funds about what
management decisions are effectively being made by committees. That is not an
effective way to manage a business, and it shows up in the results.
Mr. Por: If we believe that the board's role is only to wait five, six or ten
years until the CEO proves to be incompetent to run a corporation, then the
board's role of replacing the CEO or not is a blunt instrument. By the time you
do that, unfortunately, the value-added component of that corporation is lost.
Boards follow a number of rules today. First, they must accept a strategic plan
developed by the management team. It is up to the board to decide to what
degree they want to get into the details of that plan and whether it makes
They cannot avoid dealing with institutional investor pressures because these
people are sitting in large public-sector and non-public-sector pension funds
-- money managers aside -- analyzing the hell out of companies. They must
respond to that.
If a board of directors wishes to take its role seriously, it could do so, but
it requires a different mindset, which is developing. If we had had this
conversation in 1991, it would have been in a completely different context.
Most of the directors I know are seriously considering what their role and
responsibilities should be, who they are, and what they should do about it. In
the late 1980s, I do not think this question was ever asked.
Being the member of a board of directors is an onerous task. It will take 15
years to develop how these practices will actually affect the governance of
these corporations. There is no question that these forces are in place.
In the North American system, where capitalism, capital markets and freedom of
the press are much stronger than in Europe, these issues are coming to the
forefront much earlier. In Germany, strong representation from boards came
about in 1936-37 when freedom of the press and capital markets were not as
strong as they are today in the U.S. Therefore, they had to create an effective
instrument, which was the supervisory board.
Senator Angus: Perhaps I can get to the point I am seeking in another way with
respect to investment counsellors, mutual funds and other institutional
investors, besides the big public pension funds you are concentrating on.
The manager of the CN pension fund appeared before us about one-and-a-half years
ago. He listed, in descending order, approximately 14 or 15 cardinal points
that he watches for amongst the management or the governance of a publicly
traded company. A threshold of alarm bells ring for him. Could you suggest a
similar list of points that an investor should watch out for, in terms of
institutional investors? Where are the soft spots and the warning bells starting
to ring? Again, I focus more on the investment counsellor and the mutual fund
where you see widows and estates. Maybe the original benefactor is a
sophisticated investor, but the widow, or the family, is left with these large
pools of capital. They fall into the hands of these individuals. They are not in
a position to know. One of our missions here is to delineate a list of signals.
Mr. Ambachtsheer: The key thing that I would look for in hiring a third party or
outside investment counsellor would be the alignment of economic interests.
With respect to large public funds, they are directly accountable to a set of
stakeholders. They are looking after their interests.
Once you go to a third party, whether it is investment counselling or most of
the mutual funds, there is an interesting dichotomy of economic interest, in
the sense that these businesses are owned by other people who are trying to
maximize their own bottom lines. They are in the business of running that
business, and they are looking at revenues, less costs, equalling their profits.
There is a question as to whether there is a clarity of economic interest
between serving the customers well and how they enhance their own bottom lines.
In theory, the market should work these things out. But unfortunately, this is
an area of great informational asymmetry where the sellers know a lot more
about the nature of the product and what the services are than the buyers
generally. Economics tell us that when you have informational asymmetry,
generally the outcome is low-quality products at too high a price. That is one
of the challenges -- namely, how do you deal with great informational asymmetry
typically between the buyers of investment management services and the sellers
of investment? I do not have an obvious answer to that, other than raising the
general level of clarity about what the product is producing and a level of
understanding of capital market efficiency. We have a high degree of
informational efficiency, and chasing these money managers to do better is very
Mr. Por: One thing people tend to forget, even corporate clients who are CFOs
and treasurers, is that the pension fund business is completely different than
the mutual fund business, or money managers for that matter. Money managers are
there to manage money and attract further money in order to enhance their fees.
That is their business. Pension funds are there to fund reasonably
understandable promises in the long term. They could elect to be conservative
and immunize the portfolio, or they could mismatch their portfolios according
to their abilities. At the end of the day, mutual funds or money managers will
always try to attract more money.
How do they do that? They never emphasize the money you have to pay for the
service. They always emphasize short-term results. You never see, for example,
that over the last 15 years they have beaten the TSE by 15 basis points. That
information is not sexy.
At the end of the day, the answer is a thorough education. I am always surprised
by how little these facts are known by people in corporate finance and by the
general public. Unfortunately, this is not a good story. Whenever you read an
article about mutual fund performance, you are always dealing with the stars
and the dogs. You are never dealing with the efficiency of the markets and the
fact that it is horrendously difficult to beat them.
In my view, even the media has a lot of catching up to do. They are misleading
the public, telling them they should look for the stars to get them to Nirvana.
Senator Angus: It is too late when you get to that.
Mr. MacIntosh: I agree absolutely.
If I were a beneficiary of a pension fund, or investing money in the market in
any capacity, I would want the people investing my money to know a few basic
things about capital markets. One is that Canadian capital markets are pretty
much efficient, at least in the larger firms that institutions tend to invest
in if not in the small-firm sector, and that means that it is very difficult to
beat the market on the basis of fundamental information; that is, reading
articles in the newspaper and looking at balance sheets and income statements.
It is very tough because in an efficient market public prices reflect all
publicly available information.
That is very important datum reflecting on the value of active management.
Active management, as Mr. Ambachtsheer said earlier, seeks to sell over-valued
stocks and buy undervalued stocks. There is a tremendous amount of evidence
that that is very tough to do. I would want someone investing my money to
understand these basics about efficient markets.
Also important is the value of portfolio diversification. It sounds trite, but
economists will tell you that your best risk-return trade-off is achieved when
you buy something called the market portfolio, which is all financial assets
that are available in the proportion that their value bears to the total value
of the whole market. You want a wide range of asset classes to achieve this best
risk-return trade-off. I am not sure that many retail investors know as much
about diversification as they ought to.
Finally, indexing strategies, whether you are a retail investor or an
institutional investor, are extremely low-cost and very effective strategies.
You cannot underperform the market. You will never outperform it, but you have
a very low-cost strategy. If you buy an index like the TSE 300, away you go. It
does not matter how big or small the fund is. It a very low-cost and effective
way to go.
Senator Austin: I should like to thank you, Mr. Chairman, for organizing a
fascinating morning with remarkable expertise.
I have a number of questions scattered around the topic. First, I should like to
go to the question of the 20-per-cent limitation. What was the original public
policy, as you understood it, that imposed the original limitation which became
20 per cent?
Mr. Ambachtsheer: The earliest evidence that I was able to find was from a
gentlemen called Edgar Benson in a 1971 budget. At that time, it was the
10-per-cent rule. Some of us spent many years labouring to get it from 10 per
cent to 20 per cent.
The original motivation was a perception that Canada was a huge capital
importer, that we had not a very good and sturdy financial infrastructure in
this country and, therefore, protection was required. The way the story is told
is that pension funds and investors are getting this tax break and therefore
they ought to put something back. They invest in Canada, which creates jobs, et
cetera. That is the myth you are dealing with.
Senator Austin: What is the reality today as you see it?
Mr. Ambachtsheer: Whether you buy this capital-importing argument or not, it is
certainly gone. If you look at capital flows today, you see huge flows going
out and coming in. It is not an issue any more. A huge change is the fiscal
position of the federal and provincial governments. Five years ago, it could be
said that we had to borrow $50 billion every year. That is not true any more.
If you look at the relative prices of the Canada 30-year bond and the 30-year
Treasury bond, you will see that the yield on the Canadian bond is now lower
than on the U.S. bond. Whatever conditions may have existed in the past, they
The real shame in this process is that, in the last 20 years, we have missed
building a significant, material international investment capability in Canada.
It has not been in the interests of our financial investment community to staff
up the very expensive process of investing internationally, with the result,
today, that much of the Canadian pension fund money is being managed out of
London, Hong Kong, Tokyo and New York rather than out of Montreal, Toronto and
Mr. MacIntosh: It is worthwhile to point out that to some extent the 20-per-cent
rule can be circumvented by constructing so-called synthetic portfolios using
derivatives. I am sure you are aware of that, but that takes a certain amount
of expertise and not every small fund will have that expertise. It is probably
more effective just to do away with the rule.
Senator Austin: We certainly have today a North American money market. In the
days when Mr. Benson introduced his budget, there was a separate Canadian
capital market. I was sure that that was your answer and I am persuaded that it
is the right answer.
If we lift the ceiling, is it your view that it should be lifted gradually, to
allow a learning curve, or should we simply drop it totally? If we did that,
what would be the consequences?
Mr. Ambachtsheer: I think we could let it go tomorrow with no observable
consequences in terms of currency changes.
More realistically, when we campaigned to get the 10 per cent ceiling moved to
20 per cent, we said that just in case there was some short-term movement it
should be done in 2 percentage point steps. Our mistake was to say to go from
10 per cent to 20 per cent. Now the recommendation is to go from 20 per cent to
30 per cent and then let it go.
In those economies where there are no restrictions, the U.K. for example, 30 per
cent foreign exposure seems to be a natural resting point. In all investment
situations there is a natural home country bias related to information. It is
not like the natural position will be 2 per cent Canadian, 98 per cent outside.
We believe the natural resting point -- and we have checked this with pension
funds -- would be about 70 per cent domestic and 30 per cent internal. However,
individual funds could have different proportions. We believe the fiduciaries
Senator Austin: You were talking earlier about informational asymmetry. The
further you get from the Canadian base, would you agree, the more asymmetry
will exist for the fund manager?
Mr. Ambachtsheer: There are two kinds of asymmetry. There is potentially
asymmetry among professionals, but there is also asymmetry within a market
between professionals and non-professionals. There are the two phenomena. That
is an interesting question. I think it relates a lot to what segment of the
market you are investing in.
For example, the broadly traded major bond markets have become very integrated.
It is almost treated like one bond market with different currencies. There is
convergence toward major multinational publicly traded corporations being
treated as one. It is sometimes hard to tell whether IBM is a U.S. company or a
global one. There is that segment of the market, and then there is the smaller,
more local segment which naturally will be informationally more efficient for
Senator Austin: I am seeing, whether correctly or not, that in the developing
countries -- China being one example, but there are others -- there are
enormous numbers of new equities being offered to the international market on
the basis of factual patterns that are perhaps less full in their disclosure
than we have become used to.
Do you think the market can address that issue or do you believe that there
should be some constraints established by standards, either government or
Mr. Ambachtsheer: Again you are into the challenge of creating knowledgeable and
powerful institutional investors that understand the concept of due diligence.
As long as there is bottom line accountability for producing results, it is
natural that at the top of the list of the people who have the designated
responsibility for investing in developing markets would be due diligence.
Mr. MacIntosh: Senator, I would certainly agree with Mr. Ambachtsheer. I would
add that there is more informational asymmetry when you go into a smaller
developing market and that returns to outside investors are not the same as
they are to local investors.
To some extent, the problem is taking care of itself in that many of these
developing countries are cognizant of the fact that, in order to continue to
attract capital, they must raise their legal standards. If people go into those
markets and they do not do well, then they simply withdraw their capital.
One of the more interesting developments in international securities regulation
around the world in the last 10 years is a tremendous raising of standards in
many of these less-well-developed markets. For example, we have seen the
implementation of insider trading laws. Many of these markets did not have
those laws. Basic disclosure laws and adoption of accounting conventions will
also tend to reduce the informational asymmetries. I do not think they will
ever entirely disappear, but I agree that we should leave it up to
sophisticated institutions to choose the markets where they will put their
Senator Austin: We have seen, however, a tremendous volatility in third-world
markets. We have seen tremendous losses taken by funds managed astutely by
investment managers but, nonetheless, enormous losses in third-world funds. How
does the market explain, after all this diligence, why these losses have been
Mr. Por: I am perhaps the only person in this room who actually grew up in a
country where government always tried to protect its citizens from the vagaries
of capitalism and the market, which actually was good for Canada because
eventually I got sick of this.
Investors are grown-ups. Unfortunately, governments with laws and guidelines
cannot protect them from doing certain things. How do markets actually work?
Markets look at information and draw certain conclusions in a certain way and
try to react. Sometimes there are over-reactions. Eventually, the results will
show that overreaction. That is why volatility is permanent. We do not really
know the right price of an equity or the right price of a country's equity
Senator Austin: So something is wrong with our due diligence process?
Mr. Por: No. This is the nature of the market. There is a famous fiduciary case
which is always quoted. Most of you are lawyers so I am on thin ice here. In
1836 or 1837, the Harvard case said: Do what you may, but capital is a hazard.
Surely, you invest in these markets to a certain degree. An institutional
investor may put money into these markets at up to 5 per cent. Even if there is
a major disaster in those markets, because the fund is well diversified, there
is no disaster. People learn to invest in those markets in the same way that
people learn how to invest in capital markets here in Canada.
Senator Austin: That is the price then of learning our way in global flows?
Mr. Ambachtsheer: I will give a venture capital example to address your
question. There is a 2-6-2 rule in venture capital which is widely known.
Everyone knows venture capital investing is risky, so you only do it with a
part of your portfolio. But even within that piece, you go in expecting that, of
ten investments, two will be complete write-offs, six will be "walking
wounded," and two will be big winners.
Senator Austin: Then you will be even as a result.
Mr. Ambachtsheer: In fact, history shows that the Microsofts, if they are among
those two big winners, will carry your walking wounded and your dead.
Mr. Ambachtsheer: There is a risky part of the financial markets. Even though it
is risky, as long as you have generally a movement towards pricing where risk
and reward are reasonably in balance, then just because you know there will be
some write-offs, it does not mean you should not go into that area.
Mr. MacIntosh: It is important to emphasize that a large number of studies show
that international investing actually reduces your risk. The various
international markets are not perfectly correlated. One goes up and one goes
down. If you buy a lot of these different markets, you actually have more
insulation from risk than if you are just holding one domestic market. You are
not putting all your eggs into one domestic basket. You can achieve by
international investing a better risk-return trade-off. You can get rid of some
of that portfolio volatility.
Senator Austin: That was the theory up until a few weeks ago. Now we are seeing
the commonality of market responses because of currency relationships.
I have simply been trying to provoke a discussion. For us, the issue is the
degree to which there is a need for public policy to set criteria. I personally
favour public policy which allows the market and the institutions in the market
to create their own system of checks and balances. The best regulatory system
is found in knowledgeable operators, provided their interests are sufficiently
diverse and provided there is sufficient power in each of the stakeholder
sections to balance the power of other sections.
That brings me to my general question: Are the stakeholders reasonably balanced?
You have spoken about governance questions with respect to boards and with
respect to the public pension management. You have identified those issues.
We had an interesting witness in the corporate governance study by the name of
J. P. Bryant who runs Gulf Oil in Calgary and, to quote him reasonably
accurately, he said that corporate governance is nonesense.
Senator Angus: Actually, he said it is guacamole.
Senator Austin: The point he was making was that you must let the entrepreneurs
be entrepreneurial; you must let the board understand the business; and,
essentially, the investment community should be followers and not governors of
corporate performance. There is a risk here, in his view, that institutional
standards will blunt entrepreneurial performance; that the institutional system
is more interested in the quarterly accounting of revenues and in its own
performance than they are interested in the performance of the capital markets
or business sector.
Mr. Por: This is a very delicate question because you are asking us to comment
on those practices in Canada and the United States which are a source of
revenue at least for me. The spectrum is very wide. There is a wide variety of
excellence out there, as well as the lack thereof.
Generally, no, we as a society did not think this through. It is one thing to
say that a board should be good, impartial, and knowledgeable, but how to
produce such a board is open to question. Unfortunately, that is the story of
In general, there are few well-governed boards. As a society, or even among
academics, we did not agree on what constitutes a good board. The Canadian way
of saying this is that the stakeholder groups should be sitting with their
representatives, and there will be a board process whereby these issues will
play out and the decisions will have a reasonable chance of success.
Unfortunately, that view is sometimes cloudy because the very people who are
sitting there must actually respond to constituency pressures.
For example, if I am a employer representative working for the government as a
middle manager, I have little freedom of decision-making on that board because
I am being told by my bosses what to do and what not to do.
We must consider how to ensure the excellence of that board, which is what the
CPP is facing. One way is to nominate people to sit on that board. You as the
constituency group would not sit on it, and that also holds for governments and
businesses. People are reluctant to implement that policy because they lose
control. My cynical view of human nature is that control is something which we
are reluctant to give up.
However, once there is a good debate concerning what constitutes a good board,
Mr. Ambachtsheer and others will help these people know what they should know.
There is a tremendous amount of courses and information which has either been
developed or is under development, but the notion of what is a good board and
who should sit on it is a carry-on point, in my view.
Mr. MacIntosh: In policing management, a balance must be struck. A degree of
control over management which is too interventionist can be harmful. An
illustration of that is the fact that so many corporations in the United States
have incorporated in Delaware. Back in the 1970s, an SEC commissioner wrote an
influential article about this move to Delaware. About half of the New York
Stock Exchange firms are incorporated there. He noted that the fiduciary
standards that pertain in Delaware are somewhat lower than in the other states.
It is generally agreed that they are. It turned out that when companies move
into Delaware, event studies on share prices show that their prices went up on
average rather than down. One of the reasons appears to be that the extra degree
of managerial freedom is a good thing. The laws in other states are more
constraining than they should be and do not allow enough room for this
entrepreneurial instinct to get out.
On the other hand, institutional investors do not threaten management in the
sense that they are smart enough not to micro-manage. If they were to
micro-manage and look at every little decision and interfere with day-to-day
business decisions, we would conclude that institutional oversight would be a
Institutions tend to be involved in transactions that occur rarely but are
relatively important in the life of the corporation: whether or not the
corporation will adopt a poison pill takeover defence, or whether or not the
corporation will engage in a merger with another corporation. It is an episodic
oversight in most cases and not a day-to-day intrusive oversight.
I do not think corporate governance is guacamole, and institutional investors do
have a role to play.
Senator Austin: I wonder about examples. For example, in the field of executive
compensation, we see in the United States $100 million being awarded to an
executive officer, tremendous share option plans, golden parachute plans,
tremendous rewards being given by a board of directors to its management.
People keep in mind the way in which the CEO governed his governors. I am not
saying that what was in the book is true. I am saying, whether it is true or
not, that that is the story, and it is perceived to be part of corporate
Is there a role for fiduciary investors on behalf of the public funds, and so
on, at that level, or do they simply say, "The reward is commensurate"?
Is the reward commensurate? What is happening, and how does your governance
affect that? You referred to co-option earlier in your remarks.
Mr. MacIntosh: Yes.
Senator Austin: Is co-option taking place there, and how can you tell?
Mr. MacIntosh: Co-option is a serious problem. Evidence from the United States
indicates that institutions that have business ties with various corporations
tend to vote with management much more often than institutions that tend to be
pressure-proof. If you ask institutional money managers in the Canadian
community, they will tell you the same thing. I do not think we have the same
systematic evidence, but that is the answer you always get about why life
insurance company are pretty solemn on corporate governance, or banks and some
That is why I indicated earlier that this is one of the pressing problems that
the committee needs to address in looking at the role of institutional
Mr. Ambachtsheer: The closest thing that we have identified to creating some
accountability in the situations that you mention has been the public pension
funds, and for fairly logical reasons. They are the funds where there is
probably the most clarity of alignment between the governance management and
the accountability to stakeholders. It is in their interest to call those kinds
of practices into account, and it is the area where there is the least chance
of there being some countervailing forces saying, "Oh, my God, we
shouldn't be doing that." There are not the kinds of restraints that you
see in the insurance industry and in parts of the investment counselling
industry. Do you really want to take your best client? It is a problem.
Senator Austin: I am glad you mentioned that point, because I am looking for
balance among stakeholders so that there are major stakeholders who cannot be
co-opted and will keep the system moving forward and set the benchmarks you
Senator Hervieux-Payette: I am talking as a shareholder of Caisse de dépôt,
so perhaps I am an outsider in this case. As one of probably 5 million Quebec
stockholders following what the Caisse de dépôt is doing, we have
an historical background.I have dealt with them in terms of investment. When we
talk about criterion and guidelines, and what the government's public policy
should be, we are always asking ourselves, when they invest in the three major
food chains of Quebec, "Does it help the performance of the three food
chains?" As far as I am concerned as a consumer, I do not think so, but
that must be proven. What sort of guidelines do you put in place?
When I was in telecommunications, we went to the Caisse de dépôt,
and they said, "Sorry, we have already invested in your competitor."
Why in one case would they invest in all the players and in the other case not?
It seems that there were no criteria given. One of the original functions of the
Caisse de dépôt was to pay the pensions, but it is also there to
create jobs, wealth, and to reinforce the economy of Quebec. Can we have four
goals with the same fund?
Do we need criteria? Where do you find these champions? They will have a
difficult time to find women because they will say that they do not have the
experience. I will recommend to my Prime Minister that there are probably many
nuns who have administered their congregation and could qualify. We have one
now in the Senate.
We must find people who would almost need to be saints. They should make all
their decisions in the public interest and forget about all other interests.
The guidelines or criteria are important because we will be dealing with human
beings, no matter how experienced they are.
Also, speaking of investment, some Canadians think that capitalism is somewhat
savage. When it comes to investing in an environmentally hazardous company, or
in foreign companies in which children are working or where human rights are
not respected, should we recommend some rules if we want to enlarge the
percentage for foreign investment? Should we say that foreign companies that do
not comply with Canadian standards are not eligible for investment by these
funds? It is important that we have a set of criteria with which Canadian
people will be comfortable. We have our own standards and values. If we apply
the total capitalist system, there are no rules. You just put your money where
you have the best return. In terms of public interest, how do we balance this? I
welcome your suggestions.
Mr. Ambachtsheer: I think it is problematic to mix what I would call fiduciary
investing, where there is accountability directly to the stakeholders, those
who have the assets, and an economic development sub-objective. It is clear you
have a problem. You are then faced with trying to figure out whether you are
transferring wealth from your stakeholders to some other situation which you
would not do if you did not have that secondary objective. It is problematic to
saddle investing institutions with the obligation to be fiduciaries, on the one
hand, and on the other to be responsible for a different objective.
With respect to women, my observation is that they are doing very well. If you
look at it on a global basis, in pension fund fiduciary, both governing and
managing, two of the largest funds in the U.S. are actually run by women.
The other observation I would make about Caisse de dépôt is with
respect to the transparency issue. They do take great care to report their
annual results each year. They hold a press conference, and it is reported in
all the newspapers. Unfortunately, I think they are creating data but not
necessarily information and knowledge. The problem is that Caisse is an
investment manager managing at least seven different balance sheets. There is
automobile insurance, workers compensation, the Quebec pension plan, the public
service plan, et cetera, but they add them all together and report one return
number. That is not information. They should be reporting information about how
those seven balance sheets are doing and then that can aggregate up to some
total number. Perhaps they should be encouraged to rethink what they can do
about creating information.
I do not know what to do about the economic development sub-objective. I think
it is a real problem. I will now turn it over to my colleagues.
Mr. MacIntosh: You have a problem when you have a fund with two mandates. I will
tell you about a study that I mentioned in the background paper by Roberta
Romano of Yale University. She looked at the performance of public pension
funds versus other pension funds and found that the greater the number of
political appointees to the board, the statistically worse was the performance
of the fund. In addition to that, many states have legal structures that permit
funds to invest in local enterprises, even if they do not have the best
risk-return trade-off. That was also a statistical factor in lowering fund
The difficulty I see with having dual mandates is that it is a way for the state
to disguise expenditures. That is, the extent to which the low performance
impacts on the ability of the fund to make good on its pension promise
nominally comes out of the hides of the beneficiaries. Of course, if it is a
defined benefit plan, the state simply has to step in and top-up the plan. So,
really, it is the taxpayers who ultimately foot the bill. It can be a way of
subsidizing local investments and disguising that subsidization by routing it
through a public pension fund. If the government wants to adopt local
investment initiatives, it should do it more directly, in a way which is more
Mr. Ambachtsheer: I wish to add something which is very important. The Auditor
General in the Province of Quebec recently had some questions about the Caisse,
and there were hearings in the National Assembly on the Caisse. The Caisse
created a seven-minute video about what they did. I should disclose that I was
one of the two people invited to say something about that video. Let me say
here what I said then: If you look at the performance of the Caisse, balance
sheet-by-balance sheet, they actually performed very well. That is something
that I do not think they have communicated effectively to the constituency.
This economic development program affects probably only a small percentage of
their assets, and not the other 98 per cent. The problem is actually much
smaller than a lot of people make it out to be. A lot of these things relate to
Senator Tkachuk: On the question of how large a pension fund is and how it
performs, you mentioned $1 billion as the cut-off. Over $1 billion, is bigger
Mr. Ambachtsheer: Yes.
Senator Tkachuk: So if you were comparing a $1-trillion fund and a $2-billion
fund, the $1-trillion fund would perform better? In other words, statistically,
did the pension funds perform better as they got bigger?
Mr. Ambachtsheer: It gets a bit anecdotal because there is only so much you can
learn from an 80-sample data base.
Of the eight sponsor funds that I mentioned earlier, those with an average size
of $50 billion U.S. -- which is $75 billion or $80 billion Canadian -- we had
performance data on seven. The eighth did not have data long enough to be part
of the group. They were the dominantly large funds out of the 80 and
collectively they had risk-adjusted net performance far superior to the entire
sample. When you look at the plot of the 80 dots, out of the seven for which we
had data, six performed very well and one did not perform quite so well.
Again, I do think it is a continuum. As to whether there some ultimate figure --
you mentioned $1 trillion -- I do not know. We do not have data that high. But
when you look at this issue in a global context and use numbers like $50
billion, $60 billion, $80 billion, in the scheme of things they are not
particularly large players in the global marketplace. That is the right
Senator Tkachuk: On the question of the shareholders of a fund being involved
within a company, it seems to me that they had another choice: They could have
sold the stock and got out and gone somewhere else. When they go into that, are
they trying to justify a bad investment in the first place? In other words,
when they made that investment in the first place, they were betting on the
management doing well. Obviously the company did not perform well, so now they
are saying, "Perhaps we should be involved in this company to improve its
performance." Managers might say, "I was the one who decided that we
should invest $50 million in stock in that particular company and I will make
sure that investment works if I have to take over that company." Or would
they have done just as well had they sold those 10 and bought Microsoft?
Mr. MacIntosh: In fact, the study shows that the cost of CALPERS' corporate
governance program was relatively small. It was $500,000. The aggregate
increase in value achieved in the companies looked at in the study was $137
million. Presumably, the answer is that they did a lot better by getting
involved and by increasing the performance of those companies. Some $137 million
minus $500,000 is a pretty good cost-benefit ratio.
Senator Tkachuk: We do not know for sure if they would have not been involved
and done something else.
Mr. MacIntosh: The important point here is that those are returns above the
market. That is to say the market return during that period of time was
subtracted out. The $137 million is what an economist would call an abnormal
return, namely, a return above what you would have received just by taking that
money and investing in a random market portfolio -- buying the index, for
example. The market performance was actually accounted for in that $137
Mr. Por: This whole notion of large American funds is a bit overblown. I
happened to have gained work with these companies. They are much lower-key. I
saw the same study and I must question the $500,000 expense. In monitoring
these companies, I know how much money they happen to have paid for a number of
transacting firms to do so.
The issue is not necessarily whether it could be proved economically what would
have happened had they done so because you never know. Most of these funds --
and Mr. Ambachtsheer may want to comment on this -- are fundamentally passively
managed in the U.S. because the dollars are so huge that they have a problem
finding corporations in which to invest. In most instances, they are forced to
invest in an index.
Once you invest in an index, the only way you can influence the fund's
performance is to go to the corporations and talk about what and how. The issue
is not necessarily that they should or should not do it; the issue is by what
format, by whom, at what level and at what cost. Lately, I find that the role
of pension funds in corporate governance is cut back very significantly.
Senator Tkachuk: Public sector pensions with defined benefits are unique
entities in the sense that the people most affected are those who are at the
end of the rope who, when they turn 65, receive a pension. They do not care, or
they have less self-interest in caring because they know what their pension
will be. The government is backing it up in a lot of cases. Why would the person
who works in a provincial or federal park cutting the grass, or the person
managing the park itself, care? If they know what they will receive and the
government will back it up, why would they care? The people who care about
pensions are the people who are at risk. If you are not at risk, then why would
you care? Perhaps governments should be involved in this because we have our
own stake, in that, in the end, the taxpayer must pay for bad pension plan
Mr. Ambachtsheer: I do not think it is incidental that one of the best governed
pension plans in this country is the Ontario teachers' pension plan. It is one
of the few public plans of which I am aware anywhere in the world that has
achieved crystal clear clarity about what is the real pension deal. It is a
There is an estimated normal cost for the plan, which is about 16 per cent of
pay. It is quite a rich plan and fully indexed. If going forward the investment
results were not up to the expectations that were used to calculate the
funding, there would have to be a top-up. There would have to be more money put
in. That is the at-risk question.
The 50/50 partnership in the case of Ontario teachers means that the
contribution rates of the taxpayers and of the teachers go up by the same
amount. It is a clear risk-reward, symmetrical relationship between the two
A lot of other public sector plans have not achieved that clarity. As the
federal public service plan is kind of put out on its own as a separate
standing system, I certainly hope that the risk-reward deal between the plan
members and the taxpayers will be absolutely clear.
The Chairman: You all talked in various ways about the quality of board members.
You all used that phrase in different contexts. Mr. Por, in response to Senator
Austin, made the observation that no one is quite sure what that means in a
definitive sense. As you said, it is an exploratory issue.
Given the importance that you have all attached to it, including Mr.
Ambachtsheer's study, it would be helpful for us, at the very least, to have
your guidance as to what constitutes "qualities" in a board. Or
perhaps the question should be what constitutes "non-quality."
Sometimes you can define one by a process of exclusion.
I would ask all three of you to give some thought to that question and to send
us a letter in response to it. If one of the outcomes of this study is simply
the urging of pension boards, in particular public sector pensions, to adopt a
quality criteria for their board, I think we then owe people an obligation to
define what quality means.
Gentlemen, thank you very much for your attendance here this morning. It has
been a stimulating morning.
Subject to agreement between Senator Tkachuk and myself, is it agreed that we
approve the budget for next week's CPP hearings? We have to take it to Internal
Economy on Thursday.