all findings, interpretations, and conclusions of this paper … · 2015. 10. 17. · cppib’s...

All findings, interpretations, and conclusions of this presentation represent the views of the author(s) and

not those of the Wharton School or the Pension Research Council. © 2009 Pension Research Council of the Wharton School of the University of Pennsylvania.

All rights reserved.

Risk Budgeting at CPPIB: a Case Study

Reorienting Retirement Risk ManagementWharton School of Business

Tracy LivingstoneSenior Advisor, Risk PolicyCPPIB

Sterling GunnVice President, Portfolio Risk and AnalysisCPPIB

May 1, 2009

Copyright © 2009. Canada Pension Plan Investment Board. All rights reserved.

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Outline

1. Key Messages2. CPP Primer3. CPPIB Risk Return Accountability Framework4. Risk Budgeting: Beliefs vs. Reality 5. Risk Budgeting at CPPIB6. The One Minute Summary (really)


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1. Key Messages


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Risk budgeting is not an off-the-shelf, one size fits all solution. It has to be tailored to fit the firm.

Risk budgeting reinforces the alignment of active investment decisions with total portfolio objectives

Implementing risk budgeting challenges an organization to quantify its risk beliefs


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2. A CPP Primer


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CPP has evolved in response to demographic and economic realities

Percent of YMPE

Percent of YMPE

0

2

4

6

8

10

12

1966

1969

1972

1975

1978

1981

1984

1987

1990

1993

1996

1999

2002

2005

2008

2011

2014

2017

2020

2023

2050

Legislated Pay-go

1966• CPP inception date• 10 year benefit phase-in• 3.6% contribution rate

1974 - 83• Benefit

improvements• No rate changes

1987• Benefit improvements• Pre-set schedule of

rate increases to 10.1% in 2016

1997• Benefit reductions• Rapid rate increases to 9.9%

in 2003 instead of 7.35%• Increased funding• Fully fund new benefits• “Fail-safe” financing formula• CPPIB established

We are here with a 9.8% sustainable

rate

0

2

4

6

8

10

12

1966

1969

1972

1975

1978

1981

1984

1987

1990

1993

1996

1999

2002

2005

2008

2011

2014

2017

2020

2023

2050

Legislated Pay-go

1966• CPP inception date• 10 year benefit phase-in• 3.6% contribution rate

1974 - 83• Benefit

improvements• No rate changes

1987• Benefit improvements• Pre-set schedule of

rate increases to 10.1% in 2016

1997• Benefit reductions• Rapid rate increases to 9.9%

in 2003 instead of 7.35%• Increased funding• Fully fund new benefits• “Fail-safe” financing formula• CPPIB established

We are here with a 9.8% sustainable

rate

11.4%


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CPP Reforms of 1997 created the CPPIB

Reform principles: inter-generational fairness, affordability andSustainability

Results of broad consultations:• Canadians adamant that CPP should be permanently “fixed”• Willing to shoulder the burden through higher contributions• In return, insisted that there be no government involvement with CPP

Assets

Government responded with a series of reforms to ensure the longtermsustainability of the CPP:

• Modest reduction in benefits• Dramatically higher contribution rates – 80% increase over 6 years• CPP assets were segregated from government assets and revenues• CPP Investment Board (CPPIB) was created to manage the assets• Fail-safe mechanism created to ensure long-term sustainability


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3. CPPIB Risk/Return Accountability Framework


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CPPIB: Accountability for risk starts with the Board of Directors, which uses two levers for governing CPPIB strategic risk-taking

Board of Directors

Reference Portfolio

• Viable strategy of investing in low-cost, low complexity, broadly diversified, public market indexes

• Degree of asset-liability mismatch implied in stewards expression of risk tolerance – currently 65/35 equity/debt

• Risks: market, high quality counterparties

Active Risk Limit

• Allow additional assets to be “put at risk” to earn additional returns from active management

• Additional “assets at risk” controlled by active risk limit measured as 90% VaR over one year

• Risks: market, alpha, credit, liquidity

These two levers represent the two biggest investment decisions made by the Board of Directors.


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CPPIB’s biggest risk: Adjustment Risk

Investment Returns(default-free rate;

equity risk premium,active return, etc.)

Economics(wage growth,inflation, etc.)

Demographics(fertility, longevity, etc.)

Adjustment Risk

CPPIB helpsreduce adjustment

risk through itsinvestment decisions

Must be considered when making

investment decisions, but beyond CPPIB

influence

Most factors driving a firm’s biggest risk – at CPPIB that’s adjustment risk -- are beyond the firm’s control.


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CPPIB investment strategy seeks to add value by harvesting better beta and earning alpha.

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

Illustrative (Not to Scale)

5.0

Expected Risk

Capturing Attractive Alpha

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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


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4. Risk Budgeting: Beliefs vs. Reality


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Risk budgeting assumes…

Most risk budgeting frameworks are based on idealized risk budgeting beliefs that assume:

• risk can be measured and monitored regularly for each business line

• each business line can maintain target risk level by adjusting portfolio

• risks are comparable across business lines

• people are incented to abide by their risk budgets


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Three challenges to applying a risk budgeting framework to a heterogeneous portfolio.

Investment portfolios can be a mixture of very different strategies.• Overlay manager operating transparently on balance sheet

• High frequency and high quality public market data provides firm basis for quantifying risk• Short term investment horizon

• Pooled manager reports risk once a month• Pooled fund assessed infrequently but relatively accurately• Medium term investment horizon

• Portfolio of infrastructure positions valued annually• Private equity risk exceedingly difficult to measure directly• Long term investment horizon

Ability to measure risk varies greatly • Measure of total portfolio risk cannot be better than weakest link (on a weighted basis)• Most risk budgeting methodologies rely on availability of high frequency, high quality data to

monitor risk usage• High frequency, high quality proxies often used for ‘problem’ assets.• Accuracy of proxy to mimic asset varies significantly• Character of risk can vary with investment horizon.

Fair allocation and attribution of risk• Fair comparisons across business lines presume such data exists for all opportunities• Acceptance and use of proxies results in risk budgeting to proxies, not actual assets• Risk investment horizon needs to be relevant to all asset classes


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Some examples where reality can shatter idealized risk beliefs

Hoped for idealization Reality Examples

Return Distributions

Normally distributed Fat tails, skews, time varying

Credit has asymmetric payoff

Price transparency Perfect, frictionless markets

Illiquid assets with infrequent valuation

Infrastructure

Risk measurement Perfect Limited sample sizes, use of proxies

Large errors in estimating extreme percentiles

Availability of information

Frequent and accurate for all assets

Quality and frequency varies across asset classes

Some pooled funds report infrequently

Portfolio management

Maintain risk profile Difficult to rebalance illiquid portfolios

Infrastructure portfolios

Incentives Emphasis on paying for successful risk taking

Emphasis on returns since returns are precise while risk is fuzzy

Most of us


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5. Risk Budgeting at CPPIB


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Risk Budgeting is appropriate if you believe …

• Investors must take risk to have any expectation of earning excess returns

• Risk is a constrained resource and its use needs to be efficiently managed

• Compensation should be linked to risk adjusted return, not rates of return

• Risk can be allocated and attributed fairly


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Risk budgeting supports alignment of management and investment objectives

• Accountability – explicit statement of income and risk expectations in performance contracts

• Transparency – outcome of investment decisions must be seen in order to be compared with expectations

• Comparability – invest choices informed by risk means risk is comparable and reconcilable across business lines

• Efficiency – total excess returns should be earned with as little total active risk as possible.


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CPPIB is implementing risk budgeting as part of its risk return accountability framework

Risk budgets are part of the annual business planning process, • Achieving long run excess return target requires taking active risk• Set expectations for amount of risk needed to achieve return targets• Allocate risk to departments.• Effective diversification leads to total risk budget being significantly

less than the sum of departmental risk budgets• Iterative process balancing capabilities and objectives• Integral part of performance contract• Set risk budgets where appropriate (discussed later)

Regular monitoring of risk utilization vs. risk budgets can help avoid pathological behaviour related to compensation cycle

• Success early in compensation cycle could lead to reduction in risk to preserve compensation

• Failure late in compensation cycle could lead to excessive risk taking in attempt to double down


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CPPIB currently sets a risk budget for Public Market alpha sources, and communicates risk expectations for other opportunistic investments.

Board Approved Active Risk Limit

Investment Planning Committee

Total Active Risk Expectation

Public Market Investments (Dept)

Risk Budget for

Private Investments (Dept)

Exceed PME benchmark

Real Estate Dept.Outperform benchmark

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

Source o

f Opportunistic

Source of

Opportunistic

source of

,


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R1R2R3

R4

Risk budgeting requires performance contracts to consider acceptable risk/return tradeoffs.

Active Risk

Exc

ess

Ret

urn

X

Range of acceptable risk

Range of excess return expectations

X: Target

Risk paid for if above this line (fixed information ratio)

Return expectations

Risk Budget Utilization Paid for risk Action required

Green Met Met Yes None requiredDark Green Over Met Yes Review assumptionsBlue Met/over Under Yes Review assumptionspurple Under Under Yes Review assumptionsYellow Met/over Over YesRed 4 Over Over NoRed 1 Under Over NoRed 2 Under Met NoRed 3 Under Under No

Reduce risk or gain approval of increased risk budget


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6. The One Minute Summary


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• Risk budgeting is a tool for reinforcing alignment of investment decisions with fund objectives

• Risk budgets link expectations of returns with levels of risk accepted as necessary to earn those returns

• Risk budgeting at CPPIB is a work in progress

• Implementing a risk budgeting framework is challenging, and the quality of the result is unlikely to be any better than your least understood risk

• CPPIB believes implementing and maintaining our risk budgeting framework is a good way of continuously improving our understanding of risks

Risk Budgeting at CPPIB: a Case Study

Sterling GunnVice President, Portfolio and Risk AnalysisPortfolio Design and Investment ResearchTelephone: (416) 868-6673Email: [email protected]

Tracy LivingstoneSenior Advisor, Risk PolicyInvestment Risk ManagementTelephone: (416) 868-5071Email: [email protected]


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About the CPP Investment Board The CPP Investment Board invests the funds not needed by the Canada Pension Plan to pay current benefits on behalf of 17 million Canadian contributors and beneficiaries. In order to build a diversified portfolio of CPP assets, the CPP Investment Board is investing in publicly-traded stocks, private equities, real estate, inflation-linked bonds, infrastructure and fixed income.

Based in Toronto, the CPP Investment Board is governed and managed independently of the Canada Pension Plan and at arm's length from governments. At March 31, 2008 the CPP Fund totaled C$122.7 billion.

Sterling GunnSterling Gunn leads CPPIB’s Portfolio and Risk Analysis team, supporting CPPIB asset liability modeling, investment policies, strategic portfolio design, risk budgeting and risk measurement.

He has over fifteen years of risk management experience in capital and energy markets. Prior to joining the CPPIB in 2004, Sterling was a manager at Ontario Power Generation. Before that, Sterling worked at a major Canadian bank as a risk manager.

Sterling holds an MBA from the University of Toronto, an M. Sc. in Experimental Space Science from York University and a B Sc. in Physics and Applied Mathematics from the University of Toronto

Tracy LivingstoneTracy is the Senior Advisor in the Investment Risk Management Group responsible for the risk policies and standards of practice that govern the investment activities of the CPP Investment Board, ensuring consistency and continued alignment with the firm’s vision, mission and values, and the requirements of the Canada Pension Plan Investment Board Act and Regulations. She joined the CPP Investment Board in June 2005.

Tracy is a risk management professional with ten years experience in capital markets and energy. She spent over five years at Ontario Power Generation, working first on the trading floor in Market Risk and then in Enterprise Risk Management. Prior to that, she worked in the Risk Management Systems group at TD Securities.

Tracy holds an MBA from Wilfrid Laurier University, and a Financial Risk Manager designation from the Global Association of Risk Professionals. She has an honours BA in Economics from the University of Guelph.

Disclaimer slide for online PPTs 5.11.09All findings, interpretations, and conclusions of this presentation represent the views of the author(s) and not those of the Wharton School or the Pension Research Council. © 2009 Pension Research Council of the Wharton School of the University of Pennsylvania. All rights reserved.

LivingstoneGunnRisk Budgeting at CPPIB: a Case Study OutlineSlide Number 3Slide Number 4Slide Number 5CPP has evolved in response to demographic and economic realitiesCPP Reforms of 1997 created the CPPIBSlide Number 8CPPIB: Accountability for risk starts with the Board of Directors, which uses two levers for governing CPPIB strategic risk-takingCPPIB’s biggest risk: Adjustment RiskCPPIB investment strategy seeks to add value by harvesting better beta and earning alpha.Slide Number 12Risk budgeting assumes…Three challenges to applying a risk budgeting framework to a heterogeneous portfolio.Some examples where reality can shatter idealized risk beliefsSlide Number 16Risk Budgeting is appropriate if you believe …Risk budgeting supports alignment of management and investment objectivesCPPIB is implementing risk budgeting as part of its risk return accountability frameworkCPPIB currently sets a risk budget for Public Market alpha sources, and communicates risk expectations for other opportunistic investments.Risk budgeting requires performance contracts to consider acceptable risk/return tradeoffs.Slide Number 22Slide Number 23Risk Budgeting at CPPIB: a Case Study Slide Number 25

all findings, interpretations, and conclusions of this paper … · 2015. 10. 17. · cppib’s...

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