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Business Commentary Pension funds need to focus on the long view, not a single record year

News that any organization just posted its strongest annual return ever would typically trigger a celebration, but at the Canada Pension Plan Investment Board, our employees gave this just a moment's pause.

The tempered response to a stellar year may surprise some, but it's consistent with our organization's purpose: to maximize long-term risk-adjusted returns to the Canada Pension Plan Fund. The CPP is designed to support not only this generation of retirees, but generations to come, which is why we must focus on long-term results rather than any given year.

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Yes, we are encouraged that CPPIB earned an 18.3-per-cent return, net of all costs, during our fiscal 2015. The $40.6-billion in net investment income that return represents translates into roughly $2,250 for each of the CPP's 18 million contributors and beneficiaries. But the number we concentrate on is our 10-year net rate of return, which is 8.0 per cent, or 6.2 per cent after accounting for inflation, comfortably above the 4-per-cent real (postinflation) rate of return that the chief actuary assumes is required to sustain the CPP. This longer-term result is cause for continuing public confidence by workers in Canada that the CPP will be there for them when they retire.

Maintaining a long view in a world dominated by short-term thinking requires discipline, especially during periods of large market gains or losses, when human instinct tells investors, large or small, to pop out the champagne – or to cut losses and run. As an organization, we develop systems and processes to instill long-term discipline for both the ups and downs, and we have the institutional memory to remind us that good times come to an end and that troubled markets tend to revert in time.

During CPPIB's 2009 fiscal year, which coincided with the global financial crisis, we posted a net return of minus 18.6 per cent, almost the mirror image of our gain this year. I was not yet CEO then, but I was a senior member of our investment team. I'll confess that it's not easy to brush off a year like that.

As an organization, we dug deep and concluded that our long-term strategy remained sound. However, we did modify a number of investment programs to take into account changes in the market (such as improving our management of liquidity).

If anything, our biggest mistake during the financial crisis was that we did not press our advantage, being a bigger buyer when others were running for the exits. To be clear, being long term does not mean "set it and forget it." Organizations such as ours must have a long-term vision that is assessed in light of conditions in the near term. Businesses, large and small, need to keep their focus fixed on the horizon, but they must also occasionally glance down to ensure that they aren't about to trip.

This approach does not mean we will avoid exposure to general short-term market conditions. Rather, we must have the patience to tolerate them in pursuit of our ultimate goal: maximized long-term outcomes. For instance, unlike many pension funds globally, CPPIB generally doesn't hedge its foreign currency exposure. Doing so might smooth out our results year to year, but hedging comes at a financial cost with no expected benefit over the long term. We lost $10.1-billion in fiscal 2010 by accounting for our foreign holdings in Canadian dollars, but in the years since, we have realized currency gains of $16.1-billion.

Long-term thinking also affects the way we view the costs we incur. CPPIB is a relatively young organization; we began actively managing Canadians' money in 2006. A significant part of our activities is not purely investment related, but rather focused on building the talent, global office network and systems that a sophisticated global investor requires to compete effectively.

Once we made the decision to pursue active management, there was no room for half measures, especially when some of our competitors are trillion-dollar behemoths. We opened offices in Hong Kong and London seven years ago, and are now seeing the deal flow that those local offices secured pay off. And our teams in these offices have an important role in managing the portfolio and helping to mitigate risk. We're confident that the expense we're currently incurring to open an office in Mumbai will similarly pay off down the road.

We are ever mindful that we invest in a market where value-destroying behaviours and human nature too often win. In one recent survey, more than three-quarters of executives admitted that they would take actions to boost quarterly earnings at the expense of long-term value creation. The amount of cash that's currently parked on corporate balance sheets in Canada and the United States is at historical highs. While there are a variety of reasons for this, the general trend toward sitting on cash rather than investing it productively is emblematic of a short-term mindset.

As one part of the Focusing Capital on the Long Term initiative, CPPIB helped bring together nine organizations managing more than $7-trillion (U.S.) in assets to develop practical ideas for how institutional investors might reorient their portfolio strategies and practices to emphasize long-term value creation and, by doing so, be a powerful force promoting a long-term mindset throughout the investment value chain. I am pleased to note that the FCLT initiative is gaining momentum.

From weighting incentive compensation toward longer-term performance, to evaluating how the benchmarks they choose influence the behaviour of their investment professionals, to understanding the appropriate risk appetite an exceptionally long-term investor should truly take on, institutional investors around the world are starting to tackle questions that, at the core, challenge them to resist – or pre-empt – the human nature to overemphasize the short-term win. As managers of Canadians' pension fund, we challenge ourselves to think beyond this year's earnings to build an organization that will serve not only Canadians' retirement needs, but also their children's needs and their children's needs. That's our yardstick.

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