Post on 12-Jan-2016
description
Measuring and Managing Return, Risk
and Incentive Compensation
International Centre for Pension Management
Donald M. Raymond Senior Vice PresidentPublic Market Investments
June 3, 2008
John H. IlkiwSenior Vice PresidentPortfolio Design and Risk Management
Copyright © 2008. Canada Pension Plan Investment Board. All rights reserved.
2
Overview
1. Background
2. 2000-2005: Early Years as a Largely Passive Investor
3. 2006-2008: Becoming an Active Global Investor
4. 2008+: Challenges and the Road Ahead
Copyright © 2008. Canada Pension Plan Investment Board. All rights reserved.
3
Actual Rate
Background:Why We Exist: How Crisis Led to Reform
Contribution Rates
0%
2%
4%
6%
8%
10%
12%
1965 1975 1985 1995 2005 2015 2025 2035 2045
Pay As You Go (PAYGO) Rate Long term
PAYGO rate
-10
-5
0
5
10
15
20
Annual Net Benefits
(Benefits-Contributions)(Bn C$*)
Reforms (1997)
First cash flows to CPP Investment Board (1999)
Contributions to exceed benefits for over a decade
Excess loaned back to governments until 1983
* 1966-2004 : Actual $ 2005+ : 2005 constant dollars
Copyright © 2008. Canada Pension Plan Investment Board. All rights reserved.
4
Background:Large Start Up/Developing Organization
0
20
40
60
80
100
120
140
1999 2000 2001 2002 2003 2004 2005 2006 2007 2008
Year
Ass
ets
($ b
illi
on
s)
0
50
100
150
200
250
300
350
400
450
No
. o
f em
plo
yees
Assets
Employees
* For years 2007 and 2008 are estimates only
* *
Copyright © 2008. Canada Pension Plan Investment Board. All rights reserved.
5
Background:Our Mandate
• To invest its (CPP) assets with a view to making a maximum rate of return without undue risk of loss, having regard to factors that may affect the funding of the Canada Pension Plan and its ability to meet its financial obligations on any given business day
• maximum rate of return without undue risk of loss We need to determine and take into account the risk
preferences of our stewards
• having regard to factors that may affect the funding We need to take the net liabilities into account
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6
Overview
1. Background
2. 2000-2005: Early Years as a Largely Passive Investor
3. 2006-2008: Becoming an Active Global Investor
4. 2008+: Challenges and the Road Ahead
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7
Early Years:Significant Constraints
1. Have regard to factors that may affect the funding (legacy $42B nonmarketable bond portfolio) 100% invested in stocks
2. Foreign Property Rule 70% invested in Canada
3. Passive in Canada 70% passive Canadian stocks 30% passive foreign stocks
While constraints largely determined the portfolio, decisions were made to:• Remain passive in foreign stocks (initially)• Leave the foreign exposure unhedged (currency)• Manage the total portfolio relative to the net liabilities
Over time, the constraints were removed (2005, ~2005, 2002)
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8
Early Years:Risk Adjusted Net Value Added (RANVA)
RANVA is a measure of value added
= R(t) – RMRP(t) – C(t) – λ * Risk (t)
Where in a pension fund context:
R(t) = gross fund return
RMRP(t) = return on minimum risk portfolio (MRP)
C(t) = operating costs
λ * Risk (t) = cost of risk capital
Copyright © 2008. Canada Pension Plan Investment Board. All rights reserved.
9
0%
2%
4%
6%
8%
10%
12%
1965 1975 1985 1995 2005 2015 2025 2035 2045-10
-5
0
5
10
15
20
Early Years:The Minimum Risk Portfolio
Annual Net Benefits
(Benefits-Contributions)(Bn C$*)
Future Net Benefits
Net cashinflows
Net cashoutflows
• The Minimum Risk Portfolio (MRP) is the portfolio of assets/contracts that best hedges the CPP net liability
• With limited analytical tools, we proxied the MRP with a portfolio of long duration real return bonds.
• We currently use the less ambiguous term ‘Net Liability mimicking Portfolio’ (NLMP)
The CPP net liability is the present value of future net benefits
* 2005 constant dollars
Copyright © 2008. Canada Pension Plan Investment Board. All rights reserved.
10
Early Years:Total Portfolio Managed Relative to MRP
1. Build a Better Beta Portfolio1. Build a Better Beta Portfolio
1. Portfolio1. Portfolio
1. Capture Attractive Sources of Alpha1. Capture Attractive Sources of Alpha
1. Build a Better Beta PortfolioTotal Portfolio Benchmark
1. PortfolioMinimum Risk (MRP)
Portfolio
1. Capture Attractive Sources of AlphaAlpha measures Value-Added Negligible active
risk in the early
years
NecessaryAsset-Liability
Mismatch
Copyright © 2008. Canada Pension Plan Investment Board. All rights reserved.
11
Overview
1. Background
2. 2000-2005: Early Years as a Largely Passive Investor
3. 2006-2008: Becoming an Active Global Investor
4. 2008+: Challenges and the Road Ahead
Copyright © 2008. Canada Pension Plan Investment Board. All rights reserved.
12
Becoming an Active Global Investor:Sources of Enhanced Performance
1. Build a Better Beta Portfolio1. Build a Better Beta Portfolio
1. CPP Reference Portfolio1. CPP Reference Portfolio
1. Portfolio1. Portfolio
1. Capture Attractive Sources of Alpha1. Capture Attractive Sources of Alpha
1. Take Advantage of CPPIB1. ’1. s Unique Situation1. Take Advantage of CPPIB1. ’1. s Unique Situation
NecessaryAsset-Liability
Mismatch
1. Build a Better Beta PortfolioBuild a Better Beta Portfolio
1. CPP Reference PortfolioCPP Reference Portfolio
1. PortfolioNet Liability Mimicking
Portfolio
1. Capture Attractive Sources of AlphaCapture Attractive Sources of Alpha
Core Elements of CPPIB’s
Approach to Adding Value
1. Take Advantage of CPPIB1. ’1. s Unique SituationTake Advantage of CPPIB’s Unique Situation
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13
Becoming an Active Global Investor:Accountability System – Measuring Success
Expected Real Rate of Return
4.2 9.8
10.0
Illustrative (Not to Scale)
5.0
Expected Risk
Expected Real Rate of Return
4.2 9.8
Improved returns relative to CPP
Reference Portfolio
10.0
Illustrative (Not to Scale)
5.0
Expected Risk
Capturing Attractive Alpha
11
33
22 Building a Better Beta Portfolio
CPP Reference Portfolio
•
•
• 1
3
2
•
2 Building a Better Beta Portfolio• 22 Building a Better Beta Portfolio•
1 CPP Reference Portfolio• 11 CPP Reference Portfolio•
Capturing Attractive Alpha3 Capturing Attractive Alpha33 Capturing Attractive Alpha
11
33
22 Building a Better Beta Portfolio
CPP Reference Portfolio
•
•
• 1
3
2
•
22 Building a Better Beta Portfolio• 22 Building a Better Beta Portfolio•
11 CPP Reference Portfolio• 11 CPP Reference Portfolio•
Capturing Attractive Alpha33 Capturing Attractive Alpha33
TheoreticalEfficient Frontier
SustainableContributionRate (%)
Low CostLow ComplexityDiversification
Active Risk relative to CPP Reference Portfolio
3 Inv
Depts
IPC
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14
Becoming an Active Global Investor:Accountability System – In “Active Space”
Illustrative (Not to Scale)
Improved returns relative to CPP
Reference Portfolio
Illustrative (Not to Scale)
Reference Portfolio
0
250
0 200
ExpectedValue Added
Expected Active Risk1
2
3
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15
Becoming an Active Global Investor:Organizational Structure
Private Investments
PublicMarket
InvestmentsReal
Estate
Portfolio Design and Risk Management
Finance and Operations
Investment Planning Committee
Board of Directors
Hu
man
Resou
rces
Communications
Leg
al
Corporate Infrastructure
PrivateInvestments
PrivateReal Estate
Portfolio Design and Risk Management
Finance Operations
Investment Planning Committee
Board of Directors
Hu
man
Resou
rces
Communications
Leg
al
Corporate Infrastructure
AccountabilityCPP Reference
Portfolio
Better Beta
Alpha
1
2
3
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16
Becoming a Global Active Investor:CPP Reference Portfolio is 100% Indexed:Low Cost, Low Complexity Strategic Alternative
40%Foreign Equity
25%NominalBonds
10%Real Return Bond
25%Canadian
Equity
Easy to understand by stakeholders
A viable strategic option
Embodies return requirement and systematic risk exposure envisioned by federal-provincial stewards
Low cost, low complexity diversification
Partially matches CPP net liabilities
Easy to evaluate management decision-making
40%Foreign Equity
25%NominalBonds
10%Real Return Bond
25%Canadian
Equity
40%Foreign Equity
25%NominalBonds
10%Real Return Bond
25%Canadian
Equity
Easy to understand by stakeholders
A viable strategic option
Embodies return requirement and systematic risk exposure envisioned by federal-provincial stewards
Low cost, low complexity diversification
Partially matches CPP net liabilities
Easy to evaluate management decision-making
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17
Becoming a Global Active Investor:Risk budgeting supports alignment of management and investment objectives
• Accountability – explicit statement of income and risk expectations in performance contracts
• Transparency – setting, monitoring and reviewing risk budgets and their use
• Comparability –risk based performance can be compared across business lines
• Efficiency – investment decisions are focused on portfolio risk and return contributions
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18
Becoming a Global Active Investor:Current CPPIB Risk Governance Implementation
Board Approved Active Risk Limit
Investment Planning Committee
Total Active Risk Expectation
Public Market Investments
Risk Budget
Private Investments
Real Estate
Opportunistic strategies. Opportunities reviewed to
determine rebalancing strategy. Benchmark used to transfer
beta risk to IPC, charge premium to business line
Sub portfolio
Risk budget
Sub portfolio
Risk budget
Sub portfolio
Risk budget
IPC Portfolio
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19
Becoming a Global Active Investor:Incentive compensation framework
Principles Choices Application
Competitive Benchmark Total Fund
Aligned Hurdles Departmental
Tiered Target Group/Asset Class
Fair Weighting Multiples Strategy
Retains Slopes Portfolio
Multi-year horizon Caps/floors
Risk-adjusted Time horizon
Reward alpha
Reward skill-based beta
Simple
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20
Becoming a Global Active Investor:Market beliefs underlying PE incentive compensation\\
CONVENTIONAL WISDOM ON PRIVATE EQUITY CPPIB
Wide return dispersion across managers Yes
Managers returns exhibit persistence Yes
Manager selection and access key to success Yes
Poor liquidity Yes
TWR and IRR returns not comparable, but investors have no alternatives Yes/No
Strategic returns above public equity net of GP fees No
Good risk diversifier No
Diversification of PE exposures essential No
Specify and manage to a pre-determined PE policy exposure (eg 5%) No
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21
Becoming a Global Active Investor:Example PE transaction: $400 million buy-out
… …
US Index Exposure
Con
sum
er D
urab
les
… …
$400 million
Con
sum
er D
urab
les
US Index and Active Exposures
… …
US Index Exposure
Con
sum
er D
urab
les
… …
$400 million
Con
sum
er D
urab
les
US Index and Active Exposures
… …
US Index Exposure
Con
sum
er D
urab
les
… …
$400 million
Con
sum
er D
urab
les
US Index and Active Exposures
… …
US Index Exposure
Con
sum
er D
urab
les
… …
$400 million
Con
sum
er D
urab
les
US Index and Active Exposures
… …
US Index Exposure
Con
sum
er D
urab
les
… …
$400 million
Con
sum
er D
urab
les
US Index and Active Exposures
… …
US Index Exposure
Con
sum
er S
tapl
es
… …
$400 million
Con
sum
er S
tapl
es
US Index and Active Exposures
Invest $400 million inbuy-out of US
consumer staples company
• Sell $400 million across US consumer staples sector
• Removes sector exposure
• Captures private equity alpha decision
• Manage index fund to adjusted weights
• 1.3 PE beta introduces residual risk
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22
-6
-3
0
3
6
9
-1,000 -800 -600 -400 -200 0 200 400 600 800 1,000 1,200
Performance Value Added (bps)
Mu
ltip
lier
PI - Developed Markets
Threshold
Target
Becoming a Global Active InvestorTranslation to annual incentive compensation curve
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23
Becoming a Global Active Investor:Recent HRCC Discussion
• Confirmed logic and consistency across sequentially developed incentive structures
• Focused on private market incentive structures – highest payouts
• Acknowledged uncertainty around key parameters
• Acknowledged noise from sticky pricing and volatile public markets
• Expect over/under payments to even out over time
• Recognized that mid-stream change of compensation parameters counter-productive
• Moved to dollar risk allocation of public markets
• Looked to external consultant for confirming guidance
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24
Overview
1. Background
2. 2000-2005: Early Years as a Largely Passive Investor
3. 2006-2008: Becoming an Active Global Investor
4. 2008+: Challenges and the Road Ahead
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Road Ahead:New questions, new challenges
Refinement of Reference Portfolio• Current reference portfolio understood to be “temporary” • Accommodated numerous binding constraints• New reference portfolio largely “constraint free”• Numerous issues on the table
– Equity/debt exposure– Foreign exposure– Currency hedging– Expand RP portfolio asset classes– Adjust criteria for RP asset classes
• Should we discount future restructuring events, and how• Distinguish between market and self-imposed
constraints
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26
Road Ahead:New and exciting tool will help answer some questions
Custom asset-liability model• Multi-period – 75 years, with 3-year restructuring windows• Dynamic optimization – optimal RP is path dependent• Stochastic assets and liabilities• ICAPM relationships
Valuable new decision metric• Restructuring index• Equals estimated probability of restructuring• Called an “index” to recognize restructuring event subject
to some actuarial discretion• Can apply discounting to restructuring events
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Road Ahead:Sample Results: Indicative Scenario
Equity Allocation
20%
40%
60%
80%
100%
2008 2023 2038 2053 2068
Average 5th percentile 95th percentile
Survival Rate
0%
20%
40%
60%
80%
100%
2008 2023 2038 2053 2068
Key Assumptions:
Equity Risk Premium = 475bp over cash
Bond Risk Premium = 100bp over cash
Expected Inflation = 2.0% pa
Expected Productivity Growth = 1.7% pa
OCA “best estimate” demographics
Restructuring Index = 0.18
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28
Road Ahead:Impact of new Reference Portfolio not fully understood
• Response for stakeholders – especially Chief Actuary
• Response from federal-provincial stewards
• Active risk – measurement and management
• Investment department activities
• Performance benchmarks
• Incentive compensation
• Reporting and disclosure
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29
Concluding Remarks
• Risk-based fund governance requires clear link between risks taken and returns earned
• Essential for budgeting, measuring, attributing and managing risk
• Clarifies accountability• Ensures objectives and compensation are aligned
• Easy to state – but challenging to implement
• CPPIB has developed and is implementing a simple but powerful operating model to forge the link between risk taken and returns earned. We believe it is:
• Competitive• Aligned• Evolving• Pragmatic• Imperfect
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30
End