The past few months have brought significant announcements regarding changes to the investment rules affecting pension plans, including, most recently, the federal Government’s announcement of amendments to the federal investment rules and a consultation regarding the 30% rule. Perhaps somewhat overshadowed by these announcements has been the final version of the Guidance Note on Prudent Investment Practices for Derivatives released by the Financial Services Commission of Ontario (FSCO) in March.
The Guidance Note was released in draft form in October of last year and has been modified following a period of public comment. While the Guidance Note does not represent a legislative change, it is nonetheless significant in that it provides guidance as to the prudential expectations that the Ontario regulator has regarding derivatives investments.
As noted in an earlier blog post on the draft Guidance Note, the Note is framed as a set of starting point expectations for plan administrators investing in derivatives. It contemplates a system for internal oversight of derivatives investment practices that is extremely broad in scope.
FSCO’s Guidance Note sets out explicit expectations for documentation, risk mitigation and risk monitoring as follows:
- Documentation is expected to include more robust authorization regarding derivatives investment and the use of collateral in the Statement of Investment Policies and Procedures (SIPP) and to include risk monitoring practices policies or guidelines relating to derivatives investments.
- Risk mitigation strategies for over-the-counter derivatives should include an evaluation of pricing and other terms and conditions to ensure they are appropriate, and standardized netting agreements. Administrators should also consider appropriate collateral requirements for all derivatives, impose “specific and unambiguous” quantitative limits on a fund’s exposure to derivatives (including “soft limits, where positions must be analyzed, and hard limits, where positions must be liquidated”), and ensure compensation for staff involved in derivatives activities is set so as not to induce undue risk-taking.
- Risk monitoring for derivatives is expected to be more precise and frequent than for other investments, including monitoring of market risk, liquidity risk, counter-party risk, basis risk and operations and systems risk. Scenario analysis and stress testing are expected to be carried out.
The draft version of the Guidance Note provided for a 10% limit on exposure to derivatives transactions with the same counterparty or associated counterparties. The final Guidance Note removes the expectation that administrators would be required to comply with a fixed 10% or other set limit on exposure to derivatives transactions with the same counterparty or associated counterparties. The revised expectation is that administrators will prudently set specific soft and hard limits on derivatives exposures and measure such exposures using widely accepted methodologies. While providing less certainty about what FSCO will consider prudent, this approach gives plan administrators more latitude to consider a prudent limit in the specific context of their plan and risk management considerations.
We had also noted in our prior blog post that FSCO expects that administrators will implement appropriate risk management practices and procedures for pooled fund and master trust investments that engage in derivatives transactions. While FSCO recognizes that it may not be possible for a plan administrator to ensure that a pooled fund that is open for investment to unrelated entities meets the standards set out in its Note, FSCO nonetheless sets out due diligence requirements with respect to pooled fund investments that may involve derivatives, including reviewing the pooled fund constituent documents and considering whether the operation of the pooled fund meets the standards set out in FSCO’s Guidance Note. In the final version of the Note, FSCO has added that administrators are expected to conduct reasonable inquiries into the pooled fund investment manager’s overall internal control environment and its risk management practices relating to the use of derivatives. As a result of the new requirements, fund managers may see increased scrutiny of their derivatives practices from pension plan investors.
Now that the Note is final, plan administrators will need to consider what the implications of the Note are for their pension plan, including:
- Reviewing and, if necessary, revising their SIPP to ensure sufficient detail is provided regarding permissible derivatives investment, collateral, and exposure limits;
- Considering whether appropriate risk management policies and procedures are in place relating to derivatives investments and, if not, developing or revising same;
- Reviewing derivatives investment practices, both internally and with external managers, to ensure that risk mitigation strategies are appropriate and that risk monitoring is adequate;
- Reviewing investment management agreements and/or investment guidelines for managers to reflect FSCO’s expectations, including ensuring that responsibility for compliance with the requirements of the Guidance Note is appropriately allocated; and
- Reviewing due diligence practices with respect to investments in pooled or master trust funds that invest in derivatives to ensure that part of the due diligence involves a review of the fund’s derivatives practices.