Module 8: Complying With Legislative and Best Practices in Plan Asset Investment

Question 1

Identify the most significant investment provisions covered by the Income Tax Act (ITA) and its regulations.

Answer 1

The most significant investment provisions covered by the ITA and its regulations are:

(a) Conditions under which a plan remains registered under the ITA and its regulations—including the investment rules that must be followed for non-pension registered plans (e.g., Group Registered Retirement Savings Plans and deferred profit-sharing plans)

(b) The kinds of property that are considered “qualified” investments for non-pension registered plans.

Question 2

Describe the ITA investment provisions that, if met, allow for continued registration of a pension plan under the ITA.

Answer 2

Continued registration under the ITA is dependent upon maintaining compliance with three ITA requirements:

(a) A pension plan may not invest “prohibited investments,”—basically, shares of the employer that sponsors the RPP, unless the shares are listed on a prescribed stock exchange.

(b) For plans that permit borrowing, such activities must meet certain restrictions identified by the ITA.

(c) A pension plan must comply with the applicable pension standards legislation.

Question 3

Describe how the ITA defines “qualified investments” for such plans as RRSPs and deferred profit-sharing plans (DPSPs).

Answer 3

Generally, the definition of “qualified investments” is the same for both RRSPs and DPSPs and includes:

(a) Bonds, debentures, notes, mortgages, hypothecs or similar obligations issued by or guaranteed by the federal government, a provincial or municipal government, or a federal Crown corporation

(b) Securities listed on a designated stock exchange

(c) Guaranteed Investment Certificates (GICs) issued by a trust company under the laws of Canada or a province

(d) A bond, debenture, note or similar obligation of a corporation, the shares of which are listed on a designated stock exchange or issued by an authorized foreign bank and payable at a branch of the bank in Canada

(e) A unit of a mutual fund trust

(f) An annuity contract issued by a licensed annuities provider that meets certain requirements.

Question 4

Describe the unique restrictions applied by the ITA rules for investments held by DPSPs.

Answer 4

The ITA prohibits a DPSP trust from investing in:

(a) Notes, bonds, debentures, bankers’ acceptance or similar obligations of the employer that sponsors the DPSP or of a corporation with which the employer is not dealing at arm’s length. This restriction is targeted at debt obligations of the employer that sponsors the DPSP. Investment in shares of the employer may be possible under certain conditions.

(b) Shares of a corporation if 50% or more of the property of that corporation consists of notes, bonds, debentures, bankers’ acceptance or similar obligations of the employer that sponsors the DPSP or of a corporation with which the employer is not dealing at arm’s length.

Question 5

Explain in general terms how investments of a registered pension plan (RPP) are regulated across the various pension jurisdictions in Canada.

Answer 5

The general regulatory environment for registered pension plans extends to the investments made with plan assets; that is, in order to obtain and keep registered status, a pension plan’s investments must comply with both Income Tax Regulations and the pension standards legislation in effect in the various jurisdictions. Pension standards legislation is not applicable to nonpension registered plans such as Group RRSPs and DPSPs.

All jurisdictions’ investment regulations include three key aspects:

1. The requirement for a written investment policy statement, often referred to as a “statement of investment policy and procedures” or SIPP
2. Quantity restrictions applicable to certain types of investments
3. Rules relating to related party transactions (often referred to as “self-dealing rules”).

The federal Pension Benefits Standards Act (PBSA) contains investment rules applicable to all federally registered pension plans, and these rules also generally apply in some other jurisdictions (Alberta, British Columbia, Manitoba, Newfoundland and Labrador, Nova Scotia, Ontario and Saskatchewan) that have chosen to adopt the federal rules. The federal PBSA investment rules (and other terms of the federal PBSA) also apply in Prince Edward Island, which has not enacted pension standards legislation.

New Brunswick and Quebec have their own investment rules applicable to plans registered in those jurisdictions.

Question 6

Describe the general requirements for investment policy statements (SIPPs) as outlined in pension standards legislation.

Answer 6

All jurisdictions require that the pension plan administrator (or in Quebec, the pension committee) establish an investment policy statement (SIPP) in respect of the pension plan’s investments, subject to the following.

(a) Plans subject to the federal PBSA, plans in jurisdictions that have adopted the federal investment rules and plans registered in Quebec do not require a SIPP when the pension plan consists of “member choice” accounts. “Member choice” accounts are those within a defined contribution pension plan where individual members are permitted to make investment choices.

(b) Ontario continues to require a SIPP for any pension plan that contains both defined benefit provisions and defined contribution provisions that allow member choice of investments. New Brunswick requires a SIPP for a “member choice” pension plan.

(c) While unusual, not all defined contribution pension plans offer members the choice of investments and, as a result, administrators of such plans must establish a SIPP.

Most jurisdictions (Alberta, British Columbia, New Brunswick, Newfoundland and Labrador, Nova Scotia and Quebec) include requirements for the SIPP to consider the nature of the plan and its liabilities and/or take into consideration factors that may affect the plan funding and solvency as well as the ability of the plan to meet its financial obligations. While the federal PBSA does not include this requirement, CAPSA Guideline No. 6, which identifies “prudent” investment activities, does recognize that prudence requires considering the nature of the plan.

Question 7

Identify the general elements normally included in a statement of investment policy and procedures (SIPP) for an RPP.

Answer 7

The statement of investment policy and procedures (SIPP) will normally include descriptions of:

1. The nature of the pension commitment (e.g., are pensions indexed?) and the goals of the plan sponsor (e.g., is the plan intended to meet conditions imposed by collective bargaining?)
2. How governance and other responsibilities have been allocated among stakeholders and outside service providers
3. The long-term asset allocation of the pension fund and any benchmark portfolio associated with that allocation, usually expressed in terms of capital market indices
4. Quantitative objectives and constraints
5. Qualitative objectives and constraints.

Question 8

Describe how Canadian pension standards legislation imposes quantity restrictions on a pension fund’s investments.

Answer 8

All jurisdictions specify certain quantity restrictions for the investment of a pension fund. For federally regulated plans and those in jurisdictions that have adopted the federal investment rules, investments are subject to the following limits:

(a) A maximum of 10% of the market value of plan assets can be invested in any one entity except for investments that are guaranteed by the federal or provincial government, in insured deposits, in mutual funds that themselves comply with this 10% limit or in a fund that replicates the composition of a recognized market index. The limit is applicable at the time that the investment is made and applies to the aggregate of debit and equity investments.

(b) A maximum of 30% of the voting shares of any corporation—except that in the case of real estate, resource and investment corporations, the limit may be exceeded under certain conditions.

New Brunswick and Quebec each include quantity restrictions that are similar but not identical to those above.

Question 9

Identify the exceptions provided by pension standards legislation relating to the prohibition of transactions with related parties.

Answer 9

For federally regulated plans and those in jurisdictions that have adopted the federal investment rules, related party transactions, including loans to employees, are prohibited unless:

(a) The transaction is required for the operation of the plan, and its terms and conditions are not less favourable than market terms and conditions, or

(b) The value of the transaction is nominal, or the transaction is immaterial to the plan.

It is also allowable for a plan administrator to invest in the securities of a related party if the securities are held in an investment fund or segregated fund in which investors other than the administrator and its affiliates may invest and that complies with certain prescribed quantitative limits.

New Brunswick and Quebec also have regulations relating to the ability of related parties to obtain a loan from a pension fund, and New Brunswick has rules to deal with securities lending.

Question 10

Identify who may have a fiduciary relationship with a pension fund.

Answer 10

Persons who may have a fiduciary relationship with a pension fund include:

(a) Pension committee

(b) Trustee or custodian

(c) Appointed administrator or recordkeeper

(d) Consulting professionals.

Question 11

Describe when an individual is considered in breach of their fiduciary duties regarding retirement plan investment management.

Answer 11

A breach of a fiduciary relationship is presumed where the fiduciary acts out of self-interest. A breach could also result where a fiduciary fails to meet a high standard of care in providing information or counselling.

Question 12

Describe the “prudent person rule” as it typically applies to pension plan activities. as outlined in CAPSA Guideline No. 6, Pension Plan Prudent Investment Practices Guideline.

Answer 12

When pension plan administrators and their appointed agents are undertaking investment activities, they are required by most Canadian jurisdictions to exercise the care, diligence and skill in the investment of a pension fund that a person of ordinary prudence would exercise in dealing with the property of another person. This is generally known as the “prudent person rule.” The prudent person rule is a substantive rule of law that is intended to lead to balanced decision making rather than dictate particular outcomes.

Application of the prudent person rule requires individuals with responsibility for managing a pension fund’s assets to do so in a professional manner with regard to the best interests of pension plan beneficiaries. In the pension investment context, a key element of the prudent person rule is that fiduciaries must exercise due diligence. This includes making decisions based on proper consideration of adequate information as well as documenting the final decisions, reasons for the decisions and the circumstances considered.

Question 13

Identify the nature of fiduciary responsibilities held by plan sponsors and service providers under a Group RRSP or a DPSP as outlined in CAPSA Guideline No. 3, Guidelines for Capital Accumulation Plans.

Answer 13

CAPSA Guideline No. 3, Guidelines for Capital Accumulation Plans (CAP Guidelines) are intended to assign and clarify the duties and responsibilities of service providers and plan sponsors (e.g., employers or unions) that offer their employees or members defined contribution (DC) pension plans, Group RRSPs and DPSPs with one thing in common—Employees or members make their own decisions about how to invest all or part of their contributions. These types of plans are collectively known as capital accumulations plans (CAPs).

The CAP Guidelines describe fiduciary responsibilities for all CAP sponsors and are perhaps most useful as guidance for sponsors of Group RRSPs and DPSPs, which are not subject to minimum pension standards legislation. According to the CAP Guidelines, sponsors of CAPs hold fiduciary responsibility for certain aspects of the plan’s design and operation. In broad terms, this fiduciary responsibility is the plan sponsor’s legal responsibility to watch over and act in the best interests of its plan members—whether in a formal pension plan or a less regulated Group RRSP or DPSP. “Acting in the best interests of plan members” means accountability for investment management, administration, registration and communication aspects of the plan, including situations when the actual delivery of these services could be from a third party.

Question 14

Explain the fiduciary standard of care required when the employer acts as plan administrator as outlined in CAPSA Guideline No. 6, Pension Plan Prudent Investment Practices Guideline.

Answer 14

For many pension plans, the administrator is the employer that is sponsoring the plan. In these situations, the employer is held to a fiduciary standard of care when acting as plan administrator. While the employer also retains certain rights and powers with respect to the pension plan when the employer acts as plan sponsor, while acting as the plan administrator, the employer is a fiduciary whose actions and decisions must consider the best interests of the pension plan’s beneficiaries.

In the plan administrator role, the employer is responsible for ensuring the pension fund is administered and invested prudently in accordance with the investment policy/statement of investment policies and procedures (SIPP), other pension plan documents and applicable legislation.

Question 15

Outline the activities for which the plan sponsor is not held to a fiduciary standard of care in relation to the pension plan and the pension plan beneficiaries.

Answer 15

The plan sponsor is responsible for determining the design of the pension plan; setting the benefit structure for various classes of members; and establishing, amending or terminating the pension plan. The plan sponsor is also responsible for determining the level and nature of pension benefits. During these activities, the plan sponsor is not held to a fiduciary standard of care in relation to the pension plan and the pension plan beneficiaries.

The roles and responsibilities of the plan sponsor are very different from those of the plan administrator. In the plan sponsor role, the employer is entitled to act in its own best interests but may be subject to an implied duty of good faith.

Question 16

Identify the principles that assist in ensuring a prudent approach to the investment of pension plan funds as outlined in CAPSA Guideline No. 6, Pension Plan Prudent Investment Practices Guideline.

Answer 16

The principles outlined in CAPSA Guideline No. 6 that assist in ensuring a prudent approach to the investment of pension plan funds are:

(a) Adhering to the prudent person rule

(b) Prudent delegation of plan administrator tasks

(c) Setting well-defined investment objectives

(d) Identifying and managing the risks associated with plan investments within the plan’s risk tolerances

(e) Establishing and implementing an investment policy/SIPP

(f) Allocating assets in accordance with the pension plan’s investment policy

(g) Applying due diligence in selecting investments

(h) Establishing effective plan monitoring and disclosure practices

(i) Documenting processes, policies and procedures.

Question 17

Describe two specific activities associated with pension plan investments that call for the particular attention of pension plan administrators when considering the prudence of their activities.

Answer 17

Securities lending and “soft dollar” transactions call for the particular attention of pension plan administrators when considering the prudence of their activities.

Question 18

Explain how a pension plan administrator can demonstrate a prudent approach to delegation as outlined in CAPSA Guideline No. 6, Pension Plan Prudent Investment Practices Guideline and the CAPSA Self-Assessment Questionnaire on Prudent Investment Practices.

Answer 18

A plan administrator can assess the extent to which the administrator has the right internal structures, processes, resources, skills, knowledge and expertise to effectively perform its duties with respect to investing and administering the pension fund.

If the plan administrator determines it does not have these factors in place, it is prudent for the plan administrator to delegate these tasks to parties with sufficient skills, knowledge and expertise to ensure the pension fund can be invested and administered in accordance with the standards of the prudent person rule.

If it is determined that certain activities are to be delegated to external service providers, internal committees or staff, then 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.

The plan administrator remains responsible for the delegated activities and should monitor those activities to ensure they have been appropriately and prudently carried out.

Question 19

Describe how a pension plan administrator can demonstrate a prudent approach to documenting decisions and activities related to the plan’s investments as outlined in CAPSA Guideline No. 6, Pension Plan Prudent Investment Practices Guideline.

Answer 19

The plan administrator can 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 administration obligations have been fulfilled. Any key decisions can be well-documented, including the reasons and circumstances considered. The CAPSA Self-Assessment Questionnaire on Prudent Investment Practices can be used as a tool to assist in this process.

Question 20

Outline the general approach to securities lending by pension plans.

Answer 20

All Canadian jurisdictions allow pension funds to engage in securities lending through their custodian; some include specific requirements relating to collateral requirements, while other legislation is silent regarding specific lending practices. Regardless of the legislative requirements, it is generally recommended that pension funds engaging in securities lending require at last 102% of the loan as collateral. Despite historical experience that shows that a low default risk exists within the securities lending market, it is generally recommended that an indemnity clause be included in the lending contract with the custodian. For example, the custodian may be asked to provide a guarantee against any losses due to default by the borrower. Government of Canada bonds and actively traded stocks issued by large corporations are the most commonly lent securities.

Question 21

Describe restrictions placed on securities lending within North America as outlined in the Office of the Superintendent of Financial Institutions (OSFI), Guideline B-4, Securities Lending.

Answer 21

OSFI Guideline B-4, Securities Lending indicates that for securities lending within North America, eligible collateral should be readily marketable and normally restricted to the following assets, denominated in Canadian or U.S. dollars:

(a) Cash

(b) Widely traded debt instruments having a rating of single A (or the equivalent) or higher from a recognized, widely followed North American credit agency

(c) Commercial paper rated A-1 or R-1 (or the equivalent) by a recognized, widely followed North American credit rating agency

(d) Acceptances of bank and trust and loan companies whose short-term deposits are rated A-1 or R-1 (or the equivalent) by a recognized, widely followed North American credit rating agency

(e) High-quality common and preferred shares.

Unconditional, irrevocable letters of credit that comply with the standards of the International Chamber of Commerce and that are issued by banks and trust and loan companies whose short-term deposits are rated A-1 or R-1 (or the equivalent) by a recognized, widely followed North American credit rating agency may also be acceptable collateral. Convertible preferred shares and convertible debt instruments may be taken as collateral when they are immediately convertible into the underlying security lent.

Question 22

Describe the practice of “soft dollars” and explain how it has been dealt with by investment regulators.

Answer 22

“Soft dollar” transactions refer to activities that arose historically when stockbrokers used by pension fund managers were subject to regulated commission rates in respect of their services. In an attempt to compete among firms when their prices were fixed, brokerage firms provided “soft dollars” to their clients by extending additional research services, computer hardware and software, research seminars, etc. Some “soft dollar” practices continued after the advent of deregulation and negotiable brokerage fees in the early 1980s.

The ability to negotiate brokerage fees created the possibility for portfolio managers to negotiate commission rates with dealers that involved the use of commissions for purposes other than order execution and research relating to investment advice. Concerns were raised about possible conflict of interest situations where managers might arrange to use commissions for their own benefit rather than the benefit of their clients.

In response, the Ontario Securities Commission (the regulatory agency that oversees the Toronto Stock Exchange where most pension fund trading occurs in Canada) has issued guidance to licensed investment dealers that addresses soft dollar transactions. It stipulates criteria that must be met when client brokerage commissions are directed to a dealer in return for the provision of order execution goods and services by the dealer or a third party.

While only larger pension funds may benefit from “soft dollar” transactions, plan administrators should be aware of their existence, how they work and the policies their fund managers have in this area.

Question 23

Outline some of the requirements of National Instrument 23-102.

Answer 23

National Instrument 23-102 stipulates certain criteria that must be met when client brokerage commissions are directed to a dealer in return for the provision of order execution goods and services or research goods and services by the dealer or third party. The criteria are:

1. That the advisor ensures that “the goods or services are to be used to assist with investment or trading decisions, or with effecting securities transactions on behalf of the client or clients; and . . . a good faith determination is made that the client or clients receive reasonable benefit considering both the use of the goods or services and the amount of client brokerage commissions paid.”
2. Further, registered dealers are prohibited from accepting, or forwarding to a third party, a client brokerage commission or portion of those commissions in return for the provision to an advisor of goods or services by the dealer or third party.
3. National Instrument 23-102 also calls for certain disclosure requirements in advance of the opening of a client account by an advisor, and at least annually after the account has been opened. These disclosures generally describe whether any “soft dollar” transactions might be provided and the method used to ensure that the client receives reasonable benefit.

Question 24

Describe how pension standards regulators deal with the requirement for prudence in the context of “member choice” plans when SIPPs are often not required.

Answer 24

Some jurisdictions no longer require SIPPs in the case of “member choice” accounts. However, legislation in some of those jurisdictions prescribes the nature of the investment options that should be offered to plan members, usually confirming the need for prudence in this activity. For example, the federal PBSA requires that a “member choice” plan must offer investment options of varying degrees of risk that would allow a reasonable and prudent person to create a portfolio of investments that is well-adapted to their retirement needs. A plan administrator who meets this requirement and other requirements of the regulations is deemed to meet the stated prudent person standard of care for investing plan assets. Alberta, British Columbia, Manitoba and Quebec take a similar approach within their pension standards legislation.

Question 25

Identify factors CAP sponsors consider when choosing investment options, including any default option that may be selected by the CAP sponsor as outlined in the CAP Guidelines.

Answer 25

Factors outlined in the CAP Guidelines for plan sponsors to consider when choosing investment options, including any default option, include:

(a) Purpose of the CAP

(b) Number of investment options to be made available

(c) Fees associated with the investment options

(d) CAP sponsor’s ability to periodically review the options

(e) Diversity and demographics of CAP members

(f) Degree of diversification among the investment options to be made available to members

(g) Liquidity of the investment options

(h) Level of risk associated with the investment options.

The degree of diversification and liquidity and the level of risk associated with the investment options are particularly relevant for CAPs that are established for retirement purposes.

Question 26

Identify the types of investment options for CAP sponsors to consider including in a CAP as outlined in the CAP Guidelines.

Answer 26

The CAP Guidelines identify investment funds, GICs, annuity contracts, employer securities, government securities, other securities and cash as types of investment options a CAP sponsor can include in a CAP.

Question 27

Identify factors CAP sponsors consider when choosing investment options if one of the options chosen includes an investment fund as outlined in the CAP Guidelines.

Answer 27

If the investment options chosen by the CAP sponsor include investment funds, the CAP Guidelines suggest that the following factors be taken into account when selecting the funds that are to be made available to members:

(a) Attributes of the investment funds, such as investment objectives, investment strategies, investment risks, the fund manager(s) historical performance and fees

(b) Whether the investment fund(s) selected provide members with options that are diversified in their styles and objectives.

If investment funds are offered in a CAP that is an RPP, the funds must comply with the investment rules under applicable pension benefits standards legislation.

If the investment fund is a “mutual fund” under securities law, it must comply with the rules that govern conventional public mutual funds.

Question 28

Identify factors a CAP sponsor must comply with if one of the investment options chosen by a CAP sponsor is an insurance product.

Answer 28

If a CAP sponsor chooses an insurance product as one of its investment options, the CAP sponsor must ensure the funds comply with:

(a) Investment rules applicable to individual variable insurance contracts
(b) Investment rules that govern conventional public mutual funds, or
(c) Investment rules under applicable pension benefits standards legislation.