The Office of the Superintendent of Financial Institutions has released a draft guideline on best practices for derivatives used in federally regulated private pension plans.
The guidance provides a comprehensive definition of derivatives, both exchange-traded and over the counter. It states prudence may require some plans to have more rigorous practices and procedures than others and outlines what those practices should include.
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If used prudently, derivatives can be an effective means of mediating risk tied to interest rates, exchange rates, market fluctuations and commodity prices, the guideline notes. However, given that derivatives are themselves a risk-bearing investment, a pension fund should take them on with due consideration of its risk tolerance, according to the guideline. The derivative’s place in the overall makeup of the fund is therefore key to consider, as well as the defining features of different types of derivatives.
It also stresses the need for due diligence on the part of the plan advisor, which in addition to considering risk, must also include a thorough analysis of how the derivative fits in with the overall investment goals and strategy of the fund in relation to the other assets at play.
The guidance highlights that the Pension Benefits Standards Act requires plan administrators to create a statement in writing of investment policies and procedures. Further, there must be a written delineation of the fund’s policy on handling various asset classes, including derivatives.
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The guidance also suggests the need to consider:
- Who can enter into such transactions on behalf of the plan;
- An outline of the authorized investment strategies for the asset class;
- Clear delegation of responsibility for the supervision of the plan’s activities regarding derivatives;
- A risk management outline, including limits on the asset class consistent with the overall tolerance of the plan;
- A periodic review of the risk management framework to measure effectiveness.
The regulator is accepting comments on the draft guideline until Sept. 29, 2017. If finalized, the draft guidance will replace a previous guideline for best practices around derivatives issued in 1997.
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