Demystifying Pension Fund Benchmarks

Following up on my last comment on CPPIB getting grilled in Ottawa, I received a few questions on benchmarks. I will elaborate on benchmarks in this post.

But first, CPPIB contacted me to tell me that they posted Ms. Warmbold's opening remarks to the Standing Committee on Finance. I am still waiting for PSPIB to post Mr. Valentini's remarks on their website, but given that the last press release dates back to October 2007, I doubt they'll post his remarks on their website.

Anyways, back to Ms. Warmbold's opening remarks (added notes are mine):
Good morning, Mr. Chairman and Members of the Committee.

My name is Benita Warmbold, and I am Senior Vice President and Chief Operations Officer of the CPP Investment Board. With me today is Mr. Don Raymond, Senior Vice President and head of Public Market Investments.

When the federal and provincial ministers of finance successfully reformed the Canada Pension Plan in the mid-1990s, they endowed the CPP – and the CPP Investment Board – with a number of advantages. Three of those advantages have proven invaluable in the recent economic environment.

The first is the clarity of our investment mandate enshrined in legislation to maximize returns without undue risk of loss.

[Note: It is not that clear to me what is meant by "undue risk of loss". Specifically, how much active risk is CPPIB taking to generate 100 basis? Is it 400 basis points of active risk? 500 basis points?]

The second is a governance model that balances independence with accountability. The CPPIB operates at arm’s length from government and is overseen by an independent board of directors which approves investment policies and makes critical operational decisions. To balance that independence, the CPPIB is accountable to the federal and provincial finance ministers who act as stewards of the CPP. And we have a high degree of transparency so Canadians can see how their pension fund is managed.

[Note: CPPIB does have a high degree of transparency EXCEPT for stating what its benchmarks are in both public and private markets. This will be discussed below. As far as accountability, the stewards have not performed a comprehensive performance, operational and fraud audit of the CPP Fund. This will surely come in the next Special Examination.]

The third is stability, through the legislation that protects the CPP assets and governs the CPP Investment Board, which requires the cooperation of the federal and provincial finance ministers to change.

All of these advantages reinforce our ability to earn investment returns to help sustain future benefits for the 17 million Canadians who participate in the CPP.

To fulfill this objective, the investment strategy of the CPP Fund is designed to generate returns over decades and generations and as a result we have a long investment horizon.

That long-term focus is central to my remarks today.

[Note: Focus on the long-run but we should then have ten or twenty year rolling returns on your bonuses along with clawbacks and high-water marks in case you blow up in the short-run.]

The combination of our long-term focus and the funding structure of the CPP -- in which contributions are expected to exceed benefits through 2019 -- has proven extremely valuable in helping the CPP withstand a prolonged market downturn.

The assets of the CPP Fund have grown steadily as the portfolio has been diversified over the past 10 years. As at December 31, 2008, the CPP Fund had assets of $108.9 billion. That’s an increase of $71 billion as a result of investment returns and contributions from employees and employers.

The fund today is a broadly diversified portfolio of public equities, private equities, real estate, inflation-linked bonds, infrastructure and fixed income instruments.

[Note: Ms. Warmbold forgot to mention that CPPIB also invests in hedge funds.]

Just under half of the fund – about 49% -- was invested in Canada and the balance was invested globally as of December 31.

As recent results have shown, the CPP Fund is not isolated from the storms buffeting financial markets and the global economies. Sharp declines in global equity markets have negatively impacted our recent results. For the first three quarters of the fiscal year, the fund declined $13.8 billionreflecting a return of negative 13.7 percent.

While we recognize that Canadians may be concerned about these short-term results, our long investment horizon creates advantages and opportunities.

First, the portfolio we manage today is not being used to pay benefits today. In fact, it will be another 11 years before money from the fund will be required to help pay pensions.

Secondly, as a result of new cash flows for the next 11 years, we have the opportunity to invest in quality assets at attractive prices, when many other investors cannot.

And thirdly, our portfolio reflects our long term mission and is designed to generate returns over 4 year periods, rather than focusing on a single year.

Appropriately, our policy on management compensation reflects our long term investment strategy, our portfolio design and our long-term outlook.

The key principles are that compensation rewards performance over the long term as measured in 4 year periods; that pay for performance is based on two factors -- how the fund performs overall and whether we generate returns above a market-based benchmark.

[Note: There is a great deal of uncertainty regarding the long-run. Towers Perrin has today warned that the pensions industry will not recover from its exposure to the financial crisis for more than twenty years. Will you be around in twenty years if your long-term bets go sour? I doubt it, but you have no problem collecting millions in short-term and long-term bonuses based on four year rolling returns. Something does not add up there. Then there are reporters like Andrew Willis of the Globe and Mail who do not bother to analyze benchmarks in detail but just blindly shill on your behalf, stating that politics threaten CPP Investment Board's integrity. ]

Overall, the program balances pay-for-performance with the ability to attract and retain the best investment professionals to manage the fund.

[Note: It's a secular bear market in the financial industry. You can attract a lot of talent to CPPIB, paying them a fraction of what you are paying those senior VPs!]

In summary, the CPPIB is very confident that we have the investment strategy to generate the long term returns required to help sustain the CPP.

Given recent conditions, we know Canadians are placing an even higher value on a strong public pension system. We take very seriously our responsibility to help sustain one of Canada’s most important social programs for decades and generations to come.

Thank you.

As I stated in my last post, CPPIB does not disclose its benchmarks (read their latest investment policy; there is nothing on benchmarks), preferring to give returns of the broad asset classes and of the overall fund.

But without proper disclosure of all the benchmarks governing each and every investment activity, including hedge funds, private equity, real estate, and infrastructure, we simply do not know whether the managers are taking appropriate risks relative to their performance benchmarks.

So what is a benchmark? I take the following definition from PIMCO:
In most cases, investors choose a market “index,” or combination of indices, as their portfolio benchmark. An index tracks the performance of a broad asset class, such as the investment-grade bond market, or a narrower slice of the market, such as investment-grade corporate bonds. Because indices track returns on a buy-and-hold basis and make no attempt to determine which securities are the most attractive, they represent a “passive” investment approach and can provide a good benchmark against which to compare the performance of a portfolio that is actively managed. Using an index, it is possible to see how much value an active manager adds and from where, or through what investments, that value comes.
When talking about the stock market the typical benchmarks for large cap U.S. stock is the S&P 500. If your mutual fund is underperforming the S&P 500 (most of them do), then you are paying fees to someone who is not capable of returning "market" returns.

There are very few major disagreements when it comes to plain old stock and bond benchmarks. You might argue that the S&P 600 is a better index of small cap stocks than the Russell 2000, but they are both reflective of the performance of small cap stocks. Most institutions use the same indexes to track the performance of public markets.

Where things get tricky is in private markets and hedge funds, what we call alternative investments. There is no consensus on what constitutes the appropriate benchmark for private equity, real estate, infrastructure and hedge funds. It amazes me that global pension funds never got together to figure out what will be the pension industry's benchmarks for private market assets and hedge funds.

Instead, each fund uses their own benchmarks. For example, in real estate, some funds use a spread (typically 500 basis points) over CPI while others gauge their performance using a benchmark like IPD Market Indices which better reflect actual property transactions in commercial real estate by region. Other funds will use a stock market real estate index like the Dow Jones REIT Index.

Being an economist, I like using benchmarks that reflect the opportunity cost of an invesment. If a pension fund is investing in large U.S. buyout funds in their private equity portfolio, then the benchmark governing these asset class should be some spread above the S&P 500 like S&P + 500 basis points
and lag it by on quarter for valuation purposes. The spread is there to reflect the illiquidity of these investments and the embedded leverage of private equity deals where general partners borrow to finance their purchases of private companies.

If you are investing in private real estate or infrastructure investments, then try to benchmark these assets relative to some market index of real estate or infrastructure stocks that captures the "beta" of these investments and add a spread for illiquidity and lag it by on quarter for valuation purposes.

Unfortunately, it's not always possible to find the appropriate benchmarks that fits all pension funds in each of this alternative asset classes, but that is why you need a comprehensive performance audit to make sure they are not gaming their benchmarks to easily beat them.

Take hedge funds for example. Some strategies are liquid, others are illiquid, some use leverage, others use no leverage, and so on. Using an absolute return benchmark of T-bills + 500 basis points might seem appropriate, but what if your pension fund manager is investing in highly leveraged illiquid strategies? Up until last year, they would have trounced that benchmark, reaping huge bonuses, but then the music stopped and credit markets seized, effectively killing these strategies.

As I discussed before, it's all about the benchmarks stupid! Unless the benchmarks reflect the risks, beta and leverage of the underlying investments, then you simply do not know if the value added your pension fund manager is claiming to add is really that or just a free lunch.

Let me end by looking at specific examples from pension funds. First, let's look at PSP Investments' Policy Portfolio from their latest investment policy:

(Click to enlarge:)

You will notice that all the public markets indexes are properly disclosed but when it comes to private markets like private equity, real estate and infrastructure, PSP states that "for competitive reasons these benchmarks are not disclosed."

What are these "competitive reasons"? Who is PSP Investments competing against? For crying out loud, it's a public pension fund and a Crown corporation, not some secretive hedge fund! It is absolutely scandalous that they and CPPIB are refusing to disclose their private market benchmarks but see it fit to say that they added "significant value" in private markets when it comes time to collect their huge bonuses.

hat's a clear indication that a benchmark does not reflect the risks of the underlying investments? Again, take a look at the 2007 real estate returns from the large funds:

(Click to enlarge:)

You'll notice that while OMERS, CPPIB and PSPIB "significantly outperformed" their real estate benchmarks, the Caisse underperformed it. This is because the Caisse policy benchmark for real estate is a lot tougher to beat because it accurately reflects the underlying beta, liquidity and leverage of their real estate investments.

The Caisse's Policy Portfolio is clearly presented on page 32 of its 2008 Annual Report:

(Click to enlarge:)

The Caisse is not perfect. The benchmark governing non-bank asset backed commercial paper clearly did not reflect the risks of these investments and it ended up costing the Caisse billions.

[Note: Those of you who read French, should read Francis Vailles' article in La Presse concerning the risks portfolio managers were encouraged to take in ABCP to reap huge bonuses.]

The message behind this short synopsis of pension fund benchmarks is that no fund is perfect. Some are more transparent in most areas but fail to disclose their benchmarks in public and private markets (CPPIB), some are much better with their real estate benchmarks but screwed up on their money market benchmark (Caisse), some are excellent with their public market benchmarks but their private market benchmarks are totally inadequate (PSPIB).

And the travesty in all this is that we have reporters like Andrew Willis telling us to leave these public pension fund managers alone and keep compensating them with millions of dollars because they are the experts and they are governing in the best interests of their beneficiaries.

If only that were true, I could then stop writing my blog and go to sleep early every night.