Proceedings of the Standing Senate Committee on
Banking, Trade and
Commerce
Issue 8 - Evidence - Afternoon meeting
TORONTO, Tuesday, February 17, 1998
The Standing Senate Committee on Banking, Trade and Commerce met this day at 1:00 p.m. to continue its study of the governance provisions contained in the Canada Pension Plan Investment Board Act (previously Bill C-2).
Senator Michael Kirby (Chairman) in the Chair.
[English]
The Chairman: We have, as you know, two witnesses this afternoon. Claude Lamoureux is the President and CEO of the Ontario Teachers' Pension Plan Board, and he will be followed by the CEO of OMERS.
Thank you again, Claude, for taking the time to be with us. You were very helpful to us when we did the corporate governance study on the CBCA a year or so ago, and we all found your comments very pertinent. As you know, virtually all of them wound up in our recommendations. I have been told by the government that those recommendations will be included in the new CBCA when it is tabled in a month or so. Thank you very much for coming, we really appreciate it.
Claude Lamoureux, President and Chief Executive Officer, Ontario Teachers Pension Plan Board: Thank you, Mr. Chairman, for giving me the opportunity to express my thoughts regarding the CPP Investment Board. I always prefer questions to a prepared text, so feel free to ask questions.
I will begin by saying that, from what I have seen of the legislation, it has been thoughtfully crafted. There are, of course, details that need attention.
I believe that the legislators who prepared and passed Bill C-2 have listened to the pension investment industry. I make this statement as an actuary, and as someone who has experience setting up a pension investment fund.
Mr. Chairman, I have four recommendations that I think will be of use to your committee. Firstly, create a strong board with qualified members and give them a clear mandate. Secondly, give the new investment fund freedom to operate; let them make mistakes. Thirdly, hire top quality people, and pay them market rates. Lastly, do not ignore your liabilities, but rather, think of matching your assets and liabilities. Let us take each of these points in turn.
Nothing is more fundamental to managing an enterprise than people. This starts at the top, with the best board possible. Therefore, select board members who will, as a group, possess the appropriate qualifications to oversee the fund. This is crucial, especially during the critical early years of the fund, because major decisions and overall directions come from the board.
Although the proof will be in the pudding, it seems to me that the non-partisan nominating committee named last fall is a good first step to creating a strong board. I am told, Mr. Chairman, that this committee is now busy compiling a list of some 20 people. The committee is looking for qualified individuals, most of whom should, or will, have financial experience and expertise. Once this list is presented to the Minister of Finance and to his counterparts, they will together select 12 members for the Investment Board. Why are these details important? I think that an independent nominating committee helps create a strong independent board.
This process should be used to find experienced people who understand that their role would be as overseers of the fund, not managers of it. Further, it will help to create a strong board by removing it from direct control by any one government. The nominating and selection committees are non-partisan; this gives or should give the board a better chance of not having ties, real or perceived, to any government or particular political agenda.
This is important because sooner or later, and I predict that it will be sooner rather than later, the board will have to resist pressure from politicians, unions, private sector groups, and others with special interests and concerns.
The CPP fund will need to invest broadly. Investing broadly invariably results in the accumulation of investments which may be high profile or controversial. At the Ontario Teacher's Plan, for instance, we have invested in responsible companies that have generated healthy returns. These investments have, nevertheless, been controversial at times, as some of our members felt that the fund should reflect political and social issues.
Similarly, individual Canadians or groups may lobby the investment board to divest itself of, or to support, particular holdings for social, political and environmental reasons.
A strong board of qualified members will be better able to remain focused on its mandate which, as the legislation states, is to manage the fund in the best interests of the contributors and of the beneficiaries, and to achieve a maximum rate of return without an undue risk of loss. It will be interesting to see how long it takes for people to forget that. The chair is critical to keeping the board focused on its mandate. Do not underestimate this role -- get the most highly skilled person that you can to fill this post.
At Teachers' we have been fortunate. Our current chair, Ted Medland, is the former chair and CEO of Wood Gundy. Before that we had Gerry Bouey, the former Governor of the Bank of Canada, as chair. They are both independent people who were able to help management.
This brings me to my next recommendation. It must be clear to whom the board is accountable, and do not handcuff the board by placing unnecessary restrictions on their investment activities.
To ensure a smooth entry into domestic equity markets, a finance department document restricts the board's equity investment entirely to index funds. To define index investing is not easy. At one extreme it means full replication of the index, 100 per cent of the time. This is certainly an unrealistic goal. Investment strategy would be better directed by the CPP investment board, with the help of management. For example, to enhance returns, the board may want flexibility in the timing of the purchase of stocks or in the use of quantitative techniques.
The Minister of Finance should offer guidelines that provide the board with room to manoeuvre. If the direction is too specific, then you may be restricting the board.
After reading the legislation, it is clear to me that the Minister of Finance has power over the board that may, and let me stress the word may, interfere with identifying who is ultimately accountable. For instance, the minister can order a special audit of the board or of any of its subsidiaries.
I think that, if the board is responsible and properly establishes its audit function, the minister's power to order a second audit forces the question, where does the buck stop? Is the board responsible for the operation of the fund or is the minister responsible? I am, of course, talking about day-to-day responsibility, as opposed to the responsibility for defining a general direction. As you know, Mr. Chairman, the board is accountable to the participating governments and to the public through its annual report.
Furthermore, we should not be afraid to let the board make mistakes. Let us accept that the CPP investment board will invariably invest in losers. That is the nature of investments. There are risks, thus, we should not become overly excited when a CPP investment under performs.
My next recommendation stems from the notion that you get what you pay for. Compensation for those asked to perform the day-to-day management of the fund should be competitive with compensation offered to those working in the investment industry. This will help the investment board to hire and retain the best people for the job.
Compensation should be tied to performance. Individuals are rewarded when their performance meets or exceeds annual objectives, and external investment benchmarks. Within the investment industry, bonuses for performance form a large part of the compensation. Low bonuses, or no bonuses at all, should mean sub-par investment results.
Finally, as an actuary, I feel compelled to remind you that there are two sides to any ledger; assets and liabilities. An investment policy needs to consider the plan's liabilities by matching them with assets that perform in a similar fashion. Simply stated, if assets are rising but liabilities are rising faster, then the plan will eventually encounter difficulties.
I am amazed by how much reporting is required on the asset side. I presume that this is because assets can be more easily valued. However, more meaningful numbers, such as the relation of liabilities to assets, are not mentioned anywhere in the legislation.
The CPP investment board must always remember that it is working to keep the pension promise. That is why maximizing long-term results is more important than doing so for quarterly or annual ones.
Mr. Chairman, in your copy of my remarks I have included two appendices. Appendix I refers to several minor details in the legislation which this committee may wish to examine more carefully. Appendix II is in keeping with the tradition begun by Professor Jeffery MacIntosh when he appeared before you in November. I have selected a passage from the writings of Dr. Seuss that I think you might find appropriate.
In conclusion, these are four fundamentals to establish a sound pension investment fund, namely: create a strong, independent board with a clear mandate; do not handcuff your investment professionals; attract and keep the best people; finally, match your assets to liabilities. I believe that these four pillars will serve as a solid foundation on which to build a prosperous CPP investment board.
The Chairman: Thank you very much, Mr. Lamoureux. While you were reading I read your second appendix. Dr. Seuss' comment is an appropriate response to the comments that Professor MacIntosh used when you were with us earlier in the year.
I will begin with Senator St. Germain. In the time available to us, however, I would like to ensure that we give Mr. Lamoureux an opportunity to go through Appendix I, because it does deal with specific elements of the legislation which he thinks we ought to reflect on in our recommendations. So let us keep that in mind as we go through the questioning process.
Senator St. Germain: Your brief is informative and very interesting, and you have a lot of experience. I have taken the liberty of speaking on behalf of the Ontario Teachers' Pension Plan, because of the way that they have selected their boards. My questions will concern the board itself, its composition, and how it is selected. I think that, once a proper process is established to select board members, and if a high quality board is selected, the rest will look after itself.
You may correct me, but I am sure that they will come up with a CEO as qualified as you are, and I feel that, if they did so, we would, as Canadians, experience tremendous success in the pension fund.
I would like speak about the members of the nominating committee. I am concerned that this is the beginning of possible partisanship, and I wonder whether these people really have the qualifications to make this choice. One of the witnesses this morning said that we should be going to a head hunter as opposed to just establishing a board.
I do not want to take anything away from these people, but most of the members of the board that has been selected are top level bureaucrats from the provinces. I am wondering whether you believe this to be the type of person who should be recommending these board members, because I don't think that they really have the expertise that is required to make the highly qualified selections that have to be made.
Mr. Phelps, who was formally a bureaucrat within the government system, worked his way through to West Coast Energy after leaving his government position. I don't know who Mr. Brian McNeil is, other than that he is President and CEO of IPL Energy. Making this selection, we have two people in the energy field , and the rest are bureaucrats. I would like your comment on that.
I have made the suggestion, Mr. Lamoureux, to the minister, and also in the Senate, that the transparency of this particular board is of utmost importance. This is not a partisan issue -- I think that it is important for the future of the fund.
I based this recommendation on how you select your board at Teachers'; apparently the Ministry of Education selects half of the board, the teachers' organization select the other half, and then they jointly select a board chair. My suggestion was that, as opposed to saying that the federal government "may consult" the provinces, the provinces ought to select half of the board. The federal government would choose the other half, and then they would jointly agree on a neutral chair.
I think that this would give the board transparency, inspiring the confidence that people need in a board of this magnitude, which will be managing possibly $100 billion dollars. I would like your comment on the nominating board and on the process, sir.
Mr. Lamoureux: Well, I agree with you that this is the probably one of the most important decisions to be made, and that the most important one of all is the choice of a chair.
I can describe the process that was followed at Teachers'; initially the board was not selected half by the government and half by the teachers. At first, five members were to be selected by the government, and three by the teachers. As I understand it, the first person selected was Gerry Bouey. Gerry was selected because someone knew his daughter, which reflected very well on family values there.
The Chairman: Or patronage.
Mr. Lamoureux: Patronage of a different kind.
I know, though, that he had a lot of influence on the process which was used to select the board's first members. He wanted to make sure that these people were the best available. Many of them were personally known by him.
On the teachers' side -- they only selected three members -- Gerry wanted to make sure good choices were made, and I am sure that he had discussions with people, but even the teachers did not initially select people who were just "teachers". They realized that they needed somebody with knowledge of the financial service industry, so only two of the three people initially chosen were teachers.
At the same time, because Gerry was concerned that the board would not be seen as being equal, he made sure that every committee had equal membership representation. He had asked the teachers to name two more people to the investment committee, which obviously was the most important one, because all of the members, in our case, are members of the investment committee.
That was the initial process that got the ball rolling. As I recall, Gerry told me many times that we had to establish a strong foundation. I appeared on the scene and I was recruited by the whole board. I had never been interviewed by eight people at once, but that is how I ended up with the job.
As you know, each member of the board has a two year mandate, which can be renewed for up to eight years. I take the time to talk to people who represent both sides, and I can assure you that some coaching goes on behind the scenes. If someone is leaving the board there are discussions about how possible openings will be filled. I see a board as a hockey team; you need all kinds of people. You can't just have financial people, you also need people who have legal backgrounds, people who will understand the plan, and people who represent the members.
We tend to spend some time considering openings -- for instance, I will talk to our chairman, Ted Medland. We will give suggestions to both sides as to who ought to be considered. In the end it is their decision to make, and I will work with any board member, but I know that it is much better for the overall organization if we have board members who can keep us on our toes. I am a strong believer in that. I think that a good board will make an organization much better.
I did not know what the process was in the federal government, but I think that you need somebody with an opinion, and I know that I can give you mine. A few times someone on the government side has wanted to recommend an ex-politician, and I have argued against it. In one case it was an ex-politician versus an ex-bank president, who happened to be Robin Corteau.
The argument I was given was that this person had been on many boards. I pointed out that he had not, however, been with the TD Bank. This person is someone that I am sure would have contributed, but he was definitely not of the same calibre as Robin Corteau.
In my mind it was clear; some people may think that "a board is a board is a board", but I do not share that point of view. People with a lot of experience can definitely ask much better questions, and provide much better reviews of our proposals. I speak as a staff member, as I am not on the board. The best board members ask the best questions, and the breadth of his or her views is apparent. It is really helpful and such members add value to our proposals.
Senator St. Germain: Is there a check and balance that flows back and forth between the government side and the teachers' side? If we were to go with the provinces on one side and the federal government on the other, I expect that one group would be checking the other, and I wonder whether that experience takes place in your organization.
Mr. Lamoureux: If you came to listen to one of our board meetings you would not know who is represented by whom. I am very proud of that. Everyone on our board knows that he or she is there to act in the best interests of the teachers of the province, and their beneficiaries. We have never had an issue that was decided with one side opposing the other.
I have spoken to people involved in public sector pension funds, as I occasionally give talks to them. On one such occasion, someone asked me how we resolve situations in which one side does not agree with the other. I could not even conceive of what the person meant, although I realized that the reference was to those times when the union side is against the management side. I explained that we don't have that situation -- we have never had it. I cannot recall a vote that was divided along those lines.
It goes back to the original intent, which is why I think that a good chair can make a big difference; the chair makes sure that everybody knows why he or she is there. In our case I can tell you that it works very, very well.
Senator St. Germain: If the board is appointed by the government do you think that its investment decisions could be influenced by its social commitment, to the detriment of the financial well-being of the fund itself?
Mr. Lamoureux: We are there to invest to the best of our ability for the benefit of the member. We have reminded the board and our members of that. On occasion, we have even reminded the government of it, and we have not deviated from that position.
I can tell you that, in our case, the only thing question concerns the suitability of the investment to the fund, and whether it will give us the type of return that we expect down the road.
It is clear in my mind what this legislation asks for. Investments must be made for the sole benefit of the member, and investments must be made to maximize the return.
There is a famous case in England, which is similar to this one, in which the coal miners did not want their pension fund to invest in alternate energy forms or to invest outside of England. The High Court determined that that was not the mandate of the fund. We have followed that rule; it has never occurred to us to do otherwise.
There is significant pressure, however <#0107> we receive requests and calls daily.
The Chairman: Your Maple Leaf Foods reference was a good example.
Mr. Lamoureux: I was not going to name Maple Leaf Foods, but it is a good example. Although there is a labour dispute at the moment, it is an investment that we made three years ago. The company has now negotiated 95 labour agreements out of 100. The five which remain are obviously the toughest ones; the Teachers' union has taken exception to our investment and wants us to divest. If we were to divest right now, it would certainly be very bad. We have invested in approximately 350 Canadian companies. Labour disputes do occur, and we cannot get involved in them.
The fact remains, however, that we will get pressure on social issues. As I point out in my text, there will be pressure from day two of the operation of the board. I guarantee it.
Senator St. Germain: There is a 20 per cent restriction on foreign investment and $100 billion coming into the market. In your experience, is this a problem?
Mr. Lamoureux: We do not see it as a problem because we use derivatives a lot. As to our economic interests, in cash we are roughly 12 per cent invested outside Canada, but economically, we are over a third outside Canada. We have done through derivatives.
I do not know if you are familiar with this. We can invest in Canadian bonds and change the return, thus getting the English index, which is called the FUTSE. We can take $100 million and transform it into a return of something else.
The Chairman: By doing a swap.
Mr. Lamoureux: Yes.
The Chairman: But the swap does not physically take place and therefore your investment is not technically complete.
Mr. Lamoureux: Our investment is a Canadian investment and our return is a foreign return. When we look at it, we consider it as cash versus economic interest.
It is not that exotic and we did not invent it, as both the Minister of Finance and his ministry are well aware. I recall that, when we started, Gerry Bouey wanted to make sure that this was legal, and that people knew that we were doing it. This is well publicized in our annual report.
Senator St. Germain: Okay thank you, Mr. Chairman. Thank you, Mr. Lamoureux.
The Chairman: Senator Kelleher.
Senator Kelleher: Within 10 years this fund will grow to somewhere between $75 billion and $100 billion, and there has been a great deal of discussion about this quick growth. This prompts two questions: First, in your opinion what impact will the investment of these funds have on our capital markets in Canada?
Second, should mechanisms be implemented to ensure that the investment of these funds is used as neither an economic nor a social policy measure? As we all know, in the past the Caisse de dépôt in Quebec has been used for the implementation of social and economic measures which the province holds dear. What would appropriate measures be?
I would like your comments on these two questions.
Mr. Lamoureux: All right. I will start with the last one.
The law is very clear that whoever runs this fund must invest in the best interest of the members. Period. End of story.
I certainly would object if I were managing the fund, although it's true that you must listen. I always say that it's possible to miss something, so you have to listen to different suggestions. In the end, however, if you feel that you're not going to get the right returns you must decline to invest.
There will always be pressure. The legislation requires that the board hold meetings every two years in each participating province. I can guarantee that very few people will come to the board to say that it has done a great job; those who come to the meetings will do so to complain that the board has not invested enough in the province or in the region.
The law is very clear, however, and the board and its management need only point out that they are following it. I know that, if they do not follow it, they can be sued. Having a very clear law, then, is the best that you can ask for.
Senator Kelleher: Given what we have seen happen in Quebec with the Caisse de dépôt, should we not have some mechanisms to prevent that?
Mr. Lamoureux: I believe that, in its mandate, or at least as part of it, the Caisse de dépôt has a responsibility to develop the economy of Quebec. That is how they get around that.
The Chairman: That is correct. The objectives stated in the Caisse's legislation are different from what you espoused, and different from those in this bill.
Mr. Lamoureux: You have to rely on the law. I know that, in our case, we have spent a fair amount of time educating our board members as to what the law requires of someone running a pension fund in Ontario. This is why our members are all of the same mind. It is not, as pointed out earlier, about one side versus the other. It is obviously very important to have a good board that can resist pressure and determine to do the job that it was asked to do.
As to the impact on the Canadian market -- there will definitely be one. I do not think that that is necessarily a bad thing. If Canadians save more, that should help us to invest, to create more jobs; in the long run that money has to be put somewhere. The board would certainly ensure that this money is invested in very productive organizations, which could lead to a decrease of the interest rate. I am not an economist and an expert would be better suited to discuss impacts with you, but I am sure that there would be one.
I could see an impact on the stock market if a lot were to be bought at one time, but maybe we would be a seller at that point. In other words, for every buyer there is a seller. If the perception is that you are over paying, people will be more than happy to sell to you.
As I have said, however, it is hard to predict what will have an impact on the Canadian market, and I don't think that I am qualified to make that prediction.
[Translation]
Senator Hervieux-Payette: I hope that you applied for the job. I think you would be a very good candidate. You must certainly exchange information with your fellow fund managers. Are your investment managers mostly relying on internal analysis or are they also calling on experts from outside?
We came back this morning on the famous Brex-X incident. What kind of inquiry are the large pension plans making? You are in a much better position than small investors to inquire about the nature and the level of risk of any investment you make, given the size of your holdings. How far do you carry out your analysis?
Mr. Lamoureux: We make detailed analysis of any companies in which we intend to invest. But let us stand back a little bit. There are two kinds of investments: indexed and active ones. It is crucial that you understand how a pension plan like ours came to invest in Bre-X. The reason is that most of our investments are indexed. In our case, we should talk of quantitative rather than indexed investments, since we use quantitative techniques to make our investment decisions.
To put it fairly simply, we can always make indexed investments, since we know the set of rules which apply for common stocks to be included into the index. Also, we are able to anticipate that such and such company is soon going to become part of the index or to be taken out of it.
In the case of Bre-X, our investment was of that type. It was totally passive and strictly made through the index. With that type of investment, we don't make any inquiry. If you talk with our quantitative investments managers, they will tell you that they just follow their model. Perhaps a good analogy would be flying an airplane just by instruments. The members of the flying crew don't have to look outside, and they fly their plane just on instruments. That's what happened in the case of Bre-X.
On the other hand, when we go for active investments, we do a lot of research. A standard report may include 20 to 40 pages. The company is kind of dissected. One of the questions we often ask is about the board's members, who they are, how and why they have been appointed, and whether some improvements should be brought at that level. We insist that those analyses are very thorough. Of course, we call on experts from outside. A number of stock brokers would give us some suggestions, but, in our case, we essentially manage 90 per cent of our funds ourselves. We only have 10 per cent of what we call EAAFE. We give EAAFE mandates to external investment managers whose approach is one with which we are very familiar, and which we call "value investing".
Coming back to your first question: do fund managers talk to each other? First, as we already said, the legislation does not allow us to do so. Four pension plan representatives cannot meet into a room to inform each other of their investment intentions. In our case, we are generally very careful about that. We make our own decisions. It doesn't mean that, occasionally, if someone ask us what we intend to do concerning such and such proxies, we'll never reveal anything, but in general we keep our opinions for ourselves.
Senator Hervieux-Payette: Talking earlier about foreign investments, you told us that you had a special way to deal with that issue. What Caisse de dépôt managers are regularly asked concerns their percentage of investments in fixed-interest securities versus equity. In Quebec, that percentage has progressively been raised. Do you have rules and regulations about that, or do you rely on the market place rules and economic cycles? Does that mean that this is your policy, but that your policy varies according to economic cycles?
Mr. Lamoureux: The most important decision that a board must make once its management team has been hired is to establish a mix of assets. In our case, before doing anything else, we found it essential to know what the extent of our liabilities was. Those liabilities are fully indexed to the cost of living. In other words, there is a ceiling, but that ceiling is very high. If we ever reach it, we have what we call a "carryover."
In our case, we first looked at our liabilities. In fact, the only sector of investment where our assets are really matching our liabilities is "real return bonds". It is through those bonds that we can best lessen our risk. Very early, we managed to raise our rate of equity investment to two thirds of our assets, and we recently brought it to 75 per cent. Why did we start with two thirds? Initially, we had zero equity and 100 per cent Ontario bonds, although, admittedly, our analyses showed that we could have 80 per cent in equity.
Our board felt more comfortable to go to two thirds, instead of going from zero to eighty per cent. They thought it would take much longer to reach that level; with our famous derivatives, we got there fairly rapidly, and once the two thirds were reached, we went up to 75 per cent. Roughly, our leeway range as investment managers is around 5 per cent on both sides. We can go to 70 or 80 per cent, but the board decided that the risk that they were ready to take, given our liabilities, was 75 per cent in equity. From there, what we have to decide is whether we invest in Canada, in United States or in Europe. But we must always maintain our 75-per-cent-equity ratio, with a 5 per cent margin both ways. We do not try to speculate, to do what we call "market timing".
Studies tend to establish that, in the long run, it's a game where it is very hard to make money. We have a policy and we try to stick to it.
I am quite familiar with what the Caisse de dépôt does, and I think that their way of operating is rather similar to ours. Recently, they raised their equity investment ratio, but we essentially all start with that type of mix, the selection of which is our most important decision.
Senator Hervieux-Payette: Up until now, you had a greater freedom than the Caisse de dépôt to raise your equity investment ratio. They were simply adjusting to those considerations. As for your non-indexed investments, you never take into account such things. If I tell you that, it's because in Quebec, we hear a lot of criticism about the fact that our domestic funds are not invested enough in Quebec.
As far as you know, is that factor taken into account by your decision makers, or do they only take into consideration their return on investment?
Mr. Lamoureux: In our case, we only look at the level of returns. Our first aim is returns. That's what we are required to do under the law.
Senator Hervieux-Payette: You talked of having more detailed information about "liabilities". Could you explain what you meant by that?
What do you believe our committee should recommend to the government to ensure a more balanced approach about the way of reporting those elements?
Mr. Lamoureux: Let me answer with a question. Could any member of your committee tell me what means "the unfunded liability of the Canada Pension Plan"?
Senator Hervieux-Payette: Surely not me.
Mr. Lamoureux: I work on the assumption that your pension fund's mandate is to pay pension benefits. Historically, a pension plan actuarial valuation used to be made every three years. When I started my career, we needed a fairly long period of time to valuate a large pension fund. Nowadays, with a PC on your desk, you can do it quite quickly. I can tell you what my actuarial surplus is every week. I told you that we don't manage assets, but a surplus. Why is it so? If I am asked to maximize my return on investments, usually I am also asked to match an index. In the case of the ScotiaMcLeod index, for example -- I think that people here are familiar with the word "term" -- for every interest rate point, the term of bonds is five years. That means a 5 per cent fluctuation. On that basis, I can beat the ScotiaMcLeod index by 50 points.
On the other hand, the term of my actuarial liabilities is 15 years, which means that I will have to invest in long term bonds. My goal is not to beat some other fund manager, but to get enough money to meet my liabilities. It's generally for that reason that a lot of private pension plans tend to make equity investments. Ask them to tell you about their liabilities. Most committee members wouldn't be able to tell you a word about liabilities. I can assure you that, in our case, our board members know exactly how big is our quarterly surplus. Any actuary can tell you if our surplus is over or under 2 per cent. It's rather precise.
The legislation insists on reports being provided about assets, but fails to impose the same requirements concerning liabilities. In my opinion, it would preferable to have statements on both assets and liabilities. If I am not mistaken, the Canada Pension Plan is being valuated every three years, or so. I wouldn't be able to tell what it is by heart. On the other hand, all our board members will tell you exactly what our actuarial surplus is if you ask them.
Senator Hervieux-Payette: But isn't it easier for you to have quickly in mind that information, since you already know all of your teachers, you know exactly what your age pyramid looks like? In the case of our pension plan, it seems to me that it is going to be more difficult to figure that, since it is impossible to know who is going to receive benefits. Those benefits are going to be dependent on income testing. Some people won't qualify.
Mr. Lamoureux: To be able to make an actuarial valuation, you must have access to some data. Whether you make it for ten people, or for one thousand, or for ten million, the computer will just take a little more time to calculate it. That's the difference, these days. We must not say that because the calculation is more complex, it doesn't have to be done. It is in that sense that I make those comments. Surely, it will be more complicated. Our pension plan is one of the largest in Canada. We have 200,000 members. We can use certain techniques. For example, every week, we closely observe the fluctuations of real return bonds, and on that basis, we then make a new valuation of our liabilities.
Senator Hervieux-Payette: That will suggest us a few interesting questions to ask to the board members when the appear.
[English]
Senator Callbeck: You spoke about the number of directors, and I believe that you said that you wanted members who were knowledgeable about the financial service industry. What other criteria do you look at? Do you look at regional representation at all, or is that a factor?
Mr. Lamoureux: I think that here it probably should be a factor, but I am not sure that you can find good people across Canada. Should it be a factor? I think that, by law, it is a factor, and I can live with that. I do not think that this is something that should be a big handicap, but you do need a certain number of people who understand the financial market.
Senator Callbeck: Right. I was just wondering whether you take regional representation into consideration in your pension plan?
Mr. Lamoureux: Not in Ontario, no.
Senator Callbeck: In your present mix, long-term investment mix is 75 per cent, 25 per cent debt. How often would that be changed? Is that something that you do annually?
Mr. Lamoureux: No. We do it very infrequently. We probably look at in depth every two or three years, but I would not see anything change in 20 years. This is such a fundamental decision, and it is so anchored in our liabilities, that it's not the sort of thing that we would change drastically.
You have to remind yourself of the possible dangers -- for example, a drop in the markets. In life, luck helps you. If we had started out in 1970 instead of 1990 -- in 1973 and 1974 the market dropped 40 per cent. That is a major adjustment. The year before, to cite a U.S. pension fund example, 125 per cent of the cash flow of pension funds went into equity. That was a record. In 1974 and 1975, the percentage was 25 per cent. That was also a record.
Even professionals get taken off guard, and a board is only as good as its weakest member. Sometimes you have a weak member who makes a lot of noise, and the deck begins to shift. If that happens, you have to remind yourself and the board that education is mandatory, that attention must be paid to how these things have worked in the past.
I am not saying that it is easy. We have seen what happened in Asia recently. I read in The Wall Street Journal that the small investors were the ones that stayed with Asia, whereas the big investors walked out. That is interesting, as it is the reverse of what one would expect.
In our case we had just decided to participate in a real estate fund in Asia, and I said, "Hallelujah, great timing." You always have to go against the cycle and against the grain, and I will not say it is easy.
Senator Callbeck: No.
Mr. Lamoureux: We have not been tested, I can tell you. We started in 1990, and the market has been very kind to us. I am sure that you read the newspaper; everybody knows that we started in a deficit, but that we now have a surplus. A lot of people think that this will continue forever, and that is a danger. We cannot expect that we will have the same situation in five years that we have today.
The Chairman: Senator Austin.
Senator Austin: This morning we had some witnesses, and we discussed the concept of an index. It was not very clear which index one should choose. Malcolm Hamilton, from Mercer, gave us a very interesting picture of how the economy works, within the context of a long term pension system.
For his model, however, he needs a very broad definition of "index". He told us that he needed 300 companies in an index for that model to work. As the Canada Pension Fund Investment Board is to be an indexed fund, I am curious as to how the industry defines the word. We do not have a definition, and some definitions are quite broad.
In The Globe and Mail for today, there happens to be a story on U.S. pension funds investing in foreign stocks. Their result is a median 6.7 per cent return, compared with a 1.9 per cent total return paid by the index. The index is the Morgan Stanley Capital International: Europe, Australia and Australasia, and the Far East.
Mr. Lamoureux: It is called the EAAFE index.
Senator Austin: The EAAFE index of 21 major overseas markets. That is quite a spread -- between 6.7 per cent and 1.9 per cent. According to InterSec, the article goes on to say, active managers have beaten the index in seven of the past ten years. InterSec, as you know, is a private tracking fund -- InterSec Research Corporation of Stamford, Connecticut. I am really curious about these indices.
Let me stop there and ask you to define index. Also, what you think that the Canada Pension Plans' index group should be?
Mr. Lamoureux: Broadly speaking, there are two general types of indices. You are all familiar with the Dow Jones. The Dow Jones is essentially 30 stocks. The price of these 30 stocks is added up, divided by 30, and then compared to the next day. That is how the Dow Jones is calculated. This is an old style index.
The Chairman: Straight mean.
Mr. Lamoureux: Exactly. It gets more complicated because you have splits, replacements, and all of that, but I won't go into that. Then there is what we call a capitalization base index.
As an easy example, BCE might represent 10 per cent of the TSE 300. That would be the number of shares multiplied by the price. We add that up and then, in the case of Canada, we have 300 stocks. Each of the banks is more or less 2 per cent of the index, but this is capitalization base.
Senator Austin: Market cap.
Mr. Lamoureux: Yes, the number of shares outstanding times the price. There are a few restrictions; for example, if a company is controlled by a group at 50 per cent, that 50 per cent will not be in the index -- it is called a free flow. In other words, these are to be shares that one could buy.
Generally that is the index that we look at. The TSE is a cap weighted index. The SNP is a cap weighted index, as is EAAFE. That is how these indices are constructed.
Following an index is a very cost efficient way to invest, and the U.S. market is the most efficient market. Our U.S. exposure is 95 per cent indexed through derivatives. As I've said, the American market is very efficient, and it's therefore difficult to beat the index. In the last 5 years I doubt that 10 per cent of managers have beaten it.
Senator Austin: Is the index you are referring to Standard & Poor's?
Mr. Lamoureux: Yes. Standard & Poor's. It is generally the one that is considered, but Russell is also used.
Senator Austin: There are others, yes.
Mr. Lamoureux: There are a number of others, the majority of which are capitalization weighted, except for Dow Jones. Dow Jones is, as I said, the oldest index, but it is also the crudest of the indices. Most of us do not follow it.
When you look at EAAFE, you have a number of countries. And the big call in the EAAFE market has been, are you in Japan or are you out of Japan? I would bet that the people to whom you referred, the ones who have beaten the index for seven out of ten years -- they're all out of Japan, and that is how they have been to consistently beat this index.
But if you look at each one of the countries in the sub-index, you will see that it is quite a different story; these markets are not as efficient. The UK market is very efficient, but Portugal, which was recently admitted into the EAAFE index, will not be as efficient as, let us say, the U.S. market. It is a very efficient way to invest.
When you define the index for an expert, then, it is a clear definition. It is a capitalization weighted index. Problems arise, however, when you say that you must be at the index all the time. That is impossible to do.
In Canada, we separate the index into two parts, and sometimes into three. Let us just deal with two. The first 100 and the bottom 200. In the bottom 200 the majority of stocks are not liquid, and it is very tough to accumulate any volume. As a result we use different techniques; instead of what we call full replication of the index, we will use a sampling technique.
In my paper I suggested that some freedom must be given to the managers if you say that they have to be at the index. If someone on the other side knows this, as they would, his or her role would be to take advantage of it.
There has to be some freedom. Considering the amount of money that this fund will deal with, it will not be able to be at the index all of the time.
Earlier you mentioned Bre-X -- a non-liquid stock like that one creates an interesting situation, increasing the index by 5 or 10 per cent.
Senator Austin: That would be because indexed funds have to buy it.
Mr. Lamoureux: Yes, they have to buy it; they don't have a choice. Dealers generally have a good inventory of the stocks that are about to hit the index.
In my opinion, Bre-X should have been in the index earlier; you will have to form your own conclusions as to why it was not. If you look at the role of the TSE, it probably should have been in earlier. The Canadian index, however, is unlike other indices.
Senator Austin: Is a market cap index.
Mr. Lamoureux: Yes, but it is also run by the people who make the market. The S & P is run by the Standard & Poor's organization, so it is not run by the stock brokers.
As you can see, the people who run the index can also have great influence on its composition -- there are a lot of subtleties when you get into the index game.
Senator Austin: In the first stage of the Canada Pension Plan Investment Board, it will only be authorized to buy the index, as I understand it. After a period of time, the federal government and the governments of the participating provinces will come together to consider loosening those index rules.
On the surface, then, it would appear that the new board and its chairman are being handcuffed to some extent, and exposed to market gaming. Is that your view?
Mr. Lamoureux: There really does need to be some flexibility. If the law says that you must be at the index, there are two obvious problems. First, it is impossible to do so -- you will break the law every day. Second, you are exposing yourself -- if I know that you must be at the index, I will use that knowledge. It is not necessarily the smartest position for you to be in.
The Chairman: Under the regulations, the board's domestic equity investments -- as opposed to its foreign equity investments -- will be required to mirror one or more major market indices, rather than being able to pick individual securities.
If you were the CEO, how would you interpret that? The reference is to major market indices <#0107> that is, indices as opposed to a single index. How would a practical CEO, operating within that restriction, interpret it? As you pointed out in your response to Senator Austin, there are several definitions of what constitutes an index, and there are several indices.
Mr. Lamoureux: In Canada it's easy; it is the TSE 300. It could also be the TSE 35, the TSE 100 or the TSE 200 -- these are the sub-sets.
The Chairman: They are all sub-sets of the 300?
Mr. Lamoureux: Yes.
When the law says "must mirror", I must question it, because I know that it is impossible to comply. You might be able to do so with the TSE 35, because it represents 50 or 60 per cent of the capitalization. When you reach the TSE 100, you are up to 75 or 80 per cent.
The Chairman: At number 299, then, you have a problem.
Mr. Lamoureux: At 299 you definitely have a problem.
If the law says "must mirror," the first thing that I would do would be to find a lawyer who would tell me that "mirror" could mean a fuzzy picture as opposed to an exact picture.
The Chairman: That kind of lawyer is available, I am sure.
Mr. Lamoureux: I do not know.
Senator Austin: I am going to ignore all of these negative words -- imagine being a lawyer and a senator.
Mr. Lamoureux: Lawyers are my best friends, and a lawyer who did that would be providing a great service.
Senator Austin: As to replicating broad market indices -- these are, if I understand it correctly, draft regulations. I am sure that your advice will prove very useful in providing the necessary flexibility to the regulations. I appreciate your answers.
Mr. Lamoureux:You can ask the people from OMERS the same question and you will get a similar answer. We run by far the largest quantitative fund in Canada, and it is impossible to be at the index all of the time.
Senator St. Germain: I have two quick questions. First, based on what you have read in the legislation, do you believe that the selection process that has been implemented will be able to generate people of your calibre?
Second, as you mentioned, you get what you pay for. In other words, if you pay peanuts you get monkeys. What compensation level do you see for the position of CEO? Also, do you see the chair as a full-time position?
Mr. Lamoureux: I will answer the questions in reverse order. In our case, I would advocate that the chairman be a non-executive chairman.
The Chairman: Which is what the legislation calls for.
Mr. Lamoureux: In our case Gerry probably spent a little bit more time in the office than Ted Medland does, but not that much more. I speak to Ted several times a month, but he does not currently spend half a day at the office, at the board, except when we have committee or board meetings. We tend to run those meeting very efficiently; we run like a financial institution. An investment committee might run from 8:30 until 12:30, and would have a very full agenda. Following the committee, we would have a short board meeting. On occasion we might be done before, and after that we will have a short board meeting
I don't see that as a full-time job, no. The danger is that, if it becomes a full-time job, the person eventually manages the place. Then who is the boss? You cannot have that, although it is done.
Your second question involved the calibre of person to be accepted. If you have a chairman who says that he will be there all the time, and every decision will thus be second-guessed, you do want to have top notch people. That's definitely the case.
In terms of compensation levels, there are a number of surveys which reflect what is being paid in the industry. Unfortunately, if the compensation is disclosed, it will become a political issue. If you are a money manager today, though, you are a hot commodity, and even on the quantitative side the salaries are fairly high.
Senator St. Germain: What would IBM's pension fund, or these U.S. organizations, pay to people who hold positions similar to yours?
Mr. Lamoureux: I am not familiar with IBM. I am more familiar with GM, but the salary base would be $1 million.
Senator St. Germain: A base of $1 million?
Mr. Lamoureux: Yes. I know Allan Reid, the CEO of GM, very well. He would also receive an incentive on top of the base. He runs an extremely large fund, however. It would be the same case with IBM; that would be a huge fund.
On the commercial side, the pay in the U.S. is very attractive. Generally, however, the U.S. public pension funds do not pay their people that well. As a result they have a fairly high turnover rate -- and an inexperienced money manager is very costly. Although you may not realize it, you are paying for tuition fees, and they can quickly run into the millions. Nobody accounts for that, though.
I heard a speech by the treasurer of the State of Connecticut, and his fund was in the bottom 1 per cent of all U.S. funds.
The Chairman: The bottom.
Mr. Lamoureux: The bottom 1 per cent. The 99th percentile.
The Chairman: Yes.
Mr. Lamoureux: He took the fund over and made a number of changes.
Again, though, you are exposed when you do not pay people well. This is an industry where you are invited to conferences around the world, and you can spend all you time at them.
Some American boards, and here I am speaking more about abuse in the U.S., can take three or four days for a board meeting. You may not realize it, but you are paying for it. People take trips; they visit investments in India.I look at some of these things, and I have to ask what they are doing there.
The Chairman: We have to wrap up, but I would like you to take three or five minutes to look at your first appendix. You have some specific suggestions on issues that ought to be looked at. They are quite straightforward, but I wonder if there are two or three to which you think we ought to draw particular attention?
Mr. Lamoureux: One thing that bothered me was that you have two audit committees. You have an audit committee, you select a good board, they select the auditors -- but every six years the minister is going to come and have an audit done. I do not think that that is good corporate governance.
In the end someone has to be responsible; if they are no good, do not hire them. It is that simple. Some people feel that checks and balances should exist, and this may reflect that feeling.
I will remind you of what George Morfit, the auditor of British Columbia, said about BC Hydro. He said that it was a corporation designed not to work; it reports to seven bodies, and is therefore accountable to no one.
To fall into this trap is not good corporate governance.
Senator St. Germain: Would you mind commenting on section 52? That is the section that asks who the board is accountable to; to Parliament, or to each citizen.
Mr. Lamoureux: The question is, do you want direct accountability? In this section, they ask the board to go across the country every two years to meet people. To me, this is a nice show, but I do not think that it adds to the substance of the operation. Parliament is elected, and they should be the ones doing the answering; it should not necessarily be the management doing the road show. What will happen is that every investment that they did not make will be criticized.
There will be mistakes. We have received at least 100 letters from teachers regarding Bre-X. The discipline of investment, however, is that, even if you had it all to do again today, you would do the same thing. That is the discipline of quantitative investment management. If our manager did not do that, I would be on his back telling him that he had not followed the discipline.
A lot of other good stocks come with a Bre-X , and those which did have appreciated by much more. I could give you a whole list. Nobody ever writes about that, though.
The Chairman: Your conclusion, then, would be that the accountability ought to be to Parliament, and not to the individual pensioners?
Mr. Lamoureux: I think so. I do not mind talking to an individual teacher, but I know who my boss is. I report to the board, our management team reports to the board, and you only get one set of directions at that point. If you get too many conflicting sets of direction it is very hard to run a lean show and one that will produce the kind of results that you would expect.
The Chairman: You have repeatedly referred to the importance of the board. Do you have a training program for new board members? That is, is there a process to educate them -- not just about what you do, but also about the way that the whole process works?
Mr. Lamoureux: We have a two-day orientation session for directors. The first day deals strictly with the plan, and the second day looks at the investment operation.
When Ms Bennett joined our board, she joined five or six other boards at the same time.
The Chairman: She is the former VP of Manulife, so she understands.
Mr. Lamoureux: She felt that our orientation was very good. She commented that it helped her to quickly realize what to expect and what to do.
In addition to that, we have probably spent 20 or 25 hours with our board on an issue like derivatives. We had an eight hour meeting -- just on derivatives -- with one of the top people in the world.
Malcolm Hamilton spoke to you about liabilities. Initially, we spent about 25 hours on that, in order that the board could understand the dynamics of what happens, and that the liability is not a number, but a range of numbers.
The Chairman: Is it fair to conclude that you would urge an immediate orientation program for the new board?
Mr. Lamoureux: An orientation is necessary for every board, and for every board member. Every board, you know, and every board member needs and should get an orientation. I think that these people deserve it. Sometimes someone may, for example, have a very good background in law, but not know that much about capital markets. You need to bring him or her up to date on that. The lawyer would obviously be well informed about the duties of the board, and someone who knows capital markets needs to know that we are here to invest in order to maximize return.
The Chairman: Mr. Lamoureux, we could go on for ages. I appreciate that you take the time to be with us. Thank you very much for coming -- we will inevitably call on you again.
Senators, our final witnesses for today are from OMERS, the Ontario Municipal Employees Retirement System. Mr. Dale Richmond is the CEO, and Mr. Tom Gunn is the CFO.
Dale Richmond, President and Chief Executive Officer, Ontario Municipal Employees Retirement Board: OMERS is the second largest public sector pension plan in Ontario. We are fully funded and managing to a surplus, so the pension promise is secure. We have about 250,000 members -- if you take into account their families, who depend on this pension plan, about 1 million people are involved.
We are one of the older plans. We have been in existence for some 35 years, during those 35 years we have been allowed to invest pretty freely in the capital markets. We therefore have a long experience of investing in the capital markets, certainly within Canada, but also internationally.
For the use of the committee we have some material that represents our experiences. We do not pretend to know all the answers, but we have tried a variety of things in a variety of circumstances. The information that we have is just a fact sheet on the fund itself. We have enclosed the table of contents for our investment policy manual so that you can see what material the manual covers. The manual itself is very large. We have also included a popularized version of our investment objectives.
We have included our conflict of policies because we saw that the legislation, to a considerable extent, dealt, with that particular issue, and we wanted to show you how we had managed it in our system.
We have proxy voting guidelines, initially issued in 1992, which refer to how a big institutional investor interacts with the companies in which it invests, but we did not bring them. We are in the process of updating and reformatting them, and they are at the printer as we speak. If committee members are interested in seeing them, we will certainly send them along when they are completed.
The Chairman: We are interested in them, and not solely for the purposes of this hearing. As you know, we are involved in a different study on institutional investors, which we will be talking to you about this spring. The whole role of proxy voting, and activist, versus non-activist, institutional investors, is important to us. No doubt we will discuss it with you in May.
Mr. Richmond: I will end my opening remarks with some general comments about governance.
We have a 13-member board. It is composed of employer representatives, employee representatives and pension representatives. We have a long history of operation with it, and because of the size of the plan we have access, of course, to experts at any point. I think that, once the Canada Plan Investment Board is actually structured, and managers are put in place, we can probably help them deal with some of the start-up issues, et cetera.
We have some general comments on a variety of topics, and I will turn to Tom Gunn for them.
G. Tom Gunn, Chief Investment Officer, Ontario Municipal Employees Retirement Board: I have been personally involved in drafting legislation in the past, and I know how difficult some of these tasks can be. The legislation may mean well, but it does not necessarily work the way that it was intended to.
There are a couple of small issues that I would like to bring to the attention of the Senate. I know that Claude Lamoureux brought some indexing issues forward. I would be happy to expand on those as well.
I would like to comment on natural powers for a moment. I am very happy to see that section 6 of this act actually does specify natural powers for the investment plan. While this may seem to be a small point, I believe it to be an extremely important one, as there are a whole set of financial instruments that are created from time to time, and which are very difficult to describe initially. To ensure that there are broad corporate powers in the Canada Pension Plan, I think, will serve everyone very well.
The Chairman: For non-lawyers what does "natural powers" mean?
Mr. Gunn: You can draft legislation in one of two frameworks. In one, you can limit, in very detailed terms, the powers of the fund to invest. It can be restricted only to those things created, or, if you like, only to the sort of instruments that one would define today. Things that may be created in the future that would not fit under that.
The Chairman: You would not have had legislation listing derivatives 20 years ago?
Mr. Gunn: That is quite correct, and 20 years ago you would not, for example, add an investment in the bridge to Prince Edward Island.
We would like to make a point about the qualification of directors. We see that any Canadian is eligible to be a member of the board -- that is a particular issue that we have with OMERS. It is generally considered that a person can be in conflict simply by virtue of being a member of a pension plan.
There is no reference to that in this document, and we applaud this. We believe this to be a proper issue of corporate governance; that a person not be deemed to be in conflict simply because he or she is a contributor to the Canada Pension Plan. Within OMERS this is deemed to be a potential conflict, and we are glad to see that the Senate is moving to eliminate this anomaly.
On conflict of interest, though, one of the changes in the legislation was to remove the de minimis standard. You may well find that this should be put back in the act.
It is entirely possible, given the nature of the investment business, that there will be a whole series of events which will have to be reported under the standard, and potentially some quite trivial issues. In the best governance of the plan, it would be better to give some flexibility in order to ensure that trivial events do not have to be reported.
The Chairman: What would such a trivial event be?
Mr. Gunn: For instance, it would be a conflict of interest for any member of a board to approve an investment in which, whether directly or indirectly, he or she had an investment. Considering that his fund is going to index -- that is the intention -- and any person could also hold index investments, that would be an immediate conflict.
The Chairman: Your reading of the law is that any member of the board who invests in the market is not eligible to be on the board?
Mr. Gunn: That is entirely possible.
The Chairman: Okay. I am sure that that is not what was intended. That may be what is written, but it is not what was intended. That is a very useful comment.
Senator Callbeck: Mr. Chairman, did I understand you correctly? Did you say that, if you are a director of that board, and if you have shares in the Bank of Nova Scotia, and the board decides to buy shares in the bank -- that is a conflict?
Mr. Gunn: The way that this legislation is drafted, that would have to be disclosed as a conflict of interest.
Senator Callbeck: Okay.
Mr. Gunn: This is something that can be corrected.
Lastly, I would like to comment on the role of non-indexing investment and directed investment.
In Canada, one of the points that has been made to the public sector pension plans is that they ought to look to invest for job creation. This does not necessarily mean for social investment, but that they ought to consider that the economy of Canada can benefit from the action of pension funds. That seems to be at odds with the concept of indexing.
In our understanding, the pension plan would potentially be restricted to 20 per cent foreign content, without the use of derivatives. This, too, is at odds with the concept of indexing.
In a free-trade world, this raises an issue as to whether or not this actually is in the best interest of all Canadians -- which, as you know, is defined as an object of the pension fund.
From the standpoint of job creation, under free trade, it is entirely possible that a Canadian company might be bought by an American company, and it would thus cease to be an eligible Canadian investment. It is actually possible that the TSE index could shrink, and that an index fund could hold securities which become ineligible by corporate actions.
There is an unemployment issue; if a foreign corporation buys a Canadian company, it is likely that its next plant will be built in the United States or elsewhere. On the other hand, if a Canadian company buys a foreign company, it is entirely likely that the subsequent plant will be built in Ontario, Nova Scotia, or Prince Edward Island. We should all be aware that the 20 per cent foreign content limit can actually indirectly restrict job creation.
Given that the Minister of Finance believes that this social concern is an appropriate activity for the provincially based plans, it would be worthwhile for the Canada Pension Plan to give some thought to the reflection of this feature, and to its overall governance.
The Chairman: Thank you. I would like you to expand on some points.
There is a provision that, for the first three years, the fund must be an indexed matched fund. We discussed that this morning with officials from the Department of Finance. Every private sector witness that we have had since then has said that this won't work in practice; that it is an interesting idea, but it doesn't work. We have had different rationales as to why it will not work in practice.
It would help to complete our record if you could tell us why an index fund does not work. The word index is defined in the legislation and in the regulations as "broad market indices"; I would like to know what the possible spins on that are.
To return to the 80/20 rule -- I think that you were here when Mr. Lamoureux explained that, legally, you do not have to stick within the rigid 80/20 rule. I think he said that he was roughly a third in Canadian securities, the gains for which were foreign derived.
I am not quite clear on whether or not this strategy is available to the CPP. The teachers' fund uses it, as do all kinds of other pension funds -- yours, I suspect, included. Is it your understanding that this strategy is not available to the CPP?
Mr. Gunn: After meeting with officials in Finance, it is our understanding that the Canada Pension Plan would be directed to adhere strictly to a 20 per cent absolute limit, and to not take advantage of some of the other features which would allow the content to be expanded.
The Chairman: They will have a tighter restriction than any other pension fund?
Mr. Gunn: That was communicated to us as a possible direction for the operation of the CPP.
The Chairman: That came from private meetings with Finance?
Mr. Gunn: Yes.
The Chairman: We can deal with that when we have Finance officials back later on in the hearings.
Can you talk to us a bit about the indexing issue? Clearly the intent was that, as this fund established itself, it ought not to take wild gambles, but rather to stick to what the market was generally doing. To a lay person that might seem to be a reasonable policy.
We recognize the intent or the spirit of the policy, but every private sector witness has told us that it will not work. How do we deal with that problem?
Mr. Gunn: Let me start by saying that, while teachers might be the largest indexed plan in the country, OMERS is the largest actively managed plan, which is to say that it relies the least on indexing.
So, let me join the crowd of my professional colleagues and agree that the idea of indexing is interesting, but it will not work.
What is an index? The concept of indexing is very closely tied to an American theory of efficient markets. That is an American theory -- it is based on actions within the United States market. It is also time restricted in its application. There are people who believe that indexing works in a narrow sense, while there are others who believe that, intellectually, it works on a broader sense.
Over the past ten years, as Mr. Lamoureux noted, it has been extremely difficult for most U.S. pension fund managers to exceed the Standard & Poor's index. However, Standard & Poor's index is a limited index in the United States. It is generally considered that the broader index is the Russell 3,000. Because of the technical make-up of this index, it is believed that managers can out perform it; that is to say, add value over and above it.
It is generally considered that the Canadian market is not as efficient as the United States market.
The Chairman: Why?
Mr. Gunn: Partially because of the size of companies. We have smaller companies that are less actively traded; it is therefore difficult for any fund to get a reasonable exposure at a reasonable price.
There are also some technical features built into an index itself -- especially the ones created by the Toronto Stock Exchange -- that assume that you can buy all securities at all times, without any price effect of entering the market and creating a quantum effect. In the real world this does not happen. In the real world the presence of a major fund creates what is called a "market maker effect" and, as such, it becomes very difficult to actually duplicate the neutral index. The neutral index works in mathematics, it does not work in real markets.
As I said, there is the Canadian phenomenon -- which is that the Canadian market, in relation to the market in the American market, is not as efficient. The Canadian market, I believe, is the 10th largest equity market in the world. If you view it in that context, it is not surprising that there would be more efficiency in the UK, Japan, or Germany. This has to do with the concept of price discovery, and how active markets are.
The nature of the Canadian market itself, the nature of how the index is created, and the size of companies below the 100 stocks in the TSE 100 -- all of theses create technical difficulties to be overcome.
I would say that the core of the argument is a technical one, not an intellectual one. Intellectually, of course, it is possible to index practically. It is not, however, possible to index very effectively in Canada. Further, given the eventual size of the CPP's direct investment, it would become increasingly difficult to do so.
The Chairman: There is debate as to whether or not this is the right policy. Let us assume for the moment, though, that the intent of the policy was to avoid gambling -- to ensure a small "c" conservative approach to following the market. Is there a way to convey the spirit of that intent while at the same time allowing for what Mr. Lamoureux called "sufficient flexibility"?
Mr. Gunn: It would be relatively straightforward to place a percentage limit on the indexed fund, and to allow for what would otherwise be defined as a basket of other securities -- this would allow the fund managers to have flexibility. There was a basket provision in the old financial legislation, and it may well be appropriate to reintroduce it.
The Chairman: The basket provision requires a certain percentage of the total portfolio to be roughly consistent with the TSE 300?
Mr. Gunn: It could require something like 80 per cent of Canadian content to replicate one or several indices selected by the board -- the other 20 per cent would be eligible for investment in other equities selected and approved by the board.
The Chairman: The regulations refer to indices in the plural -- the exact term, if I remember correctly, is "broad market indices." Several witnesses have wondered exactly which indices they were talking about. We have always used today, in front of the senators, the illustrious example of the TSE 300, but what other indices would make sense? Someone must have had others in mind, and not just sub-sets of the 300.
Mr. Gunn: The Toronto Stock Exchange index group is considered to be the lead index in Canada and the broadest based. I think that, conceptually, people are referring to the sub-set indices -- the TSE 35, 100, and 200.
The TSE, however, is not the only stock exchange in Canada -- it is simply the largest, which is a point that may well arise at some point.I do not think that anyone -- other than in a regional sense -- would suggest that the CPP would ignore the Vancouver index, or Calgary or Montreal, all of which are quite different.
I think that that would be a technical decision of the board = it would have to decide which indices to emulate.
Senator St. Germain: We would hire qualified people like you gentlemen or like Mr. Lamoureux to get into the technicalities of all of these things.
The general public has a lot of cynicism in regard to political appointments today, and my question is about accountability. During the debate and the hearings that we had, I suggested to Minister Martin that, as opposed to going straight to GIC appointments -- which are always considered to be political -- we ought to choose half from the federal side and half from the provinces. The provinces, after all, are players, and they ought to be involved. The stipulation would be that the minister may consult these people, not that he "shall" or "must" consult them.
In this system, the representatives from the federal government, along with those from the provinces, would choose a neutral chair. Do you think that this would give the board more transparency, more credibility, for the general public, the shareholding people?
Mr. Richmond: That is difficult to comment on. I do not think that the general population sees a distinction between the political motives of provincial and federal people -- a political appointment is a political appointment.
Somebody is going to have to stand up when the party is over, and it obviously would be the ministers responsible for the plan. Regardless of who makes the appointment to the proposed board, as long as caution is exercised and a nominating committee process is used, you are almost always going to end up with good, interested, and competent people.
During the rounds of discussion, the government has heard from experts, from experienced pension plans, and from the general public, and has listened to them. The government has not tried to depoliticize it, but, within the political realm, it has tried to make it as responsible as possible. They are trying to ensure that the right people, with the right capabilities, will end up on the board. They also want representation from employers, members, and probably also from pensioners in the plan.
Senator Tkachuk: How could they make appointment to the board more political than it already is? What I am trying to get at is that a political appointment is a political appointment is a political appointment.
I am asking you -- considering the way they are making those appointments -- how could the appointments be more political than they already are? They had to come from somewhere to get where they are.
Mr. Richmond: Let me answer it from our own perspective, based on our experience at OMERS. OMERS has had a politically appointed board for 35 years. When the government makes an appointment, however, it does not make it from its own -- depending upon which position is becoming vacant, it solicits nominations from employers, employee representatives, or pensioners.
Although the OMERS board is politically appointed, it is not a political board. It is a board that has functioned in the interest of the beneficiaries. The plan has always been managed to a surplus, and we have a good staff. We have had access to all of the investment vehicles, and we have used all of the techniques.
In my opinion, if it is done the way that it has been done at OMERS, everything will be fine.
Senator Tkachuk: The provincial government, however has a self-interest in seeing that the pension fund of the municipalities is healthy, because if is not healthy they have a problem.
Under the CPP there is no self-interest, because it is a tax. By extraction -- by law -- they force what I pay to the fund. I am not actually contributing to a pension fund. I am being payroll taxed to pay for the pensioners of today. I am not putting it into my own -- I am paying for today's pensioners.
Mr. Richmond: There is some truth in what you say. If your plan is not fully funded, by definition there is some inter-generational transfer.
This plan and its investment board, however, are charged with moving away from the pure taxation, pay-as-you-go mentality that we have seen in the past -- they are to move to a more fully funded program. The goal is to normalize, not only the investment activity, but also the contribution that investment activities make in the funding of the plan. This will mirror what a lot of the other public sector plans in Canada are doing.
Senator St. Germain: I am concerned more with tomorrow than I am with today. We have seen so many horrific failures in Crown corporations in the past; they have run up huge debts and then they have been sold off for virtually nothing.
My concern is not the first board; hopefully the first board will be the ideal board. It will set the parameters and be a perfect board. It is subsequent boards that generally create problems, as is obvious if you look at the histories of a lot of Crown corporations that have been set up. That is really my concern.
I would like to return to the set up where 50 per cent is appointed by the provinces and 50 per cent by the federal government, with a neutral chair. Only your expertise can tell me I am asking for something that is not necessary.
Both of your organizations have extremely successful track records; if it is operated so well, why not have the government take a look at something similar that provides the checks and balances. After all, this is not a political thing -- this is looking after the future of all Canadians.
Mr. Richmond: There are some distinguishing characteristics here, even in comparison with other Crown corporations. We have a precedent, in that, historically, public sector pension plans have functioned well, not only in Ontario, but also in British Columbia, Alberta, and Nova Scotia, et cetera. The models are there.
A lot of Crown corporations did not accomplish their goals the way that they were initially intended to, or never even got around to doing what they were set up to do. For pension plans, however, there is a pretty standard format.
Further, this will be a very visible organization, although I do not believe that it is a Crown corporation.
Senator St. Germain: No.
Mr. Richmond: A subtle distinction.
The Chairman: Last week some of us were in London on a different matter, and the subject of staffing came up; the issue of hiring competent staff, the difficulty of being in a quasi-public sector, and of meeting street salaries.
Would it be correct to say that you are not constrained? That is, you can pay market salaries, street salaries, even though you are in the quasi-public sector and therefore must adhere to some -- even unofficial -- guidelines. Am I right on that?
Mr. Richmond: That is correct.
The Chairman: Most of your investment staff receive compensation which is, in part, performance based, do they not?
Mr. Richmond: Yes.
The Chairman: If their investments have a bad year, then, they personally have a bad year?
Mr. Richmond: They do not have as good a year, but the base salary is still a significant component of the compensation system. They receive a base salary and then incentives.
The Chairman: Without pinning you down to an exact number, is the base salary closer to 50 per cent or to 80 per cent?
Mr. Richmond: Closer to 50 per cent in our case; but closer to 80 in some of the other cases.
The Chairman: This morning we had Keith Ambachtsheer, John Por, and Malcolm Hamilton with us, and they told us their views regarding the characteristics desirable in a good board member. Earlier this afternoon, Claude Lamoureux, as opposed to talking about individual members, referred to the desirability of getting the best board possible.
What would you do if you were starting from scratch? Forget about the selection process itself -- what characteristics should individual members posses? Also, what would constitute the best board?
Mr. Richmond: I will let Tom answer that.
Mr. Gunn: Pension plans are regularly asked to comment on what constitutes a good corporate director, and we study corporate boards quite seriously in order to determine what works for corporate Canada.
There are four characteristics that are essential. Firstly, any member of the CPP board must have a solid understanding of investment matters. Secondly, that person must also have a solid understanding of benefit matters, as this plan is designed to pay pensions, and it is therefore not simply an investment fund
The Chairman: When you say benefits and investments, does that include the problem of matching assets and liabilities?
Mr. Gunn: Yes.
The corporate director of any financial institution needs to understand the management of assets and liabilities, and how the two come together; that is a core element. I would say, however, that it is not a requirement that a member of this board be recognized as an expert in leading investment objectives, any more than it is a requirement for any other corporate director to be seen as the foremost expert in a field.
The purpose is to come together as a board, and to operate through collective strengths. When the board is put together, then, there will be people who have an understanding of a particular subject, but a willingness, also, to take solid advice from experts in particular fields.
A solid background -- which includes experience in a high level position in Canada, where one has been able to rely on experts -- is an important characteristic for any director.
The Chairman: In the first part of your answer, you stressed the importance of a knowledge and understanding of investments, investment activities, and how the markets work. This implies that, as board members, you want people who understand your business.
Corporate boards, however, frequently appoint people who, while they may not understand business, are able to provide perspective on the world in which the business operates that is quite different from that of the rest of the board.
Mr. Gunn: That is true.
The Chairman: From time to time you might question why someone is on a board, and then you discover that the member is able to provide a useful perspective to the board.
You seem to really emphasize the importance of everyone on the board having experience that relates to the business of the board. It may well be that, in your business, it is important that everyone know the business of the corporation -- I am not being critical of that.
Since your board is appointed by the government, however, you will understand that there will be tremendous pressure on the federal and provincial governments to appoint a "collectivity"; that is, the appropriate mix of members.
At some point, that "appropriate mix" may well be deemed more important than the emphasis on skill sets -- that is certainly a fear that has been expressed at this table several times today. How do you think we ought to deal with these problems?
Mr. Gunn: It was not my intention to say that the board ought to be filled with investment experts. It is important, however, that individuals, if they do not have initial knowledge of the pension business, demonstrate a willingness to learn it, as it is obviously the core business of the CPP.
It would be better to have a board member with good, general knowledge than to have an expert member who is unwilling to consider the opinions of others. It has happened, on some boards, that people who have been brought in as experts try to prove themselves by refusing to accept other opinions. That is not good board governance.
This going to be a fiduciary board;as such, it will be perhaps more like a trustee board than a corporate board.
The Chairman: What is the difference, in your view?
Mr. Gunn: The welfare of all of the citizens of the nation is dependent on the CPP. That requires a certain level of care, and a certain level of understanding, from the board. Corporate Canada has high standards, and, as we all know, those standards are, in fact, increasing. The board is not responsible for producing a product or a profit, however and it must meet a higher standard. The standard for fiduciary care, by law, is a higher standard.
Anyone joining the board would have to realize that the role of a board member is to be a trustee for all Canadians.
The Chairman: Thank you. Dale, do you have anything to add?
Mr. Richmond: Although the OMERS boards have been politically appointed, they have always had a certain magic; people have come from different walks of life, representing employers, employee organizations, and pensioners.
Many of these members have distinguished themselves in their own careers, but, when they enter an OMERS board meeting, they take their hats off and really represent our goal of balancing assets with liabilities. That is, the compassion of what the pension fund is, versus the hard-nosed, bottom-line, investing return that we want out of our private placement.
The plan has a fiduciary responsibility to the beneficiaries -- not to the people that appoint the board, nor to the board. Its responsibility is neither to create a product nor to produce a profit. It takes the right mix to end up with a balance on something like a pension plan; the board has to ensure that the beneficiaries will benefit in a way that the board members themselves would be conflicted if they tried to benefit.
The Chairman: Claude Lamoureux told us that, if we were to listen to one of his board meetings, we would be unable to tell which board members were representing the union, and which represented the government. They act as a collective group, in much the same way that this committee typically does. We have had split votes in this committee, but they are virtually never split along party lines.
We had a great donnybrook over the Sports Illustrated bill -- which was kind of fun because Lowell Murray, who was the former Conservative leader in the Senate, supported the government, and I opposed the government. It had nothing to do with partisan politics; it had to do with different views of what was in the public interest.
Is what Claude Lamoureux said about his board also true for yours?
Mr. Richmond: It is, and we have had a 35-year history of joint management. The appointment process gets people there, but six do have to be from the employers, while the other six have to be from the employee side. It is true that, if you were a fly on the wall, you could not determine which side is represented by whom. Further, there have never been any close votes, which is quite remarkable.
The Chairman: I have one last question on indexing. That issue is really bothering me; it intrigues me that an idea could sound so simple -- sort of like tax imbedded pricing -- and not necessarily work in the real world.
Earlier you said that, if you were not using the TSE index, there is a Vancouver index and an Alberta index -- which I did not realize. My instinct would tell me, though, that it would actually be much harder to match the Alberta and Vancouver indices, because there are smaller floats, than it would be to much the TSE. To put it another way, as Claude Lamoureux said, you could use the TSE for the big stocks, but when you got down to number 299 you would have a problem.
I do not know quite enough about the Vancouver and Alberta indices, but am I correct in thinking that it would be an even more difficult problem out there?
Mr. Gunn: Yes, it would. It gets back to the point of capitalization, and aggregate market value of securities. The value of the listed securities that compose the TSE 300 by far overwhelms all other securities in Canada.
The aggregate market composition of the other stock exchange indices and of the other stock exchanges in Canada is very small. It would make the job extremely difficult.
It would also create another issue, in that the Canada Pension Plan would likely become a dominant market maker force in those markets. That has other implications, and I don't think that those were thought through.
The Chairman: Right; it would become a dominant market maker simply because of the volume of capital being invested. By definition, at that point you are skewing the index because you are the dominant player. Mathematics tells you that.
Mr. Gunn: That is right.
The Chairman: Given the facts as you have just presented them, I think that there are two options. I think that I know which one I would choose, but I would like to see what you think.
As I see it, the first option would be that you do not invest in stocks listed on the Alberta or Vancouver exchanges. The second would be to rethink how index matching is defined, allowing for more flexibility, so that you do not create the market skew. Is that correct?
Mr. Gunn: Yes. I would certainly choose the latter. If you were to blindly direct money at an index, what would likely happen is a misallocation of capital away from other sectors of the economy that we can use. Blindly following an index would not be in the best interests of economic development, either.
The Chairman: Right. You said that yours is the largest un-indexed public pension plan in the country, and that Teachers' is at the other end. Even Teachers', however, cannot be even close to perfectly indexed because of the skew in the marketplace. Is that correct?
Mr. Gunn: Yes, that is correct. It is a very interesting idea intellectually. It is very difficult to implement, and that is where the problem is.
The Chairman: Well, that is why I used the analogy of the tax pricing, which all kinds of countries have, but they don't try it in just three small provinces.
Mr. Gunn: That is correct.
The Chairman: I am sorry, but we have to adjourn. We are holding hearings in Calgary tomorrow, and we have to catch a plane.
We look forward to chatting with you about institutional investors in May. Thank you for coming.
Senators, we are adjourned until nine o'clock sharp tomorrow morning in Calgary at the Delta Bow Valley.
The committee adjourned.