In 1999, the Canadian Labour and Business Centre (CLBC, formerly known as the Canadian Labour Market and Productivity Centre) published Prudence, Patience and Jobs: Pension Investment in a Changing Canadian Economy, a first-ever report on the relatively new position of pension funds as key players in Canada's financial system and economy. Prudence, Patience and Jobs considered the rapid asset accumulation of trusteed pension plans, especially over the past decade, and their ever-increasing influence in an array of capital markets.

The issues raised in Prudence, Patience and Jobs remain of key importance to business, labour and public policymakers in Canada - not just as they pertain to pension funds, but to all institutional investors - trusteed and other pension funds, insurance companies, investment companies, philanthropic funds, endowments and other groups. These investors share not only growth rates in common, but an affinity for specific types of capital market participation, based on similar organizational mandates, structures and long-term investment horizons.

This fact was recognized by the Organization for Economic Co-operation and Development (OECD), when in a 1998 report (Institutional Investors in the New Financial Landscape), it commented on the rise of the institutional investor sector in most industrialized countries, including Canada. Among other things, the OECD found that the so-called "institutionalization" of savings has led to "an increased supply of long-term funds" that should also lead to "an increase in the supply of risk capital". National governments were urged to pay close attention to this phenomenon, given the many public policy implications of greatly enhanced institutional clout.

Indeed, when taken as a whole, institutional investors may already form the largest source of financial resources in the Canadian economy. At between $600-700 billion at the beginning of 2001, trusteed pension funds were the second largest pool of capital in this country's financial system, after the banks. However, at an estimated minimum of $1.5 trillion, the combined assets under management by Canadian pension funds and other institutional investors may currently exceed the total assets of Canadian banks.

In light of these statistics, pension funds and other institutional investors cannot help but register an impact, one way or another, on Canada's ability to convert savings into productive investment and capital formation that, in turn, generate economic output, jobs and incomes. Of course, as they grow, individually and collectively, the real and potential impact of these investors on economic outcomes grows commensurably. For instance, with growth, the very largest private and public sector pension funds are continually challenged to locate new sources of portfolio diversification that will maximize returns. With portfolio diversification usually comes more diffuse capital market participation and still more indirect effects on the economy.

As Prudence, Patience and Jobs discovered, however, the new economic relevance of pension funds and other institutional investors in Canada is limited by certain factors that are also worthy of public policy attention.

In a survey undertaken in conjunction with the Pension Investment Association of Canada (PIAC) in 1998-99, the CLBC found that pension funds face significant barriers to entry or sustained engagement in private investment activity of varying degrees of risk, such as term lending, venture financing and other types for privately-placed debt and equity. For this reason, most Canadian pension funds have little or no exposure to related capital markets. This was a critical finding as such activity is closely linked to growth and productivity in Canada's fast-changing economy - investing in small and medium-sized businesses, in restructuring traditional sectors, or in emerging technology sectors.

Table 1 summarizes the findings of the CLBC survey of PIAC membership of 350 pension fund organizations (of which, 53% responded). Of fourteen identified barriers to pension fund participation, and submitted to pension managers for their comment, nine received an overall rating of "important" or "very important". Six of these barriers, all pertaining to impediments implied in the complex and prohibitive structures of private capital markets, were so rated by very wide margins - from two-thirds to three-quarters of total respondents. The apparent suggestion is that, experienced in them or not, Canadian pension managers believe these market venues present clear and daunting challenges to involvement by their funds.

Table 1: Key Barriers to Canadian Pension Fund
Participation in Venture Capital

(Source: Prudence, Patience and Jobs, CLBC, with the co-operation of the Pension Investment Association of Canada, 1999)

The results of the CLBC survey raise serious concerns. What will be the consequence if pension funds - and, doubtless, other institutional investors - feel they must remain on the sidelines as the Canadian economy negotiates fundamental changes in the years ahead? Will there not be lost opportunities for growth, employment, wealth and higher living standards if one the country's largest pools of capital is not engaged in financing the necessary long-term investments?

Such questions have been posed in other countries - the United States, the United Kingdom, Australia and New Zealand, to name a few - where, it must be readily observed, pension funds face precisely the same hurdles to engagement in private placement as those encountered at home. Interestingly, pension funds and other institutional investors in some of these countries, particularly the United States, have developed creative organizational strategies for overcoming barriers that invite investigation, and may be worthy of emulation, even in comparatively small, and perhaps less evolved, capital markets in Canada.

Prudence, Patience and Jobs highlighted several strategies that have been introduced over time to venture financing, private equity and quasi-equity markets in the United States, frequently at the behest of leading American pension funds. Such strategies have immediate applicability to a Canadian context and, with modification, are equally pertinent to other kinds in private placement activity in both countries, including term lending and investing in real estate and infrastructure development. Examples include:

•Introduction of "best practices" that bring transparency and some alignment of the interests of the institutional suppliers of capital and those of market professionals who manage capital externally (e.g., in limited partnerships or other limited liability structures).

• Rendering of market institutions and resources "pension-friendly" by greater appreciation of pension fund organization, trusteeship, fiduciary responsibility and legal restrictions.

• Development of the local stock of skilled investment specialists, agents and intermediaries, including those market experts that operate strictly on behalf of pension funds (e.g., "gatekeepers").

• Greater use of alternative pooling vehicles (e.g., fund-of-funds) that intermediate cost-effectively between institutional investors and external managers.

• Creation of private placement returns databases, performance assessment and measurement tools.

• Improvement of private capital market education for pension managers and trustees.

• In some cases, a role for government in investment partnerships, leveraging and cost-sharing or advancement of any of the above initiatives.

• Development of the concept and practice of "targeted investing".

These and other strategic solutions have enfranchised pension funds and other institutional investors in the United States in establishing a "comfort zone" in the rocky terrain of private investment and, eventually, a long-term stake in diverse private capital markets.

Perhaps a good illustration of this "comfort zone" is revealed in markets for long-term loans, mezzanine financing and other varieties of debt and quasi-debt financing, in which American insurance companies currently occupy a dominant supply position. American pension funds, of all types and sizes, are equally integral to the ebb and flow of capital supply conditions in a broad range of private equity markets. Evidence of the latter is seen in venture capital during the 1990s, when private and public sector pension funds south-of-the-border were typically responsible for approximately 50% of all new capital commitments on an annual basis.

Needless to say, this is not the experience of Canadian pension funds and other institutional investors. Exceptions include a handful of extremely large public sector pension funds, or their money managers, such as the Caisse de dépôt et placement du Québec (CDP), the Ontario Municipal Employees Retirement System (OMERS), the British Columbia Investment Management Corporation (BCIMC), the Ontario Teachers Pension Plan Board and the Hospitals of Ontario Pension Plan (HOOPP). By dint of sheer size, these entities have developed the capacity to overcome barriers and enter markets for private placement of above average risk, both domestic and international.

In the everyday business of investing, regardless of the marketplace venue, pension funds and other institutional investors will often generate what economists refer to as "collateral benefits", or positive effects in the Canadian economy that are ancillary to the primary aim of obtaining optimal earnings in a prudent manner.

In the majority of instances, collateral benefits will happen incidentally, meaning that while pension funds, et al, have allocated assets solely in the pursuit of financial returns, they have inadvertently created non-financial ones. These can include growth or jobs, among other social goods, and can be elicited due to involvement in multiple private or public capital markets and market segments. Of course, being incidental doesn't make benefits any less valuable.

A high profile example of private investment undertaken by institutional investors for its superior earnings, but also renowned for its collateral benefits, is venture financing. At the end of 1999, Canadian companies backed by venture capital achieved growth rates that outstripped performance in the rest of the economy by wide margins - 39% growth per year in jobs, 31% in sales, 38% in exports and 52% in research and development spending, with young firms in emerging technology sectors expanding at an even more accelerated pace. Impressive as these economic outcomes are, for most venture investors, they are incidental to the main purpose of sharing in the profits of successful deal-making.

Collateral benefits can also be obtained with more deliberation. Among pension funds, this activity is sometimes described as "asset-targeting" and entails a calculated and strategic intention on the part of trustees and managers to produce certain ancillary effects from investment while continuing to treat responsibility to plan members, prudent behaviour and risk-adjusted returns as the first and over-riding priorities. To guarantee this, successful targeting of investments is directed within a strict fiduciary framework.

A clear illustration of the targeted approach is provided in the American idea and movement known as "economically targeted investments" (ETIs). While there is no common, universally-accepted definition of ETIs, in general terms, these refers to programmatic initiatives of financial institutions, and particularly pension funds and other institutional investors, to identify so-called financing "gaps" - also know as challenges to "access to capital", predominantly in private placement markets - that can lead to under-investment in key economic sectors.

In so doing, institutions are encouraged to focus on collateral benefit objectives of their asset allocations, such as job creation or protection, community economic development, affordable housing or development of infrastructure, public works and social services. In theory and practical application, ETI proponents argue, these can be secured by targeting financing to such investees as small and medium-sized businesses, technology company start-ups, restructuring manufacturing plants, minority, women or disadvantaged entrepreneurs, residential or non-residential real estate, or locales within a fixed geographic area.

Over many years of existence in the United States, ETI programs have met with both notable success and, on occasion, notable failure. With respect to the latter, several ETI experiments have floundered due to disregard for sound fiduciary and market principles. On the other hand, a great number of ETIs have flourished, attracting tens of billions of dollars from public sector pension funds and single or multi-employer pension funds in the private sector (e.g., the so-called "Taft-Hartley" funds, or jointly-trusteed funds established under legislation), as well as other investors, based on a win-win formula of attaining both risk-adjusted returns and collateral benefits. According to ETI observers, this formula is tenable when the act of targeting is linked unambiguously to marketplace signals and disciplines, and especially those integral to strategies for overcoming barriers to private investment activity, as previously discussed.

The ETI phenomenon was given a major boost by American pension fund regulators in the mid-1990s. During that period, the federal Department of Labor (DOL), agency for the Employee Retirement Income Security Act (ERISA), provided ETIs with an official definition, acknowledging their focus on collateral benefits, such as "expanded employment opportunities, increased housing availability, improved social service facilities and strengthened infrastructure".

With this action, ERISA thereby countenanced a pension plan's selection of an investment "for the economic benefit it creates", so long as that investment has a risk-adjusted, market-grade rate of return that is equal or superior to a comparable investment (of comparable risk) and otherwise supports a plan's fiduciary imperatives. In other words, a violation of ERISA would occur only if, in attempt to ensure collateral benefits from investing, the governing or managing fiduciaries of a pension plan compromised its financial bottom line, by tolerating "reduced returns or greater risks."

The effective consequence of this DOL action - which has largely been reinforced at the state level - has been some validation of ETI programs, in part because government regulators have clarified the legal parameters for designing and implementing these programs in the context of the "prudent person rule."

Understanding of ETIs has also been furthered advanced by pension funds themselves. For instance, the largest pension fund in the United States, the $175 billion California Public Employees Retirement System (CalPERS), has crafted its own ETI guidelines. Adopted in 1993, the "Economically Targeted Investment Policy" defines ETIs of interest to CalPERS as those "intended to assist in the improvement of the economic well-being of the State of California, its localities and residents." For CalPERS, this goal includes "job creation, development and savings, business creation, increases or improvement in the stock of affordable housing and improvement of the infrastructure." Perhaps not surprisingly, CalPERS is currently one of the biggest sponsors of ETI initiatives.

Based on a similar philosophy and set of guidelines, other top American pension funds and institutional investors have crafted formal ETI programs. Some of the best known have existed for several decades, and have been documented and studied for their relative prowess in generating both collateral benefits and risk-adjusted returns, by a range of government bodies and independent agencies, including the DOL, the federal Small Business Administration, the Washington-based Center for Policy Alternatives, as well as scores of academics and researchers.

Outside of formal ETI programs, there are more informal versions of targeted investments, or what may be described as "ETI-like" activity. For instance, a significant number of major American public sector pension funds (e.g., the Public Employees Retirement Association of Colorado, the New York City Employee Retirement System, the Pennsylvania State Employees Retirement System and the State of Wisconsin Investment Board) have suggested that "where feasible" or "all things being equal", they will invest locally to positively affect economic growth or jobs - at the municipal, state or regional level, depending on the entity engaged. In some instances, this mandate is expressed in written statements of investment policy, and in others, it is simply the unexpressed practice that is apparent.

As stated previously, pension funds and other institutional investors in Canada have very limited exposure to private capital markets, at least as compared to their American counterparts. Given that most examples of asset-targeting in the United States - be they under the auspices of a formal ETI program or otherwise - occur in such market environments, it should not be surprising to find relatively little history of initiatives reflecting comparable objectives and strategies in this country. And, of course, there is no broad legal framework in Canada that clarifies, and establishes parameters for, the targeted investing concept, as exists for pension funds south-of-the-border.

This said, there exist several important Canadian models that share many of the principles and practical elements of ETIs or ETI-like programs in the United States and that involve a similar mix of institutional investors.

For instance, like CalPERS and other American public sector pension funds, CDP has for almost forty years invested in a manner consistent with economic growth and job creation goals in Quebec - an activity that justifies its extensive and long-term participation in venture financing and other markets for privately-placed debt and equity. In recent years, pension funds in some other Canadian provinces have sought to follow CDP's lead in this direction. In addition, in British Columbia, the pension fund-supplied Concert Properties and Mortgage Fund One mirror in mandates and design features, those massive American ETI pools that offer financing to build affordable housing and commercial real estate, with the backing of Taft-Hartley and public sector funds, such as the Housing and Business Investment Trusts sponsored by the American Federation of Labor-Congress of Industrial Organizations.

In other words, despite the much more limited experience of Canadian pension funds in the highly risky terrain of private placement, there are a handful of pioneers of the still-more-complicated act of targeting investments according to the collateral economic and social benefits they produce. Similarly, there are a few established precedents, particularly in Quebec and British Columbia, for pension funds and other institutional investors in Canada to pursue such ends within a rigorous prudential framework of first attaining optimal, risk-adjusted returns that are satisfactory to fulfilling obligations to plan members.