According to Benefits Canada, total assets in Canadian registered pension plans passed the $1 trillion mark earlier this decade. A question often asked by plan administrators responsible for investing all this money and by those who advise or do business with such administrators is: What are the principal legal rules governing the investment of pension fund assets?
In the early days of pension regulation in Canada, the answer to this question was simple. There was a list of permitted investments set out in the federal or provincial pension regulations applicable to pension plans registered in that jurisdiction. If an asset category appeared on that list, it was legal. If an asset category did not appear on that list, it was illegal. End of story.
Approximately 20 years ago, the above “legal list” approach was replaced across the country by the “prudent person” approach. Now, the most important question which must be asked in regard to any particular proposed investment is whether it is prudent in the circumstances. The precise wording of the fiduciary prudence standard varies slightly from one pension statute to another, but the underlying principle is the same.
A common misconception is that the replacement of the legal list approach by the prudent person approach means that there are no more specific or quantative restrictions applicable to pension fund investments in Canada. However, nothing could be further from the truth. The remainder of this article is designed to set out a brief checklist of specific pension fund investment rules and the places where those rules can found.
First, every pension plan must have a written statement of investment policies and procedures or written investment policy setting out the principal dos and don’ts for investment of that plan’s assets. Persons proposing to do business with that pension plan (e.g., investment managers or other service providers, derivatives counterparties) should review carefully the terms of such document. Occasionally, other plan documents like the custodial agreement or plan text itself may also contain investment constraints.
Second, the federal Pension Benefits Standards Regulations (applicable to pension plans registered at the federal level and in every province except Quebec and New Brunswick—the latter two provinces have their own rules which are generally quite similar) contain a number of quantitative and other specific restrictions. One is the so-called “10% rule”, which essentially precludes a pension fund from placing more than 10% of its eggs in any one basket. It is important to note that there are certain exceptions to the 10% rule, which can be relevant, for example, in the context of an investment in units of a pooled fund or segregated fund. Similar anti-concentration restrictions exist for real estate and resource property investments.
Another quantitative rule in the Pension Benefits Standards Regulations is the so-called “30% rule.” This rule prevents a pension fund from acquiring more than 30% of the shares of any corporation which can be voted to elect the corporation’s directors. There are a number of exceptions to this rule, e.g. with regard to real estate corporation holdings, but this restriction has proven a challenge in recent years to many major pension funds seeking to deploy large amounts of capital. The CRTC hearings earlier in 2008 on the proposed acquisition of BCE Inc. by an investor group including the Ontario Teachers’ Pension Plan Board shone a spotlight on some of the sophisticated structuring occasionally employed to ensure compliance with this rule.
A final broad category of rules in the Pension Benefits Standards Regulations applies to related party transactions. The definition of “related party” for purposes of these rules is quite technical.
A third, sometimes overlooked, source of restrictions on pension fund investments is the federal Income Tax Regulations. There are two rules in the Income Tax Regulations which are potentially relevant in this regard. First, there are restrictions on investments in securities of the pension plan’s sponsoring employer. Second, there are significant restrictions on the borrowing of money by pension plans.
Careful attention to the possible application of the borrowing restrictions should be paid by pension funds and their advisors and counterparties when entering into certain types of derivatives transactions or adopting other “alternative” strategies. For example, certain variants of the trendy new “130/30 strategy” can be caught by these restrictions in the Income Tax Regulations.
Until 2005, the Income Tax Act itself was a fourth source of very significant constraints on pension fund investments, in the form of the infamous foreign content rule. However, in that year the foreign content rule was repealed. The Income Tax Act does still have rules relevant not to pension funds themselves, but to the investments of pension funds’ captive subsidiaries often used, for example, in the real estate area.
Lastly, certain large public sector pension plans are subject to special legislation, and that legislation sometimes contains particular investment rules. Service providers and counterparties dealing with plans in this category should ensure that they examine any such special legislation.
The above description barely scratches the surface of some of the legal and technical issues that can arise in the structuring of pension fund investments. Given the liability potential in this area, great care should be taken to avoid breaching any of the applicable restrictions.
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