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The Canadian Association of Pension Supervisory Authorities (CAPSA) has been very busy and recently released consultation drafts of a series of risk management guidelines on Cyber Risk, Leverage, and Environmental, Social and Governance (ESG) considerations for pension plans.  They’ve also made a proposal to create an ‘inclusive’ Risk Management Guideline to bring all of this and more together.

These guidelines are intended to support plan administrators in fulfilling their fiduciary obligations.  In particular, as noted by CAPSA:

I am supportive of some of the guidelines but not all.  I’m certainly supportive of CAPSA’s proposal to unify and consolidate all of these risk management guidelines in a single document – I’m a fan of one-stop-shopping!  However, given that they are all separate documents now, let’s go through them one by one.

Draft ESG Guideline

This ESG guideline is certainly required reading for all plan administrators.  CAPSA clearly expects that ESG factors that may have financial implications will be taken into account by all pension plans.  They have captured their key recommendations in three principles:

The good news is that CAPSA recognizes that these recommendations are intended to be applied proportionately so that the ‘smaller’ pension plans that hold their assets in ‘simple’ investments don’t need to go as crazy as the larger plans with more complex and exotic investments.

Reading between the lines of CAPSA’s recommendations, a plan administrator needs to primarily focus on expected risk-return results and may only use ethical and impact investment considerations as a tiebreaker.  The primary purpose of a pension plan is to provide retirement income and not to be an activist investor.

That being said, some ESG factors can certainly figure into the long-term risk-return expectations and CAPSA is clearly saying that these cannot be ignored.  However, investors needs to be wary of ‘greenwashing’ and ESG branding – in fact, some investment professionals appear to be moving away from ESG terminology and replacing it with less politically charged and frankly more descriptive expressions such as ‘considering material risk factors’.

As a reminder, since 2016, Statements of Investment Policies and Procedures (SIPPs) for Ontario registered pension plans must contain information about whether ESG factors are incorporated into investment decisions and, if so, how.  Pension plans that filed their SIPP saying that they aren’t taking ESG factors into account may want to reconsider this choice in light of these soon-to-be-finalized guidelines.  In my experience, some plans may have said ‘no’ because they don’t take any ESG considerations into account directly and instead simply assumed that their investment managers would only take into account financial considerations.  However, I think if a plan administrator asked the investment manager that manages its pooled fund investments, they will likely say that they’ve always considered some ESG factors in their risk-return calculations and decision making around investments.  Taking ESG factors into account doesn’t mean that you’re an environmental activist that needs to be net-zero.

Draft Leverage Guideline

For those unaware, pension plans can use leverage for a variety of purposes in their investment portfolios.  Leverage certainly adds layers of complexity related to risk management and operational requirements and is therefore generally recommended only for larger pension plans that can suitably manage these requirements.

We at ASI are not investment experts and don’t provide investment advice, so I’m not going to have many insights into this proposed guidance other than to say that it’s well written and appears comprehensive to a non-expert such as myself.  It’s definitely worth a read if your pension plan is already using leverage or is thinking about it.  The remainder of this section will provide a brief summary of CAPSA’s draft guidance.

Common types of leverage used by pension plans include:

• Financial leverage – essentially borrowing additional funds for the purpose of investing.  This can be in the form of a margin loan or mortgages on real estate.
• Synthetic leverage – using derivative contracts to increase exposure to certain investments like long-dated fixed income.
• Embedded leverage – indirect leverage obtained through pooled funds that employ leverage within the fund.

Even though the above descriptions include scary words like margin loans and derivatives, there can be some very reasonable and rational purposes for which pension plans use leverage, including:

• Implementing Liability Driven Investment (LDI) strategies – pension plans can have very long durations given that their promised payments can stretch out for decades and there are not always available direct investments with matching time horizons; however, the duration of the investments can be lengthened considerably to match the liabilities with the use of derivatives.
• Increasing exposure to return-seeking assets – real estate investments are often well-suited for pension plans and often come with associated mortgages.
• Seeking investment efficiencies and opportunities – leverage can be used to increase diversification and/or reduce volatility in the investment portfolio.

The adage of ‘no free lunch’ in the investment world holds true with leverage in that the potential benefits come with additional risks:

• Market Risk – while leverage can amplify gains it can also amplify losses.
• Liquidity Risk – sometimes you really need cash and complex investments can be harder to sell quickly.
• Counterparty Risk – some forms of leverage such as derivatives involve counterparties who can sometimes fail to live up to their side of the bargain.
• Operational Risk – complex investments provide more opportunities for something to go wrong due to failed processes or errors.
• Refinancing Risk – leverage often depends on the availability of credit, which can sometimes be restricted or come at a high price.
• Performance Measurement Risk – if the calculations of risk and return prove to be inaccurate then the benefits of leverage may prove to be overstated.
• Model Risk – most of the above risks are interrelated and can behave in unforeseen ways during periods of market volatility or financial shocks.

CAPSA’s leverage guideline reminds plan administrators that they have a fiduciary duty and therefore they must have a sound understanding on how leverage affects both investment risk and potential rewards.  There must also be sound oversight and risk management, which the CAPSA guideline provides all sorts of suggestions and advice.

Draft Cyber Risk Guideline

As drafted, the cyber risk guideline is problematic for me – it seems odd that CAPSA is issuing this kind of guidance with the narrow focus of pension plans.

While cyber risk is definitely huge and has the tendency to keep people up at night, it’s not restricted to pension plans, as cyber risk impacts all of us individually and collectively.  Every business needs to worry about cyber risk, not just in the context of their pension plan, but for virtually every aspect of their business.  For a recent example, I refer you to last month’s Rogers outage – it’s not just about protecting yourself from cyberattacks, but building contingency plans and risk mitigation strategies for when something bad happens that wasn’t directly your fault.

CAPSA’s cyber risk guideline is fine in that it talks about the data and assets under the control of plan administrators and their third-party service providers that must be protected.  The guidelines go on to describe various controls for cyber risk management, incidence response plans, seeking expert support, etc.  This is all perfectly true and reasonable; however, as I said earlier, it should not just be limited to the pension plan and should apply to virtually all aspects of an organization.

While ESG and Leverage have pension specific issues that CAPSA is rightly issuing guidance on, cyber risk is universal.  It would be as if CAPSA was issuing guidelines on how to run viable business so that you don’t go bankrupt and put all your employees out of work with a potentially underfunded pension plan, or guidelines on the risk of fire destroying pension records and providing advice on how many fire extinguishers you need.

In my view, it would be much better if CAPSA ultimately created a single risk management guideline with various appendices dealing with all sorts of risks faced by pension plans.  That way cyber risk would just be one more thing on the list.  I have little doubt that organizations are already fighting the cyber security battle to protect many aspects of their business including their data, their production systems, their employees, etc. and their pension plan should already be captured in the inventory of critical systems.

What’s next?

The comment deadline for these consultations is September 15, 2022.  Given that I would expect broad support for a consolidated risk management guideline, I’m thinking that it may take a while for CAPSA to rework these three draft guidelines along with more foundational risk management concepts.  l would therefore expect that a final version of these guidelines is many months away.  It may even be worthwhile for CAPSA to go through a second round of consultations on the draft consolidated risk management guideline.

As a reminder, CAPSA is also in the process of refreshing of Guideline No. 3 – Guidelines for Capital Accumulation Plans (CAPs) and I wrote about that last month.  That comment deadline passed a couple of weeks ago and I wouldn’t be surprised if we saw a final version of Guideline No. 3 sooner rather than later.