Module 8: Managing Retirement Plan Assets

Question 1

Discuss in general terms information contained in a pension plan’s statement of investment policies and procedures (SIPP).

Answer 1

The SIPP is the principle governing document for the planning and implementation of the investment program for a pension plan. It identifies the investment objectives, the investment strategy, the investment constraints and the investment policies of the pension plan.

The SIPP discloses permitted and prohibited investments and practices, establishes an appropriate asset allocation, provides for an internal and/or an external investment management capability, describes what risks are acceptable, and details the requirements for performance reporting and monitoring. Most importantly, the SIPP defines governance and accountability. The outcome is full disclosure and continuity for stakeholders.

Regulations to the federal Pension Benefits Standards Act (PBSA)—including section 7.1(1), which states the content to be disclosed within the SIPP—have been incorporated by reference into the pension standards legislation of most other Canadian jurisdictions.

In addition, the Office of the Superintendent of Financial Institutions (OSFI) issued guidelines for the content of a SIPP. The guidelines are consistent with the statutory requirement of an administrator of a pension plan to maintain a high standard of care for the members of the pension plan.

Question 2

Outline requirements of Canadian pension legislation as it pertains to preparation and review of a SIPP.

Answer 2

All Canadian defined benefit (DB) pension plans and administrator-directed defined contribution (DC) pension plans, with the exception of those registered in PEI, are required by law to have a written SIPP. The requirement for a SIPP for member-directed DC pension plans depends on the jurisdiction. Similarly, the requirement to file the SIPP with the regulator depends on the jurisdiction.

The SIPP for all Ontario-registered plans is required to disclose its policy regarding environmental, social and governance (ESG) factors.

Pension plan administrators are to review and confirm, or amend, the SIPP with respect to the assets of a DB or administrator-directed DC plan or provision at least once each plan year. Ontario pension standards legislation includes rules around the review, approval and filing process for SIPPs, in addition to those required by the regulations to the federal Pension Benefits Standards Act (PBSA). These include requirements that:

(a) Plan assets are invested in accordance with the SIPP at all times; meaning that amendments to a SIPP must be made before any investment policy change is implemented

(b) The initial SIPP, and any amendment, must be filed with the pension regulator within the prescribed time frame

(c) The SIPP be made available to prescribed parties

(d) Prescribed SIPP content be disclosed in annual or biennial statements to members and former members.

Question 3

Describe SIPP content suggested by the Office of the Superintendent of Financial Institutions (OSFI) that can be seen as the standard of good practice for registered pension plans.

Answer 3

OSFI’s guidelines on the content of a SIPP suggest that SIPPs should:

(a) Identify responsibilities and accountabilities of the board, prominent subcommittees such as the investment committee or pension committee, management, staff and key external service providers

(b) Set out the process for approving and implementing decisions

(c) Enunciate relevant investment risks, how they are measured and how they are managed

(d) Determine the frequency and format of reporting and performance measures

(e) Identify policies and procedures to protect the plan assets from conflicts of interest

(f) Address borrowing and pledging of assets.

Question 4

Identify quantitative and related-party restrictions on a pension plan’s investments contained in federal pension standards legislation.

Answer 4

Federal pension standards legislation limits pension funds:

(a) To owning a maximum of 30% of a company’s shares eligible to elect a board of directors

(b) With some exceptions, to investing in a maximum of 10% in any one entity

(c) To allowing related-party transactions subject to certain conditions (for example, investment in company stock through an investment fund that is available to investors other than the pension plan administrator)

(d) To allowing related-party transactions if the value of the transaction is nominal in accordance with the plan administrator’s definition of “nominal.”

Question 5

Outline items to be specifically addressed in a DB pension plan SIPP under the federal PBSA.

Answer 5

A SIPP for a DB pension plan is required to disclose:

(a) Categories of investments and loans, including derivatives, options and futures

(b) Diversification of the investment portfolio

(c) Asset mix and rate of return expectations

(d) Liquidity of investments

(e) Lending of cash and securities

(f) Retention or delegation of voting rights acquired through plan investments

(g) The method of, and basis for, the valuation of investments not regularly traded at a marketplace

(h) Related-party transactions and the criteria to be used to establish whether a transaction is nominal or immaterial to the plan.

Question 6

Outline the federal PBSA requirements for a DB pension plan SIPP in terms of asset mix and rate-of-return expectations.

Answer 6

Information that should be included in a SIPP for a DB plan regarding asset mix and rate-of-return expectations includes:

(a) Expected rate of return of the portfolio

(b) Expected volatility of the expected rate of return of the portfolio

(c) Types of return expectations

(d) Over what time frame the rate-of-return expectations should be achieved

(e) How the investment manager’s performance will be monitored.

Question 7

Outline the federal PBSA requirements for a SIPP in terms of lending of cash and securities under the federal PBSA.

Answer 7

Information that should be included in an investment policy statement regarding lending of cash and securities includes:

(a) Circumstances under which lending of cash and securities will be carried out

(b) Those authorized to commit the plan to lending

(c) Maximum exposure in aggregate and by counterparty

(d) Required collateral

(e) Margin requirements.

Question 8

Identify factors a DB pension plan administrator should consider when preparing a SIPP.

Answer 8

A DB pension plan administrator should consider these factors when preparing a SIPP:

(a) Current investments in place

(b) Rate of future contributions

(c) Amount and structure of current and accruing liabilities

(d) How liabilities and investments being contemplated would respond to plausible economic events

(e) Financial situation of the plan

(f) Tolerance for risk

(g) Maturity of the pension plan

(h) Estimated cash flow requirements

(i) Financial risks the plan sponsor may face regarding funding the pension plan.

Question 9

Identify membership and benefit provisions a DB pension plan administrator should consider when developing a statement of investment policy.

Answer 9

A DB pension plan administrator should consider these membership and benefit provisions when developing a statement of investment policy:

(a) Whether pensions in payment are increased to keep pace with the cost of living

(b) Whether the pension formula adjusts to increases in salaries over time or whether the plan administrator intends to grant increases to keep the formula current

(c) How obligations are distributed among categories of members and former members and how obligations are distributed by age and time to retirement

(d) Whether changes in employment levels or conditions are likely to change patterns of retirement

(e) Whether there are important ancillary benefits contingent on full or partial termination

(f) Whether any plan changes are anticipated (i.e., conversions, etc.).

Question 10

Describe how conflicts of interest can exist within pension investment processes and how a plan administrator may manage such potential conflicts.

Answer 10

Potential conflicts of interest within the investment function can include:

(a) Limiting entirely or substantially the investment options offered to members of a member-directed plan to options that are proprietary to the plans sponsor or an affiliate of the plan sponsor

(b) Acceptance of gifts or any other thing of value from anyone engaged or seeking business from the pension plan

(c) Participation in an investment manager search while employed by that investment manager

(d) Ownership of an investment fund that is managed by one of the plan fiduciaries

(e) Captive execution of all of an investment manager’s securities trading. That is, all trading is handled by a single, often affiliated broker/dealer, rather than seeking the best available execution for the plan’s securities trading.

(f) Soft dollar arrangements, whereby higher trading commissions are paid in return for services other than trade execution, such as research

(g) Revenue-sharing arrangements between a mutual fund and third-party administrator

(h) Valuation and investment of pension assets being the responsibility of the same party.

According to the Canadian Association of Pension Supervisory Authorities (CAPSA), a plan administrator should provide for the establishment of a code of conduct and a policy to address conflicts of interest. A code of conduct should be established for both the plan administrator and its delegates that sets out the required behaviour, establishes a control procedure for conflicts of interest, and provides for due process and a dispute mechanism. A review process should be established, a procedure to disclose and address conflicts of interest should be set up, and the policy should address both actual conflicts and the appearance of conflicts.

Question 11

Describe the “two hats” concept as it relates to a pension plan.

Answer 11

An organization may serve as both the pension plan sponsor and pension plan administrator. By wearing these “two hats,” the organization may find it is in a conflicted position in which a decision may favour the plan sponsor to the detriment of the pension plan or vice versa.

Question 12

Describe investment-related information that the administrator of a federally regulated member-directed DC pension plan must provide to members of such a plan.

Answer 12

In a member-directed plan, the member decides how to invest their contributions and those of their employer based on a set of investment options made available by the plan administrator. The plan administrator must provide the following information, annually, to each member of a federally regulated DC pension plan that is member-directed:

(a) A description of each available investment option, including:

Its investment objective
Its types of investments and degree of associated risk
Its ten largest asset holdings based on market value, each expressed as a percentage of total assets
Its performance history
A statement that past performance is not necessarily an indication of future performance
The benchmark that best reflects the composition of the investment option
The fees, levies and other charges that reduce return
Its target asset allocation
(b) A description of how the member’s funds are currently invested

(c) Any timing requirements that apply to the making of an investment choice.

Question 13

Identify factors plan administrators should consider if investment options chosen for a non-pension Capital Accumulation Plan (CAP) plan include investment funds.

Answer 13

If the investment options chosen by the CAP plan sponsor include investment funds, factors that should be considered when selecting the funds that are to be made available include:

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

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

Question 14

Identify the types of information administrators of a DC plan should provide to members where they are allowed to make investment choices.

Answer 14

For DC plans that allow plan members to make investment choices, the plan sponsor should provide:

(a) Sufficient detail on the investment options available in the plan so plan members can make informed investment decisions

(b) Information on any changes to the menu of investment options available

(c) Information on how plan members’ contributions will be invested if they do not provide investment instructions (e.g., the default investment option).

Question 15

Outline the main steps involved with the selection of an investment manager and summarize each.

Answer 15

Define the mandate.

Meet manager constraints (Identify any manager constraints as early as possible in order to avoid unnecessary analysis in the selection process. A constraint could be that the search mandate size fails to meet the minimum investment amount set by the manager.)

Define screening parameters. (Identification of parameters can narrow the candidate field. One such parameter is a minimum number of years of experience in providing investment management services.)

Apply screening tools to facilitate the analysis.

Develop and issue a request for proposal. (Screening tools assign weights for each parameter, and manager scores can be assigned for each parameter.)

Conduct finalist interviews.

Develop scoring systems.

Question 16

Describe the purpose of a request for proposal (RFP) for the selection of a pension fund investment manager. Identify best practices for inclusion in an RFP and explain the risk of weighing manager selection upon past performance.

Answer 16

Superior past performance is not predictive of superior future performance, and it is imprudent to select a manager based principally on superior past performance. The scope of a fund manager search can be greatly expanded through a request for proposal (RFP) that follows best practices.

The purpose of the RFP is to expand on the due diligence scope of the manager search. It allows plans to examine the critical factors pertaining to investment managers, including organizational stability, soundness of investment approach, the experience of the investment team, strength of governance policies and practices, effectiveness of relationship management and communication skills, how competitive their returns have been, and reasonableness of fees. Best practice RFP documents include:

(a) An introduction to the pension plan and to the specific mandate

(b) Instructions to the candidates on how to complete and return the RFP

(c) Specification of the scope of services the manager is to provide

(d) Questions that probe key technical areas of the manager

(e) A detailed questionnaire on fees, itemizing each applicable fee

(f) The evaluation criteria for RFP responses

(g) The schedule of events, such as the delivery of the RFP, deadline to return, interview dates, etc.

(h) Standard terms and conditions, including confidentiality provisions and, if applicable, freedom of information requirements.

Question 17

Discuss the components of investment manager monitoring activities and identify examples of metrics used in those activities.

Answer 17

Manager monitoring is part of an effective and prudent reporting and disclosure regime for pension plans. Monitoring of investment activity seeks to:

(a) Measure success at meeting objectives

(b) Assess individual manager success

(c) Acquire information to serve as the basis for sound investment decisions

(d) Gauge conformity with risk tolerances and risk management policies

(e) Measure compliance with laws, regulations and policies

Different monitoring metrics are applicable under different circumstances (for example, whether the monitoring is of individual manager mandates or the total pension fund). Some common metrics include:

(a) Value-added return attempts to identify the value-added return that managers create through their special skills

(b) Batting average is a measure of the frequency of value-added success

(c) Standard deviation is a statistical measure of the dispersion of returns in a portfolio. A lower risk tolerance prefers a lower standard deviation.

(d) Conditional Value at Risk (CVaR) is the expected average loss in a statistical range. Typically, CVaR quantifies a large, low probability loss often characterized as a “tail risk.”

(e) Credit ratings are independent assessments of the ability of a debt issue or issuer to pay its interest and to repay its principal

(f) Sharpe ratio is an example of a risk-adjusted return measure

(g) Attribution monitoring attempts to explain the reasons why a manager outperforms or underperforms a benchmark.

Question 18

Define “beta” and “alpha” as they pertain to investment returns. Explain the two prevailing attitudes about alpha.

Answer 18

“Beta” is the return of an investment portfolio that is attributed to exposure to the particular investment market. “Alpha” is the return on the investment portfolio that exceeds the return attributed to exposure to the investment market.

Supporters of the efficient market hypothesis argue that security prices reflect all available public information, and that manager skill cannot generate additional returns (i.e., alpha). This view believes that in the short term, alpha is the product of random chance and over the long term it will net to zero.

On the other hand, behaviouralists contend that markets are populated by irrational investors who render markets inefficient. This creates the opportunities for skilled managers to capture alpha.

Question 19

Identify reasons why an investment manager might be terminated. Describe a typical plan of action when fund manager underperformance persists.

Answer 19

Investment managers might be terminated because of:

(a) Failure to meet performance metrics

(b) Changes in the plan’s overall structure, strategy or policy, such that the manager’s services are no longer required

(c) Changes in the manager’s investment personnel, organizational structure, assets under management, investment process or investment philosophy that might adversely affect future performance

(d) Increases in investment management fees

(e) Failure to adhere to the SIPP or the manager’s investment policy for its own investment fund

(f) Changes in applicable law.

The following steps are typically followed when fund manager underperformance persists:

(a) A manager who fails to achieve a predetermined performance level of a predefined period is placed “on watch”

(b) If the manager fails to achieve an acceptable performance level after a defined period, a series of reviews are triggered: a review of the portfolio’s mandate, a review of the appropriateness of the benchmark, a review of the manager’s compatibility with the fund’s objectives and an attribution review of where the manager is adding or subtracting value

(c) A complete reassessment is done of the manager’s structure, decision making and personnel

(d) Termination of the manager and the search for a replacement manager.

Question 20

Outline the types of investments most represented in employer-sponsored pension plans and describe two ways that the pension plan can hold them.

Answer 20

Categories of investments most represented in employer-sponsored pension plans include pooled vehicles, bonds, stocks, mortgages and real estate. Pension plans can either hold investments directly or utilize pooled funds.

Pooled funds allow smaller retirement plans to access diversified investment portfolios that may not otherwise be available to them. They operate by “pooling” funds received from a retirement plan with others through the purchase of units of the fund itself. (In this way, a pooled fund is very similar to a mutual fund.) Many pooled funds are offered as segregated funds of an insurance company. The pension fund owns units of the pooled fund. Pooled funds may include only one class of security, such as Canadian bonds, or may contain a mixture, such as Canadian bonds and mortgages.

Question 21

Bonds are a fixed income security commonly included in the investment of pension plan assets. Outline the key characteristics of bonds.

Answer 21

Bonds are instruments of debt. They have a specific maturity date, at which the principal will be paid, and they normally bear interest until maturity (except stripped bonds, in which the coupons have been removed or stripped from the bond). The interest is usually paid semiannually. The rate of interest is referred to as the “coupon rate,” because many bonds have coupons attached to them that provide for the payment of interest. Sometimes specific pieces of real property are pledged to secure the bond. In this case, the bonds are called “mortgage bonds.” If there is no specific real property securing the bond other than the general ability of the issuer to make the payments, it is called a “debenture.”

Some bonds give the owner the option of converting them into common stock at a rate specified in the instrument, in which case they are called “convertible bonds.” There are also numerous other types of bond market instruments including mortgage-backed securities, sinking funds, serial bonds, purchase funds, redeemable bonds, extendible bonds, retractable bonds, income bonds, perpetual bonds, stripped bonds and inflation-indexed bonds.

Question 22

Other than bonds, describe commonly used securities for pension fund investments.

Answer 22

Stocks: These include both common and preferred stocks, which represent an ownership position in the issuing corporation. Stocks give the owner a stake in the corporation and its profits.

Mortgages: These are debt instruments that are secured by specific real property. Mortgages are normally issued on an amortized basis, requiring regular equal periodic payments containing both interest and a portion of the principal.

Real estate: This includes land and everything affixed that cannot be moved as described by specifying its attached rights, its shape and its boundary dimensions. 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.”

Question 23

Describe how the balanced investment management approach compares to the specialist approach.

Answer 23

Under a balanced approach, pension funds look to increase the diversification of the assets/securities held in the fund. This can be done by using a balanced manager—a single investment manager whose expertise includes the supervision of portfolios containing a variety of asset classes (e.g., bonds, stocks and cash reserves) or by using a number of balanced managers, each managing a portion of the pension fund and effectively competing against each other.

Proponents of the specialist approach perceive that no single money manager will excel in every asset class. As a result, in a specialist approach, pension funds employ a number of specialist investment managers, e.g., one for bonds, another for Canadian equities and still another for foreign equities. Each is supposed to be a specialist and should achieve better results in their particular area.

Question 24

Distinguish between active and passive fund management.

Answer 24

Within the investment industry, a distinction is often made between passive management and active management. Passive management is a low-cost investment strategy where a portfolio manager mirrors a market index. Within the investment policy mandate, passive fund management is a buy-and-hold strategy, meaning securities are held for relatively long periods with small and balancing changes made as required.

Portfolios that passive managers hold may be portfolios that are tailored to suit clients with characteristics that differ from those of the average investor (e.g., a portfolio of high-dividend stocks for a corporate investor, since all Canadian dividends received by a corporation are exempt from corporate income tax), or they may be surrogates for the market portfolios known as index funds.

The active manager seeks to add value through active fund management, attempting to outperform market indexes. Active management includes buying/holding/selling securities, trading between similar securities to improve quality or enhance yield and making shifts in asset mix to capture market risks or maintain defensive reserves in down markets. There is a cost to having money managers select investments since both operating expenses and investment management fees are higher for active management vs. passive management.

Question 25

Identify key investment risks outlined in the Guideline for the Development of Investment Policies and Procedures for Federally Regulated Pension Plans.

Answer 25

Credit risk: The risk that a counterparty will not pay an amount due as called for in the original agreement and may eventually default on an obligation

Mismatch risk: The risk that a solvency deficiency will develop 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: The risk that the market value of a financial instrument will fluctuate due to changes in exchange rates

Price risk: The risk that the market value of an investment or of a financial instrument based on investments will fluctuate

Interest rate risk: The risk that the market value of a security will fluctuate due to changes in market interest rates

Other risks: Include inflation risk, timing risk and political risk in emerging markets.

Question 26

Define “asset return risk” and describe another risk that might be greater for pension plans

Answer 26

Pension plan risk management often focuses on “asset return risk,” which is the variation in the returns of assets on an absolute basis or around a benchmark.

The risk that a plan fails to meet its funding objectives due to an imbalance between the values of assets and liabilities may be a greater risk. If assets grow but liabilities grow faster, a mismatch exists between assets and liabilities that can pose a greater risk than asset return volatility.

Question 27

Explain the role of liability-driven investing (LDI) in managing pension plan risk and describe the basic process of LDI.

Answer 27

Liability-driven investing is based on the theory that if an investment policy is to help meet the pension liabilities, a superior result is achieved when liabilities are included in the investment process. Liability-driven investments (LDIs) are commonly used in the funding arrangements of defined benefit (DB) pension plans where the ultimate measurement of investment success is to meet all the future cash payments owed to plan members in retirement. This includes the preservation of the funded position of a DB pension plan over time. An LDI approach can assist a plan sponsor in cash flow planning or assist in establishing the timing for a plan wind-up once a plan is shown to be fully funded.

The first step in LDI is to model plan liabilities as a stream of future expected cash flows and try to match those annual cash flows through the investment portfolio. A common way to measure the degree of the match between assets and liabilities is via a metric called duration, which measures the approximate sensitivity of a security to a change in interest rates. In practical terms, once the duration of the liabilities is known, a fixed income portfolio with the same duration can be established and managed. This process results in the removal of interest rate risk from the pension plan as liabilities and assets will move in the same direction to approximately similar extents, as interest rates change.

Question 28

Define “responsible investing (RI),” and outline some common RI strategies.

Answer 28

“Responsible investing (RI)” is the integration of environmental, social and governance (ESG) factors in the selection and management of investments.

Some examples of common RI strategies are:

(a) Use of positive and negative screens in the selection of investments

(b) Community investments to improve the economic and social development of local communities

(c) Shareholder advocacy to attempt to influence corporate behaviour

(d) An integrated approach that embeds ESG factors in the analysis of individual securities.

Question 29

Describe the various types of alternative investments.

Answer 29

Private equity: This provides capital to enterprises not publicly traded on a stock exchange. The two main types of private equity are venture capital and buyout. Venture capital can be used to develop new products and technologies. Buyout capital facilitates the buyout of a privately owned business or the buying of a business by experienced managers.

Hedge funds: There are four principal hedge fund strategies: equity hedge funds, event-driven funds, macro funds and relative value funds. Equity hedge funds hold long and short positions in equities and equity derivatives. Event-driven funds maintain equity and debt positions in companies involved in significant corporate transactions such as mergers, restructurings or takeovers. Macro funds search for return in equity, fixed income, currency and commodity market based on movements in major underlying economic variables. Relative value funds seek to exploit price discrepancies between related securities such as the price difference between an equity issue and its related convertible debt.

Commodities: Funds hold a wide range of these types of alternative investment: energy, agricultural, industrial metals and precious metals. Securities used include commodity index futures, over-the-counter derivatives, commodity futures and commodity-linked bonds.

Infrastructure: Positive infrastructure investments are gas and water distribution networks, toll roads, rail, pipelines, airports, power generation facilities and port facilities.

Question 30

Describe the main benefits of alternative investments.

Answer 30

Potential to experience a higher return: Alternative markets may offer a premium return because they are less efficient and less liquid. Hedge funds argue that the prospect of additional gain is driven by an opportunity set that is larger than that of the traditional portfolio manager. Hedge funds can short sell and capitalize on poor-performing equities and hold leveraged long positions with the proceeds of short sales.

Better matching: Infrastructure assets and private equity have the ability to match the long-term character of liabilities. Matching is achieved through the ability to hedge inflationary increases in the benefit promise with assets that rise with inflation (i.e., commodities and other infrastructure assets).

Greater diversification: There is a reduction of overall portfolio risk because alternative assets have a low correlation with stocks and bonds.

Question 31

Outline potential challenges of alternative investments and provide examples where possible.

Answer 31

Potential challenges of/concerns regarding the use of alternative investments include:

(a) Valuation and performance measurement. As an example, determining fair value in infrastructure and private equity involves subjective judgments. Also, there are no standard benchmarks for many alternative investments. This can result in two funds with identical investments in the same private equity venture reporting radically different value-added returns due to the use of different benchmarks.

(b) The use of leverage in many alternative investments

(c) Emerging strategy risk. As an example, alternative assets have short histories and lack robust data. This should temper confidence regarding studies showing weak correlations between alternative assets and traditional assets.

(d) Alternatives tend to be high-cost assets. As an example, a hedge fund manager will often charge a base fee and an incentive fee for performance. Such fees are often several times the investment management fee for a stock or bond portfolio. The high cost is compounded when, in order to diversify risk, a pension fund may own private equity or hedge funds in a fund or fund arrangement. This arrangement introduces a manager or manager tier of fees. Investing in alternative assets tends to be labour intensive when dealing with nonstandard transactions, which involve higher costs.

(e) There may be less control over alternative investments. The standard separation of duties between a discretionary investment manager and a custodian is not always in place for alternative investments.

(f) Regulations applicable to alternative asset portfolio managers may vary by location of the manager. As an example, portfolio managers or advisors to hedge funds must be registered in Canada but are exempt from registration in the United States.

(g) Alternative investments may be more complex than mainstream asset classes and may require a heightened level of due diligence.