The world is watching to see how pension funds manage risk in a challenging and changing market environment.

Pension funds, especially defined benefit (DB) arrangements, are unlike most other investors. They have a specific objective: the provision of a promised retirement benefit. And they are prudent investors, legally mandated to deal with other people’s money in a way that responsibly seeks to fulfill that objective without undue risk.

Prudence, in a pension context, must be understood in relation to the retirement funding objective. Courts frequently remind us that the goal of a pension fund is to provide the promised retirement income. This is a significant social objective. Prudent funding requires conservative actuarial assumptions. Prudent investment strategies must be designed to meet the plan’s funding needs without taking undue risks in the pursuit of gains.

But in the wake of the present financial crisis, pension funds find themselves in a dramatically different and much more challenging economic environment. Plan sponsors and trustees know that more bad news awaits them. But how should they anticipate it and respond when the bad news hits?

In the short term, pension funds (being generally disciplined institutions) are unlikely to change asset allocations or strategies quickly in the face of a sharp disruption. There are exceptions, of course—especially where plans have exposure to alternative assets and, most especially, where that exposure is leveraged.

As the crisis matures, the short term will give way to the medium term. At this point, the risk component of the risk/reward trade-off will take on new prominence. Asset allocations may become more conservative, and leveraged strategies, if they’re available, will be constrained.

Longer term, however, the crisis will have an even more profound impact. Problems originating from within the real economy—housing, for example—will rebound in the financial economy (mortgage-backed securities) and then in the shadow banking system (derivatives and credit default swaps). There will be no easy solutions because the problems will be multi-faceted.

Fiduciary scrutiny will no doubt be applied to investments that have failed in this crisis. Plan administrators will be asked to explain their due diligence, especially with regard to significant illiquid investments. Did fiduciaries understand the material characteristics of these investments? Did they understand their material risks when they considered potential rewards? Did they take the right advice from people with the right skills at the right time? Did they have the right information and ask the right questions? Particularly dangerous will be opaque hedge fund investments, the risks of which were poorly understood by plan fiduciaries at the time of the investment decision.

Subsequently, many more difficult issues will present themselves.

First, the viability of private pension delivery, as opposed to an expanded form of the Canada Pension Plan (CPP), will no doubt come into sharper focus. As sponsors confront higher DB plan deficits and members are presented with depleted defined contribution accounts or poorly funded DB commitments, attention will come back to the CPP alternative. Is the private system too expensive, too risky or too volatile to deliver decent retirement incomes? Would the CPP alternatives be less expensive for plan sponsors and more stable and reliable for Canadians?

The current financial crisis has also raised a number of questions about how markets are regulated. Financial deregulation has been the order of the day for more than 30 years. As a result, an unregulated credit default swap and derivatives market has mushroomed. These instruments have been used to hedge, and to gamble. Now, it is clear that unregulated financial engineering imperils not only the entire financial system but also the economy in general.

For better or worse, financial markets have become considerably more complex during the period of financial deregulation. Re-regulating them will be challenging. And pension funds, as large and sophisticated consumers of financial services, should play a big role in the mechanics of re-regulation. While other financial institutions will likely play a role, too, few of them will be fiduciaries with a view to maintaining the long-term best interests of the people who rely on the financial markets for income security after they retire.

Murray Gold is a partner with Koskie Minsky LLP in Toronto. mgold@kmlaw.ca

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© Copyright 2008 Rogers Publishing Ltd. This article first appeared in the November 2008 edition of BENEFITS CANADA magazine.

 

Copyright © 2019 Transcontinental Media G.P. This article first appeared in Benefits Canada.

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