Mark Newton December 7 2011 CAPSA introduces guidelines on prudent investment practices and funding policy Heenan Blaikie LLP | Employment & Immigration - Canada Mark Newton Employment & Immigration IntroductionPension Plan Prudent Investment Practices GuidelinePension Plan Funding Policy GuidelineIntroductionOn November 15 2011 the Canadian Association of Pension Supervisory Authorities (CAPSA) released two guidelines on pension plan governance: Guideline 6: Pension Plan Prudent Investment Practices Guideline and its companion Self-Assessment Questionnaire on Prudent Investment Practices, both of which provide guidance to plan administrators on the application of prudence in the investment of pension plan assets; and Guideline 7: Pension Plan Funding Policy Guideline on creating a pension plan funding policy in the context of defined benefit plans. Pension Plan Prudent Investment Practices GuidelineGuideline 6: Pension Plan Prudent Investment Practices Guideline provides a variety of prudent investment principles that a plan administrator should bear in mind when managing investments. Generally, the goal of the administrator (in its investment management role) is to generate returns while taking into account the plan's liabilities, cash-flow needs and risk tolerances. The details of the role of the administrator and the standard of care that must be met are set out in legislation. The plan administrator has a duty to invest the pension fund's assets in a prudent manner.In this guideline, CAPSA encourages plan administrators to assess their current investment practices to ensure that prudent practices are in place. The focus of the guideline is to ensure that plan administrators have a robust, process-oriented decision-making framework in place within which investment management activities are conducted.Below are the specific guidelines issued by CAPSA in relation to investment management.Guideline on the Prudent Person RuleThe prudent person rule applies to fiduciaries generally and is intended to lead to balanced decision making. It is an objective standard of conduct for fiduciaries: a fiduciary is expected to discharge its duties with the care, skill, prudence and diligence that a prudent person acting in a like capacity would use.The prudent person rule is focused on process and stresses the importance of having a good governance structure, deliberate decision making, appropriate documentation and appropriate recordkeeping. Further, the prudent person rule requires that fiduciaries exercise due diligence. In the pension investment context, the guideline suggests that fiduciaries exercise due diligence by: proper consideration of adequate information; documenting the final decision; documenting the reasons for the decision; and documenting the circumstances that were considered. An important aspect of the rule is the ability of various parties (eg, the plan administrator, the regulator, beneficiaries and others who may have an interest) to monitor investment management practices. In relation to this, the guidelines states that:"In order for effective monitoring to occur, there must be adequate information available. Policies must be established and processes must be documented to support the decisions that are made and actions that are taken."Guideline on Prudent DelegationGuideline 6 provides guidance on the delegation of investment-related functions and the responsibilities of the plan administrator when delegating. Investment-related tasks should be performed with sufficient skills, knowledge and expertise in order to meet the standard required by the prudent person rule.The guideline first suggests that the plan administrator should assess the extent to which the administrator has the appropriate internal structures, processes, resources, skills, knowledge and expertise to perform its duties effectively with respect to investing and administering the pension fund.Then, if the plan administrator determines that it does not have the structures, processes, resources, skills, knowledge and expertise in place, the guideline suggests that it may be prudent for the plan administrator to delegate these tasks to another party, such as an external service provider.If a plan administrator decides that it is prudent to delegate, the guideline suggests that the written governance documents of the plan should clearly set out the authority to delegate, the requirement of the delegate to report back to the plan administrator and the obligation of the plan administrator to monitor the delegate. Whether the delegate has authority to sub-delegate should also be set out.The guideline stresses that the plan administrator remains responsible for the delegated activities and should monitor and review these activities to ensure that they have been carried out appropriately and prudently. This includes monitoring and reviewing service provider activities based on established policies and performance procedures.Guideline on Investment ObjectivesDefining investment objectives helps to ensure that: risks are understood; risks are consistent with the pension plan's risk tolerances; and steps can be taken to actively manage risks. The guideline states that a plan's investment objectives must be well defined. Moreover, investment objectives should be consistent with the pension plan's retirement income objective, the liabilities of the plan, the plan's demographics and the ability of the plan to deal with volatility in investment returns.Finally, the investment objectives should take into consideration relevant legal provisions and fundamental investment principles (eg, asset allocation, diversification and liquidity).Guideline on Risk TolerancesGuideline 6 suggests that risk should be managed by taking into account the plan's investment and funding objectives at various stages: when setting and implementing the investment policy; when evaluating ongoing performance of the fund; and when evaluating the effectiveness of the investment policy. Risk factors to be managed include: investment risk; interest rate risk; foreign exchange rate risk; credit risk; liquidity risk; market risk; funding risk; demographic risk; longevity risk; and legislative and regulatory risk. Guideline on Investment Policy/Statement of Investment Policies & ProceduresLegislation requires that a plan administrator establish a written Statement of Investment Policies and Procedures (SIP&P). While the SIP&P by itself may be used as the plan's investment policy document, the guideline suggests that pension plans may decide to have a broader investment policy including or referencing other documents.The plan administrator is urged to consider whether a comprehensive investment policy in several documents or the SIP&P on its own best suits the plan's specific circumstance.A plan's investment policy reflects the investment objectives of the pension plan and sets out investment principles, strategic asset allocation, performance objectives and risk tolerances. Further, it sets out processes for the regular monitoring and review of the objectives and tolerances.The guideline suggests that the investment policy should also include a process for selecting and replacing asset managers, as well as ways to monitor and review performance and asset allocation.Guideline on Asset AllocationAsset allocation (ie, the process of apportioning a plan's total assets among major asset classes or other types of investment) is a significant component of a pension plan's investment strategy.The guideline recommends that asset allocation reflect the characteristics of the pension plan's liabilities, demographics and risk tolerances. It further recommends that decision makers should consider a full range of possible investment opportunities. Additionally, for each asset class or type of investment in which the pension fund is invested, decision makers should consider whether active or passive management is more appropriate, given the efficiency, return expectations, liquidity and transaction costs in the given market.Active management should evaluate the level of expertise required and whether the decision makers possess the necessary expertise.Guideline on Investment Selection and Due DiligenceWhen considering particular investments, the plan administrator or its delegate should use appropriate methods to research investments and review the investment decisions prior to investment. In this context, due diligence includes carrying out an independent and thorough investigation to determine the advantages and disadvantages of a particular investment before making an investment decision.Guideline on MonitoringInvestment activities should be monitored to ensure that policies are being followed. The plan administrator should: review investment objectives and risk tolerances; ensure that adequate investment procedures are in place; review key decisions regarding pension investments; ensure that service providers are monitored, measured and evaluated; and review the investment performance of the pension fund. The plan administrator must have adequate information to perform its duties, monitor the risks facing the plan and map out strategies for managing those risks.To monitor the pension plan and fund for compliance with statutory requirements and policies that have been adopted by the plan administrator, sufficient information should be provided to appropriate individuals and an effective reporting and disclosure regime is needed.Guideline on Documenting Processes, Policies, and ProceduresThe plan administrator should set up a process for documenting decisions and activities, and have documented processes, policies and procedures to help demonstrate that the prudent person rule has been applied and plan administrator obligations have been fulfilled. Any time a key decision is made, it should be well documented and the documentation should include the reasons and circumstances that were considered.Use of the Self-Assessment Questionnaire on Prudent Investment PracticesGuideline 6 suggests that the plan administrator should use the Self-Assessment Questionnaire on Prudent Investment Practices when establishing and reviewing the investment practices in place for its pension plan.Pension Plan Funding Policy GuidelineWhile Guideline 6 outlines expectations relating to the investment of a plan's assets, Guideline 7: Pension Plan Funding Policy Guideline provides guidance on best practices when developing and adopting a funding policy for a pension plan that provides defined benefits. In this context, a funding policy documents the plan sponsor's funding objectives and methods for achieving these objectives.In defined benefit pension plans, the objective of funding is to ensure that sufficient assets will be accumulated to deliver the promised benefits on an ongoing basis and to protect pension benefits in situations that involve employer insolvency.Accordingly, the purpose of a funding policy is to establish a framework for funding taking into account a variety of relevant factors, including: benefit security; stability and affordability of contributions; the financial position of the sponsor and competing organisational demands for cash; the demographic characteristics of the plan's beneficiaries (any person with an entitlement under the plan); the minimum funding requirements under applicable pension legislation; the financial position of the pension plan; the terms of the plan documents and any related agreement (eg, a collective bargaining agreement) between the plan sponsor and plan beneficiaries; the Income Tax Act maximum limits applicable to pension plans; and legislative and plan provisions with respect to utilisation of funding excess. Although a funding policy is not required by legislation, CAPSA states that it is good governance and good practice for a plan sponsor to develop such a policy.A number of advantages come with developing a funding policy: The exercise of developing a funding policy may lead to more robust governance; It may increase the plan sponsor's discipline around funding decisions and result in more predictability in funding; Transparency of funding decisions may be increased; and A funding policy may also provide guidance to the plan's actuary when selecting actuarial methods and assumptions. CAPSA believes that addressing the following 11 elements constitutes best practice when establishing a funding policy. Other issues may also be relevant, depending on the specifics of the plan.Plan overviewThe funding policy should include an overview of the features of the plan, related financial information and characteristics of the plan sponsor.Funding objectivesThe funding policy should indicate how the funding objectives integrate with the plan's investment policy, as well as the plan sponsor or plan objectives. These objectives can be stated as they relate, for instance, to benefit security, stability of contributions and contribution or benefit levels. The policy could also document circumstances in which funding in excess of the legislated minimum would be considered.Key risks faced by the planThe funding policy should describe the key risks that are faced by the plan from the perspectives of various stakeholders. These risks can include the extent to which the plan's assets are mismatched against its liabilities and the demographic characteristics of the plan beneficiaries. Due consideration should be given to how these risks may affect the security of beneficiaries' benefits.Funding volatility factors and management of riskThe funding policy should document the structure of the plan's liabilities as it affects funding risk. It should describe the plan's tolerance for volatility in funding requirements. The policy should also take into account the characteristics of the plan's liabilities and the link of the plan's liabilities to the performance of the plan assets. The policy could include any scenario testing practices that are used as a tool to evaluate the effect of different hypothetical situations on the plan's funding position and requirements. Details on scenario testing practices could include the frequency, the timeline for projections and the specific risks that are being evaluated.Funding target rangesThe funding policy should describe any funding targets, contribution target levels and established cost-sharing arrangements (if they are relevant to the plan's structure). Funding targets can be expressed in relation to liabilities for a going concern, solvency, winding up or some other measure, depending on the plan's funding objectives. The funding policy can also describe any mechanisms that would allow flexibility in funding and accommodate potential short-term operational requirements.Cost-sharing mechanismsIf relevant, the funding policy could include considerations for cost-sharing mechanisms between plan beneficiaries and the employer. This could include establishing total target contribution levels and determining the extent to which costs will be shared between both parties.Utilisation of funding excessWhile utilisation of funding excess is subject to the terms of applicable plan documents and legislative requirements, the funding policy should describe the plan sponsor's policy on using funding excess for an ongoing entity and, if appropriate, could cover its use in the event of plan termination. If funding excess can be used for contribution holidays or benefit improvements, the policy should establish the factors that may be considered in deciding how and when to use the funding excess. This includes any desired margins that the plan sponsor wishes to keep before using the funding excess.Actuarial methods, assumptions and reportingThe plan sponsor can provide useful guidance to the plan actuary in selecting actuarial methods and assumptions that are appropriate for the plan sponsor's risk management approach. This guidance can include the going concern actuarial cost method, desired margins or provision for adverse deviations and acceptable asset valuation methods and ranges. The plan administrator would provide information on, among other things, data, investments and historical experience to assist the actuary in developing these assumptions. This combined input would normally be reflected in the actuary's selection of methods and assumptions – in particular, the margins for adverse deviations – provided they do not lead to assumptions that deviate from accepted actuarial practice.The actuary's report would normally outline the range of contributions that are permitted. This includes the minimum contributions that are required under applicable pension standards legislation and the maximum contributions that are permitted under tax statutes. As a result, the plan sponsor would need to make additional decisions on funding that could be guided by the plan's funding policy.Frequency of valuationsThe plan sponsor may establish standards for the frequency of valuations, subject to any legislative requirements. These are useful for internal monitoring purposes and for the production of reports that are filed with regulators.MonitoringManagement and implementation issues around the establishment and ongoing maintenance of the funding policy should be documented, including the circumstances or events that should trigger a review or amendment of the policy. This includes documenting the roles, responsibilities and oversight of the funding policy, as well as the frequency of review.Communication policySharing funding information is strongly encouraged. The plan sponsor or plan administrator should consider what information would be available, as well as when and to whom. Proving a summary of the plan's funding policy to plan beneficiaries can help them to understand a number of factors affecting their pension plans. These can include factors that affect the security of beneficiaries' benefits and the variability of funding costs, as well as the risks that are faced by both their pension plan and others. In addition, it can help plan beneficiaries appreciate the funding decisions that are made by their plan sponsor or plan administrator. In communicating information on the funding policy to plan beneficiaries, it is understood that the plan sponsor will not communicate information that is counter to its commercial interests.Further considerations for multi-employer pension plansAlthough the elements listed above apply to all defined benefit pension plans, special considerations apply to multi-employer pension plans (MEPPs). The guideline states that the funding policy for a MEPP should describe the approach used to set benefit levels and describe issues relating to the use of fixed contributions. These issues could include how the plan's financial position affects benefit levels and in what manner benefit levels may be adjusted. These plans should also document the respective decision-making roles of trustees, employers, and collective bargaining agents. The issues of how to apply an even-handed treatment of beneficiaries (both the current and future generations) and the policy on benefit reductions or restructuring should also be discussed.For further information on this topic please contact Mark Newton at Heenan Blaikie LLP by telephone (+1 416 360 6336), fax (+1 416 360 8425) or email ([email protected]).