Measuring and Managing Return, Risk and Incentive Compensation

1. Measuring and Managing Return, Risk and Incentive Compensation International Centre for Pension Management Donald M. Raymond Senior Vice President Public Market Investments June 3, 2008 John H. Ilkiw Senior Vice President Portfolio Design and Risk Management

2. Overview • Background • 2000-2005: Early Years as a Largely Passive Investor • 2006-2008: Becoming an Active Global Investor • 2008+: Challenges and the Road Ahead

3. Background:Why We Exist: How Crisis Led to Reform Pay As You Go (PAYGO) Rate Long term PAYGO rate Actual Rate First cash flows to CPP Investment Board (1999) Reforms (1997) Annual Net Benefits (Benefits-Contributions)(Bn C$*) Excess loaned back to governments until 1983 Contributions to exceed benefits for over a decade * 1966-2004 : Actual $ 2005+ : 2005 constant dollars Contribution Rates

4. Background:Large Start Up/Developing Organization

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 • Background • 2000-2005: Early Years as a Largely Passive Investor • 2006-2008: Becoming an Active Global Investor • 2008+: Challenges and the Road Ahead

7. Early Years:Significant Constraints • Have regard to factors that may affect the funding (legacy $42B nonmarketable bond portfolio) 100% invested in stocks • Foreign Property Rule 70% invested in Canada • 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. Early Years:The Minimum Risk Portfolio The CPP net liability is the present value of future net benefits Future Net Benefits Annual Net Benefits (Benefits-Contributions)(Bn C$*) 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) * 2005 constant dollars

10. Early Years:Total Portfolio Managed Relative to MRP Necessary Asset-Liability Mismatch • Capture Attractive Sources of Alpha Alpha measures Value-Added • Capture Attractive Sources of Alpha • Capture Attractive Sources of Alpha Negligible active risk in the early years • Build a Better Beta Portfolio Total Portfolio Benchmark • Build a Better Beta Portfolio • Build a Better Beta Portfolio Minimum Risk (MRP) • Portfolio Portfolio • Portfolio • Portfolio

11. Overview • Background • 2000-2005: Early Years as a Largely Passive Investor • 2006-2008: Becoming an Active Global Investor • 2008+: Challenges and the Road Ahead

12. Becoming an Active Global Investor:Sources of Enhanced Performance • Take Advantage of CPPIB Take Advantage of CPPIB’s Unique Situation • ’ • s Unique Situation • Take Advantage of CPPIB • Take Advantage of CPPIB • ’ • ’ • s Unique Situation • s Unique Situation Core Elements of CPPIB’s • Capture Attractive Sources of Alpha Capture Attractive Sources of Alpha • Capture Attractive Sources of Alpha • Capture Attractive Sources of Alpha Approach to Adding Value • Build a Better Beta Portfolio Build a Better Beta Portfolio • Build a Better Beta Portfolio • Build a Better Beta Portfolio CPP Reference Portfolio • CPP Reference Portfolio • CPP Reference Portfolio • CPP Reference Portfolio Necessary Net Liability Mimicking Asset-Liability Mismatch • Portfolio Portfolio • Portfolio • Portfolio

13. Becoming an Active Global Investor:Accountability System – Measuring Success Illustrative (Not to Scale) Illustrative (Not to Scale) 5.0 5.0 Theoretical Efficient Frontier Improved returns 3 Inv Depts relative to CPP Reference Portfolio Sustainable Contribution Rate (%) Expected Expected IPC Real Rate Real Rate of Return of Return 9.8 9.8 4.2 4.2 Active Risk relative to CPP Reference Portfolio 10.0 10.0 Low Cost Low Complexity Diversification Expected Risk Expected Risk

14. Becoming an Active Global Investor:Accountability System – In “Active Space” Illustrative (Not to Scale) Illustrative (Not to Scale) Improved returns relative to CPP Reference Portfolio 3 ExpectedValue Added 2 Reference Portfolio 1 Expected Active Risk

15. Becoming an Active Global Investor:Organizational Structure Communications Communications Board of Directors Board of Directors Investment Planning Committee Investment Planning Committee Finance and Operations Finance Operations Portfolio Design Portfolio Design Legal Legal Human Resources Human Resources and Risk Management and Risk Management Public Market Investments Private Investments Private Real Estate Real Private Estate Investments Corporate Infrastructure Corporate Infrastructure Accountability CPP ReferencePortfolio 1 Better Beta 2 Alpha 3

16. Becoming a Global Active Investor:CPP Reference Portfolio is 100% Indexed:Low Cost, Low Complexity Strategic Alternative

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 Investment Planning Committee Total Active Risk Expectation Opportunistic strategies. Opportunities reviewed to determine rebalancing strategy. Benchmark used to transfer beta risk to IPC, charge premium to business line Public Market Investments Risk Budget IPC Portfolio Sub portfolio Risk budget Sub portfolio Risk budget Sub portfolio Risk budget Private Investments Real Estate

19. Becoming a Global Active Investor:Incentive compensation framework

20. Becoming a Global Active Investor:Market beliefs underlying PE incentive compensation\\

21. Becoming a Global Active Investor:Example PE transaction: $400 million buy-out • 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 Invest $400 million in buy-out of US consumer staples company $400 million $400 million $400 million $400 million $400 million $400 million Consumer Durables Consumer Durables Consumer Durables Consumer Durables Consumer Durables Consumer Staples Consumer Durables Consumer Durables Consumer Durables Consumer Durables Consumer Durables Consumer Staples … … … … … … … … … … … … … … … … … … … … … … … … US Index Exposure US Index Exposure US Index Exposure US Index Exposure US Index Exposure US Index Exposure US Index and Active Exposures US Index and Active Exposures US Index and Active Exposures US Index and Active Exposures US Index and Active Exposures US Index and Active Exposures

22. 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 • Background • 2000-2005: Early Years as a Largely Passive Investor • 2006-2008: Becoming an Active Global Investor • 2008+: Challenges and the Road Ahead

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 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

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