3. Risk Management
The Plan is subject to certain risks and engages in risk management practices to help ensure that sufficient assets will be available to fund pension benefits. These risks relate primarily to the uncertainty inherent in achieving sufficient investment returns and in making forecasts with respect to the ultimate pension liability. Investment risks arise from the investment activities and include market risk (interest rate risk, foreign currency risk and price risk), credit risk and liquidity risk. The management of these financial risks is addressed through the Statement of Investment Policies and Procedures which defines investment and risk philosophy, performance return expectations, asset mix and diversification policy, and guidelines for the management of investments.
a. Market Risk
Market risk is the risk that the fair value or future cash flows of a financial instrument will fluctuate as a result of changes in market prices, whether specific to the individual security or its issuer, or to factors affecting all securities in the market. In addition to investment management practices designed to optimize the relationship between risk and return and through the diversification of investments across a variety of asset classes, the Plan uses the smoothing of investment gains and losses and uses margins of conservatism in economic assumptions to provide capacity to mitigate the negative impact of market risk. Market risk is comprised of the following types of risk:
(i) Interest Rate Risk
Interest rate risk is the risk that the fair value or future cash flows of a financial instrument will fluctuate because of changes in market interest rates. The potential exposure results from either changes in floating interest rates reducing cash flows, or changes in the asset values for fixed rate securities (e.g. bonds). During periods of rising interest rates, the market value of the existing fixed income securities will generally decrease. See Note 4 for interest rate sensitivity analysis.
The Plan manages interest rate risk for investments by establishing a target asset mix that provides an appropriate mix between interest-sensitive investments and those subject to other risks. A portion of the interest-sensitive portfolio is actively managed, allowing managers to anticipate interest rate movements to mitigate or take advantage of interest rate changes. There are also certain alternative investments which may have interest rate components making them subject to interest rate exposure.
(ii) Foreign Currency Risk
Foreign currency risk is the risk that the value of foreign investments will be affected by changes in foreign currency exchange rates for Canadian dollars. OPTrust employs currency managers that utilize currency forward contracts to manage the Plan’s foreign currency exposure. The Plan’s policy is to hedge approximately 50% of its currency exposure to investments in developed markets. In addition to the Plan’s policy hedging program, the active currency managers may take positions that deviate above or below the 50% target. The impact of a 1% absolute change in the Canadian dollar against other currencies, holding all other variables constant would have resulted in a $31 million change in the Plan’s net assets available for benefits as at December 31, 2010.
The Plan’s exposure to foreign exchange risk is as follows:
|As at December 31 ($ millions)||Gross Exposure||Impact of Derivatives||Net Exposure||Net Exposure|
|Investments subject to currency risk|
The impact of derivatives as set out above represents the fair value of the currency forward contracts and reflect the unrealized gain or loss on these instruments.
(iii) Price Risk
Price risk is the risk that the fair value or future cash flows of a financial instrument will fluctuate because of changes in market prices (other than those arising from interest rate risk or foreign currency risk), whether those changes are caused by factors specific to the individual financial instrument or its issuer, or factors affecting all similar financial instruments traded in the market. OPTrust is exposed to price risk through its investment in public equities, private and real estate instruments. OPTrust manages price risk through the use of an asset mix and diversification policy as well as adherence to guidelines for the management of investments.
(iv) Value at Risk
OPTrust uses Value at Risk (“VaR”) methodology to monitor market risk exposure in the overall fund. VaR is a statistical technique that is used to estimate the potential loss in value of an investment as a result of movements in market rates and prices over a specified time period and for a specified confidence level. VaR is estimated by using an analytical method incorporating monthly returns, evaluated at confidence levels of 99% and 95%. OPTrust uses a normal VaR model which assumes independent and normally distributed rate of returns. VaR does not specifically consider losses arising from severe market events. It also assumes that historical market data is a sound basis for estimating potential future losses. If future market conditions and interrelationships of interest rates, foreign exchange rates and market prices differ significantly from those of the past, then the estimated potential loss could materially differ from those estimated. The VaR measure provides an estimate of a single value in a distribution of potential loss that the fund could experience.
OPTrust uses VaR to reflect the Fund’s risk profile expected over a one year horizon. The figures calculated are meant to represent a “worst-case” loss at the 95% and 99% confidence levels.
The table below highlights the “worst-case” expected loss that could be experienced in a year, based on the VaR methodology with 95% and 99% confidence. The potential yearly loss calculation is based on the total fund’s monthly historical return data from inception.
99% confidence level
95% confidence level
|As at December 31 ($ millions)||Potential loss||Total assets||% Potential loss||Potential loss||Total assets||% Potential loss|
* Exposure includes both equity and other assets held by the investment managers based on their equity mandates.
Duration is a measure of the sensitivity of the bond portfolio to parallel shifts in the yield curve. The table below shows the duration for each portfolio group in OPTrust’s fixed income portfolio and their respective sensitivity to interest rate changes.
|Portfolio Group||Fair value
||% of portfolio||Duration||Duration contribution||Impact of 0.25% increase
in interest rates
|As at December 31||($ millions)||(years)||(years)||($ millions)||(%)|
* Portfolio group includes fixed income investments held by the investment managers based on their mandates.
v) Credit Risk
Credit risk refers to the potential financial loss arising from a counterparty being unable to meet its contractual obligations. The Plan is exposed to credit risk principally through its investment securities, securities lending, balances receivable from sponsors and counterparties to derivative transactions.
Investment restrictions within the Plan have been set to limit the credit exposure to security issuers. Short-term investments require a rating of “R-1” or equivalent and bonds and debentures require two minimum ratings of “A” or equivalent as determined by any of Moody's, Standard & Poor's or the Dominion Bond Rating Service. Credit exposure to any single counterparty is limited to maximum amounts as specified in the investment policies and guidelines. The fair value of the fixed income investments and over-the-counter derivatives exposed to credit risk, by credit rating, is as follows:
|As at December 31($ millions)||Short-term investments||Government & corporate bonds||Real return bonds||Swaps||Forwards||Options||Real estate||Total||%|
The counterparty credit risk associated with derivative transactions is managed by only engaging in transactions with counterparties with credit ratings of A and higher. In addition, for interest rate swaps, a credit support annex has been put in place with each counterparty which requires that collateral be obtained when there is exposure to these counterparties. As at December 31, 2010, collateral of $46 million was held (2009 – $nil).
Credit risk for investments in derivatives is measured by the positive fair value of the contractual obligations with the counterparties less any collateral or margin received as at the reporting date. The Plan has exposure to derivatives as follows:
|As at December 31($ millions)||amount||Assets||Liabilities||amount||Assets||Liabilities|
|Interest rate swaps||$||2,184||$||49||$||–||$||1,978||$||19||$||7|
|Foreign exchange forwards||4,756||64||(13)||3,349||46||9|
|Currency options- put||33||–||–||–||–||–|
|Currency options- call||27||1||–||–||–||–|
|Equity index options||29||–||–||–||–||–|
vi) Liquidity Risk
Liquidity risk is the risk that the Plan has insufficient cash flows to meet its pension obligations and other commitments and expenses as they become due. OPTrust also has significant investment commitments which are still to be funded (see Note 13) that expose the Plan to certain liquidity risk.
Cash inflows are derived from member and employer contributions, earned income, principal repayments on fixed income investments and the proceeds from sales of other securities. Excess cash flows, after meeting pension obligations and operating expenses, are re-invested. The Plan forecasts and manages cash flows to ensure it meets its obligations when due, without unintended early liquidation of assets.
In addition, 75% (2009–74%) of the Plan’s investments are marketable and can be liquidated relatively quickly. The Plan also invests in real estate and private markets which typically are more illiquid. As a result, these investments may not be able to be liquidated at their fair values in a short timeframe, which may expose the Plan to certain liquidity risk.
The remaining terms to contractual maturity or repricing dates, whichever dates are earlier, of interest bearing investments, including derivatives and mortgages, are as follows:
|As at December 31($ millions)||Term of maturity|
|Within 1 year||1 to 5 years||5 to 10 years||Over 10 years||Total||Yield to maturity|
|Government of Ontario debentures||132||728||–||–||860||2.2%|
|Interest rate swaps||(543)||(25)||32||585||49|
|Mortgages related to real estate||(40)||(202)||(119)||–||(361)|
OPTrust maintains $250 million (2009 – $250 million) of unsecured credit facilities to meet potential liquidity requirements primarily for investment purposes. As at December 31, 2010, the total amount drawn on the credit facility was $ 4 million (2009 – $ 13 million).
b. Securities Lending
The Plan participates in a securities lending agreement whereby it lends securities to approved borrowers. OPTrust secures its exposure through the receipt of security or cash collateral of at least 102% of the value of the securities lent. All securities lent are recallable on demand at the option of OPTrust. The program includes cash collateral lending under which cash collateral held is reinvested to earn a rate of return in excess of the interest paid on the collateral to the borrower.
Credit risk associated with the borrower is mitigated by requiring the borrower to provide collateral with market values exceeding the market value of the loaned securities. Credit risk associated with the reinvestment of cash collateral is mitigated by the investment policies and practices of the reinvestment fund which emphasize preservation of capital. However, there is liquidity risk related to the lack of liquidity in certain short-term markets which can result in discounts on longer maturity instruments.
As at December 31, 2010, the Plan’s investments included loaned securities with a fair value of $838 million
(2009 - $1,270 million). The fair value of collateral received in respect of these securities on loan was $873 million
(2009 - $1,307 million) which includes cash collateral of $156 million (2009 - $947 million) and other securities of $717 million (2009 - $360 million).
The following table shows the fair value of cash collateral and obligation under securities lending agreements, and the net investment income from securities lending:
|As at December 31 ($ millions)||2010||2009|
|Reinvested cash collateral included in short-term investment||$||151||$||938|
|Obligation under securities lending agreements||(156)||(947)|
|Net income from program|
|Reduction in unrealized loss||4||14|