Over the last several weeks, we have witnessed an unprecedented financial crisis in the U.S., Canadian and international markets which has had—and will continue to have—a significant impact worldwide. Canadian defined benefit (DB) and defined contribution (DC) pension funds and their administrators are feeling the effects of this crisis.
The Impact on Pension Funds
Pension funds, like other investors, have been exposed to plummeting asset values as a result of the recent free falls in capital markets worldwide. As recently reported by RBC Dexia, market volatility has slashed 8.6% of the value from 40 major Canadian pension plans in the third quarter, their worst three-month drop in a decade, bringing the Sept. 30 year-to-date decline to just over 10%.
The severity of a particular plan’s exposure may depend upon the extent to which such funds are invested, either directly in securities issued or guaranteed by failed or rescued financial institutions such as Lehman Brothers and AIG, or indirectly through investments in hedge funds, funds-of-funds, etcetera.
Recent events could also trigger a number of secondary—or knock-on effects—for DB and DC pension funds, including the unitized investment funds which they may hold, such as the marking down of similar investments held with other financial institutions.
These market downturns, coupled with the expected lowering of long-term interest rates, may have a significant impact on solvency ratios determined in the next DB plan valuation and on member account balances disclosed in the next DC plan benefits statements. This may also result in plan funding and financial statement consequences as well as member anxiety.
Investment Practices Subject to Increased Scrutiny
In the circumstances, plan administrators may find that the investment practices of their plans will be subject to heightened scrutiny by members as well as by pension regulators. In Ontario, this is already happening.
In 2005, for example, the Financial Services Commission of Ontario (FSCO) undertook an investigation into the investment practices of a large multi-employer pension plan. The investigation turned up what in FSCO’s view were a number of investment rule breaches and questionable governance practices. In 2006, charges were laid against members of the Board of Trustees in office at the relevant time and the case went to trial this September. This and other regulatory activity by the Ontario regulator has resulted in at least two class action lawsuits against this plan administrator and various service providers.
Legal Framework for Pension Plan Investing
Pension plan investing is regulated by minimum standards pension legislation. Most provinces in Canada have adopted a hybrid model that combines the “prudent person” approach with quantitative rules relating to diversification, control and conflict of interest.
The quantitative rules are complicated and not well understood. It was concerns about the meaning of these rules, for example, that lead the CRTC to halt its hearing on the Ontario Teachers’ Pension Plan buyout of BCE to give the parties time to consult FSCO. But the quantitative rules only represent the minimum standard. A plan administrator could be in compliance with the quantitative limits but still not be considered to have met the test for prudence. The prudent person rule requires plan administrators to exercise the degree of care that a prudent person—or the prudent expert, if the plan administrator has relevant professional expertise—would exercise in dealing with the property of another when investing plan assets.
What does this mean from a practical perspective? FSCO has indicated in its reports on the results of its investigations that it measures prudence mainly by the processes through which individual investments and/or strategies are selected and monitored. The vast majority of the criticisms leveled by FSCO against the investment practices it has investigated related to the failure to establish appropriate processes and procedures.
The prudent person rule applies to the administrators of DC as well as DB plans. Canadian regulators have given plan sponsors guidance on what prudence may require in the context of DC arrangements in the Guidelines for Capital Accumulation Plans issued by the Canadian Association of Pension Supervisory Authorities in 2004.
The United States has experienced a recent surge in class actions by DC plan members over investment management fees and allegedly imprudent investments, including those related to losses from subprime mortgage investments. It is possible that the recent downturn in the financial markets may result in similar lawsuits in Canada.
What Action Should Plan Administrators Consider?
Plan administrators should keep a close watch on investment performance as well as benefit security and should review:
• Statement of Investment Policy and Procedures (SIP&P) quality requirements for equities, fixed income instruments and other investments. The review should determine whether any securities held have fallen outside the parameters and whether current parameters need to be amended;
• Securities lending conducted either directly by the pension fund or by external investment managers. The review should address more particularly the process for recovering loaned securities and determine any loss exposure for the pension fund;
• Derivative contracts and counterparty management process being conducted to determine exposure and mitigate risk;
• SIP&P and investment options for any DC arrangements to determine whether changes are required to address current market conditions; and
• Determining whether communication with plan members is warranted, particularly those participating in DC arrangements.
As part of their risk management and fiduciary responsibilities, plan administrators should make it a priority to ensure that their plan’s investment governance structure complies with applicable legal requirements and properly reflects best practice guidelines issued by Canadian regulators.
Michel Benoit is co-chair of Osler’s Pension & Benefits Department in Montreal. Evan Howard and Louise Grieg are both partners at Osler’s Pension & Benefits Department and based in Toronto.