Lifting The Foreign Content Limit
By: Joe Hornyak
While elimination of the Foreign Property Rule still has some hurdles to overcome before it comes into effect, including final passage of the federal budget where the proposal was made, the pension and investment industry is already looking at the impact this long-awaited measure will have. Joe Hornyak, executive editor of Benefits and Pensions Monitor, presents some of the early observations.
The elimination of the ‘Foreign Property Rule’ may have a profound impact on the Canadian pension industry. Or, it may just level the playing field by recognizing what many in the industry already knew – that the big players were doing an end run around the act by using derivatives to increase their foreign content to well above the former limit of 30 per cent. Granted, ‘home country bias’ will probably mean investors won’t put more than 25 per cent of their money offshore. However, the decision by the federal government in its February budget to eliminate the Foreign Property Rule (FPR) does bring Canada in line with the rest of the world.
The rule has been in place since 1971. At that time, pension investors could only invest 10 per cent of their assets in non- Canadian investments. Any amounts above 10 per cent would be taxed by Revenue Canada. The limit was placed on registered pension plans and other deferred income plans such as deferred profit sharing plans, registered retirement savings plans, and registered retirement income funds. Over the last four decades, the limit was raised in stages of two percentage points per year to a maximum of 20 per cent over the period from 1990 to 1994, and subsequently raised to a maximum of 30 per cent in two stages over the period of 2000 and 2001. The limit was justified on the grounds that it increased the value of the dollar andreduced its volatility. The argument was that if the FPR were removed, there would be an outflow of capital as Canadians sought to increase their foreign security holdings. This would put downward pressure on the Canadian dollar.
Assured Source Of Capital
As well, a second perceived benefit of the FPR was that it provided an assured source of capital to Canadian firms so the cost of capital is lower than it otherwise would be. This, in turn, meant greater investment and higher real wages and/or increased employment. Without the FPR, it was argued, the capital would go abroad. However, these were largely debunked in November 2002 in a policy paper jointly commissioned by the Association of Canadian Pension Management (ACPM) and the Pension Investment Association of Canada.
The Foreign Property Rule: A Cost- Benefit Analysis, by David Burgess and Joel Fried, both economic professors at the University of Western Ontario, found:
- there was no measurable impact on the exchange rate when the FPR was eased from 20 per cent to 30 per cent
- Canada’s equity markets did significantly better internationally when the FPR was eased than in the prior twoyear period
The ACPM commissioned the policy paper because it has advocated elimination of the FPR since its first major policy paper in 1997. However, Stephen Bigsby, its executive director, says they intensified their efforts in November 2002 with the release of the FPR paper which was circulated widely in Ottawa and the provincial capitals as well as to its members and allies. In addition to the findings of Fried and Burgess, the ACPM argued that it:
- was costly to administer, especially for smaller plans
- made it more difficult to diversify and left Canadian pension plans vulnerable to fluctuations in the Canadian equities market
- lowered return for all plans by an amount estimated at between $1.6 billion and $3 billion per year
Bigsby can only speculate on why the government wants to eliminate the ceiling altogether, instead of raising it, as it has in the past, to 40 per cent or 50 per cent. “I can only guess that elimination was the only way to get rid of the ‘tracking’ costs associated with clone funds and record-keeping, so it was a very good decision.” This proposal means, however, that pension plans will be able to concentrate on getting the best risk-adjusted returns they can, without artificial barriers or restrictions that limit what they can earn on invested capital, says Bigsby. This will be very good for sponsors, administrators, and, above all, plan members.
Elimination of the rule will affect pension plan sponsors, administrators of registered pension plans, and other tax deferred employee retirement plans which are currently subject to the FPR. As well, funding agents, investment managers, service providers, and the investment industry in Canada will have to react to the new environment, says the March 2005 Blakes Bulletin on Pension & Employee Benefits. In some cases, the reaction was immediate. Just days after the elimination of the FPR was proposed, Fidelity Investments Canada reduced the MERs on the RSP versions of its mutual funds. As well, it said it would eliminate RSP funds which would no longer be necessary to add foreign content to tax-sheltered RRSPs, once the details of how life after the FPR are worked out.
Hurdles To Overcome
Still, there are some hurdles to overcome. Fidelity says there will be human resources issues if plan members believe that they are being artificially constrained in their foreign property investments (especially where foreign markets outperform domestic markets during the relevant time period). To minimize these human resources issues and any associated potential legal risk, Fidelity suggests sponsors take proactive steps including reviewing the impact that the proposed elimination of the FPR will have on their plan(s) and how the planrelated documents would need to be amended. Ideally, such a review should include the sponsor or administrator obtaining appropriate legal and investment advice.
The Blakes Bulletin expands on which documents should be reviewed. It suggests the following may require amendments as a result of the elimination of the FPR:
- SIP&Ps – The SIP&P for a registered pension plan which typically includes a description of the types of foreign property that the plan may hold, together with a target range for the amount of foreign property.
- Investment Management Agreements – Mandates imposed on investment managers may include limits on the amount and type of foreign property in which the manager may invest.
- Trust and Custodial Agreements – If the trustee or custodian is responsible for monitoring the level of foreign property held in the plan, these agreements, and the fees associated with them, will become unnecessary.
- Plan Texts – While plan texts do not normally specify investment restrictions relating to foreign property, this should be confirmed.
- Service Provider Agreements – Where the level of foreign property held in the plan is not being monitored by the trustee or custodian, contracts with other service providers to perform such monitoring may no longer be necessary.
- Governance Documents – Where the plan sponsor has established one or more committees to oversee pension matters, the mandates for such committees should be reviewed to determine whether they contain any reference to foreign property investment restrictions.
- Enrolment Forms – The enrolment forms for plans under which members direct the investment of their accounts typically list each investment option, explain which ones are considered foreign property, and state that the member may not exceed the FPR in selecting his/her investments.
- Member Booklets and Other Communications – Member booklets and other communications which describe a plan under which members direct the investment of their accounts typically include an explanation of the FPR and specify that the member must ensure that the investments in their account do not exceed such limits.
In the case of CAPs, sponsors and administrators of plans should consider explaining to plan members the approach that the sponsor or administrator is taking in dealing with the proposed elimination of the Foreign Property Rule. This will reduce the risk of members claiming that the sponsor or administrator failed to properly consider the issue and act appropriately. In the case of Defined Contribution pension plans and DPSPs, since the FPR is applied to the aggregate plan assets, administrators of such plans should carefully consider the risks associated with allowing members to exceed the 30 per cent foreign property limit in their individual accounts.
In this regard, Heath Benefits Consulting Inc. suggests the elimination of the FPR may present a significant dilemma to sponsors of CAPs. The Joint Forum of Financial Market Regulators’ CAP Guidelines require CAP sponsors to “select and monitor” investment options made available to plan participants. DC plan sponsors have the added requirement of maintaining a statement of investment policies under pension standards rules.
Foreign funds are regarded as riskier than domestic (Canadian) funds because of the added dimension of currency exchange rates. Since the FPR provided an automatic limit on the exposure of CAP members to this added level of risk, Heath suggests that CAP sponsors may want to impose a spe-cific foreign content rule relative to member selection of investments. It is highly unlikely, however, that a mass sell-off of Canadian securities will occur, says Jack M. Mintz, president and chief executive officer of the C.D. Howe Institute. Since Canada’s market is only about two per cent of the global market, risk diversification would suggest optimal portfolios would hold mostly foreign assets. However, past studies have shown investors around the world have a strong bias to holding at least three-quarters of their savings in domestic securities.
Reasons for this ‘home country bias’ behaviour include:
- investors are less knowledgeable about foreign markets, feeling much more comfortable to hold better-known domestic securities
- foreign exchange risk, which could be hedged, imposes transaction costs, especially for small investors
- the withholding tax levied on dividends and interest paid to non-residents reduces the incentive to hold foreign equities
State Street research supports this view noting that despite the easing of foreign property content limits over the years, Canadian investors have consistently demonstrated a preference for local investment. From 1995 to 1999, Canadians invested an average of $17 billion per year in foreign securities. By 2000, as a result of the ‘tech bubble’ in the U.S., that total jumped to $64 billion. However, by 2004 it had dropped back to $16 billion. As well, there is the ‘prudent person’ approach (which the ACPM has always preferred to prescriptive quantified investment rules). “It should dictate that Canadian pension plans, whose liabilities are almost exclusively in Canadian dollars, will not want to hold non-Canadian assets above a certain self-imposed limit,” says Bigsby.
Eliminating the FPR should gradually result in a number of changes to the investment strategies of DB and DC plans, says a Watson Wyatt InfoFlash Canada. These changes include:
- Changing global investment proportions: Despite the high Canadian dollar and the strength of equity markets, foreign investments should be expected to increase over the longer term.
- Increased focus on asset classes and strategies: The elimination of the FPR should lead many plans to reconfigure their asset allocations and expand their portfolios to incorporate some non-traditional asset classes, such as global bonds and hedge funds.
- Increasing importance of currency management: As increased foreign investment creates a larger mismatch between the currencies in which assets are invested and the currency in which liabilities will be paid, liquidity concerns and currency management will become increasingly important. Increasing product offerings: Although synthetic/clone funds will disappear along with the FPR, the range of products offered by investment managers will increase. Increasing importance of benchmark selection: Asset allocation modifications will require the re-examination of the appropriate benchmark to use in measuring the portfolio performance.
Elimination of the FPR is far from a done deal. First, enabling legislation must be passed so it becomes legally effective. As well, the Income Tax Act must be amended. While the necessary legislation will likely be tabled in the next few months, the minority status of the current federal government creates uncertainty as to when the amendments will be introduced. Once introduced, past experience shows it can take up to a year to become effective.
In fact, the end impact of the FPR may be a secondary consideration when it comes to pension plans in Canada. Bigsby, for example, hopes this decision is one sign that governments are beginning to understand the urgency of strengthening Canada’s retirement income system and, especially, workplace pensions. And the ACPM plans to follow up on this renewed interest to “persuade the federal and provincial governments that much more can be done through smarter legislation and regulation to encourage the establishment of voluntary workplace pension plans and to protect the security of those benefits.”
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