British ColumbiaInvestment Management Corporation

The Investment Environment and Pensions

Presentation to Financial Management InstituteDoug Pearce

Chief Executive Officer / Chief Investment OfficerFebruary 13, 2007

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

21

28

8

52

7

29

20 19

6

20

24

30

0

5

10

15

20

25

30

35

U.S. E.U. Japan China &4

Tigers*

Canada FSU Others

1980

2006

Source: IMF * HK, Taiwan, S. Korea, Singapore

% shares of global GDP based on purchasing-power parity

Latin America,Africa, Middle East, Rest of Asia

(Former Soviet Union)

Latin America: 4.5%

North America: 3%

Europe:2%

Africa: 4.5%

Former SovietUnion: 5%

Mideast: 5%

Asia: 7.5%

Economic Growth to 2016Average annual change in real GDP

Source: IMF, bcIMC

Lower Growth Volatility – “The Great Moderation”

Source: Bank for International Settlements, “The Recent Behaviour ofFinancial Market Volatility”, BIS Paper No. 29 (August 2006)

Stable, Low Inflation

-2%

0%

2%

4%

6%

8%

10%

12%

14%

16%

1975 1980 1985 1990 1995 2000 2005

Canada

U.S.

Source: Bloomberg

Year/year % change in Consumer Price Index

…Means Lower Interest Rates

0

2

4

6

8

10

12

14

16

18

1975 1980 1985 1990 1995 2000 2005

3-month

10-year

Yields on Gov’t of Canada securities; percent

Source: Bank of Canada

…and Low Equity Market Volatility

0

5

10

15

20

25

30

35

40

45

50

1990 1995 2000 2005

VIX Index of expected volatility of S&P 100; monthly

Source: Chicago Board Options Exchange, Bloomberg

= Lower World Equity Risk Premium

0

1

2

3

4

5

6

Historical riskpremium*

Minus: Impactof unexpected

cash flows

Minus: Impactof fall in

required riskpremium

Equals:Expected 21stcentury risk

premium* 16 major countries, 1900-2000Source: Dimson, Marsh and Staunton, Triumph of the Optimists (2002)

Annualized percentage return above risk-free interest rate

4.9 0.61.2

3.0

Recent Returns Have Been Strong…

8.3

-15

-10

-5

0

5

10

15

20

25

1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 10-yr.

avg.

Benchmark returns on typical pension plan (%)

Years ending Sept 30

Source: bcIMC

…But Lower Long-Term Returns Are Likely

0

2

4

6

8

10

12

14

16

18

20

2 4 6 8 10 12 14 16 18

Risk-Return Tradeoffs

Risk (standard deviation)

Return a typicalpension clientneeds

Money Market

Money Market

Bonds

Bonds

Mortgages

Mortgages

Real Estate

Real Estate

Canadian Stocks

Canadian Stocks

US Stocks

US Stocks

EAFE

EAFE

Private Placements

Private Placements

1990

2006

%

Global Challenges

Climate change

Energy Aging

Global Challenges

Water

Infrastructure

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…

Source: Department of Finance Canada, The Economic and Fiscal Update (November 2006)

Current account balances as a percent of global GDP

Sum exceeds U.S. current account deficit

… and Risk Premium is Low

0.0

0.5

1.0

1.5

2.0

2.5

2000 2001 2002 2003 2004 2005 2006 2007

Source: Bloomberg

Canada 10-year corporate BBB bond yields minus Government of Canada bond yields, in percentage points

…Fuelling Alternative Asset Markets

$0

$1,000

$2,000

$3,000

$4,000

$5,000

$6,000

$7,000

2000 2001 2002 2003 2004 2005 2006

$0

$100

$200

$300

$400

$500

$600

$700

$800

$900

$1,000

< Notionalamount

Gross marketvalue >

Source: Bank for International Settlements

Commodity derivatives outstanding Billions of U.S. $, June & December

… and Private Equity Deals

$0

$2

$4

$6

$8

$10

$12

1996 1998 2000 2002 2004 2006

$0

$50

$100

$150

$200

$250

$300

$350

$400

< Canada

U.S. >

$U.S. billions, including net debt of target

Source: Thomson Financial 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-to-market 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 SiegePlan 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 ModelsTwo models used in Canada for

managing public sector pension assets.

Consolidated Separate

Central agency provides portfolio management and

operations for several different pension plans

Pension plans manage and operate their investment

portfolios on an individual basis

Examples: bcIMC, Caisse de depot et placement du Quebec, New Brunswick Investment Management Corporation

Economies of scale mean lower costs for clients More diversification reduces portfolio risk

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 fundsBritish Columbia provincial governmentBritish Columbia government bodies

bcIMC’s ClientsAs at December 31, 2006

* Includes: BC Hydro Pension Plan

College Pension PlanMunicipal Pension Plan

Public Service Pension PlanTeachers’ Pension Plan

WorkSafeBC Pension

Gov't Bodies15.5%

CRF0.4%

Trusts2.3%

Sinking Funds5.2%

Pensions *76.6%

Assets Under Administrationas at December 31, 2006

* In Billions of Dollars

Total: $81.4 billion

Mortgages$2.7

Short-Term$4.5

Bonds$24.1

Real Estate$8.4

US Equities$10.7

Other$0.6

Strategic Infrastructure

$1.3

Canadian Equities

$13.0

Int'l Equities$14.5

Private Placements

$1.7

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

75%

25%

Source: Dun & Bradstreet, January 2002

Privately owned companies account for over US$9.7 trillion* of the equity capitalization of global markets.

US Companies with Revenues >$100M US

* bcIMC research estimate.

Overtaking the G6When BRICs’* US$ GDP would exceed the G6

Source: Goldman Sachs, Dreaming with BRICs: the Path to 2050Global Economics Paper No. 99

*BRICs: Brazil, Russia, India and China

BRICs’ 5-Year Average Annual Returns

21.9

30.85

25.8

17.8

0

5

10

15

20

25

30

35

Brazil Russia India China

Percent; in C$ terms

Source: MSCI

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.