The Canadian Association of Pension Supervisory Authorities has released an update on pension plans using leverage.
“What makes it of particular interest to pension regulators now, is that it is being used more commonly and more intensively by pension plans, principally as a component of investment strategies aimed at achieving better asset-liability matching (through higher exposures to fixed income assets) while allowing pension plans to retain significant exposure to return-seeking assets,” the CAPSA said.
A CAPSA leverage working group, formed in 2016 to study this topic, found pension plans use leverage in two ways. The first is synthetic leverage, which involves using tools like derivatives.
Hrvoje Lakota, a senior investment consultant at Mercer, says before synthetic leverage, plans had only one lever — bonds and equities — to increase returns and decrease risk, yet synthetic exposure offers two levers. “You can control how much exposure you want to the equity markets, you can control how much interest risk you want to take in the pension plan and you can make those decisions separately from each other.”
The other type of leverage used by plans is financial leverage, which is borrowing funds. One example is a pension plan issuing a bond.
“To me, the question would be how the proceeds of that bond are invested,” says Lakota. “But the thing that I would also say is you need to distinguish between actions that the very large pension plans take and the actions that the majority of pension plans in Canada take.”
Key risks associated with using leverage include include credit risk, liquidity risk, counterparty risk, refinancing risk and governance risk, the CAPSA said, highlighting there’s no simple measure of leverage that effectively captures either the extent or the risks associated with its use.
Current rules around disclosure and reporting don’t provide clarity on using leverage, according to the CAPSA update. “The working group concluded that, given the complex relationship between leverage use and investment risk, regulators cannot rely only on regulatory disclosures to identify potential problems,” it noted. “Regulators could enhance their risk assessment and oversight of pension plans by also reviewing the processes and procedures in place to manage investment risk, including the risks related to the use of leverage.”
Regulators’ areas of focus could include plan governance, expertise to support investment activities and board oversight, stress-testing and communication with stakeholders about leverage, stated the CAPSA.
While the update didn’t include concrete guidelines or recommendations, it suggested more may come. “The Working Group will make recommendations to CAPSA on the form and nature of guidance that may be needed in this area. This could include high-level guidance for regulators and plan administrators about the use of leverage and its associated risks, and regulators’ expectations on effective risk management and oversight by plan administrators.”
Currently, a general fiduciary obligation to act prudently exists, so plan administrators shouldn’t be using strategies they don’t understand, says Julien Ranger, a partner in the pensions and benefits group at Osler Hoskin and Harcourt LLP. “But I guess the regulators are asking, ‘Is that enough? Do we need to put more in place to ensure that leverage is used in a prudent way?’”
As well, aside from rules regarding prudent behaviour, there are some restrictions in the Income Tax Act about borrowing money, so pension plans need to be careful about how they structure strategies, says Ranger.
Although the CAPSA update didn’t include much that was new, Lakota says he’s looking forward to what comes next.