The Canadian Association of Pension Supervisory Authorities’ guideline for risk management provides that plan administrators should create a framework to identify, evaluate, manage and monitor their plan’s material risks.
The guideline encourages plan administrators to prepare a written statement with the plan’s risk appetite, risk tolerance and risk limits and that these elements are reflected in the plan’s risk management framework.
It describes risk appetite as the amount and type of risk that the plan administrator is willing and able to accept. Risk tolerance is described as the variation in outcomes that’s considered acceptable with respect to a risk, while risk limits are defined as the thresholds that shouldn’t be breached based on the plan’s risk appetite.
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While the definitions of these three risk terms leave room for interpretation, the following non-pension illustration may help clarify one way of viewing the distinction and relationships between them.
A traveller is planning a trip from Toronto to Ottawa. Assuming the weather forecast is good for the day of the trip, driving between the two cities exposes the traveller to the risk of getting into a traffic accident but that risk is relatively low. Considering the flexibility that driving offers — such as being able to begin the trip at any time of day — and that all modes of transportation involve some risk, the traveller concludes the risk associated with driving between the two cities is consistent with their risk appetite.
On the other hand, let’s assume that thunderstorms and high winds are forecast for the day of the trip. While the probability of a traffic accident has increased due to the forecasted inclement weather, it hasn’t increased to the degree that it’s worth cancelling the trip. It’s also unrealistic to expect perfect weather for every driving trip. In this case, the risk associated with the trip still falls within the traveller’s risk tolerance.
However, if there’s a massive winter storm that brings 20 centimetres of snow and high winds, the traveller may conclude that the probability of getting into a traffic accident is too high to make the trip worthwhile. They decide to cancel the trip because their risk limits have been exceeded.
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Preparing a written statement documenting a pension plan’s risk appetite, risk tolerance and risk limits for the first time can be difficult. The following are a few considerations and suggestions:
- It’s important for administrators to avoid the temptation of creating a ‘perfect’ statement, as this could become a barrier to getting it done.
- From a practical perspective, the statement may initially be quite general but can be updated and refined over time to be more specific.
- While a pension plan faces many risks, the statement should reflect the plan’s overall material risks.
- The statement may need to address risks that are qualitative in nature and risks that can be measured quantitatively. A significant amount of analysis may be needed to evaluate, manage and monitor the quantitative risks.
- The discussions and analyses associated with establishing the plan’s risk appetite, risk tolerance and risk limits are often at least as valuable, if not more valuable, than the final documented statement. It’s important for administrators to perform the needed analyses and to have robust discussions about how these risk terms apply to their plan.
- Comparable statements from other pension plans and financial institutions can provide administrators with ideas and inspiration.
- The statement is a living document that evolves alongside the plan’s material risks.
Although creating a written statement with the plan’s risk appetite, risk tolerance and risk limits may not be easy, a well-planned statement can serve as a valuable focal point around which a robust risk management framework can be built.
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