Background
Proposed framework
Regulatory Response Model
Risk universe and risk indicators
Regulatory powers and tools
Data sources
Business processes for quality control and framework maintenance
Medium-term strategy
Comment
On September 21 2011 the Financial Services Commission of Ontario (FSCO) released its Risk-Based Regulation Framework Document.(1) The document describes a broad-based framework for the risk-based regulation of pension plans in Ontario. This represents an enhanced form of risk monitoring by the FSCO. Pension plan sponsors and administrators with pension plans registered in Ontario should review the FSCO framework. It may be prudent in appropriate cases for pension plan governing bodies to adjust pension plan governance policies, procedures and objectives to better match the FSCO's risk-based supervisory model.
The trend towards risk-based regulation in Ontario mirrors what is being done in other jurisdictions as regulators recognise that pure compliance approaches are limited. Based on key recommendations from a report of the Ontario Expert Commission on Pensions,(2) as well as its own assessments, the FSCO is taking steps to establish monitoring programmes that will be proactive in identifying plans that may be at risk of failure or severe under-funding.
The proposed framework will consider a broad universe of risk factors in areas such as administration, governance and sponsor-related risks. The goal is that the framework will provide a base level of regulation across all pension plans, which will include:
- monitoring of key risk indicators;
- improved dialogue with stakeholders; and
- promotion of best practices.
Above this base-level monitoring, the framework will focus FSCO resources on pension plans that exhibit the greatest amount of risk.
The framework consists of five components. At its core is the Regulatory Response Model, which describes the application of risk-based supervision and proportionate responses based on risk. The response model is informed by four other components:
- risk indicators;
- regulatory powers;
- available and potential data sources; and
- proposed business processes for quality control and framework maintenance.
At the core of the framework lies the Regulatory Response Model. This model proposes to prioritise regulatory work according to the probability and impact of risk in each plan or transaction.
Following a detailed review, plans will be classified into one of four risk quadrants, which act as an internal guide for the effective allocation of staff resources and the regulatory actions taken by the FSCO.
Intervention
Plans showing both a high probability and a high impact of risk will be categorised in the 'intervention' quadrant, thereby attracting the highest level of intervention from the FSCO. Examples of events giving rise to such categorisation include:
- failure to remit contributions over an extended period of time;
- chronic and significant underfunding;
- significant member complaints; and
- plans with significant sponsor risk.
The framework proposes that if a plan or transaction is categorised as needing intervention, the FSCO will commence regular interactions with plan administrators – including site examinations – so as to mitigate risk through proactive measures. In severe cases the FSCO will take action or commence legal proceedings pursuant to the Ontario Pension Benefits Act.
Proactive supervision
Plans showing high impact risk but low probability risk will be classified as needing 'proactive supervision'. The FSCO framework document suggests that very large plans may fall into this category due to the potential for adverse impact on a large number of members. Plans classified in this category will be subject to ongoing monitoring by the FSCO, including periodic management reporting, ongoing media monitoring and possible interactions with the plan.
Monitor
Plans showing low impact risk but high probability (ie, frequency) risk will be classified in the 'monitor' quadrant. Plans fitting into this quadrant will be both small plans with clear risk indicators (eg, solvency issues) and large plans where the immediate issue is not a large impact (eg, consistently late filings). In response to 'monitor' plans, the FSCO proposes to monitor and flag the plans if identified risks persist. In such circumstances an enhanced review or communication with the plan administrator may follow.
Educate
Plans with both a low impact and probability of risk will be classified in the 'educate' quadrant. This category will generally include plans – other than very large plans – with little or no risk indicators. For these plans, the FSCO proposes simply to provide general education to plan administrators, as well as guidance notes and best practices.
Risk universe and risk indicators
The risk universe categories are meant to capture the risks inherent in pension plans. From these, risk indicators will be developed and tracked for all plans. The risk universe includes the following categories:
- funding risk – shortfalls in plan funding;
- investment risk – exposure to changes in the value of plan assets, especially:
- market risk (exposure to changes in market price);
- matching risk (mismatch between assets and liabilities); and
- credit risk (counterparty failing to meet obligations);
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- administration risk – inefficient or insufficiently effective processes or organisation in the administration of the plan;
- governance risk – lack of or poor governance practices; and
- sponsor/industry risk – sponsor insolvency or potential adverse financial impact due to industry-wide events.
The framework proposes to develop risk indicators that are consistent with the risk universe, but can also be quantified and measured using risk-based metrics. This will allow the Risk Indicator Tool to provide an initial preliminary assessment within the Regulatory Response Model. The tool will highlight potential key risk areas for further analysis and prioritise the FSCO's resources.
The FSCO's plan is initially to implement the Risk Indicator Tool using information currently available, but over time the tool will be expanded and refined to identify measures that accurately and most effectively identify high-risk plans.
Based on the results of the tool, the framework contemplates that detailed risk assessments will be performed on plans identified as needing further attention. These detailed assessments are expected to provide a full evaluation of the risks faced by a pension plan. In addition, the detailed risk assessment will classify the pension plan into one of the four risk quadrants referred to above, which will then guide the FSCO's regulatory action – if any.
Any material concerns arising from the detailed risk assessment will be communicated to plan administrators, and possibly other stakeholders, in an effort to commence a constructive dialogue that will resolve any risk concerns.
The framework document clarifies that while traditional regulatory tools are set out in legislation, it is always open to regulators to try to influence behaviour through moral suasion (eg, stakeholder communications, educational materials and guidance on industry best practices). Nonetheless, the framework is designed to be consistent with the powers of the FSCO under the Ontario Pension Benefits Act.
The regulatory powers and tools listed in the framework are meant to include a spectrum of education, monitoring and deterrence initiatives. Education activities include hosting conferences and publishing best practice guidelines and FSCO studies. As part of its monitoring tools, the framework suggests the use of external audits, review of periodic filings and desk reviews with follow-up. In the most severe situations the framework proposes FSCO investigations combined with regulatory orders or prosecution and litigation to stop plans and their administrators from breaches of the Ontario Pension Benefits Act.
In addition to the tools and regulatory powers currently available to the FSCO, the framework proposes the adoption of several new tools prevalent in other jurisdictions. Suggested changes include:
- increasing plan and transaction reporting requirements;
- allowing the FSCO to issue governance and risk management reviews by external auditors; and
- giving the FSCO the ability to issue administrative penalties.
These and other changes would require legislative changes.
The framework proposes three types of data source that can be enhanced to implement risk-based regulation, as follows:
- existing data that can be used in an enhanced manner – complaint information (categorised by severity), unremitted contributions, late filings and applications, examinations (particularly for information on administration and governance) and audit reports;
- new data to be collected in the absence of legislative change –
- industry sponsor intelligence – an intelligence process would be established to monitor both industry risks (eg, forward-looking reports on industry, backward-looking reports on industry-specific insolvency rates) and sponsor risks (ie, focus on sponsors identified as high risk and monitor news alerts and credit ratings of those sponsors);
- external scans and monitoring of emerging trends and risks – this would include ongoing interactions with industry, participation in forums and communications with peer regulators and scanning external information and reports; and
- additional data concerning plans and service providers – the FSCO would require information on who provides the plans with investment and actuarial services; and
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- potential new data following legislative change –
- notifiable events – predefined events requiring reporting by plan administrators (eg, breaches of bank covenants, senior management convictions and sponsors moving outside the jurisdiction);
- whistleblower reports – reports of legislative breaches made by sponsors, administrators or plan advisers;
- governance and risk management information – details of pension plans' governance arrangement; and
- other information – related party transactions, conflicts of interest and investment holdings outside quantitative limits.
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Business processes for quality control and framework maintenance
The key component proposed by the framework is the Risk Indicator Tool. The tool will act as a trigger mechanism to identify and prioritise plans according to risk scores calculated using the risk indicators discussed above. The tool will be automated and, to the extent possible, will provide real-time priority risk calculations that will direct FSCO resources to plans needing Tier 1 and Tier 2 reviews. The tool is meant to provide a baseline review and ongoing monitoring of all plans.
Based on the priority list from the Risk Indicator Tool, a Tier 1 review will be conducted both to validate the results from the tool and to provide a preliminary report as to the plan's exposure to risk. At this point, the plan will be assigned to one of the four risk quadrants and guide FSCO staff as to their regulatory response.
If the plan is categorised in the 'intervention' quadrant, it will become the subject of a Tier 2 review. This review will include a detailed assessment to confirm the risk classification. If the risk classification is confirmed, the plan will become case managed by a dedicated team of FSCO staff. The role of this team will be to conduct ongoing monitoring, which may include recommendations for specific orders from the superintendent, periodic and random risk assessments and other interactions with plan administrators.
Because the proposed framework is a dramatic change from the current way in which the FSCO regulates pension plans, it is expected that full implementation will take some time. However, the framework document proposes that over the next three years, the principal activities that the FSCO plans to carry out will be as follows:
- enhancing and streamlining existing risk-based processes –
- integrating the monitoring and review of funding and investment risks;
- introducing and implementing e-filings to facilitate collection of data;
- strengthening on-site examinations by identifying instances of poor governance; and
- promoting industry-wide knowledge and understanding of best practices;
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- enhancing stakeholders' understanding of the FSCO's risk-based approach through education and communication of the regulator's expectations –
- giving consultations during the period of transition which would include collaboration to develop a comprehensive risk-based approach, providing information about the new regulatory approach and communication with a broad public audience to ensure that the limits of the risk-based approach are understood; and
- providing ongoing education through periodic reports on the application of the risk-based approach, thematic reviews on areas of concern, developing guidelines in regards to plan governance and reaching out to more stakeholders through forums, conferences and the internet; and
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- establishing quality control and maintenance processes to ensure that the risk-based approach is being applied in a valid and reliable manner –
- measuring the effectiveness of risk indicators that contribute to the Risk Indicator Tool;
- revisiting and updating the framework with new or altered criteria and data sources;
- coordinating the identification of emerging or increasing risks; and
- liaising with relevant IT groups to ensure that the system is appropriately supported by technology.
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Plan sponsors and administrators should review their governance framework to determine whether it is consistent with the FSCO's approach. The questions that a sponsor or administrator with a pension plan registered in Ontario should ask are whether the types of risk identified by the FSCO are being properly monitored and what steps are anticipated to mitigate risk in cases where material risks are identified.
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]).
Endnotes
(1) http://www.fsco.gov.on.ca/en/pensions/fsco_consultations/Documents/Framework_Final.pdf.
(2) http://www.fin.gov.on.ca/en/consultations/pension/report/Pensions_Report_Eng_web.pdf.