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Special Examination or Special Sham?

Via Pension Pulse.

This is a follow-up comment to the last one on PSP Investments' FY 2011 results. I wanted to go through the Special Examination conducted by the Auditor General of Canada and Deloitte & Touch. The key findings reported on PSP's website are:


What is a Special Examination?
Special examinations are a form of performance audit of federal Crown corporations. Under the Financial Administration Act, federal Crown corporations are subject to a special examination at least once every 10 years.

In special examinations, examiners provides an opinion on the management of the Crown corporation as a whole. More specifically, they examine whether a Crown corporation's systems and practices provide reasonable assurance that assets are safeguarded, resources are managed economically and efficiently, and operations are carried out effectively.

Conclusion of PSP Investments' 2011 Special Examination
PSP Investments' Special Examination led to the best possible outcome. The joint examiners, the Auditor General of Canada and Deloitte & Touche LLP, concluded: "The Corporation has maintained systems and practices to provide it with reasonable assurance that its assets are safeguarded and controlled, its resources are managed economically and efficiently, and its operations are carried out effectively."

PSP Investments is pleased with the outcome of its special examination and with the examiners' comments. Their observations included the following:

  • The Corporation has the key elements of a strong governance framework, and its governance practices are consistent with industry practices for stewardship and oversight by boards of directors.
  • The Corporation's risk management practices, particularly in the area of investment risk, provide for identification, monitoring, management, and reporting of risks to protect its assets from undue risk of loss.
  • The Corporation's compensation framework and practices are comparable with those of the industry. The Board plays an active oversight role in the design and operation of compensation practices, and reviews and monitors them independently of management.
  • The Corporation regularly benchmarks its practices against those of comparable organizations in the industry.

The report also provides recommendations for ongoing improvements regarding the public reporting of responsible investment activities, Board appointments, the corporation's strategic planning process and new investment activities. PSP Investments agrees with these recommendations and will be taking steps to implement them.

In the 2011 Annual Report, PSP's Chair, Paul Cantor, wrote this about the Special Examination (page 4):

I am pleased to note the positive outcome of a Special Examination carried out during fiscal year 2011 jointly by the Office of the Auditor General of Canada and Deloitte & Touche LLP (the “Examiners”) in accordance with applicable legislation, which requires such an examination at least once every 10 years.

The Examiners concluded that PSP Investments maintains systems and practices that provide it with reasonable assurance that its assets are safeguarded and controlled, its resources are managed economically and efficiently, and its operations are carried out effectively. This is the best possible conclusion to such an examination.

Given that PSP Investments has existed for little more than a decade, has experienced tremendous growth, and is engaged in a business where the requisite systems and controls tend to be both complex and constantly evolving,this finding is a testament to the strength and rigour of our organization.

The Examiners also identified a few areas in which our practices could be strengthened.

One of these recommendations calls for improvements in the Board selection process, including the staggering of appointments to the Board to avoid significant turnover of membership in any given year.

Appointments to the Board do not fall within the Corporation’s purview although we seek to assist the independent Nominating Committee, Treasury Board and the Privy Council Office in expediting the process. We share the Special Examiners’ view that improvements are required to ensure that vacancies are filled and we will be proposing changes designed to improve the appointment process.

PSP Investments also concurs with the Examiners’ other recommendations and will be taking appropriate steps to implement them. I invite readers to review the full report from the Examiners, as well the Corporation’s response, can be found beginning on page 101.

Let me preface my comments below by giving you some background. I was hired by the Treasury Board of Canada in the summer of 2007 after working as a senior investment analyst at PSP (I was Gordon Fyfe's first investment hire). I was contracted to produce a study on the governance gaps of the Public Service pension plan, which includes PSP Investments, as well as government organizations that handle the administration, liabilities, and oversight of the Plan.

Needless to say, the folks over at PSP Investments were not too pleased that the Treasury Board hired me for this study. Regardless, I needed to work and completed the report. The folks over at the Treasury Board weren't too pleased either because my findings didn't reflect the "scope of the work," which is government bureaucratic double-speak for "you're making us look very bad in this report and we want you to change your findings because we have to share it with the Office of the Auditor General of Canada and show them we're doing our supervision job properly " (they weren't and as far as I can tell, still aren't).

I didn't change a thing in the final report. In fact, I kept adding more recommendations until they were fed up. They delayed my final payments, made my life miserable, but my findings didn't change. All this nonsense for a flimsy $25,000 contract! Last I spoke with the Office of the Auditor General of Canada, my 85-page report is still collecting dust somewhere in the halls of the Treasury Board, and nobody bothered implementing any of my recommendations (that would entail they actually do their job properly!). Journalists seeking this report should use the access to information to obtain it and I will be happy to go over my findings with them.

In April, 2009, I was invited to speak at the Standing Committee on Finance on matters relating to pensions and in April 2010, I was invited to the Senate Standing Committee on Banking, Commerce and Trade to discuss matters on retirement savings.

Now that I got that out of the way, let me go over the Examiner's recommendations and the "appropriate steps" PSP is taking to implement them. Go to the Appendix on page 114 of the Annual Report to see the Examiner's recommendations and PSP's response:

To assist in providing an orderly transition of appointments of members to the Board of Directors, the Public Sector Pension Investment Board (PSP Investments) should examine whether a more optimal staggering of Board appointments could be implemented and consider whether it should make recommendations to this effect to the Nominating Committee and the President of the Treasury Board (19-31).

And PSP's response:

Agreed. The Board of Directors of PSP Investments is aware of this issue. Recent appointments have been made in groups, which has led to the limited staggering of the terms of our current directors. Through the Chair of the Board of Directors and the Chair of the Governance Committee, PSP Investments will continue to have dialogue with the President of the Treasury Board and the Nominating Committee to attempt to improve the board appointment process.

The Corporation will be proposing two changes in the appointment process to address this issue. The first change will be to restructure the recommendation process of the Nominating Committee. The Corporation will propose to hold an annual meeting with the Nominating Committee to establish the candidate selection criteria, followed by one further meeting with the Nominating Committee in which the preferred candidates and alternates, based on the agreed criteria, are presented to it for recommendation to the President of the Treasury Board. The second change will be to recommend to the Nominating Committee and the President of the Treasury Board that when appointments are to be made in groups, that they be made for different term lengths to achieve a better staggering of the terms.

Since when does the "Corporation" have any say in the candidate selection process of its board of directors? The truth is that PSP's cousin Crown corporation, CPPIB, has a much better nomination process for their board of directors with clear term limits of three years (not four). In my opinion, people like Paul Cantor have to leave PSP's board. They have overextended their stay, been there way too long, and this is not in the best interest of plan members.

I would even go a step further. I strongly recommend that plan members have the right to nominate at least two qualified, independent board members who have no industry ties whatsoever. It could be finance or economics professors who are not on the payroll of some financial institutions, or it could be someone like Diane Urquhart who covered PSP's 2008 annual results on my blog and exposed significant risk management gaps that led to huge losses during that fiscal year. Hell, plan members should even consider nominating former PSP employees on the board (I'm not interested but know of a few more qualified people that just might be).

Moving on to the second recommendation, the Examiner recommends:

The Public Sector Pension Investment Board (PSP Investments) should develop and assign measurableoutcomes for its strategic goals, to enable measurement of success for each strategic goal. (45–54)

To which PSP responds:

Agreed. In its next Strategic Plan, PSP Investments will endeavour to develop additional measurable outcomes that are designed to measure the overall achievement of the strategic goals.

The third recommendation from the Examiner is:

The Public Sector Pension Investment Board’s (PSP Investments) New Product Committee should systematically review new investment activities using approved investment products to assess whether they introduce new risk exposures. These activities should be subject to the same review and approval process as all new investment products. (62–70)

To which PSP responds:

Agreed. The above concern is implicitly addressed by the Terms of Reference of the Management Investment Committee, which includes the review and approval of the business plans of asset classes, investment activities, new investment products, and other investment-related activities. PSP Investments will amend the New Product Committee’s Terms of Reference and its related procedures to expand its scope to include new investment activities using approved products.

This "New Product Committee" might have been handy prior to 2008, not sure how useful it will be now that the damage has been done. Instead, I would propose a committee made up of independent experts (can't stress that enough) that systematically reviews all investment activities, including the benchmarks governing public and private markets.

On that topic, I noted the following in the Examiner's report (page124) regarding benchmarks:

While the Corporation’s strategic goals and performance indicators encompass many objectives, central to PSP Investments’ mandate is the performance of its investments. To monitor its investment performance, PSP Investments compares its actual investment returns against its Policy Portfolio and specific asset class benchmark returns. For its public market asset classes, PSP Investments uses representative publicly available market indices as its asset class benchmarks. For all of its private asset classes, the Corporation has recently decided to move to cost of capital benchmarks. Implementation of these new measures is currently under way.

I can't stress how important benchmarks governing all investment activities are. The Examiner's report is frighteningly shallow in this regard. Not surprisingly since they teamed up with Deloitte -- an accounting firm with no expertise in investment performance auditing -- to conduct this Special Exam. They should have used a firm like Independent Fiduciary Services to conduct a comprehensive performance audit of all investment activities over the past six years.

Importantly, not all audits are equally comparable; an accounting audit is not a the same as a comprehensive review of all investment activities over the last six years to see whether appropriate risks were taken and whether the benchmarks reflected the beta, leverage, liquidity and other risks of the underlying investment activities.
This is the biggest beef I've got with this sham "Special Examination". A lot of hard questions regarding investments, reporting, human resources, etc. were never asked or answered. What sort of questions? Questions that I once outlined in detail in a previous comment. Let me make it even simpler:

  • Are the investment managers gaming their benchmarks, especially in alternatives, to maximize their bonuses?;
  • Does PSP have comprehensive operational, investment, and fraud policies to ensure assets are protected at all times and decisions are taken in the best interest of all stakeholders, including taxpayers?
  • What was the turnover rate at the "Corporation" over the last six years? Were there key departures at senior levels? If so, why? Where did these individuals end up and what is the relationship between their current employer and PSP?
  • Specifically, are any of PSP's former senior officers now working for a fund that they invested with while working at PSP? If so, why and what are the terms governing this activity?
  • Does PSP respect employment equity laws? If so, what percentage of their employees fall under recognized minority groups, including persons with disabilities? Do they have comprehensive whistleblowing policies to protect against fraud and mismanagement? have they violated any employee's rights over the last six years and if so, what remedial actions will they take? Do they continue to harass and intimidate former employees? If so, why and who is paying the tab?
  • Does the Head of Risk (operational and investment) report directly to the board or to the CFO oe CEO? If not directly to the board, why not?
  • Is PSP reporting its activities to all stakeholders, including the public, on a timely basis? If not, why not?
  • Have certified fraud examiners (CFEs) performed an independent fraud audit on the Corporation? If not, why not?

Special Exams on Crown corporations are important. They are performed once every six years. Even though PSP falls under some sections of the Financial Administration Act, it doesn't report a tenth of what other Crown corporations report.

At the end of the day, the biggest risk pension funds face is governance risk. Not inflation, not deflation, not interest rates, but governance! I can't stress that enough and that's why this Special Examination disappointed me (not really surprised, too political). I can't believe Canadian taxpayers are funding such "sham" reports that are just polished smoke and mirrors. The Auditor General of Canada should be ashamed for producing such a superficial report which looks good but really doesn't address any of the important governance gaps that impact PSP Investments' activities. When it comes to governance, Canadian funds are among the best int he world, but we have a lot more work ahead of us to bolster our public pension funds.