Proceedings of the Standing Senate Committee on
Banking, Trade and
Commerce
Issue 10 - Evidence - Morning meeting
VANCOUVER, Thursday, February 19, 1998
The Standing Senate Committee on Banking, Trade and Commerce met this day at 9:00 a.m. to begin its study of the governance provisions contained in the Canada Pension Plan Investment Board Act (previously Bill C-2).
Senator David Tkachuk (Deputy Chairman) in the Chair.
[English]
The Deputy Chairman: Good morning. We have a quorum, and I will call the meeting to order. I wish to welcome Senator Lawson.
This morning we are joined by Mr. Herb Grubel, Professor of Economics at Simon Fraser University and a Senior Fellow of the Fraser Institute. We know Mr. Grubel from his days as the finance critic for the Reform Party and as an elected member of the House of Commons. Welcome, Mr. Grubel. It is nice to be in your home province.
Mr. Herbert Grubel, Professor of Economics, Simon Fraser University, and Senior Fellow, The Fraser Institute: Honourable senators, I thank you for the opportunity to share with you today my views on the reform of the CPP initiated by the Liberal government under the leadership of the Honourable Paul Martin, Minister of Finance. I bring to this task my training as an economist and professor of international finance. I also draw on the work I had done on the subject while I was the finance critic for the Reform Party in the last Parliament.
In my presentation to you today, I will present first my criticism of the proposed reforms of CPP now going through Parliament, and then I will discuss the governance and accountability for the proposed surplus fund.
Pension reform is a complex subject, and I will touch only upon a few points. I invite your questions if you need for further elaboration.
Under the assumption that the Liberal reforms to the CPP system are going ahead, we can expect the accumulation of a large, temporary fund made up of premium income in excess of benefits paid out. Estimates are that this fund could be at least $100 billion, and possibly much more. I share your concerns about the proper operation of this fund. The following are my thoughts on how this can be accomplished.
The most important requirement is that the fund is operated under a constitution which mandates it to maximize the rate of return earned on invested assets. It should therefore be free from requirements to subsidize regional, industrial or government projects of any sort, whatever their alleged merits might be. If the investment does not earn a required rate of return for a certain risk, it should not be made.
This principle contains some important devils in the details. As you know, financial markets offer a trade-off between return and risk. How much risk should the fund be willing to accept if it wishes to increase its returns? The government has chosen to resolve this issue by insisting that the fund passively invests to maintain the Toronto stock market average. Thanks to your initiative you have had investment managers testify that this is not a workable operating principle. I agree. This issue should be debated and an appropriate direction about the desired risk-adjusted rate of return should be written into the constitution without restricting totally the freedom on managers to manoeuvre in the light of market conditions.
There is also the issue of the cost of administration, which may be considered to consist mostly of the research needed to find suitable investments and the transactions costs associated with placing the funds. The high cost of owning mutual funds has recently been brought to the attention of the public. We should therefore be reminded of the importance of that determinant on the net rate of return earned by the funds. Should there be any limits on the cost of administration?
Some investment advisers recommended buy-and-hold strategies. Others like to trade frequently, dumping non-performing assets and buying some with higher prospective returns. Which of these strategies do we want the fund managers to follow? Perhaps passive investment in the Toronto index solves this problem, but as the recent testimony suggests, this strategy has its own problems. I really welcome your initiative for broad consultation on the issue.
Should the freedom from political interference include the freedom to invest without restrictions on foreign content? Economists have very persuasive arguments suggesting that such restrictions on foreign investment are costly to the owners of assets. By having to forgo the opportunities for portfolio diversification offered by foreign asset holdings, investors are forced to accept either a lower return with the same risk or a higher risk with the same rate of return. It makes no sense to impose such costs on a huge investment owned by the broad Canadian public.
On a personal note, I have written a paper which was published in the American Economic Review in the 1970s which actually proved by how much welfare can be increased through international diversification of assets. This has been used widely in text books by investment analysts, and it is something that is imitated. The studies have been refined greatly and many imitations have been made. I am absolutely certain that we are forgoing many benefits by restricting our investments only to Canadian assets.
The Deputy Chairman: It is interesting to note, Mr. Grubel, that although we have not yet convinced the government of that, members of the banking committee of the Senate have recommended in the past and are very supportive of lifting the 20 per cent investment rule.
Mr. Grubel: For the record, let me summarize in a paragraph the way I put it to my students.
Most important, such restrictions do nothing to lower domestic costs of capital or reduce the nation's net foreign indebtedness. These two variables, which are important to many people, are determined by domestic savings relative to domestic demand for investment. For example, if Canadian savings in total are less than are demanded by domestic investors, the excess is obtained from abroad. We either get it there or do without it. What will society do if Canadians want to invest $10 billion every year in mortgages to buy houses, build factories, and their governments want to build roads and schools, but the savings generated by investment by our pension funds and own savings accounts, and all those sources where we put our excess of income over what we spend, the net savings every year to which we add mainly through our pension funds, is less than $10 billion? Let us say it is $7 billion. The $3 billion shortfall always will be met by inflow of capital from abroad. If the pension funds are told that they cannot lend their money somewhere else, it has to be invested here, the story does not change, the net inflow will always be $3 billion.
Senator Kenny: We are sold. We agree.
Mr. Grubel: Sorry to have gone on for so long.
The Deputy Chairman: This is a good argument for the public, Mr. Grubel, so please disregard that comment from Senator Kenny.
Mr. Grubel: I noticed from the finance committee how often I met people who actually follow this.
I therefore recommend strongly that the fund not be limited in its ability to invest in foreign assets. It is clear that if this recommendation is adopted, the strategy of passive investment in the Toronto index is obsolete.
Who, in these days of enlightenment on international finance, insists that foreign content be limited to 20 per cent? I would be delighted to know which special interest group advocates that? I would like to be able to pass that information on to my students.
Senator Kenny: I think it is the Reform Party.
Mr. Grubel: The specification of the preceding rules of governance and investment strategies is important and a problem of great concern to the Senate. I have read your speeches on this matter. The universal theme is that you want the fund to be free from political interference. At the same time you insist that its managers be accountable somehow to someone. You hint that they may be accountable to Parliament.
I fully sympathize with your sentiments. The problem is that if you want to hold someone accountable you need an accounting rod for measuring whether or not they have performed their duties properly. The absence of such performance standards in the basic legislation frustrates you and your instinctive response is, let Parliament decide what the unspecified standards are and whether they have been met. You expect to use your common sense and political wisdom to come up with the right measures at the appropriate time.
That model is flawed, in my opinion. You cannot have it both ways. A fund operated free from political influences but periodic reviews of its performance by politicians inevitably will have its managers look over their shoulders for hints about political performance criteria.
I sense your frustration coming from the following scenario. Consider that fund managers make any bad decisions and rates of return are much lower than they could be as judged by the performance of private investment funds. How can these managers be made accountable for their failures?
You are also worried, and rightly so, that some investments are made for political reasons but the motives are well disguised. How can one assure that this does not happen, short of having a watchdog scrutinize every investment decision and often second-guessing it?
The government tries to avoid all of these problems by its choice of the passive investment strategy of buying the Toronto index. In a way, this is an ingenuous solution to the problem, except that it may not work, it forgoes the opportunities from international diversification and it discriminates against investors in regional stock markets in Montreal, Alberta and Vancouver.
In my view -- and now we come to some suggestions for the solutions -- your concerns and the three preceding objections can be dealt with through the following strategy.
First, make certain that the managers and directors of the fund are technical experts with no political connections, that they cannot be hired or fired for any reason other than technical incompetence and fraud.
Second, hold these managers and directors accountable through the use of market incentives. Hire people with a good track record in managing large portfolios. Compensate them through a package of salary and bonuses which spurns them to do their best and punishes them financially if they do badly. Say, the best manager for a fund of the expected size demands a salary of $250,000 per year on Bay Street. Give him or her a contract under which this sum would be paid if the fund earns a return that year equal to the average of the returns on the Toronto, New York, Tokyo and London stock markets, just as an example, net of the cost of administration and showing the same risk properties as these reference markets. If the fund earns less, reduce the salary by specified amounts. Pay bonuses if the fund performs better.
Third, consideration should be given to creating a number of separate funds, perhaps three to five, each operating independently in its effort to maximize rates of return. The resultant competition would provide powerful incentives, increasing performance. The results would also provide important benchmarks by which the performance of individual funds and their managers can be evaluated.
Again there are devils in the details of contracts based on performance. Perhaps the managers should be constrained by limits on the share of investment in common stocks rather than bonds with different risks. The weight of the different national stock markets in the average rate of return has to be determined. These matters are not simple and in the end may involve some arbitrary decisions. But the issues can and should be addressed.
Fourth, the constitution of the fund should also include criteria by which managers and directors can be fired outright. Fraud is an obvious criterion. Persistent underperformance might be another. Submitting to political influence should be considered, although only after much thought is given to possible methods for proving it. There is the ever-vexing problem of conflict of interest, as might arise from executives' personal wealth holdings. There are legal and contractual precedents for how to handle these issues.
Fifth, the constitution should provide for a proper rotation of directors. New blood and ideas are needed to keep management under supervision. At the same time, boards of directors require some elements of continuity. Therefore, perhaps 20 per cent of directors should be expected to be replaced every year, with a full turnover achieved every five years.
Sixth, over time, the criteria put into the constitution initially may become obsolete technically or for political reasons. Therefore, there needs to be a clause allowing changes to be made to the constitution. The trick in the design of a process for such changes is that it be difficult but not impossible to achieve. Taking a clue from other constitutional arrangements around the world, constitutional changes may be made to require a 75 per cent majority in both the House of Commons and the Senate.
In sum, the main point of the preceding remarks is that honourable senators have a legitimate concern about the management of the proposed investment fund. You want it to be free from political interference but you also want it to be accountable. The time for political input is in the design of the constitution under which the fund operates. Make sure that the operating managers and directors are politically independent and that they have a clear set of performance criteria by which they can be evaluated periodically. Make sure that these managers and directors are held accountable in terms of these performance criteria, not the political whims of the day. Make sure that accountability is achieved through the symmetric working of financial punishments and rewards.
I am convinced that these safeguards can be put into the constitution of the fund without placing undue limits on the freedom of managers to manage and directors to direct. I recommend that you insist on the writing of such a constitution.
Good luck with your deliberations and efforts to get Paul Martin and his mandarins to see it your way.
The Deputy Chairman: I forgot to mention that the reason we have one hour for this presentation is that Professor William Stanbury from the Faculty of Business Administration at the University of British Columbia is scheduled to appear at ten o'clock. I apologize to Mr. Grubel.
Senator St. Germain: I wish to thank Mr. Grubel. As expected, his was an excellent brief with excellent points, delivered in an excellent manner.
I am bit of a one-issuer on this particular tour. You want it to be free from political interference but you also want it to be accountable. It is the freedom from political interference that I am most concerned about. I hope you will concur with my belief that if we remove the political interference and get competent people, the system will be set up, and your suggestion of a constitution most likely would be an ideal situation where the fund would work properly. Others within our party have said that separate funds to compete against each other is an excellent idea.
I have asked the minister why he has gone to a GIC-method of appointing a board of directors when there are other methodologies utilized in the private sector and with the unions for selecting boards. The stakeholders in this are all Canadians and there is no way they could be represented at a board meeting. The suggestion that I came up with as result of deliberations with the Ontario Teachers' Pension Fund was having the federal government name half the board and provincial governments name half the board, and pick a neutral chair. Then there would be transparency. We all know about GIC appointments -- I am sure you remember some when you were in the House of Commons.
Do you have a comment in regard to that?
Mr. Grubel: How to make sure a board is neutral is not in my area of expertise. The point that I was trying to make is that there is a very delicate matter in many, many things that we run in society between, on the one hand, leaving and trusting a bunch of intelligent, well-meaning people with a certain task and, at the same time, having restraints put on what they can do.
I gave many long speeches in the House of Commons about the problem of constraining the freedom of a duly elected legislature in Canada from ever burdening future generations with debt because that future generation had no input whatever on the election of those people and they carry no weight on the election of those people. Many governments around the world feel that that is a legitimate way of constraining the power of Parliament, just as we have the bill of rights. Why is that? It is because we cannot trust parliamentarians always to act in the interests of society in the long run -- therefore, here are certain things they cannot do; it is written in the constitution. Similarly, in this case, we have a problem. There is a delicate line between saying, on the one hand, that we have thought about it a for a great deal and think it is best to restrain the freedom of the decision-makers, and knowing, on the other hand, that there are many situations arising in the world in which judgment of the people elected is needed and they have to be trusted. That is the dilemma you are up against. Where precisely to draw the line is the big issue that faces you.
Senator St. Germain: Do you not see any validity, if there is the necessity to have them there, in there being checks and balances with the provincial nominees verse the federal nominees? This situation is unique. It is not like appointing people to Crown corporations or as immigration court judges. This will deal that future that you speak of.
Approximately 30 years ago the CPP plan was brought in. It was supposed to provide funding, and now we know that it cannot meet the liabilities. If the liability cannot be met 30 years from now, I would like to think that we at this end did everything we could, not so much to take away power from government or the executive branch today, but to provide a check and balance in who represents the stakeholders. Provincial governments represent us at the regional levels and the federal government has its role. Having both governments naming directors to the board is what I am trying to bring forward. I believe that if it is done correctly there are enough competent people in our society who, if put in that position, will do what has to be done and will invest as well as anyone can expect them to invest.
Mr. Grubel: Senator, I appreciate your sentiment and agree with the last statement that you made, that there are many competent people around who would be able to do that sort of thing. I do not personally see the necessity of the dichotomy between people appointed by the provinces and the federal government. That is an unnecessary source of conflict. I come not from the political end but the academic side. I would say make it one-third economists, one-third professors of finance, and one-third practitioners from the major investment houses. That would be a proper dichotomy. They are beholden to no one. You can examine how ideological they are before appointment.
I have not thought this through carefully enough to strongly endorse it. I see some artificial conflict between the interest of provinces and the federal government in that.
Senator St. Germain: You must agree that the elected people are who are chosen by the stakeholders. In your example of an academic or an economist, they are not accountable to anyone.
These people are accountable by virtue of the fact that they have to be elected, that is all I am saying.
Mr. Grubel: Every few years you are accountable also because if you are a manager or involved in the financial industry on Bay Street and you do badly your future earnings will be down a great deal. You have a very big stake to be doing the right thing. Your political input should be such that you say that you want this fund to come as close as possible every year to a rate of return equal to what could have been earned had it been invested around the world in some proportions. You are immediately constraining the ability of the fund managers to say that there is a wonderful port to be developed somewhere in Newfoundland that will help 1,000 people, let us put money there. That cannot be done under those constraints because the rate of return is not there and they all have a stake in their reputation as professors of finance -- I am kidding, of course, there are not that many professors around who are capable of doing this -- kidding again. The main thing is that they have a very great stake and that implicitly is a system of accountability that you should try to draw on in the design of the frame of reference or constitution under which this fund operates.
Senator Kenny: Mr. Grubel, your presentation has been very provocative and interesting. The first point I would like you to elaborate on is the concept of incentive-based pay or performance-based pay for the managers. How do you devise a formula that compensates for performance and yet provides for long-term security and stability within the fund?
In my experience, whenever one devises a performance-based compensation package the key question is: Is it one year, five years, 10 years? It is easy to come up with a compensation package that rewards performance for one year. It is tougher when it gets to five years, and yet we are looking for performance that will be of value perhaps 30 years out and the folks who are making some of the decisions will not be around at that point in time.
Could you elaborate for us how you would build incentives into the compensation factor?
Mr. Grubel: I see your concerns, but at the same time there is a sequence of five one-year adjustments to the expected mean income. Sometimes it is above, sometimes it is below, because of the fund overperforming or underperforming, then after five years there is an average. I do not see that the time horizon is such a serious problem. There is much to be said in favour of the one year which is used in almost all such arrangements.
Senator Kenny: I have not described the problem well to you, sir. You will see many money managers now who are focusing on how they are doing this quarter and then how they are doing this year. With this fund, we do not care that much how they are doing this quarter or how they are doing this year compared to how will they do over the decade. It is the long-term health of the fund that we are interested in. How is a compensation package devised for someone here and now when we are interested in whether the investments will prove to be prudent a long time from now?
Mr. Grubel: Ten years from now is the sum of 10 one-year bonuses. By focusing on the short run they will eventually come up in the long run. The American system that you implicitly criticize of managers focusing on the short-run gains was criticized heavily by people who said that we should do it the way it is done in Europe where the big banks are forcing them to take the long-run point of view. The Europeans are in the doldrums; they are sick. They are now saying, "Maybe what we ought to be doing in Europe as well is to focus on the short run."
You raised an important point. I do not know what the answer is, other than what I just gave.
Senator Kenny: Mr. Chairman, I would like to flag that to the committee because the compensation question is a tricky one.
Perhaps I could go to corporate governance, sir. You made a reference towards the end of your remarks to management that is not concerned about the political whims of the day. That sounds suspiciously like the Senate. The criticism or the testimony that we have adduced to date has tended to lean strongly the other way, that in fact it should be the other place that has more involvement in the supervision of this fund, and yet they by their very nature are flavour-of-the-day folks. Their committees turn over at least once every two years, frequently more often than that; there is a lack of continuity; there tends not to be a corporate memory. Your view appears to be a little different than what other witnesses have had to say to us. Would you care to elaborate?
Mr. Grubel: I would like to repeat the phrase that the time for political input is in the design of the frame of reference and the operating procedures and control measures of the fund, compensation incentives and so on. That is when all of this debate should take place. It can be fixed down the road, but again that is more difficult to do. I think it should be fairly straightforward and simple. There should be an attempt to maximize the rate of return with a reasonable amount of stability and risk in the earnings. That is all there is, and then you decide politically on how best to safeguard and prevent the temptations of people to nevertheless try to muscle in on this and keep them in place and make the thing work that way.
Do not develop a system which requires accountability sessions with either members from the House of Commons or with senators every month, every quarter, every year. That will make those who are running the day-to-day affairs constantly look over their shoulders and say, "I like this job, it pays well" -- and all those kinds of wonderful prospects -- "I wonder what they really want?" Do not do that. It is simple enough to say: "Get the biggest rate of return for the future generations of pensioners that you can get."
Senator Kenny: The last area I wish to explore with the witness is a corporate governance question.
Have you given any thought or consideration to a foundation that would initially be set up by the minister but would have the capacity to perpetuate itself, or some system of proxy shareholders that might be used in terms of the governance of the organization?
Mr. Grubel: That sounds very interesting, but I have not. Do you know who came up with that?
Senator Kenny: We heard some discussions of it in Calgary. I am about to introduce a bill that has a foundation that perpetuates itself -- which I will expose to my colleagues in the next couple of weeks. It has a foundation that is initially set up by the minister but then has a mechanism to be at arm's length and perpetuate itself.
Mr. Grubel: What has influenced my thinking on this subject is that I have done some work and have been associated with people who run very large American foundations. There is a gentleman who has said that it has been shown through research that whatever a donor wishes to be the objective of a foundation, and makes that very clear in his testament, after a maximum of five years those objectives have been circumvented and the whole thing has been perverted. Therefore, it is very important that you study how to set up the constitution of any foundation in order that this will take place. There are people who were adamant Conservatives who gave money for Conservative objectives that I am interested in and by hook or by crook, or simply by being smart, it was taken over by people who are now using it for all manner of purposes that would cause the donor to turn around in his grave. The only one that has not is the Liberty Foundation in Indianapolis. For some reason its constitution has prevented this from happening.
Senator Meighen: You stated that the trustees or the members of the investment board should strive to get the highest rate of the return without undue risk. Presumably as you move up the return curve, your risk increases.
Mr. Grubel: Yes, but that can be circumvented by proper diversification. When there is an "Asian flu," Europe might do well. When Eastern Canada is in trouble, Western Canada may boom and vice versa. There is a tremendously favourable trade-off between rate of return and risk that is made available by broadly diversifying one's portfolios.
It has been said that our banks are so successful -- and you may not want to hear this -- and by international standards have good performance criteria because, in contrast with the American banks, they are regionally diversified and therefore can balance these differences in performance. It is a fairly simple principle but one should be reminded of that especially in the context of managing a $100 billion fund.
Senator Meighen: I cannot imagine why you would think I would not want to hear that.
The first thing to determine is the liabilities or the rate of growth that you want to attain. Surely if you can determine what the liabilities will be, you can then decide what rate of growth is required.
Mr. Grubel: I do not understand the concept of liabilities in this context.
Senator Meighen: What the pension fund has to pay out, is that not the first thing to determine?
Mr. Grubel: No. Well, that might come in. We should consider the premiums which will go to 9.9 per cent as the variable realistically in five or 10 years from now.
Honourable senators, may I call your attention to two graphs attached to my paper which have been taken from the OECD. I know from my own colleagues in the House of Commons that very few people know what the story is on our pensions. This has been taken from the OECD annual publication which surveys conditions in Canada. Obviously it contains a lot of input from the Department of Finance. Nevertheless, these are objective calculations. In my introduction, I give great credit to the government for having done what it has done within the constraints that it is to be a hybrid between a fully funded and an investment fund.
The baseline scenario can be seen on Figure 35. The horizontal axis is the years. The graph shows what revenue the projected premiums before the current reforms would yield. In Graph A, the revenues would be slightly less than 4 per cent of national income and level off by the year 2020. The vertical bars represent the payments that have to be made by the fund given the projections of demographic developments.
Graph B is a strictly-pay-as-you-go scenario. They are always expressed as a percentage of GDP, so they are difficult to relate but they were expected to have to reach to about 16 per cent or 17 per cent of the eligible income, so that is a strictly pay-as-you-go.
The "full cost" scenario, Graph C, is a little more difficult to explain. However, the "steady state" scenario, Graph D, the one I adopted in current reforms, shows that it would go on that line that is seen there to 9.9 per cent. It would rise quickly in the year 2003 to 9.9 per cent. Keeping it at that level, you can see the dotted line representing the total amount of money that is available for payout as a result of the accumulation of the surpluses in the early years and the interest earned on it.
Senator, I may now return to what you said, this is based on some projections of a rate of return on those investments that allows that dotted line practically to take care of all of the unfunded liabilities. If the rate of return is lower, and there will be again black bars of significant magnitude appearing after a certain year, what will have to happen is that the solid line which gives the premiums will simply have to go up.
Senator Kenny: I have not followed you on the graph. I take it across the bottom you are giving us years here.
Mr. Grubel: Percentage of national income collected either in premiums or percentage of national income of expenditures.
Senator Kenny: I never see where you get to 9.9 per cent. None of the graphs go above 7.
Mr. Grubel: I understand. It is 4.5 per cent of national income. That is the standard by which it is best to measure these things, because the 9.9 per cent of eligible earnings is really a very fungible figure. I am giving you now information to anchor your views on this subject.
Senator Kenny: I am trying to get your relationship between 9.9 and 4 per cent. I am missing that link.
Mr. Grubel: It is not in here. I am giving it to you as additional information that would have come from reading the chapter.
Senator Kenny: I was saying that I did not understand your explanation and could you go through it again slowly.
Mr. Grubel: The steady state scenario, Graph D, is the one which the government has adopted. It shows that the premium income will remain constant at 4.3 per cent of national income, and that is achieved -- I am now adding as information to you -- at 9.9 per cent. That 9.9 per cent is done by about 2003, as you look at this graph, and you will see that after that year there will be funds available, that throughout this period the solid line representing the premium income is above the outpayments represented by the bar and that is what is going to the fund that concerns you.
Senator Kenny: My question relates to the dotted line: Is this a best-case scenario, a worse-case, or an average? It is slightly underfunded here, but I would be happier if there were three lines, showing expected case, best case and worst case. Would you care to draw in those lines for us?
Mr. Grubel: No, I do not have those. You would have to look at the details of the calculations. This is only one variable. It also depends on longevity. It depends on the rate of return on the fund. In many ways, as you have encountered often, one has to trust the actuaries on these types of things. You may want to see a variance and put some safety cushions in it, but the safety cushion is essentially that Parliament is still in charge, that if this does not work it would have to be adjusted.
Honourable senators, please turn to the next page. Here they have looked at what will be the effect of changes made to the operation of the entire pension estimate system. My hobby horse, Senator St. Germain, is: Why did they not increase the age of normal retirement? Look at the baseline scenario again at A and see that the excess of outpayments relative to premium incomes is very large. Now turn to Graph B and see by how much these outpayments decrease if we go from 65 to 67 as a normal age of retirement. If you turn that around and superimpose on it what they did with respect to going to 9.9, it would not have to go to 9.9 per cent; it might have had to go only to 9 per cent, which is an enormous amount.
I asked David Walker why they did not consider that. I asked Paul Martin why they did not consider it. They had totally unsatisfactory answers. I urge you to use your influence to have the Department of Finance and Paul Martin look at that issue again. The Americans have done it, the British have done it, various other countries have done it. This is a very powerful impression on how big the savings are. As far as I am concerned, we should even go to 68 or 69.
Senator Kenny: Some of us like 75.
Mr. Grubel: Thank you for letting me introduce these graphs to you.
Senator Meighen: Would you agree, Professor Grubel, that the Auditor General should be the auditor of the fund, or do you have a view on that?
Mr. Grubel: I suppose the Auditor General should come in to make sure there is no fraud. In the House of Commons we had many discussions over whether some of the suggestions made by the Auditor General are not infringing on the sovereignty of the political decision-making. There is always that risk. Therefore, a reputable firm of outside auditors from the free market to make sure that there is no fraud and that the books are reflecting what actually went on might be just as well, because they would be much less tempted to interject their own views on what is good for the next generation, something I think this Auditor General -- I welcome it in some ways -- might be tempted to do.
Senator Meighen: I gather they are projecting one-tenth of 1 per cent of assets as the cost of administration. In your experience, is that a reasonable amount?
Mr. Grubel: That is not my area of expertise.
Senator Meighen: In your paper you advocated, in response to what I consider to be a very legitimate concern, that perhaps when the fund gets going splitting it into two or three smaller funds. The generally accepted view is that that would increase administrative costs. Do you think it can be done without physically separation?
Mr. Grubel: I can give you only one perspective on that, and that is that in the large administrative funds of the mutual funds it is the sales commissions that really hurt, and we will not have any sales commissions. That is one of the advantages of forcing people, mandating contributions to the retirement fund. It is a huge chunk of expense. The administration expense in the age of computers is relatively small. You would also have to consider that presumably a person with a record of managing a $100-billion fund taken from among the best of the world would command a higher salary than three, each of whom manage only $33 billion.
Those are the inputs, but I have no definitive answer to that. You really have to ask Bay Street people.
Senator Oliver: When we were in Toronto one of the witnesses told us that "bigger is better". In his handout, he stated that two researchers proposed two reasons for that: First, with increased size come increased economies of scale, and hence lower unit operating costs. Second, and perhaps more important, with increased size comes the ability to support a full-time professional management team dedicated to producing positive RANVA.
Do you not think that that is a better way to go? Not only that, but some Canadian funds that have one pool of money hire three or four different managers to manage it; they are brought in every quarter before the board to account. Why could that not work? Why does it have to be divided into three funds?
Mr. Grubel: Arguments about economies of scale in the operation of such organizations are always made. Banks merge and become the biggest banks in the world and promptly do not make it. Merger mania sweeps capitalist societies every 20 years, saying economies of scale are the way to go. The ultimate economies of scale are socialism, right? We also know that there is the trade-off on the other side of getting fat and lazy, not having a measuring rod against which to compare yourself. Ideologically as I look at the record of history, I say that having competition is better and the dynamic benefits outweigh the static gains from so-called economies of scale.
Senator Oliver: In your paper, on several occasions you use language such as, "I want the board of directors to be politically independent," and you talked about how they cannot be blighted with politics or they might not make good decisions in the public interest. I have great difficulty figuring out who is this person who is free from political influence. You would not be free from political influence because you have run for office. Who is this person and what would they have to be to be so pure?
Mr. Grubel: Clearly you hit on a very important point. This is an abstract ideal. As you know we have had enough judges appointed in the United States having been grilled mercilessly by senators and then in expectation of them being Liberal turn out to be Conservative or vice versa. Once people are in positions of independence like this I trust them to see the bigger ideal rather than the narrow political interests.
Senator Oliver: Would it mean that someone who has run for political office could actually serve and on the basis of what you have just said that that would be all right?
Mr. Grubel: I suggest that honourable senators read my autobiography which will be coming out.
Senator St. Germain: Herb, you are one of a kind.
Mr. Grubel: So are you, senator.
Senator St. Germain: I say that with respect.
Senator Oliver: You were a critic in the House of Commons and I wish to ask some questions about accountability. On the Canada Board Pension Plan, I will read three or four things to you and ask you what you say about this kind of accountability based on your experience in the House of Commons.
The Canada Pension Plan investment board requires quarterly financial statements to be sent to the Minister of Finance and relevant provincial ministers. As well as an annual report on the operation of the plan to be prepared by the investment board and sent to them, the Minister of Finance is to table an annual report in Parliament. There is to be a public meeting held by the investment board once every two years in each participating province. There is to be a preparation of an annual report on the administration of the act by the ministers of finance and human resources development. The act also permits the Minister of Finance, after consultation with the appropriate provincial ministers, to request a special examination of the board to determine if its systems and practices are being maintained according to the act's requirements.
What do you say about this kind of accountability based on your experience in the House of Commons?
Mr. Grubel: I cannot say I had any contact in the house with this kind of problem, but in principle it is nice to get information out in the open. Most of what you are talking about is assuring transparency. But accountability, think about what it means. You do something and then you get either punished or rewarded for what you have done; 99 per cent of what you say is that we need transparency. There is only one threat if you underperform, that you might be subjected to a special examination by the Minister of Finance. That perhaps should be left unspecified.
However, if I were to be appointed to this board I would like to know precisely what they might want to examine me about. I come back to my argument about the need to have a constitution. You cannot later state that we expected you to do this and you did that, now we will grill you for a few days in front of the media for not having achieved what you did not know you were supposed to have achieved.
The essence of accountability is not transparency -- that is an essential part of it; it is to have a measuring rod whereby you say, you have been a good boy, you have been a bad boy. I see nothing in there and you should insist on that.
Senator Oliver: The essence of your paper is the whole concept of a constitution. Have you done some drafting or have you chosen some things that you ideally would like to see in the constitution?
Mr. Grubel: No, I have not. This has come out of the blue and I only spent a couple of days on it. The principle is clear, you have to have your political input in the setting of the frame of reference. I call it a constitution. That must include, if you want, lots of stories about transparency, and, if you want, your concerns that this transparency is correct, who audits it. What I have seen missing is criteria which say, you have been a good boy or a bad boy.
Senator Lawson: On the question of the Auditor General auditing this type of fund, the answer for me is a resounding no. We had the example in the last few weeks of the United Auto Workers and Chrysler discovering a $200-million shortfall. The fund managers had invested inappropriately in chicken futures in China and had lost $200 million and exceeded the guidelines. You cannot talk about the Auditor General coming in once a year. You would have had to have quarterly professional auditors, skilled specifically in pension funds, to audit. Would you agree?
Mr. Grubel: That is a good point, one that is implicit in what I am saying on professional, independent managers who are definitely free from political interference.
Senator Lawson: In my previous life in the United States I was involved with multi-billion dollar pension funds, so successfully, as a matter of fact, that Senator Kennedy read into the record that it was one of the few funds in America that if no further contributions were made all beneficiaries would be paid every nickel. The system was simple: make certain they had enough contributions to start with; have a modest expectation of return of 6 per cent or 8 per cent; make sound investments in the American market that they were restricted to. Anything in excess of that made it a very successful fund.
We are making this far more complex than it needs to be when there are simple, basic rules.
Mr. Grubel: I agree and I was hinting at that, but I wanted to be sure that the more sophisticated people would have some input on this. I agree with you. I am a member of the Teachers' Investment Fund. It is an investment fund which has from the beginning followed the strategy of buy-and-hold. I was teaching at American universities between 1962 and 1970 before I came to Simon Fraser University. My salary maximum at that time was $12,000 and there were contributions of $1,000 or $2,000 a year for those few years. Do you know that that fund has now grown to where next year when I retire I could expect from those eight years of contributions benefits that are more than half of what I will receive from 25 years at Simon Fraser University, because of the excellent investment performance. The power of compound interest makes an enormous difference on how much you can earn.
Senator, I appreciate your common sense on that; maybe I was too sophisticated here. In your constitution, just tell them that they are expected to earn such and such; that if the inflation rate goes to, say, 20 per cent 6 per cent is nothing.
Senator Lawson: We must maintain our access to the American market. We cannot penalize ourselves. The top five funds in this U.S. this year will average 20 per cent. Why would we deny our beneficiaries in Canada the benefit of those excess earnings?
Mr. Grubel: It could be different in the future, one does not know.
Senator Lawson: That is correct. But if the fund is based on sound contributions and minimum returns then this additional revenue is to the better.
Mr. Grubel: I would hope for the sake of my children and your children it would also put some money into Latin America; something might happen there. Even the French might some day find out how to run their country again. It may have to become much worse than it is at the moment.
The Deputy Chairman: On that note --
Senator St. Germain: Integrity has always been his hallmark.
The Deputy Chairman: I love B.C. We have Senator Lawson, Senator St. Germain and you, sir. It is an interesting place to come.
Senator Lawson: Herb Grubel did not tell you the title of his autobiography. It simply says, very humbly: Do you think I was always this great!
The Deputy Chairman: Mr. Grubel, thank you very much for appearing before the committee.
Our next witness is W.T. Stanbury. He is a Professor of Regulation and Competition Policy, Faculty of Commerce and Business Administration, University of British Columbia. We have distributed a paper that he has prepared entitled, "Accountability and the Canada Pension Plan Investment Board."
Welcome, Mr. Stanbury, and please begin.
Professor William T. Stanbury, Faculty of Commerce and Business Administration, University of British Columbia: Honourable senators, I sincerely appreciate the opportunity to comment on some aspects of the new legislation, previously Bill C-2. I propose to focus on the institutional design of the Canada Pension Plan Investment Board, with particular reference to accountability. That point has already been addressed to some degree by Professor Grubel but I will provide a little more finely textured analysis which I hope will be valuable to the committee.
On the cover page of my paper I quote Senator Pitfield and I wish to reinforce that point:
Accountability is an essential ingredient of all our systems of government -- management, justice, democracy itself. Take accountability out of them and there is nothing left but the empty husk of hope, the dream of what might have been.
I will attempt to offer a pragmatic set of recommendations which I hope will improve the quality of the accountability regime in the plan.
My general approach is to apply a model that I am developing jointly with Margo Priest, a consultant in Ottawa, an analytical framework for looking at accountability regimes in a wide variety of contexts outside the traditional parliamentary system, in particular for regulatory agencies. The framework is highlighted in sections 2.1 through 2.4 of the paper.
Next, I propose to outline some criticisms of the proposal in section 3; and then in section 4, I will propose some changes for the consideration of this committee and the Senate.
If time permits, I would like to comment briefly on the larger problem of government opportunism with respect to the plan as a whole.
If I can direct your attention to section 2.0, I have taken the model that we have developed, which has four attributes of accountability, and took the components of the legislation up to section 58 of the act and placed them under each of these four components. The first component consists of the principal's delegation of authority and the specification of instructions to the agent. The agent in this case consists of the directors of the board. I list the components of the act that seem to me to fall into those categories.
The second component of the accountability regime consists of establishing criteria for measuring the performance of the agent, in this case again the directors of the board. I list a variety of mechanisms that touch on that. I do not think it does it satisfactorily, as Professor Grubel also suggested.
The third element of accountability is the flow of information to the principal, in this case the beneficiaries, about the agent's performance. There are a number of provisions -- and those were highlighted also by Professor Grubel -- and this is a formal recitation of those things that are contained in the legislation.
Finally, there are some mechanisms -- I would emphasize they are rather weak -- for imposing sanctions or rewards on the agent to complete the accountability circle.
Let me now highlight the criticisms regarding the accountability of the members of the board of directors of the board.
First, given the importance of the fund, there should be an explicit requirement that the directors have a fiduciary responsibility to the beneficiaries, not only to the corporation, which is the board in legal parlance in the legislation.
Second, the act obviously contemplates that some directors will be in conflict of interest and so establishes rules and procedures for dealing with such conflicts. There should be some possible conflicts in the act that should simply be prohibited because right now the regime is based on disclosure. I would argue that certain kinds of conflicts that should be prohibited outright.
Third, no standard performance measures for the fund are specified. These should be publicly reported periodically, preferably with comparative data. That is one of the strongest weaknesses in the provisions.
Fourth, there is no opportunity for the Auditor General to evaluate the performance of the board or to review its control systems.
Fifth, there is no requirement that a firm of licensed actuaries review periodically the Canada Pension Plan as a whole. Of course, this would also require an analysis of the benefit side of the plan, which is controlled largely by the Minister of Finance.
Sixth, there is no requirement to widely diffuse a summary of the results of the directors' stewardship to the beneficiaries.
Seventh, there are good reasons to suggest that 12 directors for the board is too few. As I point out, there are nine provinces in the Canada Pension Plan and no doubt each one will insist on having at least one representative. Just to remind people from outside B.C., the entire population of P.E.I. is less than the riding of Vancouver Centre. I do not happen to live in Vancouver Centre but I am adjacent to it.
The duration of appointment is three years but the appointments may be renewed. Professor Grubel touched on the fact that the volume of assets will soon be large, and specialized knowledge of particular types of investments could be valuable to the board. I suggest that the board itself needs a diversified portfolio of directors.
Depending on who is appointed, several directors may be eliminated from major decisions due to conflict of interest. It is for those reasons that I am suggesting that 12 may be too few.
Let me outline the proposed changes in the accountability regime that I put forward to the Senate.
The board should be required to submit detailed information to at least two recognized experts, such as the firm of Morningstar in the United States, to permit them to evaluate the performance of the board in managing the fund in comparison to a variety of other pension plans, mutual funds and comparable investment managers. That information should include at least the following: First, a measure of the effective rate of return over various periods; second, the cost of management and administration; third, the riskiness of the portfolio. The experts' reports should be included in the annual report distributed publicly.
The Act should specify that the board must retain a firm of professional actuaries to prepare a report every three years on the actuarial soundness of the Canada Pension Plan. Particular reference should be made to the rates of the contribution roles and investment performance of the fund in seeing that expected liabilities will be met. The actuaries' report should be published and disseminated like the annual report.
The mandatory diffusion of information on the board's performance should be expanded. I suggest that the board should be required: to publish full-page ads in newspapers in Canada's 25 largest cities; to create a web site with "down-loadable" information; and to do an annual or bi-annual mail-out of a two-page summary of the performance of the board in managing the fund.
The Auditor General should be appointed to act as the special examiner under section 47 and his or her report should be made public promptly and diffused widely.
The number of directors should be increased to about 18, with a particular view to ensuring that it contains a portfolio of expertise in areas where the fund will have a major part of its investments.
No director of the board should hold any other directorship and should be compensated accordingly. The beneficiaries need to be assured that the directors are focusing much of their time on the board.
Where the board retains external professional investment advisors or creates an internal team of employees to manage a portion of the fund's assets, the act should provide (a) that the board shall specify in writing the investment objectives and how the performance of the advisors or employee team will be evaluated, and (b) publish in its annual report both (a) and the actual performance of the advisor or internal team on at least three dimensions -- the effective rate of return, the cost of management and administration, and the riskiness of the investments.
I would like to conclude by raising a larger problem and that is what I describe as government opportunism. There is a very serious risk that in the future the government will in fact move to reduce the pensions available to those people who have above-average incomes as an alternative to raising the premium. There is nothing in the charter which would stop this; there is nothing in law which would stop this. It is entirely at the political discretion of the government of the day; only political pressure would stop it.
My calculations suggest that there is an opportunity for political entrepreneurs to engage in this strategy. This type of action represents a serious threat to Canadians who are at or near retirement age and are having some dependency on the Canada Pension Plan.
Senator Kenny: Thank you for a very provocative paper. I would like to start with the last point you made, and that is government opportunism. You talked about the clawback and two aspects. We heard Professor Grubel talk about the possibility of solving some of these problems by raising the age of eligibility, popping it up to 67 or 69. Certainty the math works and the demographics of the population are there. There is an element of ageism that is oppressive to some people that requires one to leave the workforce at an early age. Would you consider it government opportunism if the age were raised to 67 or 69?
Mr. Stanbury: It is moving in the same direction because Canadians in a sense bought into this plan 30 years ago under a set of assumptions. More sophisticated ones were not naive and certainly understood that this was going to be what I call a modified or glorified Ponzi scheme with intergenerational funding and redistribution within an age cohort as it moves through time.
I feel particularly strongly about the idea that someone like myself who has paid the maximum contribution throughout their working life, which coincided rather closely with the plan itself, could face the situation over the next decade of rapidly rising taxes to fund the plan and then reach the age of 65 and find a sufficiently structured political coalition which would say that Stanbury and people like him with more than $500,000 in their private plan have more than sufficient, say our elected representatives, therefore we will impose a 90-per-cent marginal tax on the putative benefits that he was to receive under the Canada Pension Plan.
For the last five years I have been dining out and regularly asking many of my fellow colleagues in the middle class how many of them honestly believe they will ever see any money out of the Canada Pension Plan. Over 90 per cent of them are working on the assumption that they will never see a dollar out of the plan and that they have to make private plans and private savings sufficient to take care themselves.
The middle class of the country are working on the assumption that their government will act in an opportunistic fashion. First of all, it is realistic, but it is also extremely sad because what it says is that this really is a Ponzi scheme with a third dimension of opportunistic behaviour that people did not even remotely imagine at that time.
Senator Kenny: Would you draw much of a distinction between a clawback and a graduated income tax?
Mr. Stanbury: We already have a graduated income tax.
Senator Kenny: I understand that.
Mr. Stanbury: Clawbacks can be done in a variety of ways. For example, the other pension plan has been done in a staged degree of clawback depending upon the existing private income, which works in steps so it eventually gets to the high 70s, as I recall.
Senator Kenny: Do you as an individual believe that there should be a graduated income tax? Is that a fair way to tax the population?
Mr. Stanbury: A broadly based flat rate tax with limited exceptions would be my preference strongly.
Senator Kenny: I have to know where you are coming from before I can ask the question. My last question on this particular area would be: Do you believe that government has an obligation to help the weakest in society, or should it provide the same level of benefit right across to the board to folks? Should the millionaire get the same pension as the person who has not been able to be so lucky to make a million bucks?
Mr. Stanbury: I strongly advocate the role of government in redistributing income to people who are poor. However, I find that the ways that government do it are the most profoundly inefficient and oftentimes ineffective imaginable. I would like a proper definition of poverty, which is an absolute and not a relative one. I want income transfers to be overt, explicit and voted annually in Parliament so that fellow Canadians know who pays and how much. I want to do it a less costly manner. The result would be that I could lower my taxes and simultaneously increase the benefits to the poor.
Senator Kenny: How could poverty possibly be defined absolutely and not relatively?
Mr. Stanbury: People starve on an absolute level, people are cold on an absolute level, people are ill-clothed on an absolute level.
Senator Kenny: I do not want to enter into a debate, Mr. Chairman.
Mr. Stanbury: I would be pleased to debate it.
Senator Kenny: I have to live with these guys, so I will not enter into a debate but perhaps I will catch you after the meeting. My next question has to do with two areas, and I will be briefer than I have been to date.
You state that no director of the board should hold any other directorship, and should be compensated accordingly. There have been some interesting models along the lines of corporate governance that suggest that for directors to perform the role properly they should not punch in for a meeting a month, or for nine meetings a year; they should be far more involved in terms of understanding the corporation they are managing, perhaps as much as three days a month; and instead of $10,000 to $15,000 perhaps they should receive pay of $100,000. I am pulling figures out of the air. Is this what you are talking about in recommendation 6?
Mr. Stanbury: Yes, but as you can see I am going further. As I read the literature of corporate boards, and I do not claim to be an expert, people are suggesting along the lines that you have that somewhere in the order of three to four boards where you are actively and intensively involved and compensated accordingly seems to get the best supervision on behalf of the shareholders. This is unique situation. The pile of money that will be involved here will be staggering. The more successful it is the bigger it will be. This is a very solemn and deep obligation to our fellow Canadians for a person who is appointed. It ought to take precedence in the director's life over all other responsibilities. The way we can signal that is to constrain those outside obligations.
The other thing about constraining it is that it will restrict the opportunity or the possibilities of conflict of interest. One could imagine the situation with very skilled people, each of whom has five or six or 10 directorships on their belt, sitting around contemplating particular investments, particularly given the type of constraints on the eligibility of investments for the plan in which a handful of the directors would be conflicted. Therefore, if there were 12 and a handful were out, five or seven would be making the decision.
Senator Kenny: You have expanded the board and I presume you are comfortable with the bank formula where they step out of the room?
Mr. Stanbury: No, I am not, because the whole regime here is a disclosure regime and there are actually relatively modest penalties, as I can see it, for actual conflict.
Senator Kenny: To use a phrase that took some coinage yesterday, "Mickey-Mouse" it out for us. How many days a year would you see this board sitting and how much would you like them paid?
Mr. Stanbury: On principle, I would like a substantial part of the remuneration to be based on performance. I agree with you going to back to Mr. Grubel that designing it is a complex and difficult thing. I am not suggesting otherwise. I would argue that this job would probably take 18 people probably two-thirds of their time to do well. It would be particularly time-consuming at the beginning when establishing the detailed policies and the parameters of how the system will run.
Senator Oliver: The mission statement.
Mr. Stanbury: Yes, and then you are developing specific performance criteria for yourself and then for your employees and/or hired investment guns. There is a lot of work to be done in setting that up; you may wish to think about breaking it into subfunds and how that relationship should be structured.
For example, the UBC pension plan has four or five competing teams of investment advisers, each with $600 million or $700 million, which is tiny by comparison. It will take a lot of work. Once it is up and working well, it will still take a lot of work but somewhat less. I would argue that the principal role of the board is to think long term, to be well informed about the set of world opportunities for investment.
I would, like Mr. Grubel, get rid of those constraints on the foreign ownership dimension. You will have to think of the terms of the threats that this huge fund faces from a variety of dimensions and be able to move it. It will be like moving a very large ship in fairly constrained water. Although this amount will be large in domestic capital needs, when looked at worldwide it will not be all that large, but still it cannot be turned on a dime. These people will have to spend a lot of time absorbing signals from the environment and trying to factor them into the complex bundle of assets that they are trying to manage or supervise. They do not manage them; they will be supervising the management of these assets by either employees or contracted investment advisers.
Senator Kenny: Perhaps give me an order of magnitude in terms of pay for two-thirds time. Are you are talking about compensation tied to performance if they are only on the board for five years?
Mr. Stanbury: Three years is the cycle proposed now.
Senator Kenny: The previous witness was talking about five. If we are talking about a three-year horizon or even a five-year horizon, and you said your primary objective is long term, you will be talking about a compensation plan that would be rewarding people 10 and 15 years later for decisions they made during the three or five years they spent on the board. When I said Mickey-Mouse it out, paint a picture for us so we get a clear understanding of what you really are after.
Mr. Stanbury: First, as I have indicated, increase the number of directors and restrict their outside responsibilities to reduce conflicts and to allow them to devote the time. You have a base compensation which would be frankly modest. It has to be enough for a decent middle-class standard of living, but the primary part, perhaps more than half or even two-thirds, would come from the performance of the fund.
Senator Kenny: Are we talking about $100,000, $200,000?
Mr. Stanbury: Yes. I would imagine if people perform well on this you are looking at the equivalent annualized. You are correct, it will have to be taken into account over the long term and those people could easily make $200,000, $300,000, $400,000 if they are performing exceptionally well.
Senator Meighen: Are directors synonymous with manager?
Mr. Stanbury: No. We are talking about the directors.
Senator Kenny: We are talking about the board here. It is a model that cam to us during our corporate governance study, where the directors, instead of doing a day a month or nine meetings a year, actually spent three days a month, and in this case we are suggesting much more than that.
Senator Oliver: Five days a week.
Senator Kenny: I think he only got as far as four days a week.
The Deputy Chairman: I do not want to speak for you, but I think what you are talking about initially is that the board is responsible for establishing the organization, so that will require a tremendous amount of time; and later, once all that is done, they become more traditional board members.
Mr. Stanbury: I still see them as having at least a half-time role.
Senator Kenny: But you also see them after they leave the board receiving compensation down the road, if their judgments prove to be good while they were on the board.
Mr. Stanbury: That is possible. There would have to be a substantial holdback, because some of those compensations may have to be negative. There is the problem of getting it back, a practical matter, so you would probably have a contingent arrangement.
Senator Kenny: Keep it in escrow.
Mr. Stanbury: Sure.
Senator Kenny: The last area is the top of page 8, where you stated:
This should include at least the following: (a) effective rate of return over various periods, (b) cost of management and administration, (c) riskiness of the portfolio.
Here you were talking about establishing criteria. I am curious about how you would go about some of these processes. For example, the question of riskiness of a portfolio. If you are in the private sector, you can pick or choose. You can decide that you like the look of a particular fund, that it meets your risk profile, and into it you go. What sort of risk profile do you have for 30 million Canadians? How is that balanced against what is a reasonable rate of return? The rate of return that folks see out there does not attach to it the level of risk associated with it. How will you cope with those issues in a public policy environment where it is everyone's money?
Mr. Stanbury: The board of directors will have the responsibility of the risk level. They will have to think very carefully about this because it is not managing their own funds. Legally it will be a corporation but I think of it as a set of beneficiaries and potential beneficiaries. They will have to think about being able to meet the obligations as best they can under the circumstances. We all know that the government can fiddle on the benefit side, it can fiddle on the eligibility side, the retirement date. It has to have a working plan as to what is a plausible set of assumptions, so that, as Senator Meighen talked about, their liability obligations are mapped out into the future. They also have to know what the possible variability of that is to make sure that even under the worst assumptions about their risk parameters they can meet those when they are due.
Most Canadians will probably want them to be slightly biased on the conservative side. I do not know the exact number, to be honest with you, but my intuition would be slightly on the conservative side. When you then decide on the acceptable level of riskiness, and that is not an easy thing to measure, looking at the risk return frontier will tell you what the potential rate of return will be. Presumably what you are looking for is to have the managers get that money out to the frontier, given whatever risk level is chosen, then you are on the frontier to find what the effective rate of return should be.
Senator Kenny: I come full circle to the compensation question. If a premium is set on lack of riskiness, you know that you will not get the returns you want or you will not get comparable returns to private-sector funds, then how do you relate that to the compensation of the board?
Mr. Stanbury: The board is being asked to establish a set of policies that take into account three things simultaneously. I would disagree with Professor Grubel about the way he expressed it. He said maximize the return; later he added, "of course, given the level of risk." Of course that is what you do. In this case, I would argue that if you choose the target rate of return that will dictate quite a bit about the riskiness you will have to be prepared to tolerate.
Senator Kenny: Return can be established with a number; risk cannot be reduced to a number.
Mr. Stanbury: That is not true actually. Unfortunately you are required to reduce it to a number of numbers, but the critical thing you are looking at is some measure of variability. One of the things that Morningstar has innovated in the United States is measuring riskiness of funds, average returns, and administrative costs. They have all three there.
If you look behind that and get into the micro data, which is not my area of expertise, you will discover that it is complex to measure degrees of riskiness. That does not mean that it is beyond the scope and skill of Canadians and their advisers. This can be done. My point is the recognition of the fact that we must do it and discuss it overtly, in a sense state clearly at the board level what it is obligated to do and what it is attempting to do, and then the performance is measured against those targets or those norms that you establish.
In addition, the board cannot evaluate itself. That is where the outside expertise comes in. I will have a portfolio of kinds of expertise being brought to bear here to feed back to the beneficiaries.
Unfortunately, or perhaps there is no other way around it, there is a long accountability loop here because the beneficiaries then have to relate that in the next election, which in turn, with a lag, affects the board of directors. My concern when I read the document was that there was not sufficient information. It was insufficient on a comparative basis, and there was not sufficient disclosure and diffusion of that information. Thus, those beneficiaries, through the political process, can close the accountability loop; they can punish the Minister of Finance and other cabinet ministers for the choices that they made about the directors.
Senator Kenny: All of those recommendations are good ones.
Senator St. Germain: Like my good friend Professor Grubel, you have done an excellent job in putting your case forward. I am trying to help the government but there is a bit of resistance.
You pointed out that the CPP program that we are entering into will be unique, something to which there is no comparison in our business community or in government to date. We talk about the directorships and huge remuneration as a result of performance. As one responsible for a region and for the legislation that goes through, I have suggested to the minister and to others in these hearings that we should seek that transparency by a methodology other than GIC appointments for selecting board members. We must find a selection process that will lessen the cynicism of the general public in regards to partisan appointments. We will be dragged into statements, the opposition will do this and that when we get into campaigns, and accusations will be made. Those directors should be above all of that.
One of the suggestions that was made to me from representatives of pension funds that operate in Ontario such as the Teachers' Pension Fund was that the federal government be responsible for a portion of the board, the provincial government be responsible for a portion of the board, and a neutral chairman be chosen. I cite that as one example; there could be others ways. What do you think of this? Do you think it is necessary? If not, I would like your straightforward answers.
Mr. Stanbury: I have no objection to that method. However, we could strengthen both the provincial selection and the federal selection by regulating that those persons selected go before a committee of the Senate, where they will be grilled as to what they know, their background, their skills, their aspirations and ideas about how this fund ought to be managed, and that they should not be appointed until a Senate committee on free vote recommends to the government that they be so appointed. In other words, they would be a pro tempore or tentative director.
Therefore, the process could be one where a candidate would go in front of the committee to be grilled; and the outcome could be that the committee would state that while a person had obviously done good things for a certain party it did not wish to put $30 billion to $200 billion of our fellow citizens' money under his or her direction.
Politics is a necessary and important part of our democracy. I do not wish to put down politics; I wish to leaven it with the role and responsibility that we are asking these men and women to do. I want to ensure they are well qualified to do it, and that information would come out in those type of hearings. It does not have to be a circus; it can be a focused and detailed examination on what this person does and their claimed expertise.
Let me give the committee an example. I studied very closely regulatory agencies and I can vividly remember a situation where a person was interviewed after being appointed to the CRTC where the reporter asked, "What are your qualifications?" This person said, "I subscribe to a telephone company." That is very interesting. I would have thought perhaps slightly greater qualifications would be desirable. I have no objection to this person being known to the party in power, but I am looking for the knowledge and expertise to manage this type of money or to supervise the management of this type of money. It would be helpful if that hearing loop was put in there and there was a free vote held in the Senate to advise the government. I would bring them all into the Senate whether they are provincial nominees or otherwise.
Senator St. Germain: Do you agree with the basic principle of half and half? From what I have seen in the House of Commons where I have served and I sat in cabinet, and also in the Senate, under normal circumstances the Senate has been basically non-partisan. I have agreed with many things the Liberals have done. In the election mode, mentalities change and this is the danger. If there were not have half from one side and half from the other, it was purely the federal government bringing all the names forward before the Senate, whether it is a Conservative-dominated Senate, there would be a tendency of creating a circus atmosphere and possibly not being able to vet the process as purely as it should be. That is why if half were from one area and half from other, I would hope that we could provide transparency and the confidence that people should have in this. If we change the age and have clawbacks, as you suggest, this will be a huge tax grab for those of us who will not receive a nickel out of it. It is a pure tax on us, regardless of what process of redistribution. That is my concern. Ninety per cent of your friends will be saying that they have been nailed with another tax from which they cannot benefit and have no say in and that it is a purely partisan pork-barrel for Conservatives, Liberals or Reformers.
Mr. Stanbury: That is correct. If it were half and half, I would still want the provincial nominees to go through the vetting process. Maybe there should be a joint sitting of the Senate and the House of Commons. It should not be done in the run-up to an election. We would have to have think about finessing the timing. I would like to see public hearings.
I wish to generalize that major appointments should be subject to the same scrutiny. It does not have to turn into a circus.
Senator Oliver: I am surprised that you want to increase the size of boards. Many Canadian companies, with good corporate governance in mind, are actually reducing the size of their boards. There are major Canadian companies that are run with boards of directors of less than 12 people. I am not so sure that size alone is the best criteria. The questions I wanted to ask about the size have already been addressed by Senator Kenny.
Is there a Canadian Morningstar manager of performance?
Mr. Stanbury: I do not know of one personally that has the same reputation as Morningstar in the United States. I have colleagues who specialize in business finance and are much more expert on the evaluation of pension plans who could advise you. I am sure if we look around we can find either individuals or firms with that expertise who could write careful analytic reports that would be objective and hard-nosed and would be working with a criteria to establish a priority.
The critical thing is comparability. If someone tells you that they earned a 20 per cent rate of return, but you know that the market was doing 25, you would tell them that that is not a very good performance. It has to be more sophisticated than that, and that is why the three variables must be measured simultaneously -- the return, the administrative costs, and the risks. In a sense, you are looking at the "edge of envelope", as we call it in economics, to try to find out where the performance of the plan would be.
Senator Oliver: At the beginning of your section 3.0, "Criticisms Regarding the Accountability of Directors", you said:
Given the importance of the Fund, there should be an explicit requirement that the directors have a fiduciary responsibility to the beneficiaries (and not only to the corporation which is the Board).
How would you see this being done, this fiduciary relationship?
Mr. Stanbury: I would like to see them take an oath. The way the act is now structured, it uses standard private corporate governance language about the relationship of the board normally to the shareholders. In this case, there is a unique single shareholder. It talks about certain duty of care, which is the standard corporate duty of care. That does imply strongly a fiduciary relationship but the relationship legally is to the corporation, which in this case is the Board as opposed to the board of directors; however, the beneficiaries here are the ones to whom you owe the allegiance and responsibility and duty of care. I would make that excruciatingly explicit in the legislation itself.
Senator Oliver: What would be in this oath that you would have them take?
Mr. Stanbury: That they would have a deep fiduciary relationship to operate to and make decisions in the best interests of the beneficiaries. That is the group.
Senator Oliver: How is that any different from a normal director's obligation to enhance shareholder value?
Mr. Stanbury: In this case, the shareholder, legally speaking, is the minister. It is true that if the value of the fund is maximized, holding risk constant, the benefits to the beneficiaries will be maximized.
Senator Oliver: Without this special fiduciary relationship you are advocating?
Mr. Stanbury: Partly what I am after here is making it explicit. It is implicit in the way it is written in standard corporatese. I have talked this over with a couple of friends. It would strike me that most Canadians would expect to see a statement that the members of the board of directors have a fiduciary relationship to maximize the economic interests of the beneficiaries, and I would like to see that explicit. Part of the problem is the way statutes are written. I have a reasonably good education. I am not the average layman. I find sometimes they are written in a code and unless you are familiar with that code you do not know what it means.
Senator Oliver: The Income Tax Act is a good example.
Mr. Stanbury: I could suggest many statutes.
Senator Lawson: For trade unions and pension fund trustees in the United States, a violation of their fiduciary responsibility means removal from office.
Mr. Stanbury: Yes, that is implied by that kind of relationship.
Senator Lawson: And perhaps going to jail.
Mr. Stanbury: The whole conflict regime is a disclosure regime and it would take extreme conditions before penalties would be wrought upon these individuals. By making this front and centre, other things in common law flow from it, and it seems to me that we ought to do that.
Senator Lawson: I mentioned the Chrysler situation. Chrysler felt compelled to replace the $200 million that was lost as a result of this mismanagement. In the type of fund we are talking about here, the government cannot be asked to replace a $200-million loss as a result of mismanagement, but the complaint by the auto workers was that no penalties of any kind applied to the people who were responsible. You are talking about severe penalties including removal or jail time.
Mr. Stanbury: Yes. If it is criminal obviously. It has to violate the statutory provisions in that regard.
Senator Oliver: One of the things that Senator St. Germain has been saying to many witnesses is that if we could get good directors who were not tainted with politics and who were competent this would solve many problems. Yet this whole appointment process for the directors of this fund is intrinsically political. It starts with the Minister of Finance, who is an elected member, and he and other people get together and make political decisions. The only suggestion that you are making for overcoming this is to have some form of a Senate confirmation hearing like they have in the United States. The Senate itself is political. You talk about a free vote and I do not think that is enough. Do you have any other suggestions for taking the taint of politics out of the selection of the board?
Mr. Stanbury: I am not as negative about the "taint of politics." I do not mind if someone has the technical knowledge, the intellectual ability, and the integrity to do the job as a director here, if they also had some affiliation with a political party. That does not trouble me in the slightest. I want to be sure that they have the right stuff in terms of personal integrity, knowledge, and intellectual capability to do the job of protecting and advancing the interests of the beneficiaries. That is the core issue. If they happen to have come out of the political environment with some degree of connection, great or large, I frankly am not troubled by that.
I am worried about putting in political hacks whose only claim to fame is that political connection. In my opinion, it is not enough that the heads or the members of regulatory agencies only knowledge of regulation is that they subscribe to the telephone system or listen to the CBC.
Senator St. Germain: For those of us who have experience and who have been there, and I am not citing any particular party, this does happen. My concern is not on the first board, because I am sure the first board will be above reproach. It is the second, third, and following ones where people in the PMO will decide who will sit on these boards. I have sat there in that capacity and I know how it works. I see how it is working now and I know how it worked before, whether under Diefenbaker, Pearson, Trudeau, Chrétien or Mulroney. That is my concern, and that breeds cynicism and lack of confidence, and destroys the transparency. That is what Senator Oliver and I are getting at. It does not matter whether our party is there for the next 100 years. I still believe that this is fraught with that nature.
Mr. Stanbury: Yes, and it is complicated by the three-year term. It seems to me that that is too short. It has the potential to be used for a rolling opportunity to reward friends and relatives of the party. I find that troubling, particularly if we are talking long term. If, as I am also suggesting, this is very important role that would require some changes for the individual, then there is the real risk that what they will do is cut their jib to fit the wind currently blowing, shall we say, out of the PCO or the PMO and that would be tragic.
The regrettable fact is that we have set up a mandatory, national, contributory scheme which is not actuarially sound. We have given the government of the day an extraordinary amount of power over this plan, and yes, as I say at the beginning of the paper, and as Senator Pitfield says, it is not their money. The problem is: What way can be found for the beneficiaries, analogous to the shareholders of the corporate model, in a sense, to elect their own directors? The answer is: Unless some other dramatically different scheme is found, we are stuck with this one because the government created it; it was a political creature from the word go, set up as a slightly disguised Ponzi scheme. We are now beginning to try to make it more rational and sophisticated, partly because of the amounts of money involved, for a variety of reasons, and we are caught in a trap. With one leg still heavily mired in the traditional regulatory regime established by government, we are trying to liberalize it somewhat, make it more accountable to the beneficiaries, and we are part way between. That is the difficulty in the design. This is a very strange hybrid, as you probably know. It does not fit very nicely into some of the other standard models, which is why we are struggling to find a way to make it effective. I am not sure I have a monopoly on that; I am just trying to bring some of these things to the attention of the committee, in the hope that it will contribute to the debate.
Senator Oliver: Perhaps one-third of the directors should be selected by a national agency that specializes in selecting directors.
I note that you are the UPS Foundation Professor of Regulation and Competition Policy. Some of us on the committee have been in Europe studying banking and financial regulation. What is your view, in a nutshell, on the proposed Royal Bank and Bank of Montreal merger?
Mr. Stanbury: I do not have enough information. Let me explain why. I have from time to time given advice on mergers to the Competition Bureau, and from time to time I advise private clients. My experience is that what you read in the newspapers and what is conveniently available in the public domain is often not the information you need to know to advise either side well on these transactions. All I know on that one is what I have read in the papers. I have discussed it briefly with my students, who are very interested in it; it is too early days.
The Minister of Finance has unique powers in this case which do not apply in other mergers. There could be a situation where the minister would say no, and that would be the end of it, regardless of what the competition director would say, and might want to bring the case or not want to bring the case in front of the tribunal. Without a lot more information, I have to pass on that.
The Deputy Chairman: Probably wise.
Senator Lawson: On the formation of the Canada Pension Plan some 30 years ago I was a member of the Canada Pension Advisory Committee. Almost to a person we are all non-political, totally politically naive about what was going on, largely captives of the bureaucracy and the predetermined plans of the government as to how it would be achieved. That is how it got started. That explains the tradition.
Senator Meighen: All of us want to be sure, particularly with respect to investment considerations that flow from all parts of the country. There has been a suggestion by Professor Grubel and others that at a particular point in time the fund be divided into two or three smaller funds. I am not sure whether that meant actually physical dispersion of the fund operations. Do you have any view on that, in terms of ensuring that the oil and gas sector, which is largely concentrated elsewhere than Bay Street, has the full impact and input that it should have into the decision-making process?
Mr. Stanbury: I agree with him. His first principle was that potentially you want worldwide diversification. The second point, with which I also agree, is that there is much exaggeration in the name of economies of scale. That has not held at all. The evidence is exactly the opposite with respect to mutual funds, and what is this except a gigantic mutual fund of some variation?
The third point I would make is his as well, that there are advantages in terms of overall performance by having the fund broken into chunks and having it managed by different teams.
Senator Meighen: Notionally or really.
Mr. Stanbury: It could be both, actually. It could be stratified in two different ways. There might be some assets for which the only way that could be done is to have them under segregated administration. I am thinking of certain types of real property assets. If you are just talking about buying stocks, that represents a different degree of fungibility in the management of it. Generally, you want to have specialized teams. The other advantage is that you have competition, reference points. New blood can be brought in from time to time with different items about the way the world is evolving. Mr. Grubel said, give some thought to South America. I certainly would do that, but I would want someone who has been there, who has knowledge of it, to tell me something about the relative political and economic risks and say that my ideas are out of date, that things have changed and country risk analyses are conducted.
I am in favour of those three distinctions more along the lines that he suggested. I do not want to go back to your point about seeing that we are "adequately invested in oil and gas." This fund is not designed to take care of the capital needs of the oil and gas industry or of any other industry in this country. This is for the beneficiaries, the pension holders or potential pensioneers. That is whose interest ought to be maximized. When I say "maximized," it is a compound thing that is being maximized, these three particular variables simultaneously have to be taken into account. I would say that it is a positive non-obligation of the directors to take care of any sector or industry or see that it gets a "fair allocation of capital." Capital ought to be allocated to the expected best return available, given the risk, and those two things have to be taken into account simultaneously. No other criterion should be there.
Senator Meighen: That was not what I was getting at, that the oil and gas industry should be adequately represented. There are those who argue that the place to get the best advice on oil and gas, to call a spade a spade, is Calgary not Toronto.
Mr. Stanbury: That is probably true.
Senator Meighen: If that is true, and that was the thrust of my question, how do you ensure that Calgary's advice gets in? Do you have a physically situated segment of the Canada Pension Plan investment operation in Calgary? Or can it be done through notional divisions of the pool of assets and a team, or perhaps a team physically situate in Calgary?
Mr. Stanbury: There can certainly be people in Calgary who could, due to the deregulation of long-distance telephone rates, communicate with Toronto very well. The nice thing is that you get up earlier in the morning to catch them and express your views.
Senator Meighen: I understand that that is not always accepted as being full and frank input. Right, Mr. Grubel?
Mr. Stanbury: I appreciate that. My point would be that this is precisely what the directors are about, to find ways to supervise the management of this money in an effective way. If advisers are spending time flying back and forth across the country and not using the telephone, videoconferencing, and E-mail, someone has not understood how the new world is evolving. There are many ways to tap into expertise.
I have been studying networks in the last little while and people talk about distributed intelligence. That is one of the principles I would like to see applied here. Distributed intelligence is not in data bases, it is in the heads of people around this country. Some of then live in Vancouver, some live in Calgary, and some live in P.E.I. Today, knowledge is not equal to location because you can tap into so much information by indirect methods that you should not be thinking in those terms. It may well be, however, that some kinds of knowledge require a hands-on eyeball on the site, in which case, manage accordingly but do not be fixed about those ideas, they are going to have to change and adapt. The thing is to keep your eye on the performance and compare yourself all the time to how well you are doing on that performance. That does not mean that you should only be looking at it quarterly, because this is long-term obligation that has to be met.
As far as I know, for time immemorial Canadians will live and retire. This is virtually an infinity of horizons. But I am going to retire within 10 years.
The Deputy Chairman: Thank you very much, Professor Stanbury, that was very good. We would also like to thank Professor Grubel.
We are moving from the academic world to the business world. Before I introduce the next witness, I will leave the chair and ask Senator Meighen to take my place because my plane leaves at one o'clock and I do not want to leave in the middle of a presenter.
Senator Michael A. Meighen (Acting Chairman) in the Chair.
The Acting Chairman: I would like to introduce the next participant, who is from Connor, Clark & Lunn Investment. Mr. MacDougall has been a partner there since 1974 and is responsible for North American equity strategy.
Mr. Gordon H. MacDougall, Partner, Connor, Clark & Lunn Investment: Honourable senators, I have a couple of observations, and these are obviously from an investment manager's perspective, but I would like to respond to the questions and interests that you have.
One area in which I would make a comment is the area of governance. Obviously that has become a hot spot in Canada even from an investment manager's perspective. Our plan sponsors that we deal with, our clients, are asking us to document what are our internal corporate governance guidelines and what are our rules on trading. It is very key, not only from your perspective where you are sitting and looking at the Canadian Pension Plan Investment Board, but also from the perspective of the investment managers. Additionally, obviously, for the Canada Pension Plan Investment Board it is ever more important because of the high visibility of that.
The framework for the decision-making and administration is really key. Consistency on the board would be very important. I heard the last speaker talking about three years being too short. I would agree with that. From an investment manager's perspective, I have found among the clients we deal with that those who have boards that have five- to 10-year continuity, perhaps not in all of the people but in certainly a large majority, work the best. Why do they work the best? Because less changes are made from a policy point of view, from an investment asset mix point of view, and that means savings to the fund in the long run. That is an important point that I would like to make and leave with you.
From the investment side, clearly this fund has to be indexed, or a large portion of this fund has to be indexed. However, what is it indexed to? It cannot be indexed to the TSE 300, or you would own half of it or at least the bottom part of it, so there should be some definition of what is the optimization of indexation. Clearly, starting out, a high proportion of index is appropriate; adding specialty managers and managers who can add value has been demonstrated in other cases to be appropriate going further. You were talking about oil and gas earlier; perhaps there are also some other areas.
Diversification is key. Again, from an investment manager's perspective, we know that increased foreign investment not only increases return but also decreases risk, risk in our business being the volatility of those returns. Studies have shown that. Indeed, our own internal research shows that over the last 10 years the optimal equity portfolio would have been invested 55 per cent outside of Canada, 45 per cent inside Canada. Obviously we cannot do that and you cannot do that. But when you are talking about risk and return and long term, maybe that is a consideration.
My final observation on the investment side would be derivatives. This fund clearly will have to use them this future, but starting out it cannot. The derivatives market in Canada is not liquid enough at this point, but it will get more and more liquid as time goes on, and certainly that is a cost effective way to invest money and to make asset mix shifts.
Those are my comments, Mr. Chairman. I would be happy to respond to any questions or elaborate.
Senator Oliver: You stated that a large portion of this fund must be indexed. As regards the portion that is not included in the large portion, you would feel that the managers must have the ability to be able to buy and sell as they wish and not be controlled by an index. If that is the case, are you talking about 80 per cent to 20 per cent?
Mr. MacDougall: I do not know the optimal but that is probably not bad. Clearly a large majority should be indexed. You are only adding value at the margin with these. The more managers you hire, the more people like us that this fund would ultimately hire, the closer you will get to indexed returns. You can also overdiversify.
Senator Oliver: Given the nature of this fund and that it is a long-term fund for people's pensions in the future, what do you say the percentage of equities as opposed to bonds that should be in this fund?
Mr. MacDougall: I am not in a position to answer that question. Obviously actuaries have to look at that and have to look at retired lives versus working lives and appropriate strategies for both. We operate with mandates that come from the plan sponsor and the actuary, who have already looked at that question. We are dealing with investing the asset side of the balance sheet. I cannot comment intelligently on that one.
Senator Oliver: The investment board is required to establish both an audit committee and an investment committee. Moreover, the board of directors is required to establish written investment policies, standards and procedures in accordance with regulations and a requirement that these be in accordance with what a person of ordinary prudence would exercise in dealing with the property of others.
Do you support those provisions in the act with respect to the duties of the committees on the board and would you add something to them?
Mr. MacDougall: I absolutely concur with them. It is important that the audit committee and the investment committee both have clear mandates. Those have to be worked on very carefully, and the clearer they are the less problems you will have going forward with all of this.
The statement of policies will be a very important element. If this fund is only to be indexed in the first few years then that will not be as crucial. Once you start hiring or externally hiring other managers, that becomes ever more important. Clearly, those are two key areas here, areas the public will be most interested in.
Senator Oliver: From your experience in the business community, what is the best way for the government to go about choosing the best directors for this fund, which will be huge?
Mr. MacDougall: There are many pension plans in this country that are being run by good outside directors not involved with the plan sponsor, the corporation or the union. Among that community are some very knowledgeable and eligible people to work on a board such as this.
Senator Oliver: It was suggested to us today that the persons we should get should have no other directorships, to avoid conflicts of interest. Can you see Canada being able to obtain people with the competence and expertise that we need and that you would like to see being willing to give up their other directorships for this?
Mr. MacDougall: I find that hard to believe these days. You well might have someone who is a director of a couple of companies, and that does necessarily create a conflict because that person is not involved in the day-to-day investment of those funds, but obviously he would have to declare those. It is how those things are dealt with, but that is not an issue. On many pension plan boards that I report to directors are sitting on two or three different companies, some of them in companies that I tell them I do not like to invest in. Thus, we run into those situations as well.
Senator St. Germain: Mr. MacDougall, do you see any problem with the intense political involvement in the process? Many people in your business are apolitical and not involved in politics at all. They perhaps only go to the ballot box on election day. Do you see any problems with the appointment process, which is basically the normal Governor in Council appointment process? Do you see problems with that, as far as erosion of confidence and cynicism from the public are concerned?
Mr. MacDougall: Hopefully not. I would think that the quality of people to be appointed would be excellent. Obviously the first time around it is difficult because someone has to make those initial appointments. The quality of people attracted to this would be excellent and that is what you will be judged on in the end. Earlier I heard someone say that the problem will not happen with this board, it will be second and third boards. That is why I would argue for a longer duration for these people and that perhaps they not all turn over at once but every fifth, sixth, seventh year.
No matter what you do it will be seen to be political. The only way that it can be judged in the end is the quality of the people that you get. Even though those will be top quality people, will you get political criticism? Probably.
Senator St. Germain: Do you feel that it is important enough that an attempt should be made to mitigate the political influence?
Mr. MacDougall: Absolutely. Anything that can be done to mitigate the political influence, have politics as far removed as possible, would be wonderful and add to that credibility.
Senator Kelleher: Mr. MacDougall, it has been estimated that within 10 years this fund could be valued at somewhere between $75 billion and $100 billion. In your opinion what impact, if any, will this have on Canada's capital markets?
Mr. MacDougall: It can have some impact for sure. There have been other large pots of money that have gone into Canada's capital markets in the last 10 years that have not caused a disturbance or a visible upward price movement either in the equity or bond markets. It is how that decision and implementation is executed that is more important. That is a lot of money and will always be a lot of money, but the capital markets also will grow. That money can be put into the market but it has to be done appropriately, and obviously not all at once.
Senator Kelleher: Do you think there are any mechanisms that should be implemented to ensure that the investments of these funds are not used either as an economic or social policy measure; and, if so, could you suggest some appropriate mechanisms? What I have in mind is that we are aware of the use to which the Caisse in Quebec has been put and I am wondering if we can could have some thoughts from you on this possibility.
Mr. MacDougall: Clearly, it is best if that does not occur. Again, the statement of investment policies should clearly outline what should or could or must not be done. Then it is up to the board and the operating executives of the board to deal with the investment managers. In the policies, there should be nothing that allows that kind of thing, or it should be clearly set out what it is you want done or do not want done. If it is in there it should not happen. If it does, it is happening because of some influence that is not at the table and that should not occur. So the clearer the statement of policies, the less likely that is to occur.
Senator Kelleher: Drawing on your knowledge of the framework of this management and the way it will be set up, and given that you are from British Columbia and the fact that there is concern from the western provinces that they do not necessarily have input in many policy issues, not only this one, do you feel that under the proposed set-up for this board there will be sufficient input from the various provinces with respect to the operation of this fund and/or the management thereof?
Mr. MacDougall: That is a hard one for me to call. Yes, the provinces should have some input, and they will have that input through the directors of the fund -- not that they get to appoint them but they can certainly talk to them about whatever their issues are. Again I come back to the notion that this is a pension fund, in the long run, and I do not know how the provinces will influence it. If they are political influences, it should not happen when we are talking about how the fund should be run.
Senator Lawson: Earlier you mentioned derivatives. From what little I know about derivatives in the U.S., there is a negative connotation. Perhaps you could tell us a little about that. The first word that springs to my mind is "scam." Should we stay home and buy Bre-X?
Mr. MacDougall: Everyone has heard about derivatives because of the bad thing about derivatives. Those are derivatives that are employed with a leverage strategy. If things are set up properly, pension funds should not and cannot use derivatives in a leverage strategy.
Instead of buying the TSE 300 index -- and let us assume we buy all of it now, even though I have stated that you cannot buy all of it -- instead of buying each one of those stocks in the appropriate amounts to get your investment, you could buy some derivatives that get you the same portfolio. The investment manager of your fund puts up the treasury bill and a dealer contracts to deliver those shares in those proportions. You are not actually going into the market to buy the physical one, two, three, four shares. That is a very appropriate strategy. It is done effectively and it does not impact the market as quickly. The costs to the fund are less of implementing. There was a question earlier about what is the appropriate mix between stocks and bonds? Long term, that should not change much. However, there will be times when that changes, and derivative strategies to effect that asset mix change are much more effective, cost-wise, for the fund than actually selling billions of dollars worth of stocks or buying billions of dollars worth of the bonds. That is why I mentioned that that is something you should have on your list. It does not have to be enacted on day one. But since we are talking about the long term here, it is something that this fund will have to look at.
As we mention to our clients, many of whom have the same reaction as you at first blush that derivatives are a bad word, in the future you will be using them in your fund. It is not "if," it is "when."
Senator Lawson: Would this be a similar to a Vanguard indexed 500 fund in the U.S., that type of thing?
Mr. MacDougall: That is actually buying an index fund, but it is not too dissimilar to that.
Senator St. Germain: Is it like buying futures in the commodity market?
Mr. MacDougall: You are buying a future on the index that an investment dealer or someone who is authorized to sell to you sells you.
Senator St. Germain: Can you short the market?
Mr. MacDougall: No. You would write that into the rules, obviously. This is not meant to leverage the fund or put the fund at undue risk. It is a way to get money invested cost effectively without impacting the market, which was another question that the committee had.
The Acting Chairman: Which would be particularly important in the Canadian market context?
Mr. MacDougall: It is very important in the Canadian market context because it is a very non-liquid market.
Senator St. Germain: We had one witness state that we could do this on European and foreign markets and not violate the 20 per cent rule.
Mr. MacDougall: Yes, you can do that.
The Acting Chairman: That is a way of getting around that rule.
Senator St. Germain: Is that basically not just like going out to that market?
Mr. MacDougall: There are two different issues here. Yes, technically today you could increase the foreign content of the pension fund and remain within the letters of the law by doing that. The other issue is that in the European markets and the U.S. markets you can use derivatives to implement a buying strategy; you cannot in Canada because of the non-liquidity of the market. So those are two different issues.
The Deputy Chairman: Mr. MacDougall, are there any other suggestions you could make to us about the risk management strategy of the fund? This is the area that you in private practice would have particular expertise on.
Mr. MacDougall: Risk management in the investment world is becoming more and more important, and many of our clients want us to look at the opportunity that we are saying we are going to create, but they want us to measure the risk we are taking to get that. Again, in your statement of policies and guidelines there would be something to deal with the risk management diversification of the fund, being obviously the first one, and then you can get a lot more specific in each of the areas in the stock market and the bond market about what that means.
Once those are mapped out, anyone can calculate what returns might be received over a long period of time. Again based on historical facts, that is not always the case, along with what volatility or risk would be incurred to get those. Those studies obviously would be important here.
Senator Lawson: You stated that you did not agree with the three-year term for directors.
Mr. MacDougall: I personally think it should be longer than that.
Senator Lawson: I think it should be five. Do you have any particular view?
Mr. MacDougall: I like five better than three.
The Acting Chairman: But not 10?
Mr. MacDougall: Ten is a long commitment for people.
I said at the beginning that indexing this fund is the way that it has to start. Careful consideration as to what is the appropriate index or amount of indexing is important; then later on, as the fund diversifies and hires investment managers, it would also have to look at from that perspective -- perhaps an example would answer or illustrate the point I am trying to make.
Let us say that in five or 10 years from now you wished to go out to the investment community and hire firms such as ours and others to invest part of this money. Let us say, to use the example given, you had $100 billion and that in the Canadian equity side you had $40 billion and you wanted to put out 10 per cent of that, $4 billion. If you gave $1 billion to each of the top 40 managers in this country, some of them would have a heck of time investing that money. So again, it shows you not only the depth or the lack of depth in the market place but also some of the managers and their styles.
Also, if that list contained only 10 people instead of 40 and each of them were given four times the amount, some of them would say to you, as we would, that we cannot invest money the same way we invest money today because it is too much; it will impact our system and our existing clients will get hurt.
There will be those problems going forward, and that is why I come back to saying that most of this fund has to be run in an indexed manner.
Senator Lawson: I did not hear you make any comment on the previous discussion about how directors should be paid. Should they be paid fairly or should they be paid like senators?
Mr. MacDougall: I do not think I want to touch that one.
Senator Lawson: In your experience how are directors of pension funds paid? Nominally?
Mr. MacDougall: Frankly, I do not know the extent to which or how all of them are paid. Some are paid from the pension fund and others are paid by the board of directors of the union or the company that they are paid on from the corporate coffers. Most of them are paid.
Senator Lawson: The directors we are contemplating here should invest a considerable amount of time to their duties. Do you have any views on how they should be paid?
Mr. MacDougall: Do you mean from what source, or how much?
Senator Lawson: How much?
Mr. MacDougall: I have no idea. Just like with boards of directors, they vary considerably.
The Acting Chairman: There are no further questions. Thank you, Mr. MacDougall.
The committee adjourned.