RPA 1—Managing Retirement Plans Part 1 Module 8 PDF

RPA 1—Managing Retirement Plans Part 1 Module 8 Managing Retirement Plan Assets Instructor notes designed by Jeff Billard, CEBS Scope These instructor notes cover: Text - Chapter 7, pp. 185-216 Reading A - Text Commentary, Study Guide Module 8, pp. 31-38 Reading B - Guideline for the Development of...

RPA 1—Managing Retirement Plans Part 1 Module 8 Managing Retirement Plan Assets Instructor notes designed by Jeff Billard, CEBS Scope These instructor notes cover: Text - Chapter 7, pp. 185-216 Reading A - Text Commentary, Study Guide Module 8, pp. 31-38 Reading B - Guideline for the Development of Investment Policies and Procedures for Federally Regulated Pension Plans, Study Guide Module 8, pp. 39-62 Reading C - CAPSA Guideline No. 3, Guidelines for Capital Accumulation Plans (CAP Guidelines), Section 2.2, Investment Options, Study Guide Module 5, pp. 42-43 Reading D - CAPSA Guideline No. 8, Defined Contribution Pension Plans Guideline, Section 2.6, Responsibilities of the Members; Section 3.0, Information for Members During Accumulation Phase; and Section 3.1, Information Regarding Investment Options, Study Guide Module 6, pp. 36-37 Module 8 Learning Outcomes Upon completion of this module you should be able to: explain requirements of pension standards legislation to Canadian pension plans in the area of investments describe considerations and actions plan sponsors must undertake in the development of a statement of investment policies and procedures (SIPP) identify governance activities needed in respect of the investment of pension and nonpension retirement plans when a SIPP is not required explain the fund manager selection, monitoring and termination process outline types of investments that traditionally have been available to and utilized by pension funds in Canada describe types of investment risks related to pension plan investments and approaches used to manage those risks, including alternative types of investments. Managing Retirement Plan Assets This module will cover investment management and will conclude our discussion on pension plan governance. It will provide an overview of investment management; however, this is a much broader topic that will be covered in more detail in RPA 2, which focuses on plan asset management in detail. Page 1 of 8 RPA 1—Managing Retirement Plans Part 1 Module 8 Managing Retirement Plan Assets Pension standards legislation regarding investments Statement of investment policies and procedures (SIP&P) The Statement of Investment Policies and Procedures states the investment objectives, discloses what the plan will invest in, describes the process for selecting, monitoring and terminating investment managers, explains how it will measure performance and states what risks are acceptable. Office of the Superintendent of Financial Institutions (OSFI) guidelines OFSI issued guidelines regarding the content requirements of the SIP&P. The guidelines, which specifically address federally regulated pension plans, also provide the standards of good practice for provincially regulated plans and are consistent with the statutory requirement for pension plan administrators to maintain a high standard of care for its plan members. Application of the legislation to plan types All DB pension plans are required to have a Statement of Investment Policies and Procedures that defines governance and accountability and provides disclosure and continuity for stakeholders. Administrator-directed DC pension plans are expected to follow the required and recommended disclosures as per the guidelines and federal legislation; whereas, memberdirected DC pension plans outside of Ontario do not require a SIP&P. In Ontario, it must also disclose whether environmental, social and governance factors are incorporated into the investment policies and procedures, and if so how they are incorporated. Required content OSFI’s Guideline for the Development of Investment Policies and Procedures for Federally Regulated Pension Plans suggests that SIP&Ps should: identify responsibilities and accountabilities of the board, prominent subcommittees and external service providers set out the process for approving and implementing decisions enunciate relevant investment risks, how they are measured and how they are managed determine the frequency and format of reporting and performance measures identify policies and procedures to protect the plan assets from conflicts of interest address borrowing and pledging of assets A SIP&P for a DB pension plan is required to disclose: Page 2 of 8 RPA 1—Managing Retirement Plans Part 1 Module 8 Managing Retirement Plan Assets categories of investments and loans, including derivatives, options and futures diversification of the investment portfolio asset mix and rate of return expectations liquidity of investments lending of cash and securities retention or delegation of voting rights acquired through plan investments the method of, and basis for, the valuation of investments not regularly traded at a marketplace related-party transactions and the criteria to be used to establish whether a transaction is nominal or immaterial to the plan Ontario-registered DC plans are subject to the federal PBSA regulations and Ontario has identified their expectation that the SIP&P be prepared in accordance with the plan administrator’s required standard of care. Recommended plan sponsor considerations A DB pension plan administrator should consider these factors when preparing a SIP&P: current investments in place rate of future contributions amount and structure of current and accruing liabilities how liabilities and investments being contemplated would respond to plausible economic events financial situation of the plan tolerance for risk maturity of the pension plan estimated cash flow requirements financial risks the plan sponsor may face regarding funding the pension plan Review, approval and filing of SIP&Ps All SIP&Ps, once established, must be reviewed and either confirmed or amended by the plan administrator at least once each plan year. Ontario-registered pension plans are also required to file an initial SIP&P and any amendments with the Ontario pension regulator. Investment risk Some of the key risks inherent in investments are: credit risk, where a counterparty will not pay an amount due as called for in the original agreement and may eventually default on an obligation Page 3 of 8 RPA 1—Managing Retirement Plans Part 1 Module 8 Managing Retirement Plan Assets mismatch risk, which occurs when a solvency deficiency develops because an increase or decrease in the market value of the plan assets is not matched by a corresponding increase or decrease in liabilities currency risk, in which the market value of a financial instrument will fluctuate due to changes in exchange rates price risk, when the market value of an investment or of a financial instrument based on investments will fluctuate interest rate risk, where the market value of a security fluctuates due to changes in market interest rates other risks, including inflation risk, timing risk and political risk in emerging markets Plan sponsor activities regarding SIP&Ps Conflicts of interest Investments of a pension plan must comply with the investment rules under the pension legislation and the rules of the CRA. Although the Federal legislation and many of the provinces provide specific standards of care, fiduciary requirements exist whether or not there is relevant pension legislation that explicitly states it applies. The “prudent person rule” requires a person to exercise the care, diligence, and skill in the investment of a fund that a person of ordinary prudence would exercise in dealing with the property of another person. The “prudent portfolio rule” relates to the overall reasonable level of risk the plan could undertake, as a whole, and the appropriate level of diversification of the entire fund. There are many conflicts that can arise within the investment function. A plan administrator may manage conflicts of interest by establishing a written policy on conflicts of interest, based on CAPSA recommendations. A review process should be established, as well as a procedure to disclose and address conflicts of interest, and a policy should be in place that addresses both actual and perceived conflicts. Manager selection and monitoring To implement the Investment Policy, a search is conducted to find a suitable investment manager with the essential attributes, such as expertise in a specific asset class. The process starts by determining the manager structure and then identifying the essential attributes to build a “long list” of potential candidates. The list is narrowed down by conducting detailed quantitative and qualitative analysis of the long-listed candidates. The candidates identified on the short list are then interviewed to select the successful manager. Since past performance is not indicative of future performance, performance alone should not be the criteria used to select an investment manager. However, once a manager is selected, the Page 4 of 8 RPA 1—Managing Retirement Plans Part 1 Module 8 Managing Retirement Plan Assets plan administrator has a fiduciary responsibility to monitor and assess performance. Peer assessments are a common method of assessing manager performance. In some cases, the responsibility for monitoring, evaluating, and reporting on the investment program’s performance, relative to policy and benchmarks, is delegated to an independent third party that reports back to the board. Monitoring and Termination of Investment Manager Since the Statement of Investment Policy is considered the roadmap for the investment process, it should be reviewed at least annually to ensure that it is still appropriate. It is also important for the Plan Administrator to regularly review the investment manager’s performance and activities to ensure acceptable performance levels and adherence to the Investment Policy. If a fund manager underperforms for a period of time, the typical process for addressing is the following: 1. Put the investment manager “on watch” 2. After a defined period, if underperformance persists, a series of reviews are triggered: a. A review of the portfolio’s mandate b. A review of the appropriate benchmark c. A review of the manager’s compatibility with the fund’s objectives d. An attribution review of where the manager is adding or subtracting value 3. A complete reassessment of the manager’s structure, decision making and personnel 4. Termination and begin the search for a replacement manager Alpha and beta Alpha is the return in excess of that which is attributable to the broad markets. In other words, it is the component of return due to the investment manager’s skill and strategy. Beta is the return of the portfolio due to exposure to the broad market. The theory is that there should be little cost for beta but investors should be willing to pay well for alpha. There are, however, opposing views. Some who believe in the efficient market hypothesis will argue that manager skill cannot generate additional returns, whereas believers in inefficient markets argue that due to irrational behaviour additional returns can be generated by skillful managers. Financial engineering is able to separate alpha from beta. Proponents of the separation cite potential benefits of performance, risk management and cost reduction. It also provides a clear delineation for governance purposes. Page 5 of 8 RPA 1—Managing Retirement Plans Part 1 Module 8 Managing Retirement Plan Assets Overview of traditional types of investments Bonds Bonds are debt (not ownership) instruments that return a maturity value (the principal) after a fixed period of time and frequently pay semi-annual interest payments called coupons. Convertible bonds are another type of debt instrument in which the holder is permitted to convert the bonds to common stock on certain specified terms. Stocks Common shares provide an ownership interest in the company; whereas preferred shares provide a preferential ownership interest in a company. Dividends are usually paid on preferred shares which makes them somewhat similar to fixed income instruments. Any dividends paid must be paid to preferred shareholders ahead of dividends paid on common shares. Mortgages Mortgages are debt instruments secured by specific real property and provide repayments that are a blend of principal and interest. Real estate This includes land and everything affixed that cannot be moved. Pension funds can make direct equity investments in commercial real estate projects or in a pool of real estate investments known as a “real estate investment trust.” Here is a short video that describes the risk associated with the different asset classes: https://www.youtube.com/watch?v=pMB-EnUJ_iE Ways to hold investments Plans can either hold investments directly or utilize pooled funds. Pooled funds own units in a pool but do not own the underlying securities (which may be common shares, bonds, or a diversified combination of securities). Individually managed funds purchase and own a portfolio of securities directly. Balanced or specialist approaches Larger plans are able to employ more than one manager to implement a balanced approach and they may achieve overall diversification by allocating different classes of investment to a number of specialist managers. For example, they can achieve this by assigning one manager Page 6 of 8 RPA 1—Managing Retirement Plans Part 1 Module 8 Managing Retirement Plan Assets to specialize in Canadian equities, one to specialize in foreign equities, and another one to specialize in fixed income investments. Passive or active management Passive management usually involves holding the securities that make up a market index, in the same weights as the index, in order to achieve market returns. Active management involves buying and selling a selected group of securities to achieve a higher return than what could have been achieved through passive management. Overview of alternative investments/investment approaches This video provides an overview of alternative investments. Alternative investment types Alternative investments may include: private equity – commonly venture capital and buyout with investments through limited partnerships, co-investment and direct investment hedge funds – four categories (equity hedge funds, event driven funds, macro funds and relative value funds) commodities – energy, agricultural, industrial metals, precious metals infrastructure – can include gas and water distribution networks, toll roads, pipelines, airports, power generation facilities, port facilities Benefits of alternative investments The benefits of alternative investments include: higher return potential better matching greater diversification The potential pitfalls and challenges include: difficulty with valuation and performance measurement concerns around the use of leverage emerging strategy risk should be acknowledged due to short histories and lack of robust data tend to be high cost assets there is less control there is limited regulation Page 7 of 8 RPA 1—Managing Retirement Plans Part 1 Module 8 Managing Retirement Plan Assets Liability-driven investing (LDI) LDIs are commonly used in the funding arrangements of defined benefit pension plans where the ultimate measurement of investment success is to meet all the future cash payments owed to plan members in retirement. Click here for a short video explaining liability-driven investing. Responsible investing (RI) Responsible investing integrates environmental, social and governance factors in the selection and management of investments. The narrow form involves positive and negative screens and community investment. The broad form of RI includes shareholder advocacy and the use of environmental, social and governance factors in the security analysis process. Research indicates that there is no statistically significant performance difference between RI mutual funds and conventional mutual funds, or between RI indices and traditional indices. Page 8 of 8