The importance of risk management isn’t new for the majority of defined benefit pension plan sponsors and administrators.
The impact of long-term interest rates, market volatility, changing demographics and increasing longevity, inflation concerns, geopolitical events and other large economic, environmental and social factors are all contributing to the need to manage the financial risks associated with sponsoring and managing a pension plan.
Pension regulators have increased their focus on risk management as a way to address investment risk and promote plan members’ benefit security. Simply put, in an increasingly complex environment, pension regulators are now attempting to address pension plan risk management in a more focused and coordinated way.
One early signal — in February 2022 — was when the Canadian Association of Pension Supervisory Authorities established a new committee with a mandate to develop a risk management guideline. The CAPSA said it was establishing the committee “to be responsive to the International Monetary Fund’s call to regulators to strengthen their oversight of large pension plans and gain a greater understanding of vulnerabilities in the system.”
It also noted good risk management is key to operating a pension plan “and an important part of protecting members’ benefits.” While risk management techniques will vary depending on the type and size of the plan, the CAPSA’s upcoming guideline will provide guidance on a pension risk framework that can be adapted to each plan and its unique characteristics.
In March, the Office of the Superintendent of Financial Services released a consultation paper on investment risk management. The paper introduced several principles the OSFI believes are relevant to federally regulated pension plans in four areas: independent risk oversight, portfolio and risk reporting, risk appetite and risk limits and valuation policies and processes.
The OSFI indicated its proposed guidance on investment risk management would expect plan administrators to have a risk oversight function that’s independent of operational management. By designating an independent person or body to perform the oversight function — such as the administrator’s own internal audit function or a third-party service provider reporting directly to the administrator’s board of directors — there would be some assurance of independent review of the plan’s risk management approach and potential conflicts could be avoided. The role of this individual or body would be to establish the risk management framework, to identify and assess risks, to set risk limits and to establish risk monitoring and reporting requirements.
While this would introduce an extra level of complexity into a plan’s governance structure, it should be possible for most DB pension plan sponsors to implement some kind of independent risk oversight function by using its existing risk management process and/or audit function.
The OSFI also proposed that plan administrators articulate or document their risk appetite — or the amount and type of investment risk the plan administrator is willing to accept in pursuit of the plan sponsor’s objectives. For example, this could be defined by reference to the acceptable degree of volatility of the plan’s solvency ratio or funding requirements. In addition, the OSFI proposed that plan administrators set risk limits and operate within those maximum risk tolerances. While this could prove a challenging task for plan administrators, few would doubt the value of going through such an exercise.
Consistent with general pension governance principles, the OSFI has also proposed that plan sponsors establish processes to ensure that plan administrators are provided with access to timely and comprehensive portfolio and risk reporting. This approach should cover all asset classes and include such elements as leverage, derivative exposures and foreign exchange exposures, it said, noting it should also quantify material investment risks to which the plan is exposed — including market risks, credit risk and liquidity risk — and should also provide a sufficient look at the underlying holdings of investment funds in which plan assets are invested. Comprehensive reporting would ensure the plan administrator’s ability to identify, quantify and manage such risks.
Lastly, the OSFI said the implementation of enhanced valuation policies and processes would ensure a pension plan’s financial statements record assets and liabilities at their fair value based on current market conditions — particularly important for alternative asset classes.
While the pension governance policies for most plans identify material risks and the internal controls designed to address those risks (and plans registered in British Columbia and Alberta are already required to do so), risk management has often been poorly understood or inadequately addressed in many plan governance policies.
The recent regulatory initiatives and focus on risk management guidance for pension plan sponsors are designed to address that gap. In an increasingly complex investment environment and uncertain economic climate, it’s more important than ever for plan administrators to implement risk management practices that assist them in ensuring plan assets are invested prudently and pension plans are managed consistently with their fiduciary obligations to plan members and beneficiaries. For that reason, risk management may represent the new frontier in the realm of pension governance.