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Pension Investments in the Ice Age 2010 MAAC meeting

October 7, 2010. Pension Investments in the Ice Age 2010 MAAC meeting. Matt McDaniel, FSA, EA, CFA . The trend from DB to DC continues How many Fortune 200 companies have frozen or closed their plans? . 2009. 2006.

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Pension Investments in the Ice Age 2010 MAAC meeting

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  1. October 7, 2010 Pension Investments in the Ice Age 2010 MAAC meeting Matt McDaniel, FSA, EA, CFA

  2. The trend from DB to DC continuesHow many Fortune 200 companies have frozen or closed their plans? 2009 2006 Ongoing DB plans No DB plans Frozen, new employees Frozen, some existing employees Frozen, all existing employees Source: Internal Mercer analysis

  3. Sponsor financial risk • Market value • fluctuations in: • Plan assets • Plan liabilities • Funded status (Yesterday) (Today) • What’s different today? • Pension Protection Act • FAS 158 • Increased equity volatility • FAS / IAS convergence? (Tomorrow) • Fluctuations in: • Expense • Balance sheet/equity • Cash flow Pension Financial Risk is Changing – Volatility is being Unmasked

  4. Why are sponsors moving from DB to DC? “Volatility reduction” is almost always cited by sponsors as a key reason to freeze DB plans. Yet plans have generally not experienced reduced volatility following a freeze. Why? Source: 2006 Mercer survey

  5. How do we define risk and reward?A football analogy • 4th quarter, 1:08 remaining • Ravens have the ball • 1st and 10 on the Pittsburgh 18 yard line • Ravens call a long pass into the endzone • Was this a good strategy? • What key piece of information do you need to know to evaluate this decision?

  6. The right strategy depends on: the rules of the game and the score When is risk uncompensated? When might it be appropriate to take more risk? So why aren’t frozen plan sponsors taking risk off the table once fully funded?

  7. How do we define pension risk?Pension Risk = Funded Status Volatility Pension Frontier Asset Only Frontier MAX MAX 100% Equity 100% Equity Diversified Diversified Reward: Expected Returns Reward: Expected Returns Matched Bonds (least risk) Bonds Cash is Inefficient: Less Reward & More Risk Cash (least risk) Cash MIN MIN MIN MAX MIN MAX Risk: Funded Status Volatility Risk: Return Volatility Goal:Minimize Funded Status Volatility for a specified level of expected return Goal: Minimize return volatility for a specified level of expected return When liabilities are considered, the efficient mixes are not the same as those that are efficient in an asset-only framework… simply due to the change in the definition of “risk”.

  8. The Business Case for Derisking Funded Status (S&P1500 Companies) Aggregate funded status improved from 73% in 2003 to well over 100% in 2007 Less than 5% of plans fully funded by early 2009 Why were these opportunities missed? • Not ready: no formal plan for de-risking as conditions improve • Not aware: infrequent monitoring of funded levels • Not fast enough: lack of execution capabilities to take advantage

  9. Risk management in the pension context Yesterday Asset Only Today Liability Driven Alternatives Excess Return Active Management Diversified Return Generation Excess Return Market Exposure Fixed Income Fixed Income Equity LiabilityRisk Mitigation Fixed Income Exposure Unrewarded Risk Management

  10. Funded status (%) % growth portfolio allocation 100% 5% Desired trajectory 95% 10% 90% 20% 85% 25% 80% 30% 75% 40% 70% 50% 65% Starting point End game Time Actualfunded status Gradual de-risking from growth portfolio as funding status rises Getting from here to thereDynamic derisking Illustration of the “glide-path” How does it work? • Strategic analysis to define glide-path, trigger points, and target state in advance • Regular funded status monitoring • As funded status improves plan is derisked by transferring assets from growth to matching portfolio • Regular strategy is review

  11. How do we build a glide path? 4 Specify a dynamic program to move from current to end point in discrete steps. Translate primary characteristics in asset class allocations. 3 These primary characteristics can define each portfolio Articulate “behavior” as primary characteristics for the portfolio. 2 1 Determine the desired “behavior” of the end point portfolio.

  12. How do we build a glide path? Reducing equity allocation Increasing duration hedge Increasing credit hedge Increasing fixed income allocation Calculated based on target duration hedge and credit hedge Calculated to achieve duration hedge ratio Calculated using portfolio return calculator

  13. Financial strategy & executionDetermine the endgame strategy: retain versus transfer liabilities • Plan Termination eliminates all financial risk and ongoing administration, but at an up-front cost • Continued Management is often a less costly alternative but requires ongoing administration and management of the plans Plan termination Dedicated bond portfolio Annuity placement for a portion of liability (retirees and/or terminated participants) Settle portion of liabilities by offering lump sums Increase fixed income allocation Increasing Cost And Decreasing Risk* Interest rate hedging strategies using derivatives; retain some equity exposure Traditional asset management strategy Transfer Retain *Not to scale; information provided on directional basis for discussion purposes

  14. What are sponsors doing? Status Quo Change only with legislation driven modifications Re-allocate assets Risk hedging US DB assets$1.5 TN Transform to run like an insurance entity Annuitization / Buy-in / Buy-out Manage a completerisk transfer • Recent survey about endgame strategy: • 159 people responded from a variety of industries • Question: What is the endgame strategy for your pension plan? • Undecided 48% • Terminate in 5-7 years 24% • Terminate ASAP 16% • Maintain indefinitely 12%

  15. What are other employers doing? If yes, what is it?(54 responses) Does you have a specific endgame target?(110 responses) Wasting trust 5 (9.26%) Other2 (3.70%) 57 (51.82%) 53(48.18%) Yes No Plan termination 47 (87.04%) What is the anticipated horizon to plan termination? (101 responses) Other – please specify 6 (5.94%) Indefinite 43 (42.57%) 5+ years 28 (27.72%) 2-5 years 18 (17.82%) 0-2 years 6 (5.94%)

  16. What are other employers doing? What is the current asset allocation to risk assets, e.g., equities (110 responses) More than 50% 68 (61.82%) 26-50% 29 (26.36%) 0-25% 13 (11.82%) What is pre-disposition to de-risking in the future? (108 responses) Other – please specify 14 (12.96%) Indefinite 36 (33.33%) 5+ years 16 (14.81%) 2-5 years 6 (5.56%) 0-2 years 36 (33.33%)

  17. What are other employers doing? Funding strategy (110 responses) Other – please specify 43 (39.09%) Fund minimum 67 (60.91%) Plan for unlimited lump sum cashouts (105 responses) Other – please specify 48 (45.71%) Likely to offer in 2012 7 (6.67%) Looking at feasibility of offering 26 (24.76%) Already offered 24 (22.86%)

  18. Questions?

  19. Disclaimers • The views expressed herein are the views of the individual(s) making the presentation, and are not necessarily shared by his/her employer. • The information contained in this document (including any attachments) is not intended to be used, and it cannot be used, for the purpose of avoiding penalties under the Internal Revenue Code that may be imposed on the taxpayer.

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