Features & Departments Public Pension Fund Power in Canada: For Good...or For Evil?

Public Pension Fund Power in Canada: For Good...or For Evil?
by Keith Ambachtsheer

"...The Board's CEO John MacNaughton appears eager to use government money to expandthe CPP's role in the economy...

Québec's Caisse de dépôt et placement has a long record of manipulating its portfolios to serve its political masters...

The power of Ontario Teachers', OMERS, and other government-mandated pension plans is already greaterin Canada than elsewhere...

There is a century-old penchant of governments in Canada to pick corporate winners and favourone industry or company..."

-from the recent National Post editorial "Pension Fund Socialism" by Terence Corcoran Is Big Necessarily Bad?


Canada's top six pension investment agencies already manage a collective $300 billion today, mainly assets of large public sector pension plans in Ontario, Quebec, Alberta, and British Columbia. A seventh, the Canada Pension Plan Investment Board (CPPIB), has begun to drive that number towards $400 billion. The fledgling federal Public Sector Pension Investment Board will become the eighth Canadian public sector pension fund giant within a decade, sending the combined pension pot towards $500 billion.

By almost any standard, this massive accumulation of public pension fund assets, managed by only a handful of agencies, represents a significant concentration of economic power in this country. As just one benchmark, the float-weighted value of the Toronto Stock Exchange 300 (TSE300) stock index is about $1 trillion today. The implication is that just eight investment agencies could lock up effective control of all of corporate Canada over the next decade if they chose to do so. Thus, if used for the wrong purposes, these eight agencies could willfully distort business decision-making in Canada, and seriously damage its economic prospects for decades to come.

In his National Post editorial, Terry Corcoran suggests that it is in fact likely to happen. And of course, he is not alone. He represents a sizable constituency in Canada deeply suspicious of any concentration of economic power, especially when it resides in just a handful of quasi-government agencies.

The purpose of this article is to tell the other (far brighter!) side of the story. If used for the right purposes, the eight mega pension funds will not only serve their own stakeholders well, but also help sharpen business decision-making in Canada, and brighten its economic prospects for years to come. In short, the handful of Canadian mega-pension funds can be important forces of societal 'good' rather than evil.

Below we set out the necessary conditions to achieve this outcome, and what must be done to put those necessary conditions in place. We start with some basic economic principles and see where they take us.

Of Principals and Agents
Over 200 years ago, Adam Smith showed that competitive markets, enforceable property rights, and 'enlightened self-interest' were all critical elements in making democratic capitalism work. While Smith's core ideas have withstood the test of time, they have required continuous adaptation in their application in an in-creasingly complex world.

A more complex world requires more complex organizations to do its work. This is true for for-profit corporations, for institutions in education, health, religion, and other typically not-for-profit fields, for government agencies, for labour unions, and yes, for pension funds too. We have become a society dominated by special purpose organizations.

All of these special purpose organizations have one thing in common. The 'owners' of the organization and the 'managers' of the organization are no longer the same people. In other words, in a complex world, there is typically a separation between the 'principals' and their 'agents'. Which means we need to revisit Adam Smith's concept of 'enlightened self-interest'. Now we need to ask: whose self-interest are we talking about?

The principals' or the agents'?
Clearly, if the respective interests of these two groups are different, the organization is in trouble. As it is the agents who show up for work every day and not the principals, the agents will call the tune. And it doesn't matter whether the organization is a for-profit business, a government agency, or a pension fund. As soon as there is a separation of ownership and control, you have the potential for the agents to carry out their own agendas (economists call this 'rent seeking'), rather than the agenda of the principals.

Remedy: Good Governance
'Rent seeking' by agents at the expense of principals is not just some abstract economic concept. It actually happens every day of the week. Politicians seek favours for their friends and constituents at the expense of the electorate as a whole. Labour union leaders use member dues to further their own political ends. Business managers use shareholder funds for reasons other than maximizing shareholder value. And yes, pension fund managers too make decisions difficult to square with the ultimate best interests of the fund's stakeholders.

Let's be clear. We're discussing something far more subtle here than clearly unlawful behaviour. Wouldn't that fountain look nice on the St. Maurice river as it flows through Shawinigan? Doesn't it create jobs in a high unemployment area? Doesn't the NDP represent workers' interests? Why shouldn't part of union dues support a political party? What's wrong with revaluing senior management's underwater stock options? Won't it give them incentive to try harder? And why shouldn't we attend those educational seminars in Florida in the winter paid for by service providers?

It's for the good of the pension fund, isn't it?
How can principals protect themselves against this kind of 'rent seeking' behaviour? Complex societies need effective mechanisms that align the economic interests of the principals and agents of its many for-profit and not-for-profit organizations. These governance mechanisms may go by names such as 'parliament', 'board of directors', 'board of trustees', 'pension committee', etc., depending on the particular context.

Good governance requires a clear understanding of the interests of the organization's principals, and ensuring that the organization's agents can, and are motivated to further those interests.1

Will Pension Fund Governance Fail?
This 'good governance' rule applies to all of Canada's for-profit and not-for-profit organizations. The more powerful the organization, the greater the positive impact of good governance on the welfare of the organization's principals. For example, the federal government is probably still Canada's most powerful single organization in terms of its potential impact (for good or evil) on the economic welfare of 30 million Canadians. How good is its governance? Are there processes to evaluate it and make it better? The provincial governments and Canada's major corporations are also powerful organizations. Do they have effective governance mechanisms? Are there processes to evaluate them and make them better?

And yes, then there are those eight powerful Canadian pension fund agencies with assets likely to approach $500 billion before the end of the decade. How good is their governance? Do they have processes to evaluate it and make it better?

Make no mistake, these are the questions Terry Corcoran and like-minded folks are implicitly passing judgment on when they decry 'Bay Street Socialism'. They are predicting that the governance mechanisms of Canada's mega public sector pension funds will fail, and that the result will be 'rent seeking' by mega fund managers and their political masters on a grand scale. Are they right?

Betting the Other Way
If Mr. Corcoran would be willing to put some money on his prediction, we would happily take the other side of the bet. In fairness, here are some things he should know before deciding to proceed with the bet:

Through legislation, Canadian pension funds are explicitly required to act only in the best financial interests of their stakeholders. In other words, 'rent seeking' is explicitly forbidden by law. The only court case ever brought forward under this legislation involved 'rent seeking' by the fiduciaries of a corporate pension fund (i.e., the Enfield Case). There has never been a case against a public sector fund.

Good governance has become a high priority agenda item at all of Canada's eight public sector mega funds. The newer funds have adopted current best practices right out of the starting gate. The older funds have given their governance structures a major overhaul. In all cases, this has led to increased clarity about who the fund's principals really are, and how their financial interests are best furthered. It has also led to increased clarity about the respective responsibilities of the board and senior management, and how to measure and report organizational performance.

The quest for good governance has been spurred by recent research suggesting it may be worth as much as 50-100 basis points per annum in terms of extra return.2 This is in addition to the natural 20-40 basis point cost advantage mega funds already have due to their large scale.3 The combination of good governance and low unit costs makes the eight mega funds very competitive investment agencies compared to, for example, Canada's mutual funds.

A direct outcome of these developments has been to make pension fund board membership a more attractive proposition for people with the right qualifications. In other words, there is a board 'professionalization' movement under way.4 This movement recognizes that the ideal board possesses a number of complementary skill/experience sets as well as a sense of collegiality and a strong chair.

A further element of improved governance is greater public transparency in what each of the mega funds is trying to achieve, and how it is going about it. The fund boards and managements increasingly recognize that they do not operate in a vacuum. Public accountability is paramount to their ongoing viability as effective financial institutions. Such transparency also provides an ongoing impetus to continuously improve governance practices.

These developments will produce high good governance rankings for the eight Canadian mega pension funds relative to other major Canadian organizations (whether for-profit or not) in the coming decades. As a result, there will be little scope for 'rent seeking'.

How Mega Funds Do Good
If we are right, Canada's mega funds are well positioned to promote the financial interests of their principals in the coming decades. That is not the only good news. By doing so, they will be furthering the financial interests of Canadians at large as well. They will do so as both knowledgeable transactors, and informed holders of government and corporate securities.

As knowledgeable transactors, they will be a stabilizing influence in frothy financial markets driven by short-term investors (whether retail or institutional) whose main focus is price momentum. Against these kinds of transactors, superior fundamental information and disciplined buy and sell strategies will win the day over the longer term. Canadian financial markets benefit through lower volatility and securities prices that eventually reflect fundamental value.5

Knowledgeable transactors will also be proactive in ensuring financial markets are operationally efficient. An important focus for them will be the further development of electronic trading mechanisms where they can execute transactions anonymously at low cost. They will not tolerate paying rents to intermediaries without receiving value in return.

As informed holders, the managers of Canada's mega funds will not take kindly to any 'rent seeking' behaviour by the managers of the organizations whose securities they hold. A good example is the generous flow of stock options heading towards the senior officers of many publicly traded corporations today.

Are the boards of these corporations doing their jobs representing the financial interests of the principals (i.e., the shareholders)? In other words, are they ensuring that stock option-related compensation is reasonable, and consistent with shareholder wealth maximization? Only Canada's mega funds have the clout and the independence to pose these awkward questions, and hold the boards of publicly traded corporations accountable for good governance on their behalf.

Mega Funds and 'Rent Seeking'
We have already noted that politicians are potential 'rent seekers' too. They will only attempt to meddle in the mega funds' affairs if they calculate that the political gains from doing so will outweigh the political costs. We find it difficult to imagine such circumstances. Indeed two recent events suggest that the tide is going the other way:

The Foreign Property Rule for pension funds and RRSPs has been a (albeit clumsy) form of political 'rent seeking'. The political logic has been that because of the favourable tax treatment afforded pension plans, the beneficiaries 'owed' it to Canadian taxpayers to invest most of these funds in Canada. Originally the Rule said 90% of assets. In 1990 it was relaxed to 80%. In the last Budget it was further reduced to 70%. The political calculus is suggesting there are no votes to be gained in holding Canadian pension funds captive to fuzzy nationalistic objectives. Canadians do not take kindly to politicians meddling with their retirement funds.

The only Canadian pension fund investment agency that does have some ambiguity regarding its investment objectives is the Caisse de dépôt et placement du Québec. Its charter makes reference to furthering the economic development of Québec. We find it noteworthy that Caisse's senior management team has undertaken a recent publicity campaign to assure all who will listen that their sole objective is to earn the highest possible return for the Caisse's clients. To date, no Québec politician has dared to challenge this message.

In short, political 'rent seeking' with the pension reserves of Canadians has become a vote-losing proposition. That is the fundamental point Mr. Corcoran and his intellectual soulmates seem to be missing.

The 'Invisible Hand' Lives!
Thus, all considered, Canadian public pension fund power is far likelier to be a force for good, and not evil. Adam Smith's 'invisible hand' can continue to wave its magic wand, as long as it is guided by good governance processes.

1. In a pension plan context, 'principals' are people who have a direct financial interest in the 'pension deal'. In a defined benefit plan, these are usually both plan members and the plan sponsor (which in turn is usually back stopped by either taxpayers in public sector plans, and shareholders in corporate plans). An important duty of a pension plan's governors is to clearly understand who the plan's principals are, and what the true nature of their financial interests in the pension plan balance sheet is. Financial interests can only be aligned if they are first understood.

2. For detail, see "Improving Pension Fund Performance", Keith Ambachtsheer, Ronald Capelle, Tom Scheibelhut, Financial Analysts Journal, Nov.-Dec. 1998.

3. For detail, see "The Economics of Pension Fund Management", Keith Ambachtsheer, Financial Analysts Journal, Nov.-Dec. 1994.

4. For detail, see "Pension Fund Excellence; Creating Value for Stakeholders", Keith Ambachtsheer, Don Ezra, John Wiley & Sons, New York, 1998.

5. The assumption here is that the predominant active management strategies employed by the CPPIB, and other large Canadian public funds over time will be value-oriented rather than momentum-oriented. Such strategies are stabilizing in the sense that they tend to be net buyers of good companies which are undervalued (i.e., currently out-of-favour stocks other investors are avoiding), and net sellers of overvalued stocks (i.e., currently in-favour stocks being chased by pure momentum investors).

Keith Ambachtsheer is president of K.P.A. Advisory Services Ltd. in Toronto.

Transcontinental Media G.P.