Asset/Liability Management Pensions and Other Post Employment Benefits

1. Asset/Liability Management Pensions and Other Post Employment Benefits State Association of County Retirement Systems (SACRS) February 6, 2007 Navigating Public Pensions & OPEB with Liability Driven Investments Ryan Labs (www.ryanlabs.com) Sean McShea SMcShea@RyanLabs.com Chris Adair CAdair@RyanLabs.com Jason Johnson JJohnson@RyanLabs.com 1

2. Pension & OPEB: Problems Problems: • Under Funding • Higher Net Costs (Accrued Liabilities) • Higher Contributions • Compounding in reverse (Negative Leverage) • CPI & COLA inflation < Medical inflation • Demographics • Mortality tables • Sunset communities vs. Sunrise communities 2

3. Pension & OPEB: Crisis In Public Plans Causes: • Silo effect (optimization in isolation) • Agency problem (no one in charge) • Morality issues (wealth transfer) • Asset Only Framework (mean variance models) • Actuarial Smoothing (No economic content) • Pro forma Accounting Return Assumptions • Lack of Financial Economics in pension practices • Peer Group (Beauty Contest) 3

4. Solution Framework 4

5. Client Objectives:Public Funds Client NuclearDecommissioning Corporation Hospitals Taft-Hartley States&Municipalities Endowment/Foundation Insurance General Accounts Construction Pension OPEB Medical Lottery Prepaid Tuition Defeasance Worker’s Compensation Custom Distribution Custom Grant Endowment Pensions Medical Liabilities Construction Projects Defeasance Programs Self Insurance Incurred Liabilities Pensions Medical Liabilities Pensions Medical Liabilities Plan Terminations General Accounts Life Workers Compensation Property & Casualty 5

6. Public Plans:Assumptions Government will not default on it promise • Prefunding ensures intergenerational fairness • Current stakeholder pays fair share current cost • Future stakeholder pays only for future cost • Minimize current costs by capturing equity risk premium • Protect the municipal bond rating and bonding capacity • Participants exchange direct for deferred compensation • Stakeholders own the pro rata share of balance sheet 6

7. Public Plans:Three Key Levers • Benefit Management • Current benefits, Benefit enhancements • Contribution strategy • % of active payroll • Constrained by budget • Asset Allocation • Capture equity risk premium (Reduce cost) • Avoid risk 7

8. Teams: Asset/Liability Watch (December 2006) 2006: Good year !! 8

9. Assets vs. Liabilities Funding Volatility (December 2006) 9

10. Risk is best defined as NOT meeting the client objective: No Risk =Assets Match Liabilities High Risk = Assets Don’t Match Liabilities (Surplus Volatility) Low Risk =Assets Behave Like Liabilities Return of Portfolio – Return of Objective New Sharpe Ratio = STD (Portfolio Return – Objective Return) Risk: Risk is Based on the Objective 10

11. GASB 25 versus FASB 87/158 (Difference between Public & Private) 11

12. Public Pension Plan Funding Policy v. Investment Policy 12

13. Time: Annual Financial Statements (Private vs. Public) Annual Reporting Requirements Pension contribution annually Based on present value of assets and liabilities Private/Corporate America Pension Expense (Income Statement) Pension Contribution (Cash flow Statement) Surplus or Deficit (Balance Sheet) Public/State or City Revenue & Expense (Municipal rating) Funding Cost (Current tax rates) Surplus or Deficit (Generational or resident equity) 13

14. Rules: GASB 43 & 45(Non Pension Related Liabilities) OPEB Other post employment benefits GASB 43 Financial Reporting for Post Employment Benefit Plans Other Than pension plans Requires accrual of liabilities Replaces pay-as-you go basis GASB 45 Requires accrual of OPEB expense 14

15. Playing Field: Time Frame Long Term Horizon v. Solvency • Public Plans : Horizon (10 to 20 year horizons) • Prevailing Pension practice • Smoothing Assets (5, 10, 15 years) • Amortization of Liabilities (15 to 30 years) • Fully funding (assumes asset allocation return of 8%) • Assumes Sponsorship Longevity • Private : Economic Solvency • Best Practice methodology • Fair Value of Assets and Liabilities (Basel II) • No smoothing • 100% interest rate driven • Mark to Mark Valuation on Assets vs. Liabilities 15

16. Playing Field: Solvency / Present Value $ • Future value (Projected benefit payments) • Inflation, COLAS, Mortality • Labor costs/demographics • Plan design • Don't know the future value of assets • Present value • Determines funding adequacy • Required by SEC/FASB/PPA 2006 • 100% interest rate driven • Priced using yield curve 16

17. Public Fund Risk: Unpleasant Issues 17

18. Problem: Investment Process Prevailing Practice vs. Best Practice Current Actuarial Models and Methods Current practice is not best practice Financial Economic models expose flaws in standard modes Calls for revision of actuarial training and practice Financial Economics and Actuarial Practice Tony Day Presented at The Great Controversy: Current Pension Actuarial Practice in Light of Financial Economics Symposium Sponsored by the Society of Actuaries Vancouver June 2003 18

19. Problem: Pro Forma ReturnsRisk Premium Review 19

20. Problem: Stakeholder Current vs. Future • Generational Equality (Fair share of costs) • Pro Forma mechanism transfers risk ($1 equity > $1 bonds) • Reward is captured today, risk is transferred to the future • Smoothing feels good but contains no “economic” content • Current practice favors current management, taxpayers, plan participants, politicians, at the expense of future shareholders and stakeholders (taxpayers). Source: Risk Transfer in Public Pension Plans, Jeremy Gold, PRC WP 2002-18, 2002, Pension Research Council The Wharton School, University of Pennsylvania 20

21. Problem for Stakeholders Expected Returns • Sub Optimal Decision Making • Benefit leakage (wage / pension negotiation) • Asset Allocation focused on asset only framework • Granting of valuable options (DROPS, skim funds) • Costly financing options (i.e. Pension Obligation Bonds) • Wealth transfer devices (i.e. Infrastructure Securitization) Source: Risk Transfer in Public Pension Plans, Jeremy Gold, PRC WP 2002-18, 2002, Pension Research Council The Wharton School, University of Pennsylvania 21

22. Problem:Actuarial Valuations (Mispricing Liabilities) Actuarial Flaw: (Benefit Management & Funding) Single Discount Rate (Assumes “horizontal” term structure) Not fully determined by market interest rates (Usually 100 to 400 plus basis points too high) Present Value calculation performed annually (Usually the month plus delinquent) Liability Term Structure not visible (Short, Intermediate, Long, Very Long) 22

23. Robert North, Chief Actuary of New York City Actuarial methods based on actuarial interest rate (AIR) Ignores financial economics North ratio: NYCRS 70% Funded ($14 B deficit) 2005 CAFR : NYCRS 99% Funded (No deficit) Problem: Disclosure A New York City Pension Story Source: Life & Pensions magazine, March 2006 23

24. Problem : Generic Indexes (Mean Variance Models) • Mean Variance Models based on Generic Indexes • Represent the market (Lehman Aggregate, S&P 500) • (Subjective methodology) • (Potential bias = Investment Banking, Trading) • NOT based on client liability schedule • (Unique to each client) • Does NOT represent clients’ true objective 24

25. Goal Measure growth, size, shape of liabilities Features Market value, yield, duration, returns Return Total return, index levels Performance Money management index Quantifies asset allocation Scoreboard: Custom Liability Index 25

26. Solutions: Adopt Liability Benchmark 26

27. Structure Difference Liabilities vs. LB Aggregate 27

28. Solution: First Steps Reduce Risk, Protect Expected ROA 28

29. Solutions: Strategy Results 29

30. Goal Measure growth, size, shape of liabilities Features Market value, yield, duration, returns Return Total return, index levels Performance Money management index Quantifies asset allocation Scoreboard: Custom Liability Index 30

31. Solution: Custom Liability Index • Benefits • Represents client objective (funding target) • Supports strategic & tactical asset allocation • Benchmark for asset management • Benchmark for performance measurement • Benchmark for risk management control • Foundation for risk budgeting 31

32. Solution: Asset Allocation Liability Driven Allocation • Asset allocation based on two portfolios: • Beta Portfolio = Liability Portfolio • Bonds to outgrow liabilities • Interest rate hedge • Bonds, Futures, Swaps • Alpha portfolio = Performance Portfolio • Non Bonds • Without liability constraints • Rebalancing = Success is rebalanced back to Beta • Harvest gains 32

33. Objective: Understand the Liabilities 33

34. Problem: Negative Leverage 34

35. Solution: New Approach(New methodologies) Transparency Fair Value Accounting Asset/Liability Management Focus on Asset Allocation (Strategic/Tactical) Alternative Asset Classes (Low correlation) 35

36. Solution: New Approach(New methodologies) Traditional Approach LDI Approach Liability Risk Asset Mix Risk Active Risk Source: Leo de Bever, Ontario Teachers' Pension 36

37. Solution: Move Away From Single Focused Strategies Source: First Quadrant/Research Affiliates 37

38. Ryan Labs: Assets vs. Liabilities Monitor Annualized Annualized Twenty Year Returns - Period ending 12/31/05 Return Return 16% 16% Ryan Labs Liability Index is represented by the Treasury STRIP 14% 14% curve (1 thru 25 years) • • • • • • S&P 500 Wilshire Large 11.93% • • • Wilshire Small • Cap Value • 12% 12% • Cap Growth 12.15% • Russell 2000 12.00% • • 11.17% • • P&I Asset • • 10.61% • Ryan Labs • MSCI EAFE Liability 10.00% 11.07% • • Merrill Lynch 10% 10% High Yield • Ryan Labs • 9.26% Merrill Lynch • 30yr. Treasury Yankee • 8.79% • 8.63% • • Ryan Labs • Lehman 10yr. Treasury FInancial Times • 8% 8% Aggregate 7.58% Equity Pacific • • 7.88% 7.30 % Ryan Labs • • 3yr. GIC • • 6.75% Ryan Labs • 5yr. Treasury • 6.95% 6% 6% • Ryan Labs Ryan Labs • 2yr. Treasury 6 mo. Bill 6.16% 5.24% Very Long Short Intermediate Long 0 2 4 6 8 10 12 14 16 18 20 22 24 Volatility of Total Return (STD) Sources: Ryan Labs, Inc.- Standard & Poor's Corporation - Lehman Brothers - Merrill Lynch - Morgan Stanley Capital International - Frank Russell Company - Financial Times - Wilshire Asset Management - Crandall, Pierce & Company The information presented herein was compiled from sources believed to be reliable. It is intended for illustrative purposes only, and is furnished without responsibility for completeness or accuracy. Past performance does not guarantee future results. Assets vs. Liabilities Monitor (Last 20 years ending 2005) 38

39. 4% 4% Ryan Labs Liability Index is a proxy 2% for pension plans 2% • • • • • • Wilshire Large • • Wilshire Large Cap Value • • Cap Growth • • S&P 500 • • Ryan Labs • Liability Index • 0% • 0% n • P&I Asset Russell 2000 • Lehman • n • GC Long • • Merrill Lynch • Merrill Lynch Ryan Labs Convertible Merrill Lynch High Yield • 30yr. Treasury • • Yankee -2% Annualized Excess Returns vs. Ryan Labs Liability Index (%) -2% • Annualized Excess Returns vs. Ryan Labs Liability Index (%) MSCI EAFE • • Lehman • Ryan Labs Aggregate • 10yr. Treasury • • • • Ryan Labs -4% -4% 3yr. GIC • Ryan Labs • • 5yr. Treasury • Ryan Labs 2yr. Treasury • • FInancial Times Ryan Labs Equity Pacific -6% -6% 6 mo. Bill 0 2 4 6 8 10 12 14 16 18 20 22 24 26 Annualized Tracking Error (TE) vs. Ryan Labs Liability Index (%) Asset/Liability Return Difference And Tracking Error (Last 20 years) Asset/Liability Return Difference 39

40. Solution: Equity Correlation to Liabilities (1) RL Treasury Long Index from 1949 to 1990, RL Liability Index from1991 to 2006, 40

41. Adopt Liability Driven Investment strategy Design Custom Liability Index Document economic solvency Document cash flow budgeting Segregate Liability portfolio Segregate performance portfolio Reduce deficit, harvest gains back to liabilities Grow surplus Monitor risk Document, Document, Document Solution: Next Steps 41

42. Move from prevailing practice to best practice Create economic and actuarial reporting Replace Policy benchmark with Liability benchmark Understand limitations of peer group analysis Structure fixed income to liabilities Segregate Surplus (performance portfolio) Positive story to trustees and rating agencies Protect defined benefit pension plans Solution: Small Steps 42