The CPPIB Risk Return Accountability Framework

A Realistic Approach to National Pension Fund Management

Three principals of 1997 Reforms

Intergenerational fairness• Higher rates now, lower rates in the future• Fully fund future benefit improvements

Affordability• Legislated rate should not exceed 9.9% (hopefully)• Reduced future CPP benefits• Capital market returns help lower future rates

Sustainability• Mid-course plan design adjustments, if required• Self-correcting “fail-safe” adjustment if political process stalls

Charting the Path to Sustainability

0

2.5

5

7.5

10

12.5

1960 1980 2000 2020 2040 2060 2080

PAYGO Rate

Contribution RatePartially funded, legislated rate of 9.9%.

1997 reforms

Managing the Contribution Rate

Agree on the mechanism to change the contribution rate before you need it

Have independent monitoring of the contribution rate

Have independent means of changing the contribution rate

The CPP restructuring of 1997

Increase contribution rate to build up surpluses

Reduce costs by both reducing benefits and by investing surpluses in risky assets

Created default mechanism to make any necessary changes to the contribution rate

The CPPIB mission

Maximizing returns without undue risk of loss,

having regard to the factors that may affect

the funding of the CPP

Managing your objectives

1. Know your objective

2. Remove influences and constraints that may compromise meeting your objectives

3. Align your organization with your objective.

4. Make it easy for stakeholders to assess performance

Investment earnings are needed to meet future liabilities

-150,000

-100,000

-50,000

0

50,000

100,000

150,000

200,000

250,000

300,000

350,000

2000 2020 2040 2060 2080

year

Cas

h (

CA

D M

)

Net Liabilities

Investment earnings

Total

CPPIB Investment Strategy

Build a Better Beta PortfolioBuild a Better Beta Portfolio

Choose CPP Reference PortfolioChoose CPP Reference Portfolio

Estimate Net LiabilitiesEstimate Net Liabilities

Capture Attractive Sources of AlphaCapture Attractive Sources of Alpha

Take Advantage of CPPIB’s Unique SituationTake Advantage of CPPIB’s Unique Situation

Inc

rea

sin

g V

alu

e A

dd

Model dynamics make a differenceState variables (eg inflation)

tttrttttt

trtttt dZtXdttXBtXCtXrtXWtXrdW ,,,,,,

Portfolio returns = set of portfolio weights

Net contributionsMarket volatility

tttt dZtXbdttXadX ,,

Security prices

tttt dZtXbdttXadX ,,

Fund wealth

Estimating optimal financing

Formulate the stochastic dynamic control problem (Hamilton Jacobi Bellman)

Portfolio weights are the control variable

Minimize the probability of failing to fulfill the pension promise at some time in the future

The optimal portfolio strategy

• The optimal strategy minimizes the probability of restructuring the fund in the future

• The optimal portfolio is a combination of mutual funds• A risk free fund• The optimal growth portfolio• A mutual fund for each state variable

• The optimal portfolio strategy specifies security weights conditional on fund wealth, time and the value of the state variables

Fund wealth affects portfolio allocation …

0.00

2.00

4.00

6.00

8.00

10.00

12.00

14.00

16.00

18.00

20.00

0 0.2 0.4 0.6 0.8 1 1.2

Asset/Liability Ratio

Mar

ket

All

oca

tio

n

3.00%

4.00%

5.00%

… And the probability of restructuring.

-0.2

0

0.2

0.4

0.6

0.8

1

1.2

0 0.2 0.4 0.6 0.8 1 1.2

Asset/Liability Ratio

Res

tru

ctu

rin

g P

rob

abil

ity

3.00%

4.00%

5.00%

SummaryOptimal financing requires

• Alignment• a clear statement of objectives• Align governance and organization with fund

objectives• The CPPIB is developing innovative models to

inform its investment decisions.• Align financing strategies with these objectives

• Default mechanism to make any needed contribution rate changes

• Optimal financing aligned with Stewards risk and return expectations