1. CPBI National Conference
Managing Pension Plan Financial Risk
David Service
June 14, 2007

2. Background
Plan sponsors must always manage pension program with prudence (fiduciary obligation)
Impacts on various standard of care provisions (including funding and investment policy)
Prudence also implies a duty to manage the program within plan sponsor affordability to:
Maintain the financial strength of the employer
Maintain the plan for future employees
Corporate plan sponsors increasingly forced to consider pension plan as if it is an operating subsidiary
Establish income statement, free cash flow and balance sheet metrics within which it must operate
Develop more sophisticated tools to help manage it within required metrics
Reflects:
Increasing size of pension plan relative to sponsoring organization
Increasing maturity of the plan’s membership
Plan sponsors attempt to balance a key trade-off:
Assets must generate sufficient return to make the plan sustainable in the long term
Assets must behave sufficiently like the “liabilities” that the volatility in the key financial metrics (from year-to-year) is within tolerable bounds

3. Context of the Problem
Examined the financial leverage that exists within a number of large public sector plans
Impact of a 10% experience loss (asset and/or liability)
Amortized loss over 15 years
Expressed contribution increase as percentage of payroll
Mature corporate plans display similar financial leverage
Increasing discussion of financial economics and liability-driven investing seeks to address some of these issues

4. Contribution Policy
Current regulatory environment largely responsible for current financial situation of plans
Surplus ownership issues
Monsanto decision
Minimum funding rules (i.e. solvency) that result in excessive contributions for plans that are not intending to wind up – Results in surplus in long term
No linkage between amount of mismatch risk accepted by plans and funding targets
Rational employer choice has been to defer contributions to plans (i.e. minimize contributions each year)
Need a regime in which:
Beneficiaries’ interests are protected appropriately, and
Employers make rational cash deployment decisions in context of their “business”
Critical first step is to better define the financial framework within which the program must be operated

5. Public Sector Plans Two basic categories:
Risk shared plans: Member contributions and sponsor contributions are directly linked by a formula
Employer sponsored plans: Members typically required to contribute but deficits are primarily funded by the employer
Employer sponsored plans should be considered under the same terms as corporate plans
Ultimate stakeholder is the taxpayer
To fund cost increases, plan sponsor must:
Generate additional cash (raise taxes)
Take money from other cash expenditures
Borrow

6. Risk-Shared Plans
Unique characteristics must be recognized in “risk-shared” plans
Member and sponsor contributions are linked together using a formula
Deficits are financed by both parties
Surpluses result in contribution reductions/holidays for both parties or in benefit improvements
Intergenerational transfer is a key issue
Contribution changes only affect active members
Benefit improvements can affect both active and retired members
Benefit reductions typically only applied prospectively
Both upward/downward movements can be problematic
Contribution volatility is the key issue to manage
Can use similar approach to corporate plans in developing metrics (adjusted for obvious differences)

7. Corporate Plans – Financial Framework
Understand the financial metrics that are being used by external stakeholders to assess the company
Financial analysts
Lenders
Rating agencies
Ensure that any performance commitments that have been made to external stakeholders are recognized
For a subsidiary of a foreign parent, understand:
Financial metrics used to assess subsidiary performance
Potential consequences of underperformance
Strategic and financial goals (short and long term)
Profit implications
Free cash flow implications

8. Corporate Plans – Financial Framework
Understand key factors that could prevent company from achieving these strategic and financial goals – Which can the company control or mitigate?
Understand the debt structure of the corporate balance sheet (short vs. long term, variable vs. fixed) – Possible source of risk mitigation
Consolidate pension financials into the company financials to understand materiality and potential ability to swing:
Free cash flow
Operating profit
Employment costs
Understand degree to which economic factors that drive pension costs also drive the company’s results
Interest rates
Price inflation
Economic cycle
Currency exchange rates (and which ones)

9. Pension Financial Management Metrics
If pension contributions were to increase, where would the money come from?
Should now have a framework to develop acceptable:
Level and variability of pension contributions
Level and variability of pension expense
Balance sheet metrics
Need to manage all elements of the investment strategy to improve likelihood of meeting objectives
Remainder of presentation will focus on an investment framework that can help in maximizing the likelihood of achieving these objectives

10. Generating Returns with Appropriate Financial Risk
Initial investment focus on degree of acceptable mismatch risk
Recognizes need for plan sponsors to generate higher returns than bond yields
Plans unaffordable otherwise
Likely to lead to large scale windups
Captures risk at macro level
Need robust definition of financial risk/reward
Focuses on linkage between asset behavior and mark-to-market liabilities (solvency and accounting)
Use ALM as main tool to assess
Need to structure matching assets optimally
How much protection is needed?
How is it best achieved for key liability measure?
Recognize impact of various smoothing devices (if applicable)
Should cash investments or derivative instruments be used to effect the required changes?
Do you need to “leverage” the duration to recognize degree of mismatched investment?

11. Allocation of Financially Risky Assets
All investments that do not behave like key liability measure are “financially risky”
Need to allocate risk to generate optimal financial risk/reward profile
How much return is needed to make plan affordable in the long term?
Can risk profile be altered relative to modeled result?
Analysis can be framed relative to key liability measure (if it is a mark-to-market measure) or can be transformed into an absolute risk/return framework
Either way, risk “budgeting” concepts are changing:
Less focus on risk relative to the benchmark (tracking error)
Increasing focus on either:
Risk relative to liabilities, or
Risk in absolute terms (i.e., losing money)

12. Diversification of Financially Risky Investments
Diversify sources of market risk
Traditionally focused primarily on public markets
Recent focus on less correlated sources such as hedge funds, managed futures, real estate, infrastructure
Decide how much public market risk (beta) is desirable
Need to generate higher returns than available through market indices
Discard low tracking error managers
Invest in index funds or futures
Overlay reliable diversified basket of high alpha sources
Seek out managers with demonstrated and consistent skill
Prepackaged products being introduced
Use long only equity managers to alter the nature of market risk (beta)
Seek down market protection
Approaches focused on managing absolute risk (i.e. capital preservation)
Bottom-up stock pickers with conviction
Concentrated portfolios with high alpha potential
Private equity is a potential option

13. Framework Overview Financial Objectives Proportion Matching Assets
Financially Risky Assets
Nature of Portfolio
Duration
Real vs. Nominal
Credit Exposure
Explicit Market Risk
Modified Market Risk
Long Only Public Equity Portfolio
Alternative Investments
Diversified Sources of Alpha
Goal:
Control degree of financial risk exposure
Goal:
Seek optimally diversified market exposure and diversified sources of alpha

14. Summary
Pension plans continue to be important element of rewards package
Cost must be affordable in the long term
Financial risk to plan sponsor must be controlled within tolerable bounds
Increasing focus on managing assets relative to liabilities
Will lead to greater differentiation between plan sponsor strategies
Comparative measurement (at total fund level) will become immaterial
Need a more rational contribution policy
Clearly recognize impact of asset/liability mismatch
How much matching does plan sponsor need?
How much mismatch is present?
Better diversify the unmatched portion of the fund
Different approach to hiring long only managers
Alternative types of risky assets