Governance Best Practices: A Focus on Roles and Responsibilities

Prepared for: SDCERA November 20, 2014 Tom Iannucci Cortex Applied Research

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Agenda

Governance Principles Chain of command Role of the Board Role of the CEO Role of the CIO Role of investment consultants

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Principles

Maximize clarity of accountability – Clear and reasonable objectives – Necessary authority to make the decisions that impact

performance – Resources

Separation of duties: – Policy vs. implementation – Board should be focused on policy – Management should be focused on maximizing performance

within the policy constraints established by the Board

Investment consultants to serve only one client

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Chain of Command – Best Practice Classical/Linear Structure

Board

CEO

CFO COO CIO

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Linear Structure: Rationale Recognizes the System is a single, integrated business (e.g.

insurance company) Ensures a single executive (the CEO) is ultimately

responsible for the success of the entire organization. Ensures executive level oversight of the CIO

CEO serves as a check on CIO The Board only needs to directly oversee the CEO

Allows teamwork while CIO focuses on investments Allows for alignment of CEO and CIO interests:

CIO can’t blame CEO for lack of support

Facilitates recruitment of top CEO talent Grater independence on investment strategy (e.g. asset

classes/ OCIO).

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Linear Structure: Implications

CEO selects CIO even the Board formally appoints the CIO: A wise CEO will involve the Board in CIO selection and

termination decisions

CIO may present investment recommendations directly to the Board, but the CEO has approved/vetted them.

CEO need not be a technical investment expert, but must have enough knowledge of investments to challenge and oversee investment policy and strategy recommendations of CIO

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Role of the Board 1. Select CEO and approve/ratify CEO’s choice of a CIO 2. Approve the strategic investment direction and

organizational model for the investment program 3. Approve investment risk and return objectives:

Risk objectives are either set indirectly by approving an asset allocation policy or directly by approving a risk budget(s).

4. Approve statement of investment policy (i.e. all standard elements): Major asset classes Major investment strategies (e.g. hedge funds, tactical asset

allocation, risk balanced strategies) Social and economically targeted investment policies

5. Approve manager selection policy/process, minimum criteria, and corresponding transparency mechanisms.

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Role of the Board (cont’d)

7. Select independent investment consultants to advice Board as needed.

8. Approve investment performance benchmarks 9. Approve ethics policies regarding the investment program

(conflicts of interest, gift policies, directed commissions policies, placement agent policies.

10.Approve any performance incentive compensation systems for the investment program

11.Monitor the investment program: – Compliance with agreed-upon policies – Compliance with risk limits – Investment performance relative to expectations – Investment costs of the investment program – Staff succession

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So What is the Board Accountability For? Board decides:

Asset allocation and/or risk budget: – A choice of asset classes. – A decision to mismatch assets and liabilities relative to a minimum

risk portfolio; and – A decision to mismatch the portfolio from the industry average

allocation Whether or not to engage in active management.

Therefore Board is accountable for: Value added/lost by mismatching assets and liabilities

relative to the minimum risk portfolio or industry average mix.

Whether or not the decision to pursue active management was a good one.

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Role of CEO – Investments

1. Recommend the broad strategic investment direction and organizational model for the investment program. (e.g. internal vs. outsourcing of the investment program).

2. Select/terminate the CIO in consultation with Board 3. Direct and supervise the CIO. 4. Review , challenge and confirm all CIO

recommendations on policy and strategy (but not CIO implementation decisions).

5. Through the CIO, recommend all policies and strategies to the Board requiring Board approval.

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Role of CEO – Investments (cont’d)

6. Oversee/monitor the CIO’s implementation of asset allocation and active management (if applicable): Compliance with board policy Compliance with internal controls and procedures Performance results

7. Oversee the CIO’s managerial efforts in managing the investment department (hiring/budgeting/succession planning, etc.).

8. Supporting the CIO in the CIO’s efforts to manage the investment program.

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So What is the CEO Accountable For?

CEO is accountable to the Board for the: Quality and soundness of investment policy and

strategy recommendations going to the Board. Performance of the CIO; i.e. value added by:

Implementation of Board’s asset allocation policy. Tactical asset allocation Active management Cost control

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Role of CIO

1. Develops investment policy and strategy. 2. Determine the structure of each asset class 3. Determine manager structure within asset classes. 4. Implement the asset allocation policy. 5. Implement portfolio re-balancing 6. Execute tactical asset allocation (if applicable. 7. Determine use of active and passive management,

subject to active risk budget or other parameters approved by the Board.

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Role of CIO (cont’d)

8. Select investment managers and general partners/investment funds subject to constraints contained in board policy, and any requirements for providing full transparency to the Board on manager selection decisions.

9. Select, direct, oversee investment staff to assist in all of the above.

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So What is the CIO Accountable For?

CIO is accountable to CEO for value added/lost by the CIO and his/her team in implementing Board’s investment policy/ strategy:

Implementation of asset allocation Effective re-balancing Tactical asset allocation (if applicable) Value added/lost through by investment

managers selected by CIO and his/her team Investment costs

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Summary Accountabilities

In essence: The Board is accountable for value added or

lost by the asset mix policy decision (or beta). CEO and CIO are accountable for value added

or lost by implementation decisions (i.e. active management program). Management must have the authority to make

all implementation decisions (i.e. minimal limits on authority)

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Enforcing Accountability

If the active management program is not producing results, the CEO is accountable: CEO either terminates the CIO or gives CIO

more time to adjust. If CEO gives CIO more time and results are still

not forthcoming, the Board eventually has to decide whether to terminate the CEO.

If the asset allocation decision is not producing desired results (even though active management program may be working) the Board is accountable to the stakeholders.

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Aligning Interests of CEO & CIO

For the model to work, interests of CEO and CIO must be aligned: Chain of command must be respected Any incentive compensation programs should

apply to both the CEO and CIO (not necessarily identically).

CEO should have an incentive to hire the best CIO possible, even if it means the CIO earns more than the CEO.

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Investment Consultants – Two Roles

1. Extensions of staff and support the staff in developing staff policy and strategy recommendations and/or implementing the investment program. Such consultants are hired by and accountable to

the CIO and/or CEO 2. Provide independent advice to the Board on the

recommendations or work of investment staff. Such consultants are hired by and accountable to

the Board

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Note:

Management doesn’t necessarily have to have a different consultant than the Board’s consultant, but: If management feels it needs to hire a different

consultant to best carry out management’s job, it must have the authority to do so.

If management chooses to also use the Board’s consultant, then management is accountable for that decision.

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Chain of Command – Accountabilities

Board

CEO

CIO

Beta

Alpha

Board Consultants

Staff Consultants

Questions & Discussion