Monday, February 23, 2009

Clearing the Pensions Fog?

Last week, I read an article in the Financial Post on CIBC takes flak over chief's pension top-up:

In an era when bank executives are handing back bonuses and directors are under pressure to show prudence in granting compensation, Canadian Imperial Bank of Commerce has angered some institutional investors by increasing chief executive Gerry McCaughey's pension payout by what could amount to several million dollars.

The change is contained in the company's recently released proxy circular document in a series of notes that describe a bump-up in the maximum allowable compensation on which Mr. McCaughey's pension will be based to $2.3-million from $1.9-million.

"That's in the millions of dollars over many years [of retirement]," said Doug Pearce, chief executive and chief investment officer of B.C. Investment Management Corp., which manages nearly $80-billion in assets including bank stocks on behalf of pensioners in British Columbia. "The boards have told us they want to pay for performance but that doesn't appear to be the case... because that goes on for the rest of your life."

The proxy document says the change was made to bring Mr. McCaughey's allowable compensation for the pension calculation in line with the standards set by other Canadian banks and large insurance companies. Based on the formula, he could qualify for $1.6-million a year, up nearly $300,000.

Although CIBC continued its policy of withholding consideration of a bonus for the CEO so the board could have the benefit of another year's performance under its belt, and Mr. McCaughey gave up his cash bonus in 2007, Mr. Pearce said the B.C. pension group will be communicating with CIBC to express displeasure about the prospective top-up to Mr. McCaughey's pension.

He also expressed displeasure that investors had to "dig so deep" to find the information in the notes of the proxy document.

Canadian banks have fared better than their counterparts in the United States and the United Kingdom in the fallout of the global credit crisis, and have not faltered or been nationalized. But investors have nonetheless been hammered by bad loans and writedowns and companies deserve to come under fire for compensation practices that prompt excessive risk-taking, said Stephen Jarislowsky, founder of Montreal-based Jarislowsky Fraser which manages $52-billion in assets.

CIBC's share price slumped 27% last year, despite a relatively good performance among its peers.

"It's outrageous," Mr. Jarislowsky said of the prospective annual top-up to Mr. McGaughey's pension. "To do it at this moment in time, it shows a complete lack of judgment on the part of the board of directors."

The crisis in the financial sector has unfolded alongside eye-popping bonuses for bankers of troubled companies, prompting shareholders, politicians and regulators around the world to push for changes in incentives that are blamed for the risky behaviour that caused the meltdown.

This month, the chief executives of Royal Bank of Canada and Bank of Montreal handed back their bonuses of $5-million and $4.1-million.

Still, despite such moves and the relatively good performance of Canadian banks which won praise this week from U.S. president Barack Obama, Ottawa nonetheless seems poised to be involved with creating new international guidelines on pay for bankers before the next summit of the G20 nations.

The Canadian Coalition for Good Governance, which represents 43 pensions and other money managers who manage approximately $1.4-trillion of assets on behalf of Canadian investors, has made executive compensation a priority and will be closely scrutinizing the incentive portions of proxy documents.

"We would expect to see significant declines in executive compensation," said Stephen Griggs, executive director of the coalition. He added that any company that "might be on the verge of reducing its dividend should not be providing significant discretionary compensation to executives."

So who exactly is the Canadian Coalition for Good Governance? From the website:

The Canadian Coalition for Good Governance was formed to promote good governance practices in the companies owned by our members. Generally, these companies are members of the S&P/TSX Composite Index. Coalition members believe that good governance practices contribute to a company's ability to create value for its shareholders.

Membership in the CCGG includes a wide range of institutional investors - pension funds, mutual funds and third party money managers. Our members invest in the Canadian capital market on behalf of millions of Canadians, many of whom will rely on the returns from these investments to fund their retirement years.

Currently there are 43 members who in total manage approximately $1.4 trillion of assets on behalf of Canadian investors from all walks of life. For a list of members, visit the Membership area of the web site.

And the list reads as the who's who of Canadian institutional investors. From the CCGG's fact sheet:

Doug Pearce, Chair
CEO & CIO, British Columbia Investment Management Corporation (bcIMC)

David Denison, Vice Chair
President and CEO, Canada Pension Plan Investment Board

Dan Chornous
CIO, RBC Asset Management

Gordon J. Fyfe
President & CEO, PSP Investments

Emilian Groch
CEO, Alberta Teachers’ Retirement Fund Board

Stephen A. Jarislowsky
Chairman & Director, Jarislowsky Fraser

Wayne Kozun
Senior VP, Public Equities
Ontario Teachers’ Pension Plan

Barbara Palk
President, TD Asset Management

Don Reed
President & CEO, Franklin Templeton Investments

Kim Shannon
President & CIO
Sionna Investment Managers

The CCGG's fact sheet also claims that in 2009-2010, the Coalition will focus its efforts in 6 main areas:

1. Executive compensation – “Pay for Performance”
Using an extensive member and industry consultation process, the CCGG will develop a principles based approach to pay for performance. Our principles will focus on defining “performance”, simplifying compensation and linking performance based compensation to risk management while reflecting the reality that compensation is complex and often company or industry specific.

2. Enforcement – creating credible deterrence
We will continue to urge the federal and provincial governments to create an effective and focused national investigative and prosecutorial organization which detects, investigates and prosecutes crimes and securities law breaches in a timely manner.

3. Eliminating barriers to shareholder democracy
Today, there are a number of impediments to effective voting, including the inability to vote “against” a particular director or group of directors, a proxy voting system which has led to inaccurate shareholder vote counts and rules which allow many corporate transformational events (such as significant dilution on major acquisitions) to proceed without shareholder votes.

4. Refining processes for high performance boards
CCGG has developed a number of recommendations as to how boards should be structured and operated which we will update to reflect current thinking and experiences.

5. Communicating our views to companies, regulators and our members
CCGG will develop and implement a communications strategy to clearly communicate our views to companies (boards and management), regulators and our members.

6. Measuring the adoption of our recommendations by major Canadian companies
CCGG will continue to monitor and measure how companies are adopting and using our good governance and compensation principles, provide this information to our members, and advise companies as to how they are doing.
While I applaud these measures, I can't help but laugh at how some of the pension funds that are part of the CCGG are not following their own recommendations when it comes to how they manage their pension activities.

Take, for example, two major pension funds in Canada: the Canada Pension Plan Investment Board (CPPIB) and the Public Sector Pension Plan Investment Board (PSPIB).

Both of these pension funds are federal Crown corporations, however, they are both exempt from the Financial Administration Act (FAA), which is the cornerstone of the legal framework for general financial management and accountability of public service organizations and Crown corporations.

Nonetheless, while PSPIB and CPPIB both have fiscal years that end on March 31st, one pension fund - the CPPIB - is far more transparent than the other.

All you have to do is look at the press releases from PSPIB and compare them to those of the CPPIB to get a flavor of who is more transparent. And that is just the beginning. In almost every single category, the CPPIB is a lot more transparent than the PSPIB, right down to providing information on their investment partners in private equity, public markets (overlay managers), and real estate.

Also, unlike PSPIB, CPPIB publishes its quarterly results. Their Director of stakeholders emailed me to tell me when their results would be announced. I followed up with specific questions and got the following response with answers to my questions:

1) Do the private market valuations play a role in these quarterly results?

  • Yes – private market valuations play a role in our quarterly results.
  • The results recently reported reflect the current state of the CPP Fund portfolio, including the most recent valuations of our private market investments.
  • Our accounting policy is to reflect all holdings at fair value and this is reflected in our results.
  • Some illiquid assets are valued quarterly while others are valued annually.
  • We do assess some real estate or private equity assets quarterly if there is relevant information available. Otherwise, they are assessed annually with independent third-party appraisals.
  • Some illiquid assets (such as investments in funds) are valued quarterly based on investor reporting packages provided by the investment managers while others (such as direct investments) are valued annually. However, on a quarterly basis, internal reviews are performed on direct investments to identify any significant changes in value; and if there were, investment values would be adjusted and reflected in our quarterly results.
  • Annual valuations performed by qualified, independent and experienced third party valuators.
  • The CPPIB provides more information more often than any other Fund of its kind.

2) The funding status of CPPIB is used to state that they can take on a lot more risk than more mature, fully funded plans. At what point does this argument lose credibility?

  • The CPP long-horizon and predominately pay-go funding formula should provide the CPPIB with a strategic comparative advantage over mature fully funded plans for the foreseeable future, especially during periods of market down turns.
  • Please note that we distinguish between funding formulae not to justify taking on more risk, but to explain the different financial pressures on funds. The CPP is able tolerate a given level of risk better than fully funded plans, and as consequence, take long-term advantage of market declines – a strategy that CPPIB is actively pursuing.
  • As explained in the report of Canada’s Chief Actuary, the CPP is partially pre-funded but still predominantly financed on a pay-go basis. The Chief Actuary projects that the CPP will reach its maximum funding ratio of about 25 per cent in 2025.
  • One consequence of this is that investment earnings play a smaller role in funding CPP benefits over both the near-term and long-term than in fully-funded plans.
  • While investment returns are important, the largest proportion of funding comes from contributions paid by current and future employees and employers.
  • Economic factors such as wage growth and inflation as well as demographic factors such as fertility, mortality and immigration all have a larger impact over the long term than investment earnings.
  • Also, unlike fully-funded plans that are required to address funding shortfalls over shorter time horizons, the CPP steady-state funding formula has an implicit 75-year amortization period. As a result, within our very long investment time frame we can weather periods of sharp market downturns better than most fully funded plans.

3) As I stated in my blog, when is CPPIB going to start publishing granular benchmarks on all their investment activities so all stakeholders can gauge whether their senior pension fund managers are appropriately compensated?

  • The CPPIB is a leading proponent of enhanced disclosure regarding executive compensation and was the first Canadian public pension fund to publish a Compensation Discussion and Analysis (CD&A) in fiscal 2007. You can read our CD&A as part of our Annual Report, which is posted to our website.
  • Our measurement benchmark for each asset class allocation in our CPP Reference Portfolio benchmark is detailed in our annual report and we report the returns of each of those granular benchmarks. Further information on our benchmark is detailed in the Statement of Investment Objectives, Policies, Return Expectations and Risk Management that is available on our website.
  • From an accountability perspective, the Reference Portfolio is the cornerstone and principal yardstick for CPPIB’s total fund incentive compensation framework.
  • The CPP Reference Portfolio represents a low-cost, low-complexity and broadly diversified portfolio that embodies the investment objectives and risk level envisioned by the CPP stewards when the Canada Pension Plan financing was reformed in 1997. It is a passively managed benchmark that is designed with the explicit objective of minimizing plan adjustment risk, which is the need to increase contributions and/or lower benefits at any time over a 75-year planning horizon. CPP Reference Portfolios can reasonably be expected to earn the long-term average real return (after inflation) of 4.2% used in the Chief Actuary of Canada’s 75-year “best-estimate” projections.
  • By design, the Reference Portfolio can be implemented with a small and low-cost organizational structure. This allows the Board to evaluate the value-adding impact of CPPIB’s higher-cost active management investment decisions. Management’s objective is to earn returns above what would be earned by the Reference Portfolio, after subtracting all operating costs including incentive compensation payments.
  • The Board adopted this framework because it is the best way to determine if the CPPIB has exceeded, net of all costs we incur, the viable, low cost way of harvesting capital market returns using broad market indexes.
  • We use suitability risk-adjusted benchmarks at the departmental levels. These benchmarks are reviewed and approved by our Board every year, with the advice and counsel support of an external Board-selected compensation consultant. We have decided not to disclose the details of these benchmarks because they are integral to our Total Portfolio Approach to managing risk, which we believe gives us a competitive advantage.
  • Consistent with our long-term investment horizon, we focus on investment returns over longer time horizons. As a result, variable compensation is typically tied to performance over four-year rolling periods, not to performance in any single year.
  • Our active management strategies have delivered more than $5.3 billion above our market-based benchmark in added value over the past two full fiscal years.

4) Finally, who is responsible for the CPPIB's overall asset mix? What are the risk parameters governing this asset mix?

  • The Board approves the CPPIB overall asset mix policy, which is a fairly conventional long-horizon balance of 65 % equity and 35 % fixed income.
  • Management and board of directors as part of a strategy review in late 2005, decided to expand the range of investment programs in the CPP Fund to include greater asset class diversification and geographic diversification within this basic split.
  • Each year the board of directors of the CPP Investment Board approves an active risk limit, within which management has discretion to make active management decisions subject to regular Board oversight.
  • In its business plan for each fiscal year, management’s Investment Planning Committee indicates to the board how it intends to allocate its active risk budget across the different investment departments and the level of incremental returns it expects to earn for these risk allocations.
  • Further information is detailed in the Statement of Investment Objectives, Policies, Return Expectations and Risk Management that is available on our website.

I am not going to get into deep analysis of the answers provided here because I prefer to wait until CPPIB presents its final results at the end of their fiscal year to comment on specific benchmarks and issues related to compensation.

But I am impressed with the timeliness of their response and the depth and breadth of their answers. At least they are willing to answer my questions, which is more than I would ever expect from others.

This entry of mine is about pension transparency. Transparency and trust are the keys to the Norwegian Pension Fund:

Transparency and trust are driving forces behind the management of Norway’s revenues from oil and gas production. As sovereign wealth funds (investment funds owned by governments) receive increased scrutiny by regulators, the Norwegian Pension Fund – Global may become a model for other sovereign wealth funds.

Norway, one of the world’s largest petroleum exporters, has invested its oil wealth in a fund with a current market value of more than $350 billion. This makes it Europe’s largest, lagging behind only that of the United Arab Emirates among SWFs.

Morgan Stanley projects that sovereign wealth funds could grow from their current total of $2.5 trillion to $12 trillion within a decade. A concern in the United States and Western Europe is that secretive management under government ownership may raise national security concerns, distort markets by pursuing strategic objectives (not financial) and threathen financial stability.

“There is a serious likelihood of Western governments and funds clashing over what they can buy and where,” chief economist at Standard Chartered Bank in London, Gerard Lyons, recently told the International Herald Tribune.

Will the emergence of sovereign wealth funds really increase the volatility of markets? The opposite may be the case. Because of a long-term investment horizon for SWFs, the funds will not be forced by capital requirements or investor withdrawals to liquidate positions rapidly. “They won’t get ‘cold feet’ in down-times when other investors scramble to sell, but rather stay in it for the long haul and contribute to stabilizing the market,” said Lars Fjell Hansson, Counselor for Economic and Financial Affairs at the Royal Norwegian Embassy in Washington, D.C.

“There is a strong case for sovereign wealth funds to adopt the best practice of open funds like Norway,” Gerard Lyons in Standard Chartered Bank emphasized.

What makes the Norwegian fund different from several other sovereign wealth funds is the amount of information it makes public about its strategy and investments. Its performance and risk exposure are reported quarterly and its holdings in about 3,500 companies are detailed annually; in most cases, its investment in any company amounts to less than one percent of available shares. The fund does not seek to control companies through buy-outs. In fact, by its own rules the fund restricts its ownership in any company it invests in to five percent of shares. The investment objectives are purely financial in nature, safeguarding assets for the long term.

The Norwegian fund is an instrument for ensuring that a reasonable portion of the country’s petroleum wealth benefits future generations. This is regarded as an ethical obligation. Only the returns from the fund will be spent in the annual national budgets. The fiscal rule says that four percent of the fund may be spent, which is estimated to be the real return of the fund over time. This strategy of controlled spending will also keep inflation in Norway down.

The second ethical obligation is to respect fundamental human rights. The fund is taking a stand against serious violations of human rights, such as child labor, gross corruption, and severe environmental degradation. The fund divests itself of shares in companies which produces certain weapons, for example, cluster-munitions. Norway has called for a complete ban on such weapons. The ethical guidelines were adopted by the Norwegian Parliament in 2004.

At a hearing in the United States Senate on November 14, 2007, experts testified on the growth of sovereign wealth funds and on maintaining a balance between attracting foreign investments to the United States while managing potential security issues. Edwin Truman, Senior Fellow at the Peterson Institute for International Economics, presented a scoreboard ranking sovereign wealth funds according to benchmarks on structure, governance and transparency & accountability and behavior. The Norwegian Pension Fund - Global scored 23 out of 25 possible points. This placed the fund second among the 32 countries on the index, one point below New Zealand's Superannuation Fund.

“The U.S. government should continue to actively encourage foreign governments with large cross-border investments to develop and follow a set of best practices with respect to managing those investments in their interests, in our interests, and in the interests of the stability and openness of the international financial system. Our scoreboard provides a starting point for the development of such a set of best practices for sovereign wealth funds,” Truman said.

Placing third was Timor-Leste Petroleum Fund, followed by Canada’s fund and the Alaska Permanent Fund. “Timor placing this high seems like an anomaly, given that most developing countries placed in the lower part of the index,” Embassy Counselor Hansson said. “But it is probably because as part of its development assistance to Timor, Norway assisted in setting up the structure of the Timor Petroleum Fund. This shows that the guiding principles of the Norwegian model are solid,” he said.

Facts about The Norwegian Pension Fund – Global

  • The Norwegian Ministry of Finance has the overall responsibility of the Government Pension Fund. The operational management of the Government Pension Fund – Global is delegated to Norges Bank (the Norwegian central bank).
  • Key objectives in the management of the Norwegian Pension Fund – Global includes a high degree of transparency in all aspects of its purpose and peration, the fund’s role as a financial investor with non-strategic holdings, an explicit aim to maximize financial returns, and clear lines of responsibility between political authorities and the operational management.
  • The fund returned 7.9 percent last year and has averaged 6.5 percent a year over the past decade. After accounting for inflation, costs and management fees, it has averaged an annual return of 4.6 percent since its inception, outpacing the 4.1 percent gain in a government-set benchmark.
  • The Norwegian Pension Fund – Global has a current market value of more than $350 billion (January, 2008), equaling about $75,000 for every Norwegian, investsted in markets all over the world. Close to one third of this is invested in the United States. Over time, the share invested in equities will increase to 60 percent, while 40 percent will be invested in fixed income.

You can read more about Norway's Government Petroleum Fund by clicking here. Also, please go back and read my post on the need for independent performance and operational audits.

When it comes to pension transparency, some funds are way ahead of others in terms of outlining accountability, explaining benchmarks, explaining pension deficits, publishing board minutes and resolutions, nominating board of directors, comprehensive annual reports, reporting financial summaries and costs, travel and business expense policy, and overall communication to stakeholders.

The key point to remember is that transparency and trust are the cornerstone of pension governance. Importantly, pension funds should not just adopt best practices, but always look at ways to exceed them, making sure they fully communicate any changes to their stakeholders.

[Note: Read this comparative OECD study on pension governance for some ideas on best practices. Also, scroll down the right hand side of this blog for other excellent documents on best practices on pension fund governance.]

Finally, take the time to read a CBI study, Clearing the pensions fog: Achieving transparency on public sector pension costs. There are serious issues all around the world concerning pension costs, and as I stated plenty of times, underfunded pension plans will be the public policy issue of the next decade.

Given the problems plaguing other financial institutions, pension funds should lead by example, clearing the pensions fog by putting teeth into pension transparency.

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