Module 1: Navigating the Investment Environment of Employer-Sponsored Retirement Plans

Question 1

Explain the broad impact of legislation on retirement plans.

Answer 1

Governments regulate retirement plans from two perspectives:

(1) The federal Income Tax Act (ITA) allows for tax deductions and tax deferrals related to retirement plans, up to specified limits.

(2) Pension standards legislation in most Canadian jurisdictions applies to defined benefit (DB) and defined contribution (DC) pension plans, with the major objectives of enhancing the security of pension plan benefits and ensuring the provision of certain benefits prescribed at minimum levels.

Question 2

Define retirement plan governance. Describe its purpose and scope.

Answer 2

Retirement plan governance refers to the structure and processes for overseeing, managing and administering a plan to ensure that the fiduciary and other obligations of the plan are met.

Effective governance establishes roles and responsibilities for the following key areas of plan management:

Administration and communication

Financial management

Investment management of fund assets.

Question 3

Outline principles of pension plan funding and the purpose of a DB pension plan funding policy. Identify factors that can be relevant in developing the funding policy.

Answer 3

Funding requirements promote benefit security. The goal of funding a DB single employer pension plan is to ensure that assets together with future contributions and amortization payments are sufficient to deliver the promised benefits on an ongoing basis and to protect pension benefits in situations that involve employer insolvency or bankruptcy.

The purpose of a funding policy is to establish a framework for funding the plan. The policy should support the decision-making process and be consistent with the purpose and goals of the pension plan and the plan sponsor.

When developing a funding policy, all factors relevant to the plan and plan sponsor should be taken into consideration, including:

(a) Benefit security and the extent to which that is communicated to plan members/ beneficiaries

(b) Level of benefits

(c) Stability and/or affordability of contributions

(d) The sponsor’s financial position and competing organizational demands for cash

(e) The desire to include a buffer for adverse experience and time frame over which the objective is achieved

(f) The minimum and desired funding ratio of the plan

(g) The demographic characteristics of those entitled to benefits under the plan

(h) The minimum funding requirements (going concern and solvency) under pension standards legislation

(i) The financial position of the pension plan

(j) The material risks impacting the plan’s funding requirements and the risk mitigation strategies

(k) The limits and requirements under the ITA

(l) The terms of the plan document and any related documents (e.g., collective bargaining agreement) between the plan sponsor and plan beneficiaries

(m) Legislative requirements and plan provisions relating to utilization of funding excess

(n) Frequency of preparation of actuarial valuations and strategy for statutory filings

(o) Strategy and process for dealing with reductions in accrued benefits under target pension arrangements (TPAs)

(p) Tax planning and impact on plan sponsor’s financial statements.

Question 4

Outline the advantages of developing a funding policy identified in CAPSA Guideline No. 7, Pension Plan Funding Policy Guideline.

Answer 4

Advantages of developing a funding policy include:

(a) Improvement of the identification, understanding and management of the risk factors that affect the variability of funding requirements and the security of benefits. Undertaking this exercise should lead to more robust governance.

(b) A potential increase in the plan sponsor’s discipline around funding decisions. This could contribute to more predictability in funding.

(c) Improvement of the transparency of funding decisions and increased understanding by the plan beneficiaries of pension funding issues

(d) Provision of guidance to the pension plan’s actuary when selecting actuarial methods and assumptions in accordance with actuarial standards of practice and within the pension plan’s risk tolerance limits.

Question 5

Describe the special considerations that apply when developing a funding policy for pension plans that are target pension arrangements (TPAs) as identified in CAPSA Guideline No. 7, Pension Plan Funding Policy Guideline.

Answer 5

For many TPAs, future or accrued benefits may be adjusted depending on the financial status and the contribution requirements of the plan. As such, it would be expected that most TPAs would have formal benefit adjustment provisions or policies and that there is a strong linkage between the funding and benefits policies. For plans where both contributions and benefits may be adjusted based on the financial position of the plan (and the associated interaction and priority between contribution and benefit adjustment policies), it may make sense for the funding and benefits policies to be in a combined document. In either case, the funding policy should reflect the key features of the benefits adjustment policy.

For TPAs, benefit levels will typically need to be adjusted to reflect the funding level of the plan. Volatility in the plan’s financial position can translate into fluctuating benefit levels. As a result, stronger ties must be established between the funding policy and the benefits policy and how these are communicated to plan beneficiaries.

For TPAs, there may be situations where responsibilities are shared between different plan stakeholders, and the funding policy might be covered by more than one document. The funding policy should clearly define the roles the plan sponsor and plan administrator have in its establishment and implementation.

In the particular case of a MEPP, the plan administrator would typically be responsible for the adoption of the funding policy. In the discussion of other elements of the funding policy for a MEPP, any role that is assumed by the plan sponsor would be assumed by the plan administrator. However, the development of the funding policy for a MEPP would recognize that the administrator does not control the level of contributions made to the plan.

Question 5

Outline the key elements of a DB pension plan funding policy identified in CAPSA Guideline No. 7, Pension Plan Funding Policy Guideline.

Answer 5

The following elements are considered “best practice” issues to take into account when establishing a funding policy. Ideally, the policy would address how each issue relates specifically to the plan.

(a) An overview of the plan, including plan type, governance structure, plan provisions, plan demographic profile, related financial information and relevant plan sponsor characteristics

(b) How the funding objectives integrate with the plan’s investment policy and plan sponsor or plan objectives

(c) Key risks faced by the plan from the perspectives of various plan stakeholders, including how those risks can affect the security of beneficiaries’ benefits

(d) The risk appetite of the plan stakeholders

(e) The structure and characteristics of the plan’s liabilities as they relate to the plan’s tolerance for volatility in funding status, including how key plan risks lead to funded status volatility as well as what mitigation plans and tools are available. Scenario testing tools to evaluate the impact of hypothetical situations upon funding requirements could be included.

(f) Funding targets, contribution target levels, benefit level targets, and established cost-sharing arrangements (if applicable) expressed in relation to measures specific to the plan’s funding objectives

(g) Cost-sharing mechanisms between plan beneficiaries and the employer

(h) The plan sponsor’s policy on using funding excess for an ongoing plan and in the event of a plan termination, including any desired margins to be maintained before funding excess can be used

(i) Guidance for the plan’s actuary in selecting actuarial methods and assumptions that are appropriate for the risk management approach of the plan. This guidance can include the going concern cost method, desired margins or provision for adverse deviations, and acceptable asset valuation methods and ranges. This information can be used by the actuary in selecting methods and assumptions for the plan.

(j) Standards for valuation frequency

(k) Documentation of roles, responsibilities and oversight for the funding policy, including circumstances that would trigger a review or amendment of the policy

(l) A plan for communication of the funding policy to plan beneficiaries.

Question 6

Describe an employer’s responsibilities as identified in CAPSA Guideline No. 5, Guideline on Fund Holder Arrangements.

Answer 6

The employer is responsible for remitting contributions to the pension fund within the time periods and in the amounts required by applicable pension legislation, the terms of the pension plan and the relevant terms of any collective agreements. By fulfilling this obligation, the employer meets its funding obligation and helps ensure that the pension fund’s assets are held separate and apart from its own assets. The employer is responsible for keeping accurate, up-to-date records on each plan member’s length of service and earnings as well as any other information the administrator requires and providing all of this information to the administrator in a timely manner.

Question 7

Describe the plan sponsor’s responsibilities as identified in CAPSA Guideline No. 5, Guideline on Fund Holder Arrangements.

Answer 7

The plan sponsor is responsible for establishing the pension plan and ensuring that it always has an administrator. The plan sponsor is responsible for making amendments to the pension plan and deciding if it should be wound up. If the pension plan is wound up, the administrator is responsible for ensuring that it is wound up in accordance with the requirements of the applicable pension legislation and pension plan documents.

Question 8

Describe the administrator’s responsibilities as identified in CAPSA Guideline No. 5, Guideline on Fund Holder Arrangements.

Answer 8

The administrator is responsible for the overall administration of the pension plan and the administration and investment of the pension fund. One of the administrator’s primary duties is to select one or more fund holders to manage the pension fund and to ensure that the pension plan and pension fund are administered and invested in accordance with applicable pension legislation, ITA and pension plan documents.

Question 9

Describe a fund holder’s responsibilities as identified in CAPSA Guideline No. 5, Guideline on Fund Holder Arrangements.

Answer 9

The fund holder is the financial institution or party that is retained by the administrator to hold all or part of the pension fund’s assets exclusively for the pension plan. Fund holders are responsible for:

(a) Holding funds in a manner that meets the requirements of pension standards legislation and ITA

(b) Acting under the terms of a fund holder agreement that meets the requirements of pension standards legislation

(c) Where required, reporting omissions or delays in contribution remittances to the applicable pension regulator

(d) Meeting the responsibilities for reporting and recordkeeping that are set out in the fund holder agreement

(e) Acting on direction from the administrator, or its delegate, in accordance with the applicable legislation and the pension plan’s statement of investment policies and procedures (SIPP)

(f) Ensuring that the pension fund’s assets are kept separate and apart from the employer’s and fund holder’s assets

(g) Ensuring that the pension fund’s assets are held exclusively for the pension plan and that the fund holder has clear, accurate and up-to-date records reflecting this requirement.

Question 10

Identify requirements under pension legislation and ITA regarding who can be the fund holder of a pension plan.

Answer 10

Pension legislation and ITA dictate that the pension fund must be held in the name of the pension plan by one of the following:

(a) An insurance company licensed to do business in Canada under an insurance contract

(b) A trust—that is governed by a written trust agreement—with a trust corporation in Canada

(c) A group of individual trustees where:

There are three or more individuals
At least three of these trustees reside in Canada
At least one trustee is not a connected person, a partner of the employer or a proprietor of the employer’s business (this type of fund holder must have a custodian to hold the pension fund’s assets)
(d) Any other party that is permitted by pension legislation.

Question 11

In the context of pension plan assets, define the term “custodian,” describe its responsibilities and outline the relationships that can exist between custodians and fund holders as identified in CAPSA Guideline No. 5, Guideline on Fund Holder Arrangements.

Answer 11

Pension legislation requires that the pension fund be held separate and apart from the employer’s and fund holder’s assets and be in the name of the pension plan.

A “custodian” is a financial institution that holds some or all the pension fund’s assets pursuant to an agreement with the plan’s fund holder. Although the custodian is not a fund holder, the fund holder may also be a custodian.

The custodian’s responsibilities are generally solely related to the safekeeping and servicing of the pension fund’s assets. The custodian is responsible for holding these assets in accordance with the terms of the custodial agreement and must be capable of segregating the pension plan’s assets as well as meeting the reporting and recordkeeping requirements of the custodial agreement. A custodian does not have legal title to the assets and does not have tax-reporting obligations. The custodian is retained through a contract and owes duties only to the party that retained its services.

Question 12

Outline some of the reasons a pension plan may utilize more than one fund holder as identified in CAPSA Guideline No. 5, Guideline on Fund Holder Arrangements.

Answer 12

Pension plans may utilize more than one fund holder for any of the following reasons:

(a) The plan may provide benefits under both DB and DC provisions and engage a different fund holder for each provision.

(b) There may have been a merger of pension plans, each with its own fund holder.

(c) The plan may be large and complex, requiring more than a single fund holder to meet its investment needs.

Question 13

Outline the five key steps in the DB pension plan investment cycle.

Answer 13

The five key steps in the DB pension plan investment cycle are:

(1) Set investment objectives and constraints

(2) Determine long-term investment strategy

(3) Determine investment manager structure and roles

(4) Select investment managers

(5) Monitor investment results against objectives.

Question 14

Outline the five key steps in the capital accumulation plan (CAP) investment cycle.

Answer 14

The five key steps in the CAP investment cycle are:

(1) Set investment objectives and constraints

(2) Determine service provider structure and select provider(s)

(3) Select specific investment alternatives

(4) Provide investment information to members

(5) Monitor investment results against objectives.

Question 15

Describe the key differences between the DB pension plan investment cycle and the CAP investment cycle.

Answer 15

The key differences between the DB pension plan investment cycle and the CAP investment cycle are that:

(a) In a DB pension plan, the plan sponsor is aiming for full funding of the plan, while in a CAP, the plan sponsor is aiming to meet its responsibilities as a CAP sponsor by providing plan members with appropriate investment options.

(b) In a DB pension plan, the governance committee makes decisions regarding asset mix and specific investment options, while in a CAP, the governance committee makes decisions regarding investment options for the plan as a whole, and individual plan members decide on their own personal asset mix.

(c) In a DB pension plan, education requirements relate to benefit provisions under the plan, while in a CAP, additional education requirements exist that relate to the investment decision process.

Question 16

Outline information regarding rights and responsibilities of CAP members that the Guidelines for Capital Accumulation Plans (CAP Guidelines) recommend be provided by plan sponsors.

Answer 16

CAP Guidelines recommend that the CAP sponsor provide CAP members with information regarding their rights and responsibilities, including:

(a) Members’ right to access information about the nature and features of the plan

(b) Members’ right to request paper copies of their member statements if the statement is normally provided in another format

(c) Members’ responsibility for making investment decisions and that those decisions will affect the amount of money accumulated in the plan

(d) Members’ responsibility for informing themselves about the plan, using the documents, information, and tools available to them

(e) Recommendation that members ought to obtain investment advice from an appropriately qualified individual in addition to using any information or tools the CAP sponsor may provide.

Question 17

Outline the key policy areas that influence the overall financial performance of a DB pension plan, the net assets available for benefits and accrued pension benefits as well as whether the plan is in a funding excess or funding deficiency position at the end of any given fiscal year.

Answer 17

The overall financial performance of a DB pension plan can be seen by identifying the relationship between the plan obligations (i.e., accrued benefits) and the assets available in the pension fund to support those obligations. The relationship will show whether the plan is in a funding surplus or funding deficiency position at the end of any given fiscal year. All the components of the plan’s overall financial performance are impacted by decisions and/or performance in three key policy areas:

(1) Benefits policy—Level and types of benefit entitlements of active members and retirees

(2) Funding policy—Nature and timing of contributions

(3) Investment policy—Mix of investment vehicles and risk exposure of the plan.

Question 18

Explain why it is critical to coordinate the benefits, funding and investment policies of a DB pension plan.

Answer 18

It is critical to coordinate these policies so that the total financial performance of the plan can be managed toward the specific objectives set by the plan sponsor and once set, monitored to ensure that the policies are consistent with the objectives. While objectives vary by plan sponsor, they typically include target funding levels, level and volatility of pension expense, and level and volatility of cash contributions. Changing economic conditions and business needs may trigger the need to refine objectives or modify policies.

Question 19

Explain the importance of investment returns to a DB pension plan.

Answer 19

Investment returns can significantly contribute to the asset level of a pension fund and, as a result, the management of the pension fund becomes a key part of the DB pension plan governance process.

This is because the plan governance process for a DB plan (and MEPPs and TBPs) includes decisions made to maintain or attain a fully funded position over the long run. In a single employer DB plan, the plan sponsor holds the responsibility that plan assets are sufficient to cover the cost of future pension payments for all members. As a result, the existence of funding excesses or shortfalls affects plan sponsor decisions. In MEPPs and TBPs, the responsibility for ensuring full funding over the long term is jointly held by plan sponsors and plan members, and the existence of funding excesses or shortfalls also calls for decisions within the plan governance process.

Question 20

Describe how pension funds participate in Canadian financial markets and the roles that they may play as investors.

Answer 20

Pension funds are institutional investors and are recognized as major participants in financial markets. As such, a pension fund’s role may be:

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As a shareholder: Pension funds hold corporate shares directly.

As a bondholder: Pension funds typically hold significant amounts of debt securities.

As a unitholder: Pension funds often invest in investment corporations and mutual funds through the purchase of units.

As a limited partner in a private investment: For example, some private equity investments are made by a general partner who manages the investment and a group of several limited partners that include pension funds.

Question 21

Outline how pension funds can exercise shareholder rights if the pension fund owns corporate shares acquired through an intermediary (e.g., by investing in a pooled fund such as a mutual fund.)

Answer 21

When a pension fund participates in a pooled fund such as a mutual fund, the fund manager holds and manages the portfolio according to the fund’s specific investment objectives. The ultimate beneficiary of shares held by the mutual fund (the “beneficial owner”) is the pension fund, and dividends and capital gains from the shares accrue to the beneficial owner.

When corporate shares are owned through an intermediary, beneficial owners such as pension funds may exercise the rights that come with owning these shares if there is an arrangement established with the intermediary.

Question 22

Outline the two strategies that pension funds have generally adopted for enforcing their security holder rights.

Answer 22

Two strategies generally adopted by pension funds for enforcing their security holder rights are:

1) Engaging with corporations in which the pension fund invests by:

(a) Establishing engagement priorities such as ESG objectives
(b) Establishing a procedure to identify markets, sectors and corporations with which to engage
(c) Establishing procedures to engage informally with the target investments— setting out concerns, objectives and solutions
(d) Establishing procedures for partnering with other shareholders or interested parties
(e) Voting at shareholder meetings
(f) Filing shareholder resolutions.

2) Developing robust monitoring and litigation policies and, when needed, engaging in securities litigation, particularly class proceedings. Many pension funds have established or are considering developing securities monitoring and litigation policies that include:

(a) Monitoring portfolio procedures and engagement of service providers
(b) Allocating responsibility for participation in recovery procedures
(c) Developing procedures for identifying securities in a fund’s portfolio that are or may be subject to litigation
(d) Establishing decision-making thresholds for when to participate in securities litigation.

Question 23

What is the purpose and scope of policies like ESG and sustainable investing as they relate to the rights of pension funds as participants in financial markets?

Answer 23

Pension funds more frequently undertake assessments of their investment managers’ analysis and asset management activities in such areas as the commitment to ESG (environmental, social and governance) factors, the focus on sustainable investing or other factors.

Regardless of the specific assessment and evaluation criteria used, the underlying premise of the pension fund’s evaluation of their investment manager and/or investments is that “organizations that effectively anticipate and manage dynamic and emerging material business risks and opportunities, including climate change, are more likely to make better-informed decisions, and endure and create value over the long term.” There is an expectation that governance structures and processes enable boards of directors of those companies held in pension fund portfolios to demonstrate how they are overseeing management of these sustainability-related risks and opportunities via disclosure of financially relevant, potentially material sustainability-related factors and to allow investors to better understand, evaluate and assess these risks and opportunities, including their potential impact on a company’s performance.

Question 24

Define and compare “real assets” and “financial assets.” Provide examples of each.

Answer 24

“Real assets” generate net income to the economy and include land, buildings, machines and knowledge necessary to produce goods and services.

“Financial assets” are claims to the income generated by real assets (or claims on income from the government.) Stocks and bonds are examples of financial assets; they can earn income for their owners in various ways (e.g., interest payments). Financial assets do not directly contribute to the productive capacity of the economy.

Individuals can choose to invest by purchasing financial assets, including securities issued by companies. The companies then use the money raised to pay for real assets, such as a plant, equipment, inventory or technology. The investors’ returns on the securities purchased ultimately come from the income produced by the real assets financed by their investments.

One way to differentiate between real and financial assets is to consider how they are held on the balance sheet of investors and companies. Real assets appear only as an asset on the asset side of the company’s balance sheet. Financial assets always appear as an asset for the security owner and as a liability for the organization that issued the stock or bond.

Question 25

Differentiate among the three broad types of financial assets: fixed income (or debt securities), equity and derivatives. Provide examples.

Answer 25

Fixed income (or debt securities) promise either a fixed stream of income or a stream of income derived from a specified formula. Fixed income securities come in a variety of maturities and payment provisions. The money market refers to debt securities that are short term, highly marketable and generally of very low risk. Examples include Treasury bills (T-bills), Bankers’ Acceptance and commercial paper. In contrast, other fixed income securities are long-term bonds issued by the Government of Canada and bonds issued by federal agencies, provinces, municipalities and corporations. The degree of default risk associated with these bonds ranges from very safe (e.g., securities issued by the federal government) to relatively risky (e.g., high-yield or “junk” bonds issued by corporations). Long-term bonds are designed with diverse provisions regarding payments to the investor and protection against the bankruptcy of the issuer.

Equity, or common stock, in a firm represents an ownership share of that firm. Owners of the stocks are not promised any particular payment; instead, they receive dividends the firm may pay and have prorated ownership in the real assets of the firm. If the firm is successful, the value of equity will increase; if not, it will decrease. The performance of equity investments is tied directly to the success of the firm and its real assets. Equity investments tend to be riskier than investments in debt securities.

Derivative securities, such as options and futures contracts, provide payoffs that are determined by the prices of other assets such as bond and stock prices. One use of derivatives is to hedge risks or transfer them to other parties.

Question 26

Describe the roles played by financial assets and the markets they trade in within developed economies.

Answer 26

Playing an informational role: Stock prices reflect investors’ collective assessment of a firm’s current performance and future prospects.

Making “consumption timing” possible within the economy: Financial markets allow individuals to separate decisions concerning current consumption from constraints that otherwise would be imposed by current earnings.

Allowing risk to be allocated among investors according to their willingness to take risk: Financial markets and their diverse instruments allow investors with the greatest taste for risk to bear that risk and for the stock of the economy’s real assets to grow as a result.

Providing a means for separation of ownership from management: Owners of financial assets such as shares of a large corporation can sell their shares to other investors without affecting the management of that corporation—stability that may not be available to an owner-managed firm.

Question 27

Outline the basic decisions involved in establishing and updating an investment portfolio.

Answer 27

A portfolio is simply a collection of investment assets. Investors, including parties responsible for retirement plans, make the following types of decisions while establishing and managing their investment portfolio:

(a) Asset allocation decisions that involve choosing the proportion of the overall portfolio to hold in broad asset classes such as stocks and bonds

(b) Security selection decisions that involve which securities to hold within each asset class

(c) Updating or rebalancing decisions that result in the sale of some existing securities and the purchase of some new securities.

Question 28

Contrast a “top-down” strategy of portfolio construction with a “bottom-up” strategy.

Answer 28

These two strategies are defined by the order in which investors make asset mix and security selection decisions for their portfolios. Top-down investors first make asset allocation decisions, followed by security selection within each asset class. Bottom-up investors construct their portfolios from securities that seem attractively priced before considering broad asset allocation decisions.

Question 29

Identify the three essential types of participants in Canadian financial markets and describe their roles.

Answer 29

There are three types of participants in Canadian financial markets:

(1) Firms that need capital to pay for investments in plants and equipment. Those real assets, in turn, generate returns for investors who purchase the firms’ securities through the financial markets.

(2) Households that supply capital by using their savings to purchase securities available in the markets. Retirement plans can be included in this category of market participant—Plan funds are used to purchase securities available in the markets.

(3) Governments, which can be borrowers or lenders, depending upon the relationship between tax revenue and government expenditures. Generally, over the past several decades, the Canadian federal government has spent more than what’s been raised in taxes and, therefore, has had to borrow funds to cover its budget deficit through issuing Treasury bills and bonds.

Question 30

Describe how the existence of financial intermediaries offers advantages to the Canadian financial markets.

Answer 30

Financial intermediaries in Canada assist in the operation of financial markets by providing several advantages, including:

(a) Matching of borrowers and lenders

(b) Pooling the resources of many small investors to allow lending of considerable sums to large borrowers

(c) Reducing the risk of individual loans by lending to many borrowers

(d) Building expertise, including risk assessment and monitoring, through large volumes of business

(e) Pooling and managing the money of many investors to achieve economies of scale and to allow those investors access to a wide variety of securities

(f) Designing and managing portfolios specifically for large investors such as retirement plans, which may have their own particular investment goals.

Question 31

Identify financial intermediaries that operate in Canada.

Answer 31

Financial intermediaries that operate in Canada include:

(a) Banks and credit unions

(b) Insurance companies

(c) Investment companies, such as mutual fund and hedge fund operators, that pool and manage the money of many investors.