FINA Committee Meeting

STANDING COMMITTEE ON FINANCE

COMITÉ PERMANENT DES FINANCES

EVIDENCE

[Recorded by Electronic Apparatus]

Monday, November 17, 1997

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[English]

The Chairman (Mr. Maurizio Bevilacqua (Vaughan—King—Aurora, Lib.): Order.

I welcome everyone here this morning.

The order of reference for the finance committee today is to study Bill C-2, an act to establish the Canada Pension Plan Investment Board and to amend the Canada Pension Plan and the old age security and to make consequential amendments to other acts.

This morning we have the pleasure to have with us experts from the C.D. Howe Institute, Keith Ambachtsheer & Associates Inc., the Ontario Teachers' Pension Plan, BIMCOR, Koskie Minsky and Investment Dealers Inc.

We will begin with a presentation from each representative for approximately ten minutes to give us an overview, and then we will proceed to a question and answer session.

The first witness is Mr. David Slater, policy analyst.

Mr. David Slater (Individual Presentation): Thank you, Mr. Chairman.

I welcome this opportunity to assist the committee in its consideration of the proposed changes. I have been writing and counselling on this subject for several years, particularly since I did the task force for Ontario that led to the present form of the Ontario teachers' pension fund and the public service pension fund.

I have asked the Howe Institute to make available some papers that I've written on the subject—I hope they have—and I've also made available to the committee a little overview paper that I published in CABE News this fall.

Today's session is on the investment issues, and I'm going to confine my remarks to those. I'll speak to these notes; I won't read them all.

I'll just remind you of the main points regarding the proposed CPP investments.

Under the proposed revisions, contributions will exceed the expenditures during the next decade or so, reversing the drain from the CPP fund during recent years. The excess of contributions over expenditures will flow into the CPP investment fund, small amounts at first but larger amounts later. The intention is that the fund will earn a higher rate of investment return than a portfolio of government bonds through investments in a mixed portfolio of bonds, equities, property, and other assets acquired mainly through market transactions.

The portfolio is to be managed by a new fiduciary investment trust operating on a modest risk-reward principle expected to achieve average real rates of annual returns of at least 3.8%. Under current inflationary conditions and so on, the nominal rates would be about 6%.

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The investment earnings are to be reinvested in the fund, increasing its size in addition to the net excess of contributions over expenditures.

Reflecting both net contributions and investment earnings, the fund is expected to grow rapidly during the next decade or so, and then to grow less rapidly. The slowdown will be due to a combination of the proposed levelling-off of the contribution rate at 9.9% after 2003 and the demographic pressures toward increased expenditures after 2010-2012.

Transitional arrangements are included with respect to government bonds and index management proposals, and as you well know, the foreign property limits for pension funds are intended to apply strictly.

As to investments, the net effect will be a shift of the CPP from a very low pre-funded basis, essentially a pay-as-you-go system, to a more substantial but still modest pre-funded basis.

The most important investment issues concern, in my view, governance, prudence, accountability, and evaluation. The CPP investment fund is to be governed under the independent governance model—using my friend Keith's terminology. The investment policy is to be based on the prudent person principles for financial fiduciaries. The provisions for accountability and evaluation are severe, as they should be, in my opinion.

I'll now make comments on a few points. First of all, there has been some confusion about the potential size of the fund. The prospective size of the fund depends on hypothetical assumptions concerning demographic trends, inflation, increases in wages and salaries, rates of investment earnings, disability experience, mortality, and so on. Reasonable experts might differ regarding the assumptions and therefore their projection of the size of the fund.

Even when the fund is projected on a cautious basis, it will become a large market Canadian investment fund during the next decade, and even more so during the next three to five decades.

I provided some rough estimates of the prospective fund in my October Commentary paper, which was mainly prepared before the estimates of the chief actuary became available. The basis of my estimates was provided in that paper essentially by adjusting the projections for the CPP in the 15th annual report of the chief actuary for the effects of the proposed changes to the CPP. On this basis my estimates were for total CPP assets of about $196 billion by 2009-2010. The 16th actuarial report of the chief actuary projected assets of about $190 billion at the end of 2010.

Both of these estimates assumed a steady-state compound annual rate of inflation of 3.5%, and rate of increase of nominal wages and salaries of 4.5%. These projected rates appear to be too large for Canada's current circumstances and prospects. On the basis of steady-state assumptions of inflation of 2.5% and increases in nominal rates of wages and salaries of 3.5%, all other factors being the same, my guess is that the assets of the CPP by the end of 2010 would be more likely $140 billion to $150 billion, rather than the $190 billion of the 16th annual report.

While the smaller estimates of the nominal size of the CPP fund are of some significance for financial markets and pre-funding ratios, they do not affect the real sustainability of the CPP program. Smaller rates of increase in wages and salaries imply both smaller nominal contributions to the program—because the base will be smaller—and similarly smaller nominal increases in prospective pension and other outlays, because they depend on the contributions. It is the relationship of inflation and wage rates that matters for sustainability of the program. In both cases placed before the committee by the finance department, the assumed rate of real wage increase is 1% per annum, in line with the assumed increase in real productivity.

Nor do lower fund projections affect the prospective pre-funding ratio. The ratio at any time is the nominal value of the assets above the line, the numerator, and below the line, the present value of the accumulated future liabilities. Lower inflation rates will reduce the projected numerator and denominator by the same degree. Smaller rates of nominal inflation and earnings increases will reduce the size of the fund and thus the numerator. Similarly, since benefits are based on contributions, they will be reduced too.

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In the 16th actuarial report the long-run funding ratio is projected at 17%. It will be unchanged by adopting the lower rather than the higher inflation assumptions.

What would alter the projected funding ratio is the assumed rate of discount used to estimate the present value of the accumulated future liabilities. The numerator would be unaltered by changes in assumptions regarding discounting future obligations because it would be a firm number based on the market valuation of the known assets. However, the larger the rate of discount used in reckoning the present value of the liabilities the smaller will be the calculated denominator.

Opinions differ in the actuarial evaluation professions concerning the appropriate rates of discount to apply. Well-respected experts suggest higher discount rates than are applied by the chief actuary. I refer to the publication of the Canadian association of actuaries.

Using higher rates of discount would reduce the calculated present value of the liabilities and increase the projected pre-funding ratio for the CPP. Whatever are the estimated assets of the CP program, those under the responsibility of the investment board will be somewhat smaller, for a reason you already know.

While the contribution rate is the primary target of the revisions in the financing of the CPP proposals, a secondary target is to achieve an asset-expenditure ratio of about five. This is higher than the previous target of about two. The chief actuary's projection for the assumed CPP is more than four but less than five. In my opinion these projections are prudently cautious.

I have included in these notes some material on the rates of return, but I won't read those because others will probably deal with those matters.

Finally, about the investment side of the program, I would like to say a brief word about the generational money's worth of CPP contributions and the internal rates of return. There has been a lot of concern about the chief actuary's projections of very low real rates of return to future participants in the Canada pension fund. I'll leave my remarks on these subjects until tomorrow. I'm to return and talk about the CPP in general rather than investments. I only want to remind the committee at this point that historic trends of decline of such measures as the internal rate of return from earlier to later cohorts are far from the whole story and are doubtful indicators of intergenerational equity. The CPP is much more than a pension plan. It includes social insurance for disability, death benefits, survivor's benefits. Intergenerational equity should be viewed in a comprehensive way, not as restricted to the features of the CPP.

I readily admit to being over-generously benefited by the CPP. I guess among this crowd I'm the only one who is drawing the Canada Pension Plan. But I've paid my dues to younger generations in many other ways.

Thank you, Mr. Chairman.

The Chairman: Thank you very much, Mr. Slater.

The next presentation will be from Keith Ambachtsheer & Associates. Mr. Keith Ambachtsheer, welcome.

Mr. Keith Ambachtsheer (Consultant, Keith Ambachtsheer & Associates): Thank you. It's a pleasure to be here this morning.

I advise large retirement systems around the world on matters related to governance, finance, and investments for a living. I note in my one-pager that I acted as an adviser last year to the CPP working group on CPP investment policy and was the author of the paper “Moving to a `Fiduciary' CPP Investment Policy: Two Possible Paths”, which was released publicly in July of this year.

I took the advice that I should bring just one piece of paper quite literally, so all my remarks are in fact on one piece of paper, which I should be able to go through in less than ten minutes.

Just as in real estate the things that matter most are location, location, location, with the management of retirement systems what matters most is governance, governance, governance. This is no longer just an opinion. A major study we have just completed involving 80 major U.S. and Canadian pension funds established a statistically significant link between organizational performance and organizational design. The most important organizational design driver turned out to be the quality of the board of governing fiduciaries.

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Actually, good governance is only one of two factors that strongly correlate with good organizational pension fund performance. The other factor is fund size. Larger funds produce higher risk-adjusted net returns than smaller funds. Thus pension fund management is an industry where “bigger is better”.

These two research findings are highly material for the CPP Investment Board. Within 10 years the fund will be in an elite class of very large pension funds. Its size will give it a comparative advantage, because asset management is subject to major scale economies. Its size also ensures that it can afford to hire a full-time expert management team.

However, there is a caveat. The board must first attract 12 governing fiduciaries, directors of the board if you like, who can articulate the right vision for what the CPP Investment Board should strive to achieve, and who can in turn attract a chief executive officer capable of turning the vision into reality.

There's one visible impediment to this unfolding scenario. The 20% foreign property rule is already impeding a number of large Canadian investing institutions from achieving the levels of diversification and liquidity they would like. Within 10 years the CPP Investment Board will be facing similar difficulties.

Fortunately there is a simple solution: the foreign property rule should be removed from the Income Tax Act.

Thank you.

The Chairman: Thank you very much, Mr. Ambachtsheer.

Now we'll move to the Ontario Teachers' Pension Plan, Mr. Robert Bertram.

Welcome.

Mr. Robert Bertram (Senior Vice-President, Investment, Ontario Teachers' Pension Plan): Thank you, Mr. Chairman.

Good morning, everybody.

I'm going to talk about the experience the teachers have had and how that can perhaps help you in developing the plans for investing the Canada pension pool. The teachers' fund itself started in 1990, with $18 billion of non-marketable Ontario provincial debt, and has grown recently to a number of approximately $55 billion.

The key to the Ontario teachers' success has been to develop a proper model for managing the pension fund business. This includes establishing a proper mandate investment policy, with both assets and liabilities in mind, and implementing an appropriate governance structure, including a knowledgeable and independent board.

The challenges faced by the Canada Pension Plan are going to be similar. They consist of the difference such size creates relative to the size of traditionally managed asset pools in Canada, the extent to which beneficiaries' interests are to be paramount within that management system, and how the fund's ownership of corporations will be handled.

In looking at the market-oriented approach proposed for the Canada Pension Plan, I've highlighted a number of issues, and I'll touch on some of them briefly.

First of all, in terms of governance, pension funds, including the CPP, are retirement savings pools created essentially to provide beneficiaries with retirement income. Success for market-oriented pension investment pools requires good governance, and the first step to good governance is to identify who the stakeholders are and set up a system that invests the assets for their benefit. That is, all decisions made must be in the interest of the beneficiaries. Inserting any other interest into the decision framework will reduce the value to the beneficiaries.

When you look at setting up the pool, you have to be concerned, as the teachers have been, with conflicts of interest at the board level. Establishing an arm's-length relationship with the sponsor is needed to avoid using the fund for purposes for which it was not intended. In cases of government sponsorship, this might be serving social objectives or economically targeted objectives at the sacrifice of returns to the fund.

Governance should pay particular attention to ensure that no special favours to particular interest groups, including governments, is given. In addition to an arm's-length relationship with the sponsor, the members of the investment committee must ensure that their own interests and those of the agents and employees they retain are not in conflict with the interests of the beneficiaries. All conflicts in either case should be resolved in favour of the beneficiaries.

As the fund grows in size and as you set up this fund as well, you'll have to look at the asset mix choices. It's one thing to say you'll have a prudent means of investing the fund, but you have to look at the asset mix. Normally the key to choosing an asset mix for an appropriate diversified portfolio capable of increasing fund returns is a clear and unambiguous objective. Investing the fund in a diversified manner requires balancing risks and rewards in order to meet that objective. Normally, for a pension fund, particularly for a fund like the Ontario teachers', we've been able to rely on the liabilities as a guide for setting up what our asset mix and what our overall investment objectives are.

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Since there's little or no direct connection between funding and the cost of the liabilities for the Canada Pension Plan, because of the relative size and proportion of funding for that plan, in my mind the choice of asset mix is one of maximizing returns, subject to acceptable levels of risk or volatility.

Since the fund is such a relatively small proportion of the total liability, this also suggests that higher returns—i.e. more equity and more risk, that is, more volatility of the fund—are suitable to maximize the potential effect on costs. This type of risk and volatility, while prudent in terms of the Canada Pension Plan, needs to be managed with the longest possible investment horizons in mind.

When the fund looks at what types of assets it should be managing in terms of the context of both maximizing returns and following sound portfolio fundamentals, it suggests there should be no special access provided for any potential investees. Such access confuses the interests of the beneficiaries with those of the taxpayer and their elected representatives. Special access clearly distorts the capital allocation process based on the highest returns and the best use of capital.

As I said before, size will also be an issue in the Canadian context. The Canadian capital markets represent little more than 3% of the world's total. This relatively small size is further exacerbated by the nature of our equity markets. A larger part of those equity markets is held in the way of control positions or through special voting shares than is the case in countries such as the United States. This reduced stock float available for investors accentuates the size issue.

Size, on the other hand, is not all bad, as Keith has already pointed out. Large funds have the advantage of economies of scale in investing. These economies of scale in our case seem to outweigh any benefits of flexibility that might come from splitting the fund into smaller administrative units. Distributing the assets into a broader set of decision-makers likely would only increase the investment costs without increasing the probability of returns above the market averages.

As suggested as well, the average market returns can be obtained by buying index funds. This was suggested in the papers I've seen on how the CPP should be set up. Index funds, of course, are an efficient means of buying average market returns and implementing asset mix decisions. Buying index funds in large size also represents many challenges.

The Canadian stock market, as do most stock markets, contains hundreds of companies, but the investable value in those markets lies in a small percentage of large companies.

For example, the TSE 100, the top 100 stocks on the TSE, represents about 80% of the investable equity on the Toronto Stock Exchange. The CPP will be a reflection of that reality. To invest in smaller companies in this market, even by an index fund approach, would require the accumulation of significant proportions of the trading volume on a daily basis, and that would affect prices of those stocks.

Index funds in the size contemplated would have to be based on long-term disciplined commitment to the equity markets. In other words, you'll be able to buy the large companies quickly. You'll have to take a long time to buy your interest in the small companies.

Ownership of foreign assets also reduces risk and volatility and enhances returns. Foreign assets in rapidly growing economies, in the teachers' fund's mind, provide insurance against a poorly performing domestic economy. The converse is also true, when the Canadian economy is performing well and foreign markets are performing somewhat less well.

As with large and small companies, the investment of a large fund such as the CPP will be concentrated in large and developed nations.

The teachers' experience has been to increase our exposure above 20% of the foreign content through the use of derivatives. We currently have about 37% of our fund exposed to foreign assets. In doing so, we've been instrumental in developing and improving new domestic aspects of the investment industry.

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Derivatives have become an integral part of the strategy and execution of the teachers' management program. Even more so, they've become an integral part of the ability of investors in Canada or worldwide to efficiently implement their investment programs and to hedge risks whenever suitable. For the Canada pension plan to be successful, even if the foreign content rules are not lifted, it must have the ability to use derivatives of all types.

Whether the foreign content is above 20% or not, as long as it is above zero the fund will have exposure to foreign currency. This exposure will force a decision of when and why the fund should be buying or selling Canadian dollars in exchange for currencies of a foreign country. To protect the sanctity of the arm's-length relationship established, I think it would be wise for the fund to spell out exactly how it will manage its currency exposures in the future.

In addition, when we look at selecting assets, an equity fund or an index fund of the size contemplated for the CPP will give rise to ownership of Canadian companies in excess of 5% of their voting shares. Whenever the CPP fund buys shares in a company, it becomes a partial owner of that company. To be fair to the companies and the other shareholders, the proxies and ownership rights so obtained will have to be exercised in the pursuit of good corporate performance.

This will require the fund to take strong stands against other shareholders or against company management and the boards of directors. Ownership issues, such as underperformance of entrenched management poison pills and stock options, must be addressed as a matter of policy.

There are a number of other issues I can touch on, but perhaps I'll leave them for later in the discussion. I think they're more management issues.

There are some significant issues in terms of implementation costs. Again, a fund investing in index funds will never achieve the actual return on the index. Returns will be reduced by the amount of costs undertaken to incur it.

I think there should be some transparency of results. We should consider carefully the oversight and the auditing of a fund of this nature, particularly with respect to auditing. The use of external auditors versus the role of the Auditor General should be made explicit and clear.

In my experience, investing is a process of accepting risk. Competing sources of oversight on that task of accepting risk makes the task much more difficult.

You should consider carefully the choice of how you're going to manage the fund in terms of employees, because the marginal product of employees within a fund this size is very substantial. Anything less than the best-quality employee could cost a lot of money.

Finally, the choice of benchmarks is an integral process to indexing and should be considered very carefully.

In summary, in the case of the CPP, the costs of producing a plan can be enhanced by moving to a more fully funded program, with the resulting funds being invested in a market-related fashion. The teachers' pension plan has successfully made such a transition. It's possible to duplicate this effort on the part of CPP beneficiaries. The result will be greater confidence on the part of the beneficiaries and a better distribution of costs to the beneficiaries and the taxpayers.

Thank you.

The Chairman: Thank you very much, Mr. Bertram.

Now we will move to the representative from BIMCOR, Mr. Don Walcot.

Mr. Don Walcot (Chief Investment Officer, BIMCOR Inc.): Thank you very much, Mr. Chairman and members of the committee, for the opportunity to appear before you today in this important consultative process.

I am chief investment officer at BIMCOR, the BCE pension investment arm. I'm also chair of the government relations committee of PIAC, the association that represents pension fund systems in Canada in matters concerning pension investment and related issues.

PIAC now represent 123 member pension fund organizations that collectively manage over $365 billion in pension assets on behalf of 6.5 million beneficiaries. There are 47 public pension funds and 76 corporate pension funds. The Department of Finance consulted with PIAC in drafting this bill.

I was formerly assistant treasurer of pensions at Ontario Hydro, and president of Sunimco, the Sun Life of Canada investment management firm.

My areas of experience and expertise relate to pension fund organization and investment management policy. Regarding pension fund organization, I was involved as a committee member, with Bob Bertram as the chair, in the creation of the PIAC pension fund governance model, the first in the world. It received widespread recognition and acceptance.

It was felt by PIAC and confirmed by my own personal experience that a clear governance model can assist greatly in the successful management of pension funds. We identified four components that we felt provided a sound structure for a fund by setting out clearly the responsibilities and accountabilities of the individuals involved.

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Generally in investing other people's money the first principle is to know your client. In pension fund terms that is to understand the pension promise involved in the plan provisions. While many comments may be made, and I will be happy to discuss them further, the key point is that the promise should be expressed sufficiently clearly that all stakeholders understand it.

Secondly, the stewards of the pension plan must recognize who the stakeholders in the plan are and what accountabilities and benefits are owed to each. I think this is such an important point I'm going to repeat it. Secondly, the stewards of the pension plan must recognize who the stakeholders in the plans are and what accountabilities and benefits are owed to each.

We at PIAC identified four key features of the governance process: one, board trustee selection and organization; two, power sharing between the board of trustees and management; three, effective monitoring of management's performance; four, continual reassessment and modification of the overall governance process itself. We believe establishing an organization based on these governance principles would provide a great deal of confidence to stakeholders that the fund was being managed properly.

The second area of expertise I have had has been in the development of investment policy for a number of pension funds. As clear governance guidelines will create an organization that manages the total pension fund organization effectively, a clearly written investment policy statement will assist in the prudent management of the investment of the assets.

In creating such a policy, the following components must be included: a description of who the stakeholders are and general plan objectives; a measure of risk tolerance based on creditor volatility; identification of the approved asset classes in which to invest; asset mix ranges, for example 30% to 50% for equities, 20% to 40% for debt, and 0% to 20% for cash; performance objectives that are simple, investment-related, and quantifiable; reporting requirements, monthly, quarterly, etc., and contents; structures and ways to take corrective actions; specific policies such as on securities lending or derivatives; and very importantly, a code of ethics.

Investment policies and process are now fairly standard and have been in wide use for about ten years. They have been, I believe, a useful addition to the process and invaluable from an investment professional's point of view. As with the governance model, regular review and modification form an integral part of the investment policy process. I believe with a clear governance model and a realistic investment policy statement, all types of pension funds can be successfully managed to the satisfaction of all stakeholders.

I would like to take this opportunity to commend the government for incorporating much of this philosophy into the CPP investment structure.

This concludes my introductory remarks. I would be happy to discuss the points raised in this presentation with you.

The Chairman: Thank you very much, Mr. Walcot.

We will now move to the representative from Koskie Minsky, Mr. Mark Zigler. Welcome.

Mr. Mark Zigler (Koskie Minsky): Thank you, Mr. Chairman. As the only lawyer on this panel I'll try to be briefer than the others, if that's possible.

Our firm represents a large number of pension funds jointly trusteed, where both employer and employee groups appoint the members of the board. On occasion we end up in some litigation involving pension funds, whether it's for employees, trade unions, pensioners, or old hockey players. We seem to have seen the gamut of what happens in the pension industry.

It is important to try to translate some of that into the CPP Investment Board, and we've had the good fortune of working with some of the members of the Department of Finance staff, Mr. Foster and Mr. Seeto, in discussing the draft legislation and the current legislation we have before you. It goes a long way towards recognizing the key issues of governance, because underlying the governance issue is a credibility issue. There is a major credibility issue with the Canada Pension Plan now, and with the public that has to be resolved by ensuring the governance structure recognizes that the credibility of the plan must be enhanced through the board.

The one piece that seems to be missing is a recognition that the CPP, like any other pension arrangement, is driven by employment and employers, and employees have to be part of this governance structure. The legislation requires people who have proven financial ability to sit on this board, or related work experience. The legislation talks about regional diversity and provincial rights in appointing members of this board. But the legislation does not say the interests of employees and employers must be recognized in the appointment of members to the board.

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It is not a difficult thing to do and it probably will be done.

It is also a tough task in the sense that no one represents all employers, no one represents all employees. But certainly employer groups, whether they be manufacturing associations or other groups, or trade unions on the employees' side, or other associations of self-employed professionals, should be recognized as having personnel who can contribute to this board.

Perhaps if it's done through a signal from this committee rather than the legislation, that message should be driven home. It is the key message in terms of public credibility. It is the working people and their employers who are paying into this fund. They must know. The people who understand the employment situation, which funds the plan, also have to be involved in the investment part.

I concur with all of the spokesmen before me in terms of the issues of competence and having a hard-working and activist board. The last thing we want to see here is to create yet another bureaucracy that invests a large fund and a board that is essentially passive. That, too, is a message that hopefully can be driven by this committee.

You can look at some of the models in the pension field where activist boards actually produce much better results than those who sit back and let a bureaucracy in effect run the show. The ability to direct management is critical in these types of situations.

Beyond that, I've given you only one page because I don't think there is a great deal more to say. What this committee can do and what the minister can do, perhaps at the urging of the committee, is to ensure that the credibility issues get first attention and that they are resolved through governance structures that have the credibility the public will support.

Communication is also important. The public workers and employers must know what this committee is up to. The legislation requires meetings twice a year, but we know that that sort of thing can easily vanish without much public attention. There has to be communication with the members of the public and it has to occur on a regular basis.

Finally, there is the concern that has been echoed by one of the prior speakers, and that is the matter of political interference. Obviously political interference is necessary if there's a disaster situation, but the credibility can only be enhanced, again, if this committee sends a signal to the effect that this is a hands-off board. Political and economic concerns will not drive its decision-making power; it will be done by competent technical expertise and people who represent those who are the stakeholders.

Subject to questions you have, thank you for your attention.

The Chairman: Thank you very much, Mr. Zigler.

Now we'll go to the representatives from Investment Dealers Inc., Mr. Ian Russell and Donald Wright.

Mr. Donald Wright (Investment Dealers Inc.): Thank you, Mr. Chairman.

Good morning, ladies and gentlemen. My name is Don Wright, and I'm president and chief operating officer of TD Securities and I'm also serving as the chairman of the IDA capital markets committee. With me this morning is Ian Russell, who is the senior vice-president of capital markets at the Investment Dealers Association.

Our presentation this morning will come from a little bit of a different angle from those of some of my colleagues before me, given that our organization is representing the IDA members on the sell side of the investment business in Canada.

The reform of the Canada Pension Plan is probably long overdue, and the government should be congratulated on bringing this legislation forward at this time. The challenges in implementing such a program encompass an appropriate framework for accountability, which some of my colleagues have talked about and which we've seen around the world is extremely important from a credibility point of view, from both people in the business and those that enjoy the fruits of such a pension plan. Also, an effective investment policy is important to the plan, although the transformation of large investment constrained public sector funds to fully diversified private sector funds is not an unprecedented event. You have only to look at some of the gentlemen before you to see some tremendous successes in this particular area.

The proposed legislation envisions the CPP portfolio expanding by roughly $60 billion over the next ten years, from a portfolio of approximately $40 billion in non-marketable securities to a portfolio of marketable securities in the $100-billion range. This drastic growth—and I say drastic somewhat advisedly because with the returns that have been made on some of the portfolios to date it's clear that pension funds are growing very substantially. While I look at the historic numbers that are in the 4% range or so, if we look at the past number of years we certainly see growth that far exceeds these kinds of numbers. So any one of the large pensions could certainly double over the next 10 years as well. The drastic growth would be achieved through both higher pension rates and higher portfolio reinvestment rates.

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The purpose of our remarks this morning is to comment on the prospective investment policy of this restructured CPP fund and the impact of that investment strategy on domestic capital markets. Obviously, after our comments we'll be pleased to answer any questions and participate in any discussion on the subject.

The obvious questions are whether the CPP fund can obtain sufficient diversified and high-yielding investments, particularly domestic equity securities, to meet the investment requirements of this large fund, and what impact this sizeable availability of investable funds will have on the capital markets here in Canada.

The first point to note is that the additional savings created in the markets from a restructured CPP plan will be somewhat less than the projected expansion and growth of the CPP fund itself. This is because a portion of the fund's capital will represent the transfer of existing savings from personal investment portfolios to the CPP, a transfer more likely to occur amongst higher-income than lower-income CPP contributors. However, it's fair to say that this savings transfer will be small, and the restructured CPP will result in significantly higher net savings in the economy and exert a significant impact on capital markets.

Based on the experience of other large pension funds, the investment strategy of the CPP fund will evolve in terms of its sophistication as the fund moves through a series of progressive steps. The fund will initially focus efforts on a high proportion of new contributions and a maturing portfolio of non-marketable securities in equity securities in order to move quickly to an appropriate portfolio balance. While that portfolio balance moves around in the equity side, it's probably in the 50% area at this point in time.

If most of the new funds flowing into the CPP averaging close to $5 billion or $6 billion per year are invested in equities, this demand, which represents half of the total of market capitalization of the TSE...but as Mr. Bertram pointed out, much more than that in terms of the securities you could invest in, because a lot of them are closely held and a lot of them are smaller and are unavailable in the marketplace in terms of share turnover. So the effect on the actual flow will be or could be quite dramatic. They could well push up price-earnings multiples for listed equities. However, this availability of capital will also draw additional equity offerings into the markets as corporations take advantage of financing opportunities. The fund will also invest in listed securities of small and mid-cap companies, but as Mr. Bertram pointed out, this will be very difficult to achieve in a very short timeframe. It will take a much longer commitment to that process.

A significant portion of new funds and the reinvestment in maturing non-marketable debt securities will be directed to marketable government and corporate debt securities. The declining borrowing requirements of Canadian governments, both on the federal and provincial level, will mean that a growing proportion of debt securities will be invested in corporate bonds. This demand for corporate debt securities will put downward pressure on interest rate spreads between corporate and government bonds. It may also flatten the yield curve, reflecting the heavy concentration of corporate debt requirements in the mid-term area.

The demand for marketable debt will also promote the growth of the fledgling domestic high-yield market in Canada, initially as this demand for conventional debt forces existing high-yield funds to expand their operations, and at a later stage, as the CPP fund develops in-house expertise to invest directly in these securities.

The market for asset-backed and, most notably, mortgage-backed securities and consumer credit-backed securities will also benefit from the CPP fund as they bid up the prices of these asset-backed securities and encourage banks and other lending institutions to engage more actively in off-balance-sheet financing, originating credit at attractive yields, and then packaging and selling these assets in the marketplace. This may have the effect of putting even more pressure in a very competitive mortgage market in terms of moving rates down for the consumers, which would be a very good social effect of this fund.

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The CPP fund will invest aggressively in foreign debt and equity securities to achieve optimum portfolio balance. You heard people talk earlier about the use of derivatives. These derivatives are very broadly used now in terms of getting into foreign markets to escape the 20% rule that now exists, but it is also very important in terms of being able to rebalance one's portfolio, especially when there's a $40 billion group of securities that is not marketable. One can exchange this by the use of derivative strategies into other segments of the market. For instance, one could do a swap of some kind of derivative where you exchange the rate on government bonds in return for getting the yield on a stock portfolio either domestically or internationally.

The IDA certainly agrees with what's been said by a number of people about the international markets, how important they are and how they will continue to grow in importance to everybody participating in this market. The 20% cap for those people who are large and sophisticated has been broken many times in terms of using derivatives to get around it. A lot of the people who aren't able to take advantage of these kinds of portfolio moves are those who run their own RRSPs, and more individuals than funds.

The evidence from other funds indicates that as these pension funds mature over time the portfolios will expand to use a lot of different vehicles, whether they are equities, merchant banking, etc. While this provides some extra risk to the portfolio, it is well-balanced in terms of the risk return profile of these funds.

The CPP fund will likely follow this same pattern. The portfolio risk, while prudent, will clearly increase as the CPP fund moves along the spectrum and invests in complex and sophisticated financial assets. The experience of other large pension funds has shown that good judgment and good governance—and I'll stress that, as have my colleagues—in all of our businesses, whether on the buy side or the sell side, are extremely important to all of us. It really does make the difference in the kinds of returns you're able to affect.

The effect of diversification of portfolio assets has achieved a more favourable relationship between risk and return to the ultimate benefit of investment fund recipients. The key is that the transformation of the CPP fund from a public sector constrained investment fund to a sophisticated and diversified portfolio should proceed gradually, taking into account the large size of the fund and the expertise of the portfolio managers.

A restructured Canada Pension Plan will not only assure beneficiaries it can meet its pension obligations but will provide benefits to the domestic capital markets. As indicated in the foregoing comments, the Canada Pension Plan will create additional savings in the economy. The evidence has shown that domestic capital markets will respond effectively to the availability of new pools of capital, drawing out new investment opportunities in both public and private markets and accelerating the rate of capital formation in the economy. Thank you.

The Chairman: Thank you very much, Mr. Wright.

Now we'll proceed to a question and answer session, beginning with Mrs. Ablonczy.

Mrs. Diane Ablonczy (Calgary—Nose Hill, Ref.): Mr. Chairman, perhaps you can help me. I haven't participated in these round tables before because I'm not a regular member of the committee. Do I just direct a question to a particular individual?

The Chairman: Yes. You can direct a question to one individual or to more than one. Then members of the round table may join in and also answer the question. It's quite open and flexible.

Mrs. Diane Ablonczy: Great. So we get the best information from all the experts.

We do appreciate you gentlemen being here. I think one of the areas that has been largely unexplored in this bill is the impact of the investment fund, how it would work and how it should work.

My first question has to do with an issue a number of you have raised with respect to the accountability of the fund—the transparency of the fund and the information that flows from the fund managers to the stakeholders. When questioned, the government did not confirm whether the fund or the fund managers would be subject to access to information; that some of the mechanisms that generally make these kinds of boards and commissions more available to public scrutiny might not be there.

• 1055

What I would like to know from any of you is what measures you would specifically recommend to this committee to ensure the very highest levels of accountability, information, and transparency in this operation of the fund.

Mr. David Slater: Mr. Chairman, in the commentary paper, “Prudence and Performance”, which I wrote for the Howe Institute, box number 4 has excerpts from the act regarding the reporting requirements.

I think it's fair to say that the provisions for reporting and accountability in connection with this program are much more severe and strict than typically is the situation. The chief actuary is required to provide reports every three years, but more importantly, the investment managers are required to provide reports not only about the performance, but about what their policy is, what their policy is to be for the future, and all of these sorts of things. The CPP as a whole, as distinct from the investment board, has stiffened reporting requirements.

Nothing guarantees things in this world, but in my judgment the act as it's drafted already contains very powerful and very severe accounting, accountability, and monitoring provisions. I think people who have more experience in those matters could perhaps speak to the matter, but that's my judgment as of the moment.

Mr. Don Walcot: In my experience in investments, the most important thing you do is communicate to your client and have your client understand what you're doing. So I think your question is vitally important for the success of the fund. There actually has to be sufficient and clear communication.

I was in the United States last week talking at a conference at which there were a number of state treasurers who manage pension funds much this size. They were saying everything they had learned was that they had to be absolutely open, and more than open, in the explanations they were giving. I noticed that in the bill they say there are to be regular meetings across Canada. I think that is an excellent way to have the physical ability to talk to the managers as well as simply reading reports.

Interestingly, they also said—and I noticed it's not in the bill—that e-mail is now becoming a requirement and that a number of the members just write off through their e-mail to the government. I think the plan will have to be able to respond to this. I think the way the structure is set up, with the goals of the fund established—and that should be on e-mail as well—how they are doing.... All professional investment managers do provide reports on how they're doing, so I believe that would be readily available as well.

I agree with your concept of getting as much information out to the pensioners as possible, but I think there's going to have to be a volume process using new technologies.

Mr. Keith Ambachtsheer: There's a hierarchy we sometimes talk about. You need to move data to information, information to knowledge, and knowledge to wisdom. There's the whole challenge in this whole process, not just providing lots of data, which is very easy to do. In fact, we tend to overwhelm people with data. The challenge here is going to be to turn data into information into knowledge.

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It's my observation about the asset side of retirement systems that there's a tendency to focus on short-term results. There will be a tremendous pressure, once the CPP Investment Board is up and running, to focus on last month's return. What was the return last week?

Somehow, we're all going to have to keep it in our minds that it's irrelevant what the return was last week. The relevant question is whether this fund is on its way to producing a long-term rate of return that meets some predetermined objectives.

I think that's something we're all going to have to keep in mind. I would mention the Caisse de dépôt, for example, which got itself caught somewhat, I believe, in this “short-termism” whereby there are press conferences on what the Caisse earned last year. Frankly, it's an interesting piece of data, but it's not really information.

I think part of the challenge of this whole process is to move information about the system to a level where it's not only understandable, but it really is material to what's really going on.

Mr. Robert Bertram: I'm probably going to repeat some of the things that were said already, but with the teachers, we try to have a reporting system that is at least as good or better than any of the corporations of which we are an owner. So we put a lot of effort into the reporting that we do to our constituents, our stakeholders. We try to make the results as transparent as possible.

Having said that, we make sure we set in our constituents' minds the appropriate expectations they have as well. This is along the lines of what Keith is talking about. We don't try to tell our beneficiaries that we're going to have returns over the short term, if in fact our investment program is geared to a long-term type of expectation.

I think it becomes very important that the standards by which you're going to measure this fund be laid out well in advance in terms of the benchmarking you use to do that measurement.

I think it's also important for the organization to be given an absolute, hard, fixed time at which to report on a regular basis. I would suggest that quarterly results might be a little frequent, but certainly there should be a very hard annual date by which the reports have to come out. They should be as close as possible to the year-end after that.

Having said all that, there are certain types of information in an investment organization that I would suggest you do not want to have access to, even through access to information. I have some peers in the investment industry sitting over here who would love to know what our forward-looking investment program is going to be because they're on the other side trying to sell us assets.

So I think there are certain types of information that the fund has to be able to keep private on a going-forward basis, but certainly in terms of results they should be measured on a regular basis and reported in as transparent a fashion as possible.

The Chairman: Thank you, Mr. Bertram. Thank you, Mrs. Ablonczy.

Mr. Loubier.

[Translation]

Mr. Yvan Loubier (Saint-Hyacinthe—Bagot, BQ): Mr. Chairman, I have a question about a subject raised by three of our witnesses, including Mr. Bertram and Mr. Wright.

What would you say to panellists or people from the outside who tell us that we should not increase the percentage of foreign holdings in the Canada pension plan, because that amounts to exporting capital, and therefore exporting jobs and economic growth? What do you say to these people who raise all sorts of objections to your proposal that the 20% maximum in foreign holdings be increased?

[English]

Mr. Keith Ambachtsheer: Just as there are markets for goods and services, so there is a market for investable capital. Increasingly, that market has become a global marketplace. The benefit of the free flow of capital is that all funds, whether they're Canadian, U.S., European, or Japanese, can benefit from diversification.

When funds are able to benefit from diversification, the cost of capital goes down across the globe. When the cost of capital goes down, it creates more investment opportunities, which then become viable investment opportunities.

There was a time when Canada clearly was a net importer of long-term capital. That is no longer the case. The major change that we all have to come to grips with now is that Canada exports as much long-term capital as it imports. Having this single rule, which prevents only certain people, not a lot of other people but only certain kinds of investors, from not doing what other investors can do strikes most of us in the investment community as being highly inappropriate.

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Mr. Robert Bertram: I don't have a lot to add to what Keith has already said.

In terms of market efficiency, I would even suggest, subject to that being confirmed by academic studies, which I think it could be, that the Canadian capital markets are already inefficient because there isn't enough flexibility for them to go outside of the country. We often wonder why the returns on the Toronto Stock Exchange, for example, have trailed those in most of the large developed nations over the past ten to fifteen years. In actual fact, there are some inefficiencies that build in because of the inability to flow capital outside of the country to a higher and better use.

As an end-result, this doesn't do any good for the beneficiaries of funds, but it doesn't do any good for the recipients of the capital either, because they're now using capital in an inefficient fashion.

I think we've squandered opportunities—for example, of lower exchange rates—by not forcing companies to make better use of the capital they have. We've been giving it to them too cheaply.

Mr. Donald Wright: I might add one more thing to that. It's our experience that we sell a lot of Canadian equities to foreigners in this kind of environment. One of the reasons for that is, as Keith was saying, there's definitely a global market and they look at our marketplace and they compare against other areas around the world and they see our markets as being less expensive.

Now probably 30% or 40% of our business comes internationally on the equity side.

So it just reinforces what these gentlemen were saying. The world is not looking at Canadian pulp and paper companies; they're looking at the world of pulp and paper companies, comparing them, and putting their capital where the best transaction is for them.

To stop our pension funds or a small group of people from doing the same thing is to have that group of people really paying a penalty for having to keep their funds domestically. I just don't think that makes sense in the long run. I don't think it's sustainable.

I think people would point out to you that certainly there are ways around these provisions for those who are more sophisticated, so a small group of people are really paying the price.

Mr. Mark Zigler: I think the one big concern is the last point.

Private pension funds and private investors who are subjected to the 20% limit have ways around it. You heard about it this morning: two different types of derivative contracts or other techniques that are constantly being developed.

This fund, where every working Canadian has a stake in it, will be under a lot of public scrutiny, and some of those techniques may not be available, even though they should be. That's a great concern in terms of how the CPP investment fund will be invested.

Mr. Don Walcot: I was wondering if I could quote from a publication of a major U.S. dealer talking about the 80%/20% rule. It says this is one of the vestiges of Canada as a small and overly indebted economy. At times, as a result, valuations get a little rich on the TSE.

What that would indicate to me, therefore, is that international investors—and this is my experience—will not invest in Canada because they think that we are an immature market, that we have to protect ourselves because we're not good enough to compete in the world.

Mr. Robert Bertram: I wanted to add one thing about the derivatives. I'm sure everybody is aware of the technical details of the 20% foreign content rule. The 20% foreign content rule basically states that you can't put more than 20% of your funded book value outside of the country.

When you purchase a derivative—for example, a swap into the S and P 500—at the moment you crystallize that transaction the value of that swap is zero. So you aren't getting around the rule; you're simply trading the return on one asset for the return on the other. So as the value of the swap goes up or down it's offset by the value of a domestic asset.

The funds in a derivative transaction of that type in fact do not leave the country. The basic investment capital stays here. What you're doing is denominating the return based on some other market.

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So in my mind the derivatives don't get around the rule. The derivatives live within the 20% foreign content rule.

[Translation]

Mr. Yvan Loubier: Mr. Bertram, given the widespread use of derivatives, can it be said that the 20% rule is out of date, really way out of date.

[English]

Mr. Robert Bertram: I would say our exposure to the returns on foreign markets is in excess of 20%, but we have not put more than 20% of the capital of our fund outside the country. In fact, the actual book value of our investments outside the country is probably closer to 14%, not 20%.

The Chairman: Any further comments?

Mr. Mark Zigler: Just a small one. I wasn't suggesting people are getting around the rule by way of doing something that isn't within the legislation, but I think Mr. Bertram made the point that you can subject yourself to risks outside Canada in excess of the 20% without physically putting your money out of the country.

Mr. David Slater: The only thing I would add is to note that in the most recent Statistics Canada report on the assets held by pension funds the foreign asset holdings were about 13%, I think, which is below the 20%. But it is clear that the percentage has been increasing over the last decade.

The Chairman: Ms. Hardy.

Ms. Louise Hardy (Yukon, NDP): Mr. Walcot, you spoke about a code of ethics. I would like to know what you would see as the important elements in that code of ethics, the main components.

Mr. Don Walcot: Essentially the main concept would be that the responsibility of the stakeholders comes first, ahead of the trustees of the fund. They have to look after the interests of the beneficiaries. That would include such things as, on the practical level, whether they could buy themselves securities. For example, our code of ethics says we cannot buy any securities that are on an approved list, which is essentially the whole of the TSE. There are also relationships with providers of services. You cannot take in an abnormal amount of what might be seen as presents. In the United States they used to have a rule that you couldn't have a dinner of over $25.

So there are a number of practical rules that I think ensure and demonstrate that you're meeting an ethical ideal, which is to serve the interests of the beneficiaries; that all the returns of the fund go to serve the beneficiaries rather than other interest groups. It's a fairly standard code of ethics. Most companies would have one. They tend to be fairly specific: you can't buy securities, you can't involve yourself in certain activities.

Mr. David Slater: I can add one tiny point to this. It is very important to realize there's a whole law and jurisprudence dealing with fiduciaries and fiduciary responsibilities. That is a powerful underpinning to the whole matter of responsibility and behaviour. The sorts of things Mr. Walcot mentioned are in a sense a superstructure built on top of what is an absolutely fundamental body of law and jurisprudence governing the responsibility of fiduciaries.

If I'm off base, Mr. Zigler, who is a lawyer, I think will straighten me up.

Mr. Mark Zigler: Mr. Slater is not off base at all. That is the other protection that underlies the legislation, that ultimately the accountability can be enforced through the courts if there is a serious conflict over and above the conflict of interest code that must be developed by the investment board. There is probably legislative oversight. There's public oversight, through the requirement of public meetings. Ultimately, there can be judicial oversight with this kind of board, and I think they will very much be living in a fishbowl.

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Ms. Louise Hardy: Should the board be writing their own conflict rules? Shouldn't that come from somewhere else?

Mr. Mark Zigler: Actually, the legislation covers a lot of it in terms of the parameters of conflicts, but ultimately the board should be writing its own conflict rules within the legislative parameters. They are held to the standards of fiduciaries, so I would think that even in writing those rules they must meet those standards. Parliament, if you look at the legislation, though, has pretty well confined the ability to be creative in this area in terms of what the requirements are in this act. Compared to other legislation it is rather leading-edge in terms of trying to define conflict of interest.

The Chairman: Ms. Hardy, further questions?

Ms. Louise Hardy: Yes.

I'm wondering, if the mandate of the board is just to maximize profit, how does that translate into increasing benefits for employees when there's no provision for an employee or an employee representative on the board? How is that going to be safeguarded? I'm really struggling with all of these changes, because my understanding is that the people who are going to be depending on these pensions are going to be getting a $10-a-month increase. I'm wondering if the benefit of all these changes is going to go to those people. Why are we doing that? How does that connect with making the board, which is only supposed to maximize profit...? What is the provision to make sure that profit goes to the people who are going to need it?

The Chairman: Who would like to answer that question?

Mr. Keith Ambachtsheer: I'm going to repeat my understanding of it first. I understand the question to be how does the investment policy of the board balance the need for future pensions to be paid as promised and at the same time potentially have the fund take risks, the relationship between risk and reward, and who looks after that. Is that a reasonable restatement of the question?

Ms. Louise Hardy: Yes, I think so, except where there's no room on the board right now, no provision for employees who are going to be the future pensioners, how are we going to ensure that people who are really going to need this pension get a good pension in the end?

Mr. Keith Ambachtsheer: One of the key things to keep in mind in this is the relative size of the numbers. If you can imagine a balance sheet today that represents the assets and the liabilities of the Canada Pension Plan, and if you superimpose the new plan, the intent is that more of the asset side of this plan, instead of it being related to future contributions being an asset, is to put more securities on the asset side of the plan. So in the sense of the benefit security, to the degree that you move away from a pay-as-you-go system where all of the revenues come from future contributions, if you have assets, you have a more secure balance sheet.

The intent is not to create so many assets that they equal the liabilities. The liabilities, depending on what discount rate you use, are $300 billion. The intent is to create a fund of $100 billion, $125 billion. So the plan is only intended to be about one-third funded. So I would argue that this plan creates more security for future beneficiaries than a pure pay-as-you-go system.

But the reality is that even in the future what the risk really is...the risk is not not being paid, because it's a going concern and this plan has now been stabilized; the future risk is that the future contribution rate will go above 9.9%. In other words, the assets won't earn the assumed 3.8% real rate of return. If they earn a lower rate of return, then sometime in the future the contribution rate may have to be raised.

It's my view that we can assume the fund should earn a 3.8% real rate of return based on everything we know today about the future, which is always limited; we don't know everything about the future, but it's a reasonable assumption. So I would argue that the measures being put in place are in fact increasing the security of future benefit payments. What is not completely certain is whether the 9.9% future contribution rate will always stay at 9.9%. It could eventually possibly go higher, or it could go lower if the assets return a higher rate of return.

• 1120

Mr. Mark Zigler: There are really two points as well. Of course, this board doesn't set the benefit level. It is only an investment board and only if it has extraordinarily successful results will there be an issue as to whether the contribution should be reduced or the benefits enhanced.

The other element, though, is there is a change in this legislation from the previous draft. It is not just a case of maximizing profit. The legislation requires a balancing act, so you try to maximize profit without undue risk of loss. This board is charged to meet both of those requirements; therefore, I don't think you'll see that the legislation gives them the ability to be profit maximizers to the outer limits of that description. As for most pension fund managers, there's this counterbalancing aspect of risk of loss, and it is now written into the legislation.

Mr. David Slater: I have a couple of points to add. The first point is that there's nothing in the bill to preclude there being employees as members of the board. The bill is not explicit about that. What we should note is that in pension funds of which employees have been trustees, shared in the trusteeship, the record of responsible behaviour of the employee members of those boards is really extraordinary, and in some respects they turn out to be more conservative in a small “c” sense than the other people.

I would argue there's nothing really to fear about employee participation in the board. The Canadian record is against that fear.

The second point I would make is that this CPP proposal is only one part of the changes in the retirement income systems being proposed—the seniors' benefit replacing the OAS/GIS, the changes in the RPP and RRSP limits, and all that sort of stuff. It is not, as I understand it, a part of the CPP proposal to leave the matter of the pension benefits as a kind of open-ended sort of thing.

Those pension benefits are specified in the bill, and, as has been said, the investment board is to try to provide assets to help with the viability of that program, but it's in other parts of the changes in the retirement income system that the question of adequate pensions for low-income people really has to be addressed.

As you very well know, the proposals for increase in the income to low-income people by implementing this seniors' benefit to replace the OAS, as you are pointing to, are really rather modest.

The Chairman: Thank you, Mr. Slater. Thank you, Ms. Hardy.

Mr. Jones.

Mr. Jim Jones (Markham, PC): Thank you, Mr. Chairman. Thank you very much for all your presentations. Some of the questions I had have been asked and answered, but one concern I have or one question is the size of the fund. I know, Mr. Slater, you said that by the year 2010 it would be roughly $190 billion. Is there a point in time where the size of the fund can get so large that it would be more prudent to have multiple funds versus one large fund? Maybe the advantage would be that you could compare returns against each fund. In terms of the management, you could compare management style. And in having all of the money concentrated in one fund, you're giving that fund and the management and the board of the directors of that fund a lot of economic concentration. Are there any advantages that they should be looking at in multiple funds, especially if the fund is going to grow very quickly after 2010 and you're concentrating a lot of power into one board of directors and fund?

• 1125

Mr. David Slater: Mr. Chairman, through you to Mr. Jones, I think the important point is that $190 billion figure. That was my first crude estimate and it is a bit on the high side. But that's not the real issue. The point is that it's going to be a substantial fund whether it's $100 billion or $120 billion or $150 billion by 2010.

The act certainly does permit the managers of the fund to use multiple vehicles if they want to. They don't have to have it all in one pot that gets into everything. They certainly can divide up their assets among a number of vehicles and means of carrying out investment. I think it certainly is intended, as far as the act can go, to impose really quite strict standards of evaluation. Keith has written a great deal on this subject, and he can speak much more authoritatively to it.

It is possible...I shouldn't say “possible”. From the experience of people like Keith and others in the industry, we now know that it's not just a matter of having good intentions about evaluating management and so on, but that there are well-known standards and techniques for doing that now. I personally don't think there's much value in having separate CPP investment boards, in having two or three or four or five of them. A single board is fine. You don't have to have multiple boards in order to have a use of diverse means of investment and of evaluation.

Mr. Robert Bertram: I'd like to start off by pointing out that I'm aware of at least ten funds of this investment nature—mutual province societies' pension funds or savings funds—in excess of $500 billion U.S. today. The largest is the Japanese Postal Savings Bank, which admittedly has a bit of a government funding portion to it, but sits at $1.3 trillion U.S. today. So in terms of world funds, this isn't even projected ten or fifteen years out, this isn't a particularly large fund in world context.

You have to think about not the 2010 size in today's dollars, but of a fund of similar size in today's dollars. The capital markets are also going to grow in size in Canada while this fund is also growing.

Having said that, as Mr. Slater has pointed out, the control over the overall operation should reside with a single board. At the end of the day, a fund of this size tends to invest in the broadest possible markets. It becomes very difficult for it to achieve the kinds of returns that you see from individual funds, because typically those individual funds cancel one another out and come out to an average. The modus operandi for a fund of this size should be one of minimizing the cost of operation—both the cost of doing the investments and the direct cost of the investment. By having multiple funds, you simply increase the chance of earning average returns at a higher cost of management than if you have a single fund—or a fund that's managed by a single entity, at least—at the least possible cost.

To address your issue of power, I think all of us spoke earlier about the issue of a need for good governance. A fund not necessarily of this size but a fund the size of the teachers' fund, for example, or a fund the size of BIMCOR, has a tremendous amount of economic power. We have to have good governance in place to make sure that power is exercised in the ways the sponsors and the creators of the plan intended it to be used.

• 1130

Mr. Keith Ambachtsheer: I really encourage all of us to be thinking about these things in a global context rather than a Canada only context.

I think the other important thing is to think of the today-equivalent dollars. When I did the work with the CPP Investment Board last year, for example, rather than stating numbers as to what projections might be thirty to forty years out, it was better to try to understand them in today's context in terms of a percentage of GDP today. When you do that, yes, you do end up with a sizeable CPP Investment Board fund that may be twice the size of that of the Ontario teachers or three times the size of that, but it would be no larger than CALPERS in the U.S., for example. It would be smaller than the Dutch civil service pension fund, if I may practise my Dutch...[Editor's Note: Witness speaks in Dutch]...which in today's dollars is in fact at about $150 U.S., or about $200 billion Canadian. That's in the Netherlands' capital markets, which are smaller than the Canadian capital markets.

It's interesting to observe that in the last five years they have gone from a recognition that they can no longer operate strictly inside Holland to a removal of all restrictions from the management of those funds—and that fund is now very rapidly globalizing its investment program.

The Chairman: Do you have any further questions, Mr. Jones?

Mr. Jim Jones: Yes, Mr. Chairman, I have one other question, which has already been partly answered.

What are the restrictions on the Japanese fund? Do they have to invest only in the Japanese economy, or can they invest in every economy? As these funds grow, wouldn't it be wiser to remove all restrictions for—

Mr. Keith Ambachtsheer: The word of the day in the Japanese financial markets and regulations, of course, is called “deregulation”. They've all learned how to spell that in Japan, although they're still trying to understand the full meaning. It's very clear that in Japan it has been recognized that all these restrictions they have been under have in fact been very debilitating to the Japanese financial sector, to the rates of return on Japanese pension funds. The reason deregulation is now a formal, broad government policy is that they realize it has been very harmful to Japan to have those policies.

Mr. Robert Bertram: I raise the Japanese Postal Savings Bank because it has a number of functions, but it basically is a savings bank. In actual fact, over the last couple of years they have deregulated a significant proportion of that and have moved it into foreign-to-Japan markets as well. But they have deregulated in what it can do because there simply wasn't enough regulated market activity that this fund could continue to invest in.

The Chairman: Thank you, Mr. Bertram and Mr. Jones.

Mr. Szabo.

Mr. Paul Szabo (Mississauga South, Lib.): Thank you, Mr. Chairman.

Thank you, gentlemen, for the insights. Just in following this, I see there is a slight balancing of interests going on here. I think the Investment Dealers Association is the first group to bring to attention the impact of quickly putting a large amount of capital into the existing marketplace and, I guess in simplistic terms, potentially lowering returns for everybody, including the CPP, if it's not done properly. Yet Mr. Bertram just said this is not really a world-class-sized fund.

The balancing act seems to be a matter of being prudent. When he appeared before us to kick off our discussions the finance minister did indicate that, as was said earlier, the idea of maximizing returns was not there but rather to blend into the marketplace balanced in the form of what were traditional investment strategies.... I think there should be some assurance there.

I find fascinating, though, this thing about employee representation when you consider that we have a jurisdictional situation as well, with ten provinces and the fed being on the selection committee. I don't think that struck me as being an issue.

What I wanted to get your opinion on has to do with the dynamics of the Government of Canada borrowing requirements, which are now effectively nothing. They've vacated a demand for capital, which means that what's been raised here—the CPP all of a sudden putting in things—has to be taken in the context of what the Government of Canada has as its position, how that's moved, and how you've adjusted in your funds or in the experience in the marketplace.

• 1135

Does the CPP have to be concerned about being more balanced towards return requirements as opposed to being sensitive to the returns that other funds are possibly getting? Should we be seconding the interests of future retirees because somebody who's already in there and has been making great returns might have to sacrifice a point or two?

It's an interesting question about what priorities you have. I understand you don't want to go there and simply invest totally offshore, with high risk for high returns. What sacrifices do future pensioners have to make so that your client interest, as it were, and your professional interest wouldn't be disturbed?

The Chairman: Who's going to answer that question?

Mr. Keith Ambachtsheer: I don't understand the question.

Some hon. members: Oh, oh.

Mr. Paul Szabo: How about that? The point was made about going into the market gradually because we don't want to disrupt—

The Chairman: Paul, instead of you asking the question again...did anybody understand the question?

Mr. Donald Wright: I think I'll give this a shot.

The Chairman: Okay, Mr. Wright.

Mr. Donald Wright: Let me just restate the question as I understand it. Your concern is whether having the CPP plan in place will mean it will display some of the yield that some of the other already existing pension plans may be obtaining at this point in time and whether it will basically lower the returns across all pension funds. Is that—

Mr. Paul Szabo: That's part of it.

In addition to the issue of capacity of the marketplace to take on the capital—we know we're going to have growth in the marketplace—are there going to be economic lags that are going to create these problems? I'm trying to understand whether or not the impact of the CPP investment fund is going to or could potentially affect overall returns, given that Mr. Bertram said it's basically not a large fund by world standards.

Mr. Donald Wright: As long as we're able to expand and look at things on a global basis from an investment point of view, there are certainly.... We represent a very small part of the world's capital markets. As long as we're able to expand into those other areas, there should be returns for everybody. I don't think we'll have the effect you suggest.

At the same time, if this fund could only purchase Canadian property, for instance, it would definitely have a large effect. We're already seeing that effect without the Canada Pension Plan being involved because of both the federal and provincial governments not being in the debt markets in any way. We've already seen some serious problems in our capital markets in terms of market squeezes and whatever.

The equity side is something that these gentlemen are used to all the time. Moving a portfolio from one sector to another or reallocating a large percentage of their pension fund to the equity markets is difficult to achieve in a short timeframe without the use of international markets or derivatives to get there.

Mr. Paul Szabo: What about the Canadian bond market? If the pressure is that we want to expand the foreign content restriction from 20% to 30% or whatever and the Government of Canada isn't borrowing, who is going to invest in the Canadian bond market?

Mr. Donald Wright: Obviously, the Government of Canada. For that matter, a lot of the provinces aren't issuing very much, but remember there are billions of dollars already outstanding. There is some supply out there. I forget the exact amount but I think it's something like $600 billion.

What in fact will happen...and we've already seen this to some extent. Foreigners, because of our rates being lower than those of a lot of other governments around the world, are selling their Canadian bonds and domestic people are picking them up. We've had some problems in terms of some issues being squeezed from a bond point of view, but the other thing that's happening is that corporates are coming in—in incredible sizes—really over the past year, I guess, and picking up that slack. So I don't see any situation where we're not going to have enough bonds to go around in the near term at least.

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Most people use the 20% they have now to buy equities. They don't normally buy bonds, because to pick up an extra 25 or 50 basis points isn't really what they're after. They're looking to pick up an extra 10% or 20% or 30% return on their investment.

Mr. Keith Ambachtsheer: It's interesting to note that when you look at long federal government securities, the 30-year Canada bonds now trade, in terms of yield, below the U.S. treasury's for an equivalent amount, which is a very far stretch from where we were even three or four years ago. So I think you're seeing some of the dynamic of the relative demand and supply taking place.

I think there's a bigger issue we should be clear about. There has been a tremendous upward revaluation of security prices generally in the last five or ten years. In other words, a given dollar's worth of investment doesn't buy you the same yield it used to, whether it's in stocks or bonds. That's a much more material issue.

You have to be careful that you don't translate that revaluation upwards, which has led to very high rates of return over the last five years, including the capital gains—and they're part of the revaluation—and that you don't project those into the future. Those are, at best, one-time revaluations. At worst, you could get the revaluation back downwards again, and you could see falling security prices.

This is all part of the longer-term dynamic of financial markets. They will do what they do. What we're suggesting, I think, is that the CPP investment board has to be a participant in those markets, with no hands tied behind the board's back. It has to be able to set investment policy in a way that truly represents the best interests of the fiduciaries, without any constraints.

Mr. Robert Bertram: Most of my comments have now been stated, but basically this is a macro-economic question that's been asked. There is a market for capital, like so many other markets, and there's a supply and demand for capital. The clearing mechanism for that market is a rate of return on capital. If you increase the supply in a closed system without increasing the demand, you know what's going to happen to the price; it falls.

That's some of the concern that's been expressed here, that if we're in a closed system and you increase the supply of savings in the system, then the price will fall.

I'm under no illusion. We don't live in a closed system, even if we can't increase the 20% foreign content limit. This economy will grow. But you can't force the demand for money up by increasing the supply of capital, either, because the constraints on demand come from all of those other constraints that happen in the economy.

I personally believe the largest constraint in Canada today is the shortage of good-quality management for starting up companies, as opposed to the shortage of capital.

Mr. Paul Szabo: You get lots of assistance in terms of the provincial option for roll-overs, depending on what the marketplace is when they have their current bonds mature over the next 20 years. We could theoretically still have some of those 39 years from now.

Mr. Robert Bertram: To respond to that just for a second in terms of the provincial government demand, I have a problem, I guess—and I stated this in my opening comments—with giving particular access to certain groups to this fund. I think that causes a problem in terms of fund-managing it. That conflict can be managed the same way the teachers' has, simply by giving the fund management the freedom to swap away the returns on those assets to some other form and to manage that debt exposure that's being locked into the provincial government. You can handle the locked-in form of investment in some other fashion.

Mr. David Slater: I might add one point on this. While roll-over provisions with respect to provincial bonds are in the proposals, it's by no means clear that it's going to be in the interests of provinces, particularly those with a good financial rating, to actually take the roll-over. They get no advantage in an interest rate, because they're going to have to pay a market rate of interest according to their credit standing. So there's no advantage in that way.

As well, what good is it going to be locking up their position for 20 years? A provincial treasurer wouldn't want any part of that if he had any sense. He wants to have flexibility in his debt management, which he would be giving up if he engaged in a roll-over.

So in terms of this worry about the fund being indefinitely loaded up with great piles of provincial bonds, I don't think that's the reality.

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Mr. Donald Wright: I just wanted to make one comment on Mr. Szabo's comment about foreign markets and their risk. I think it's reasonably clear, although one can always point to the Asian collapse of recent days to counter this argument, that investing broadly globally probably decreases the risk of a portfolio, not increases the risk of a portfolio. I think in your comments you sort of said that foreign investments were riskier, and I don't really believe that's the case.

The Chairman: Any further comments?

Ms. Torsney.

Ms. Paddy Torsney (Burlington, Lib.): My question is specifically to Mr. Wright. On the top of page 3 of your presentation you talk about “the transfer of existing savings from personal investment portfolios to the CPP—a transfer more likely to occur among higher income than lower income CPP contributors”. Can you explain that to me?

Mr. Donald Wright: What I was basically saying there was that as the contribution level goes up in CPP, those lower wage earners are unlikely to replace the amount they put into CPP with other savings, whereas people in the higher-income bracket will make the CPP contribution, but will continue to do their own savings at the same level.

Mr. David Slater: I could add something that might help on this. Many pension programs have an integration of the CPP piece with a non-CPP piece. Nova Scotia Teachers—I helped fix up their problems. The Nova Scotia Teachers pension program consists of a CPP piece and a non-CPP piece. If it's going to take more money to pay for the CPP piece, though the CPP piece isn't going to get any bigger, there's going to be less money left in an integrated program to go into the non-CPP piece.

Unless the Nova Scotia teachers, just to use that as an example, are prepared to increase their total contributions to the pension program, they will find themselves with, if you like, less non-CPP pension—less saving in that as an offset to the increased contributions they're going to make to the CPP. So there is a substitution.

There is, however, a much bigger question. If you take the total package of all of the proposed changes to the pension or retirement income system in Canada—seniors' benefit, CPP, the changed RPP and RRSP limits, etc.—I think there's a fair chance that the net effect will be to decrease the total saving rates of the country, not increase them.

The CPP piece will go up, but I think because of the effects of these other things, non-CPP pieces are likely to shrink as elements of savings. But that's for another day.

Ms. Paddy Torsney: Just to clarify, Mr. Wright—the transfer, then, will more likely occur amongst low-income people than high-income people.

Mr. Donald Wright: Let me see, if I say this one more time.... We think that low-income people will substitute this extra payment into CPP for any savings they would have otherwise made.

Ms. Paddy Torsney: Right. So their personal investment portfolio will transfer to the CPP.

Mr. Donald Wright: Yes. I will have to read the words to see if I.... Did I say it backwards in here?

Ms. Paddy Torsney: You said the transfer is more likely to occur among higher income than lower income CPP contributors. I'm sorry to be so picayune, but I just got confused and didn't understand what you meant, and now I gather it was....

Well, let me know if you change your mind.

Mr. Keith Ambachtsheer: Just one further point on that—

Ms. Paddy Torsney: Yes, I had a question for you as well.

Mr. Keith Ambachtsheer: Once you get into substitution and changes in savings behaviour, I really don't think you can look at the CPP measures in isolation.

I was involved in writing a paper by the Association of Canadian Pension Management on the whole national retirement income strategy for Canada, which was actually released last Thursday. It looks at the system in a much broader sense of pillar one, which is the minimum income support component; CPP/QPP is pillar two, which is a relatively modest middle piece in the sense it's designated to replace 25% of final earnings up to the average wage; pillar three is the voluntary system, in its various components.

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The bigger problem, and this is really related to the seniors' benefit proposals, is that they focus very heavily on pillar one and minimum income support. There are some very serious clawback provisions in there that effectively claw back most of what people would get out of the CPP, simply because once you get above the minimum after-tax guarantee, let's say $18,400 for a couple...between that point and $50,000-plus, for every incremental $1 beyond that you get from, let's say, the CPP or from another retirement plan, you lose part of your seniors' benefit and you pay tax on it. When you combine those two things, you're into marginal effective tax rates of 60% to 70%.

That is a much more serious issue impacting on retirement savings behaviour than just looking at the CPP by itself. I think there are some major retirement savings issues in the proposals, but they are not specific to the CPP. You need to look at it in a broader context.

Ms. Paddy Torsney: Two things from the letter you gave to us. I think in your summation about encouraging greater retirement savings you've identified in pillar three that we need to have better mechanisms, but the other thing you mentioned in connection with the board set-up, which is what this meeting is mostly focused on, is you've suggested that the CPP investment board will play a constructive role in raising the accountability of the directors of publicly traded Canadian corporations. Is that because they will be asking tougher questions, or how does that work?

Mr. Keith Ambachtsheer: Actually, of course, Senator Kirby's commission on pension fund governance and the relationship between pension fund governance and corporate governance starts tomorrow morning in the Senate. That's really my testimony for tomorrow morning, but I'm happy to share some of it with you this morning.

What we're talking about here is creating a class of investors, the “buy” side, if you like, who have critical mass in their ability to understand the true nature of financial markets, how pricing takes place in those markets, the nature of the market for investment management services, and how that has some peculiarities to it. What you do—and this relates to the question of why bigger is better—with these larger, critical-mass, dedicated governance systems is they are clearer about what their role is in the system.

One of the things they have come to look at is their relationship with investee corporations, publicly traded corporations where they hold a significant proportion, 2%, 3%, 4%, 5%, of the outstanding shares. What they are going to do is to redefine how they create value for their plan members, given that they are sizeable holders of the securities. What they are going to discover, and have already discovered, is that it doesn't make sense to try to trade these securities with other large investors. It's like musical chairs. Who ends up without the chair? A much more productive activity is to start to evaluate the effectiveness of the boards and senior managements of the investee corporations.

When you look, for example, at some of the strategies of the Ontario Teachers Pension Plan Board, it's very much in that direction. They are becoming more interested in the effectiveness of the management of the corporations they invest in. If for whatever reason they are not happy, it's more in their interest to figure out how to deal with that issue than to try to sell the shares.

It's in that sense that informed buy-side investors are going to develop a different kind of relationship with the boards and management of the investee corporations.

Ms. Paddy Torsney: I have a constituent who likes to remind me, in particular with the big pension funds, which have a fairly high union component, that in maximizing profit and maximizing the return for the fund they are actually encouraging downsizing and job loss. Sometimes they are working at cross-purposes. The same union that's advocating for increased employment is advocating for a better return on investment. Would this have the potential to exacerbate that situation, or would it be a question of how they choose to get the board to be more effective in running the operations without necessarily downsizing?

Mr. Bertram is ready to go, if you want to think about that.

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Mr. Robert Bertram: I was hoping I could avoid answering that.

Ms. Paddy Torsney: That smirk was telling.

Mr. Robert Bertram: As you're well aware, the beneficiaries of our plan are members of a professional association in Ontario that sometimes is characterized as a union.

The discussion we have with them is along these lines quite frequently, but the way we've approached it is that our role in this thing is to make sure we get the maximum productivity out of the capital that's been entrusted to us.

In actual fact, in our minds it doesn't do either the unions or the employees of some of these companies or society in a broader context any good for us to continue to allow a company to underutilize the capital that's been entrusted to them or to underutilize the other resources that have been entrusted to them, because ultimately that company will fail in any case. So if we try to go in and invest at something less than what would be an appropriate rate of return on an investment and we don't ask the company to shape up, then ultimately we're just going to waste the investment in any case.

As I say, we have this ongoing discussion with the teachers at times, but in our minds it's in our best interest and in the best interests of our beneficiaries to make sure, whenever we invest in a company, that the company is run in the most efficient manner possible. Sometimes in the short run that does require downsizing.

The Chairman: Mr. Assad.

Mr. Mark Assad (Gatineau—Lib.): Mr. Walcot and Mr. Bertram, you made reference to one of the financial tools that is used in investment funds, the derivatives. I know it's a highly complicated subject.

We've heard some horrific stories concerning derivatives in the past year or so.

Without going into too much detail, could you explain to me how derivatives work? Why is it a very important financial instrument, considering that there's tremendous risk attached to derivatives?

Mr. Robert Bertram: First of all, a derivative in itself is not an investment. Basically, it's a way of investing in some end-product marketplace.

Typically, the danger that arises from a derivative, and most of the horror stories you hear about them, is the way derivatives are used, not in the instrument itself. That usually takes place.... Derivatives allow you to leverage your investment activity on a very high degree. For example, if you use a future in the financial markets, it's sort of a 100:1 leverage that you can get.

If, on the other hand, you use derivatives simply as an efficient means of transacting in the marketplace and you make sure that the transaction is always fully collateralized, you've taken the leverage risk out of that product and you're simply trading in a marketplace at a cost to the trade that is a significantly reduced proportion of what it would cost to trade in the cash markets.

An example of that would be trading in the cash markets in the Canadian stocks.

The better example where we make the most use of derivatives is in the S and P 500. If we were to trade in a basket of the S and P 500's top stock, the trade in and out of that market—and this is one of the most efficient markets in the world—might cost us between 1% to 3% on a basket trade. That would be a round trip in and out of that marketplace.

On the other hand, if we do that with a fixed equity swap or with a futures, we probably reduce the cost of that trade to around 0.05%.

At the end of the day, for a fund like this or a fund the way the CPP would ultimately be constituted, your ownership in an asset is going to be ongoing. Once you buy 5% of the fund in the TSE 300, you're going to own that 5% almost forever, as long as the fund is going to exist. You don't want to be undertaking high cost to tweak the results, so you end up using derivatives on a low-cost basis to change the marginal results of the fund.

Mr. Mark Assad: If I understood you correctly, if derivatives are used properly—the horrific stories of the past were because of the fact that they were not—

Mr. Robert Bertram: Right.

Mr. Mark Assad: It's like an insurance policy.

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Mr. Robert Bertram: It can be like an insurance policy. The risk is not in the derivative. It's simply a tool in itself.

Mr. Mark Assad: To protect yourself, to hedge—

Mr. Robert Bertram: Yes. One of the fellows in our office used to stand up and speak about derivatives and he used the analogy of drugs. He said there are good drugs and bad drugs. You can use aspirin to get rid of a headache, but if you take 50 or 60 of them they're not going to do you much good. That's the real issue. In fact it's how you use the derivative, not the instrument itself, that's dangerous.

Mr. Mark Assad: Thank you.

The Chairman: Mr. Walcot, followed by Mr. Wright.

Mr. Don Walcot: There is one thing I might mention. We have gone through the process of putting in a policy on derivatives at BCE, which was a lengthy process done at the policy level. They were nervous about derivatives, and certainly, as Bob was saying, it is a range of least risky to most risky. So what we had established were clear policies on who we could deal with, the amount and the type of transactions we could deal with, plus a reporting system so that the trustees would know every quarter exactly what we had done. So there are ways through the governance process to control the derivative transactions as well.

The Chairman: Mr. Wright.

Mr. Donald Wright: I'd like to expand for a minute on derivatives. We as an organization, being the TD, have very large exposures in terms of the notional amount of derivatives that are outstanding at any time.

As Mr. Bertram said, it's the way one uses derivatives. A lot of the horror stories you've heard were really governance issues or people using things inappropriately. When I say inappropriately, sometimes people use derivatives to speculate, and if that's what their fund is set up to do, then that's appropriate. But other funds are not set up to do that.

In some cases, and in a lot of the situations Mr. Bertram referred to, I think, what people do is they don't hedge by using it. You might take the return on a Government of Canada bond, for instance, in the CPP fund and decide you'd like some exposure to the S and P 500. You would pay somebody the return you're getting on the government bond. So you're receiving the government bond rate and you decide to pay it to someone else. Now you have zero return, and in return for you paying that, they're going to pay you a return based on the S and P 500. In effect what has happened is your economic exposure is to the S and P 500. The asset you hold is still the Government of Canada bonds or the provincial bonds. So the nature of the actual asset you have in your hands hasn't changed, but the nature of your economic risk has changed.

When these are used, they allow people to switch the asset mix of their portfolios in a much more efficient manner, something they could really be very hard pressed to do economically, and in some cases even physically, by doing it in the cash markets.

Everybody looks at derivatives as being extremely risky and whatever. I think with all the news that has happened over the last five years everybody has investment policies; everybody has criteria. We have criteria not only for ourselves but in terms of best practices and suitability for our clients as well.

So even though it's not our responsibility to worry about what our customers do per se, we do worry about it because it's part of what goes along with being in that market, and we take that very seriously.

It's a whole governance issue, and as these gentlemen have alluded to before, governance in this particular fund and in all funds is extremely important. As long as you do it within that framework, then I think it's not only an acceptable practice but one that's necessary to make the fund competitive with others in the marketplace.

The Chairman: Thank you.

Thank you, Mr. Assad.

On behalf of the committee I'd like to thank you very much for what I think was a very interesting round table. It's certainly going to help us as we study Bill C-2. You've provided us with some very valuable information that we will put to good use.

The meeting is adjourned.