0. Pension Plan Risk Management
Phil Kivarkis, FSA, EA, CFA, Director of Investment Policy Services
Hewitt EnnisKnupp

1. Pension Funded Status – A Wild Ride
US Debt Rating Downgrade
2008 Credit Crisis
S&P 500 aggregate pension funded status shows considerable volatility, and two extreme events in three years

2. Our Survey Shows Broad Risk Management Focus3% 2% 0%
13%
10%
38%
65%
78%
68%
69%
84%
58%
31%
20%
21%
21%
14% 4%
What changes have you made to your target investment strategy?
Source – Aon Hewitt Pension Risk Survey

3. Integrated Risk Management Toolkit
Investment
Policy
Funding
Strategy
Plan
Design
Assumptions
and Methods
Glide Path
Hedge path
Credit path
Return-seeking portfolio
Hedging portfolio
Synthetics/Collars
Pre-funding
Borrow to fund
Fund equity
Stabilizer
Close
Freeze
Cash Balance/ Career Average
Lump Sums
Asset smoothing
Rate averaging
Conservatism
Aggressiveness 3

4. Current Interest Rate Environment is Challenging
Yields are below historic levels…
Maturity
Source: Citigroup Pension Discount Curve

5. Some Opportunities Exist
Very steep yield curve…
CMT = Constant Maturity Treasury
Favorable credit spreads…
Source: Barclays Capital

6. Pension Plans Have Already Begun to De-Risk As Seen in Actual Allocations
Note: S&P 500, US plans only.
Source: Goldman Sachs Global Markets Institute; Capital IQ; company reports.

7. Dynamic Investment Policy Components

8. Improving Your Odds
These probabilities represent the chance of various return-seeking portfolios outperforming long government/credit bonds over the next three years, using our current (1Q 2011) capital markets modeling assumptions. The expected return on long gov’t/credit bonds is 4.75%.
Typical Return-Seeking Portfolio (Expected Return = 7.4%)
Allocations: 75% Broad U.S. Equity / 25% Non-U.S. Equity (Dev & Emg)
Diversify Globally (Expected Return = 8.4%)
Allocations: Market Weight Global Equity (45% Broad U.S. Equity / 55% Non-U.S. Equity (Dev & Emg))
Increased Active/Credit Risk (Expected Return = 8.7%)
Allocations: 60% Market Weight Global Equity / 30% Hedge Funds (median manager, not “buylist” – reflects credit basket allocation) / 10% Private Equity (9.2% return assumption, reflects distressed debt allocation)
Assumes 25bp value added on total return-seeking portfolio from medium term views (reflecting some use of MTV in structuring credit portfolio)
Add Alternatives (Expected Return = 8.8%)
Allocations: 50% Market Weight Global Equity / 30% Hedge Funds / 10% Real Estate / 10% Private Equity
Assumes 25bp value added on total return-seeking portfolio from medium term views
Source: Hewitt EnnisKnupp capital markets expectations 8

9. Structural Surplus Risk
Why Customize?
Improved Performance and More Effective Risk Management.
Structural Surplus Risk
More Effective Hedge
Custom Mandate Long Credit – 80%
STRIPS 20+ yrs – 20%
Source: Hewitt EnnisKnupp
Illustrative Example

10. Alternative to Immediate Extension: Two-Dimensional Glide Paths
Two-Dimensional Glide Paths offer a way to manage a pension plan out of the current low interest rate environment.
First Dimension
Funded Ratio
Return Needs
Return-Seeking Allocation
Second Dimension
Dynamic investment policies may be designed to incorporate Return Needs and Hedging Needs along two related, yet separate dimensions – Funded Ratio and Interest Rate Level.
Interest Rate Level
Desired Duration
Hedge Ratio

11. Liability Hedging Path Design
The glide path implies a certain liability hedging path…
Glide Path Hedge Ratio

12. Liability Hedging Path Design: Hedge Path Corridor
…but liabilities and interest rate views also imply certain liability hedging possibilities.
Max Hedge Ratio Using Physical Bonds
Floor at 80%
Need funded ratio to go from 80% to 100% when rates rise 2.5%.
Liability Duration is 12 years.
If rates rise 2.5%, then liabilities will fall by 30% to $70 ($100 to $70).
Assets are $80 (80% FR).
$48 LHP – ($48 LHP X 8.3 year duration X 2.5%) = $38
$38 + $32 = $70 total assets
Ceiling at 80%
$48 in LHP (60% LHP X 80% Funded Ratio)
Max allocation to 20+ year bucket is $21 based on liability profile.
$21 invested in 20+ year STRIPS at duration of 27 years + $27 invested in Long Credit at duration of 12 years = 18 year duration.
Max Rewarded Upside from Rising Rates

13. Integration of Hedge Path and the Glide Path - Illustrative
Funded Ratio
80%
85%
90%
95%
100%
Discount Rate Level
LHP %
53%
67%
79%
Significantly High (+200 bps)
72%
86%
High (+100 bps)
58%
83%
93%
Fair Value
43%
57%
71%
Moderately Low (-50 bps)
35%
48%
65%
82%
Low (-100 bps)
27%
38%
59%
Very Low (-150 bps)
19%
29%
77%
Significantly Low (-200 bps)
18%
24%
47%
74%
Key Characteristics
Tailored to Plan glide path and funded ratio goals
Incorporates Client’s interest rate views (and ours)
Provides guidance while leaving flexibility to execute
Market opportunities (medium term views)
Available instruments

14. Hedge Path Development Steps
Design Glide Path (if one doesn’t exist already)
Review Risk Budget and Investment Horizon
Develop a Hedge Path to Complement Glide Path
Develop an Execution Strategy
Update Investment Policy Statement
Consider Outsourcing Execution
Update Reporting to Include Hedge Path
Transition the Portfolio to Target Hedge Ratio on Hedge Path
Credit vs Government
Yield Curve Positioning
Use of Physicals and Synthetics

15. Key Takeaways Current Environment Duration Extension
Steep curve, spreads favorable
Asset return risk meaningful
De-risking and defeasance trends persist
Duration Extension
Two-dimensional paths provide framework for change
Ultimately, risk management drives hedge ratio
Customized Portfolios
Customization can improve hedging characteristics
Relative importance increases with hedge ratio
Diversification improves odds of success