Measuring and Managing Return, Risk and Incentive Compensation

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


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


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

* *


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


6

Overview

1. Background





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)


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


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


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


11

Overview

1. Background





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


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


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


14

Becoming an Active Global Investor:Accountability System – In “Active Space”


Improved returns relative to CPP

Reference Portfolio


Reference Portfolio

0

250

0 200

ExpectedValue Added

Expected Active Risk1

2

3


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


Board of Directors

Hu

man

Resou

rces

Communications

Leg

al

Corporate Infrastructure

AccountabilityCPP Reference

Portfolio

Better Beta

Alpha

1

2

3


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


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


18

Becoming a Global Active Investor:Current CPPIB Risk Governance Implementation

Board Approved Active Risk Limit


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


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


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


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 Exposure

Con

sum

er D

urab

les

… …

$400 million

Con

sum

er D

urab

les


… …

US Index Exposure

Con

sum

er D

urab

les

… …

$400 million

Con

sum

er D

urab

les


… …

US Index Exposure

Con

sum

er D

urab

les

… …

$400 million

Con

sum

er D

urab

les


… …

US Index Exposure

Con

sum

er S

tapl

es

… …

$400 million

Con

sum

er S

tapl

es


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


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


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


24

Overview

1. Background





25

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


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


27

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


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


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


30

End

Documents

Measuring and Managing Return, Risk and Incentive Compensation