2006 General Meeting Assemblée générale 2006 Chicago, Illinois

1. Canadian Institute of Actuaries L’Institut canadien des actuaires 2006 General Meeting Assemblée générale 2006 Chicago, Illinois

2. PD-3 Assumption Setting For Pension Plans What is a Reasonable Going Concern Discount Rate? Bill Watson Mercer Human Resource Consulting

3. Assumption Setting For Pension Plans: What is Reasonable? • Current challenges • Mercer’s process for setting reasonable assumptions • Going-concern • Expected Return on Assets under CICA • Wrap-up

4. Current Challenges • Pension costs matter • Plans have matured • Aging workforce and an increase in retiree liabilities • Now a significant part of a corporation’s financial statements/cashflow requirements • Relative to the size of the active operations • Sharp rise in costs in recent years due to decreasing interest rates • Increased volatility

5. Current Challenges • Heightened Scrutiny • Plan sponsor • Pension and corporate governance • Finance area • Auditors • Regulators • Business community

6. Current Challenges • Increased litigation • Class actions • Court decisions • Fiduciary concerns • What is the role of the actuary?

7. 7% 6.84% 6.78% 6.65% 6.51% 1.1%= 6% = 1.8% 5.72% 5% 5.45% 5.15% 4.69% 4% 4.22% Going Concern Discount Rate (FSCO Stats) Long Canada Benchmark Bonds 3% 2002 2003 2004 2005 2006 January 1st Current ChallengesLower Bond Yields

8. Actuaries must be able to justify their assumptions Current Challenges Financial Pressure + Heightened Scrutiny + Increased Litigation + Lower bond yields = Challenging Environment for Pension Actuaries

9. Setting Reasonable Assumptions Going Concern Discount Rate What rate of return can we reasonably expect the pension fund to earn over the long-term? • Not a prediction • But as much as possible, a reading of the market

10. Setting Reasonable Assumptions Going Concern Discount Rate Historically, the typical approach for a Mercer actuary was: • Stable long term economic views • Based largely on empirical evidence • Little emphasis placed on market rates

11. Setting Reasonable Assumptions Going Concern Discount Rate Mercer’s current approach • Provide actuaries with a market based model to assist in determining the going concern discount rate • The actuary must assess the appropriateness of the assumptions for each valuation in the context of the particular case and the prevailing economic environment

12. Setting Reasonable Assumptions Going Concern Discount Rate First Step: Establish long-term expected return for each asset class • Bonds • Based on current market yields in effect on valuation date • Split by Universe, Long and Real Return Bonds

13. Setting Reasonable Assumptions Going Concern Discount Rate • Equities • Long bond yields plus equity risk premium • Equity risk premium considers expected GDP, dividend yield, growth in corporate earnings • Model provides 3 equity risk premium scenarios Combine expected returns based on target policy mix

14. Setting Reasonable Assumptions Going Concern Discount Rate Adjustments to expected return • Provision for active management • Based on portion of fund that is actively managed • Provision for expenses • Expenses charged to the fund not already explicitly included in the current service cost

15. Setting Reasonable Assumptions Going Concern Discount Rate Adjustments to expected return • Margin for adverse deviations • Based on portion of fund that is invested in equities and underlying equity risk premium • Consider any margins (positive or negative) inherent in other actuarial assumptions

16. Setting Reasonable Assumptions Going Concern Discount Rate An example, Expected Return 6.98% Active Management 0.30% Expenses (0.50%) Margin for adverse deviation (0.68%) Going Concern Discount Rate 6.10%

17. Setting Reasonable Assumptions Other Going Concern Assumptions Other assumptions • Economic assumptions (inflation, YMPE, salary scale) • Based on market yields • Demographic assumptions • Best estimate approach • Future mortality improvements Otherwise, further adjustments to the margin in the discount rate

18. Setting Reasonable Assumptions Expected Return on Assets (CICA) Actuaries often asked to provide input on accounting assumptions including the Expected Return on Assets (EROA) • Same approach as setting the going concern discount rate • No margin for adverse deviations since it is a best estimate assumption

19. 7% 6.84% 6.78% 6.65% 6.51% 1.1%= 6% = 1.8% 5.72% 5% 5.45% 5.15% 4.69% 4% 4.22% Going Concern Discount Rate (FSCO Stats) Long Canada Benchmark Bonds 3% 2002 2003 2004 2005 2006 January 1st Setting Reasonable Assumptions Is 6.5% still reasonable for a plan that is invested 40% bonds and 60% equities?

20. Setting Reasonable Assumptions Let’s assume, • Discount rate is before expenses • Margins for adverse deviation = 0.5% • Yield on universe bonds = 4.6% Roughly speaking, • Implies equity return of 8.6% [(6.50% + 0.50%) - (40% times 4.6%)]/60% • Implies an equity risk premium of 4.4% (Assuming government bonds are 4.2%)

21. Setting Reasonable Assumptions Wrap-up • Challenging times for pension actuaries • Actuaries must be able to justify their assumptions • Leads to assumptions that are largely driven by observed market conditions