Draft Guideline for derivatives
On July 31, 2017, the Office of the Superintendent of Financial Institutions (OSFI) issued for comment a revised draft derivatives guideline titled “Derivatives Sound Practices for Federally Regulated Private Pension Plans” (the “Draft Guideline”), which will replace the 1997 guideline “Derivatives Best Practices”. The Draft Guideline reflects current practices with respect to the risk management of derivative activities and also sets out OSFI’s expectations for plan administrators who invest indirectly in derivatives through various types of funds, including pooled funds and hedge funds. Derivatives include a wide assortment of financial or commodity contracts, including forwards, futures, swaps and options.
This Draft Guideline should encourage plan administrators to establish clear policies and procedures regarding derivative usage. It also highlights OSFI’s recognition of the increase usage of derivatives in the investment schemes of pension plans as part of their risk management/return enhancement toolkit. Derivatives are often used to reduce risks associated with changes in exchange rates, interest rates, market indices and commodity prices, or for other purposes such as portfolio rebalancing or liquidity needs. A common example would be the use of derivatives to hedge interest rate risk through liability driven strategies.
When used prudently, derivatives can offer plan administrators efficient and effective methods for implementing risk management strategies. This Draft Guideline provides the perfect opportunity for plan administrators of federally regulated private pension plans in particular, but also for administrators of plans registered in other jurisdictions, to revisit their investment beliefs, investment policy and governance structure. The use of derivatives, particularly for risk management purposes, whether it is directly or indirectly, can be effective and entirely appropriate for a pension plan, as long as the activity is well monitored. By having clear policies and procedures governing the use of derivatives, in line with the “prudent person” standard, this can have a positive impact for the plan and provide peace of mind to plan administrators.
Impact for plan administrators of federally regulated private pension plans
The Draft Guideline outlines the factors that OSFI expects plan administrators to consider when developing policies and procedures for the sound risk management of derivative activities. As derivative strategies and investment portfolio compositions have become increasingly complex, more sophisticated risk management policies and procedures are required. The Draft Guideline encourages plan administrators to adopt more rigorous controls and standards in their plan’s internal risk management framework, in order to have a better understanding of how derivative instruments can alter the risk and return profile of the pension plan.
As such, in addition to the pension plan’s Statement of Investment Policies and Procedures (SIPP), the plan administrator should consider developing and documenting more detailed policies and procedures governing the use of derivatives as part of the pension plan’s overall risk management framework. This should include the following:
- A description of authorized derivative investment strategies;
- Clearly defined roles and responsibilities for entering into derivatives transactions and overseeing the pension plan’s derivative activities;
- Appropriate limits on derivatives risk taking that are consistent with the risk tolerance of the pension plan;
- Documented policies and procedures for identifying, monitoring and reporting the risks associated with derivative transactions, including stress testing and strategies for mitigating market, credit, liquidity and operational risk;
- Periodic review of the risk management framework to measure its effectiveness and to ensure that the framework remains consistent with the pension plan’s investment objectives, financial position and risk tolerance, particularly in light of changing circumstances.
Plan administrators should consider how this Draft Guideline applies to their pension plan, keeping in mind the plan’s investment objectives, risk tolerance and other relevant factors, and may wish to seek expert advice when establishing policies and procedures for derivatives risk management.
Additional information provided in the Draft Guideline
- The Pension Benefits Standards Act, 1985 (PBSA) imposes a fiduciary standard of care on pension plan administrators when administering the pension plan. This “prudent person” standard requires the plan administrator to invest the assets of the pension fund in a manner that a reasonable and prudent person would apply in respect of a portfolio of investments of a pension fund. It further provides that the administrator must use all relevant knowledge and skill that the administrator possesses or ought to possess.
- Plan administrators are expected to understand, monitor and mitigate the risks associated with derivative transactions. This includes making decisions based on proper analysis of adequate information and documenting the factors that were taken into account in making the decisions. The administrator must consider how the derivative fits within the plan’s SIPP, its role in the plan’s overall investment portfolio and strategy, and the plan’s potential exposure to losses.
- The main risks associated with derivative transactions include market risk, counterparty credit risk, liquidity risk and operational risk. Best practices for mitigating each of these risks are provided in the Draft Guideline.
- When a pension plan gains indirect derivatives exposure via external managers, such as through pooled, investment or hedge funds, the plan administrator retains ultimate oversight responsibility over the plan’s investment strategy and investments. The plan administrator should obtain sufficient information to determine the external manager’s strategy with respect to the use of derivatives, the extent of investment by the manager in derivatives, and such other information as may be appropriate.
The Draft Guideline will apply to administrators of federally regulated pension plans that invest, directly or indirectly, in derivatives, and once finalized, will set out OSFI’s expectations applicable to such plan administrators. In addition, the Draft Guideline may assist administrators of plans registered in other jurisdictions in understanding and applying best practices for derivative investments.
Public comments should be provided by September 29, 2017.