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The Investment Environment and Pensions Presentation to Financial Management Institute Doug Pearce Chief Executive Officer / Chief Investment Officer February 13, 2007 British Columbia Investment Management Corporation Outline Part 1 – Capital markets: yesterday and today – How the pension landscape is changing Part 2 – History of B.C. public sector pension funds – What are we doing in the new environment to meet our clients’ needs? What’s Driving Capital Markets Today? Long-term trends and issues: – Demographic changes. – Globalization, shifts in economic power and wealth – Lower volatility of output and inflation have reduced risk premia embedded in financial asset prices. – Lower macroeconomic risk means lower returns over the long run. Short-term trends and market factors – global trade imbalances – liquidity Demographics: The World in 2006 Source: UN Population Program Demographics: The World in 2050 Source: UN Population Program Globalization Signals Shift of Economic Power and Wealth % shares of global GDP based on purchasing-power parity 35 28 30 25 21 20 20 Latin America, Africa, Middle East, Rest of Asia 1980 2006 29 30 20 19 15 8 10 6 5 7 5 2 2 4 0 U.S. Source: IMF E.U. Japan China & Canada FSU Others (Former 4 Soviet Union) Tigers* * HK, Taiwan, S. Korea, Singapore Economic Growth to 2016 Average annual change in real GDP North America: 3% Former Soviet Union: 5% Europe: 2% Mideast: 5% Africa: 4.5% Latin America: 4.5% Source: IMF, bcIMC Asia: 7.5% Lower Growth Volatility – “The Great Moderation” Source: Bank for International Settlements, “The Recent Behaviour of Financial Market Volatility”, BIS Paper No. 29 (August 2006) Stable, Low Inflation Year/year % change in Consumer Price Index 16% 14% 12% Canada U.S. 10% 8% 6% 4% 2% 0% -2% 1975 1980 Source: Bloomberg 1985 1990 1995 2000 2005 …Means Lower Interest Rates Yields on Gov’t of Canada securities; percent 18 16 3-month 10-year 14 12 10 8 6 4 2 0 1975 1980 1985 Source: Bank of Canada 1990 1995 2000 2005 …and Low Equity Market Volatility VIX Index of expected volatility of S&P 100; monthly 50 45 40 35 30 25 20 15 10 5 0 1990 1995 2000 Source: Chicago Board Options Exchange, Bloomberg 2005 = Lower World Equity Risk Premium Annualized percentage return above risk-free interest rate 6 5 4.9 0.6 1.2 4 3.0 3 2 1 0 Historical risk premium* Minus: Impact of unexpected cash flows Minus: Impact of fall in required risk premium Equals: Expected 21st century risk premium * 16 major countries, 1900-2000 Source: Dimson, Marsh and Staunton, Triumph of the Optimists (2002) Recent Returns Have Been Strong… Benchmark returns on typical pension plan (%) 25 Years ending Sept 30 20 15 8.3 10 5 0 -5 -10 -15 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 10yr. avg. Source: bcIMC …But Lower Long-Term Returns Are Likely % Risk-Return Tradeoffs 20 Private Placements 18 16 EAFE Canadian Stocks 14 Real Estate US Stocks 12 1990 Private Placements Mortgages Bonds 10 Money Market 8 Real Estate 6 2006 EAFE Canadian Stocks US Stocks Mortgages Return a typical pension client needs Bonds 4 Money Market 2 0 2 4 6 8 10 12 Risk (standard deviation) 14 16 18 Global Challenges Energy Climate change Aging Global Challenges Infrastructure Water Urbanization What’s Driving Capital Markets Today? Long-term trends and issues: – Demographic changes. – Globalization, shifts in economic power and wealth – Lower volatility of output and inflation have reduced risk premia embedded in financial asset prices. Shorter-term trends and market factors – Liquidity – ”Global savings glut” Money Has Been Plentiful… Source: The Economist, January 4, 2007 Global Savings Exceed Borrowing… Current account balances as a percent of global GDP Sum exceeds U.S. current account deficit Source: Department of Finance Canada, The Economic and Fiscal Update (November 2006) … and Risk Premium is Low 2.5 Canada 10-year corporate BBB bond yields minus Government of Canada bond yields, in percentage points 2.0 1.5 1.0 0.5 0.0 2000 2001 2002 Source: Bloomberg 2003 2004 2005 2006 2007 …Fuelling Alternative Asset Markets Commodity derivatives outstanding Billions of U.S. $, June & December $7,000 $1,000 $900 $6,000 $800 $5,000 < Notional amount Gross market value > $4,000 $3,000 $700 $600 $500 $400 $300 $2,000 $200 $1,000 $100 $0 $0 2000 2001 2002 2003 2004 Source: Bank for International Settlements 2005 2006 … and Private Equity Deals $U.S. billions, including net debt of target $12 $400 $350 $10 $300 < Canada U.S. > $8 $250 $6 $200 $150 $4 $100 $2 $50 $0 $0 1996 1998 2000 Source: Thomson Financial 2002 2004 2006 H1 What’s Changing in the Pension World? Longevity and Retirement Expectations Defined-benefit pension plans designed when life expectancy was shorter. Living longer and retiring earlier makes pensions more expensive: – Living 20 years past age 65 vs. 10 years just after WWII doubled cost of pension. – “Freedom 55” (working 30 years, being retired 30 years) is twice as expensive as working for 40 years and retiring for 20. Investment returns will not solve this problem. Accounting is Driving Pension Decisions “The Perfect Pension Storm”: Equity market meltdown from 2000-02, falling long-term interest rates combine to lower asset returns, boost PV of pension liabilities. Post-Enron and accounting changes put pension plans on company books, shifted towards mark-tomarket accounting and eliminated ‘smoothing’ mechanisms in pension accounting. Results: – Pension plan directly affects corporate bottom line, net worth. – Pension plan financial risk may reduce company’s ability to take financial risk in its main lines of business. – Consultants and boards advocate freezing DB plans, shift to DC or cash balance plans for new hires. – “Liability-driven investing”. Private Sector DB Plans Under Siege Plan design changes in prior 2 years, and/or expected in next 2 years Source: Mercer Human Resource Consulting What is bcIMC doing in the new environment to meet our clients’ needs? B.C. Public Sector Pension Plans Pension plans established as early as 1920s. Lack of clarity in provincial law as to who was legally responsible for funding pension plans. Funds managed by government and invested in provincial bonds. Late 1980s – government considers diversification into equities. 1989 – diversification proceeds. B.C. Public Sector Pension Plans ‘Joint trusteeship’ arrangement implemented in March 2000. Creates shared responsibility for plans and plan funding positions, unlike many jurisdictions where government is solely responsible. Pension plans were fully funded when joint trusteeship began. Employees and employers represented on boards. Pension Fund Management Models Two models used in Canada for managing public sector pension assets. Consolidated Central agency provides portfolio management and operations for several different pension plans Economies of scale mean lower costs for clients More diversification reduces portfolio risk Examples: bcIMC, Caisse de depot et placement du Quebec, New Brunswick Investment Management Corporation Separate Pension plans manage and operate their investment portfolios on an individual basis Examples: Ontario Teachers’, Ontario Municipal Employee Retirement System, Hospital of Ontario Pension Plan bcIMC Mandate The British Columbia Investment Management Corporation (bcIMC) is a professional investment management organization located in Victoria. Legal authority to provide funds management services from Public Sector Pension Plan Act Specific mandate determined by client/trustees Legislatively clients restricted to: British Columbia public sector pension plans Publicly administered trust funds British Columbia provincial government British Columbia government bodies bcIMC’s Clients As at December 31, 2006 Sinking Funds 5.2% Trusts 2.3% Pensions * 76.6% Gov't Bodies 15.5% CRF 0.4% * Includes: BC Hydro Pension Plan College Pension Plan Municipal Pension Plan Public Service Pension Plan Teachers’ Pension Plan WorkSafeBC Pension Assets Under Administration as at December 31, 2006 Bonds $24.1 Short-Term Mortgages $4.5 $2.7 Canadian Equities $13.0 Other $0.6 Real Estate $8.4 Private Placements $1.7 Int'l Equities $14.5 * In Billions of Dollars Total: $81.4 billion Strategic Infrastructure $1.3 US Equities $10.7 bcIMC’s Philosophy and Approach Asset allocation is the primary determinant of risk and return Asset allocation strategies should be customized to reflect the purpose of each fund, investment time horizon, legal constraints, liquidity requirements, and the risk tolerance of governing fiduciaries In terms of processes, bcIMC’s roles are to: – help fiduciaries understand the implications of key policy decisions such as asset allocation – manage the funds relative to the board’s instructions – report on results bcIMC’s Investment Philosophy Managing risks is as important as generating rates of return “Three D’s”: – Diversification of investments – Disciplined approach to asset management – Due diligence of investment opportunities bcIMC’s Investment Philosophy Diversification - began in 1990. Long-only investments (i.e., can’t sell stocks short) Almost no hedge funds. Generate cash flow. Protect principal. Investing for the long term. Responsible investor. bcIMC: Recent Directions Recent challenge in markets is excess liquidity. “Hunt” further afield for returns, rather than just “gather”. Diversify across more markets/financial instruments, and real assets such as real estate and infrastructure. Private placements – opportunity to directly influence business direction to the benefit of equity owners. Looking at growth vs. developed markets. Increased Exposure to Private Markets US Companies with Revenues >$100M US 75% 25% Source: Dun & Bradstreet, January 2002 Privately owned companies account for over US$9.7 trillion* of the equity capitalization of global markets. * bcIMC research estimate. Overtaking the G6 When BRICs’* US$ GDP would exceed the G6 *BRICs: Brazil, Russia, India and China Source: Goldman Sachs, Dreaming with BRICs: the Path to 2050 Global Economics Paper No. 99 BRICs’ 5-Year Average Annual Returns Percent; in C$ terms 35 30.85 30 25.8 25 21.9 20 17.8 15 10 5 0 Brazil Source: MSCI Russia India China Responsible Investing What is responsible investing? The consideration of environmental, social and governance (ESG) issues in our investment decisions and processes. – environmental & social issues – corporate governance issues bcIMC has a responsibility to ensure that investments are managed in the best financial interests of the client. bcIMC understands that by improving a company’s corporate governance and its management of environmental and social risks, is a means of enhancing the long-term value of client equity holdings. Conclusions Recent years – strong capital market returns, lots of liquidity, perceived risk low. Many new financial products/assets – hedge funds, infrastructure, exotic derivatives. Challenge is to find assets that will generate required returns, without undue risk. Pension world is changing, particularly for private DB plans. Institutional investors increasingly active on environmental, social and governance issues.