GuidinG defined

benefit pension

schemes alonG their

path to full fundinG

by manaGinG

investment strateGy

and risk

AN INTRODUCTION TO MERCER DYNAMIC DE-RISKING SOLUTION

GUIDING DEfINED

bENEfIT pENSION

SChEMES ALONG ThEIR

pATh TO fULL fUNDING

bY MANAGING

INvESTMENT STRATEGY

AND RISK

DYNAMIC DE-RISKING SOLUTION®

4

ow, more than ever, the time is right for overburdened trustees to seek

investment solutions that continually implement their long-term strategic policy in the light of changing market conditions.”

1/1/

07

1/7/

07

1/1/

08

1/7/

08

1/1/

09

1/7/

09

1/1/

10

1/7/

10

1/1/

11

1/7/

11

1/1/

12

1/7/

12

200

150

100

50

0

-50

-100

-150

-200

-250

-300

-350

Surp

lus

£bn

Source: PPF 7800

This presentation contains confidential and proprietary information of Mercer and is intended for your sole use. The presentation, and any opinions on or ratings of investment products it contains, may not be modified, sold, or otherwise provided, in whole or in part, to any other person or entity without Mercer’s written permission.

ppf eligible schemes – aggregate surplus from 1 July 2007 to 1 July 2012

N“

1

to deliver more secure liability matching. Trustees are under pressure to close deficits quickly, but without imposing unrealistic burdens on sponsors. Thus, a continuous balance must be struck between security and affordability.

As trustees and sponsors are looking to better manage their pension risk exposures, the number of schemes that are closing even to future accrual has increased dramatically. Other risk management solutions include a commitment to gradually sell down growth assets over several years and to use liability-driven investing, protective equity options, enhanced transfer value programmes, longevity swaps, pension buy-ins and full scheme buyouts.

Mercer believes that no single tool is a panacea, but rather that the suitability of each strategy should be continuously monitored in the light of prevailing market opportunities. MDDS offers a clear framework for integrating the use of these tools in a flexible, opportunity-driven manner.

The chart on the left demonstrates opportunities where schemes could have locked in gains after periods of improved funding levels, reducing the impact of subsequent market corrections. However, many pension funds have missed opportunities to manage funding risk, largely due to a combination of:

•Inability to react quickly enough to market circumstances

•Lack of clarity and agreement over longer-term funding investment objectives

•Unfamiliarity with techniques for downside protection

UK defined benefit (DB) schemes continue to grapple with unprecedented volatility in their funding levels, caused by equity market declines, low real bond yields and dramatic longevity improvement.

According to the Pension Protection Fund’s calculations, the aggregate surplus for UK DB schemes on their basis collapsed from a surplus of £130bn at the end of June 2007 to a deficit of £200bn by the end of June 2009. This £330bn rout has arisen despite record special deficit contributions of £30bn, with roughly half of the damage caused by the equity bear market and a quarter due to real rate declines.

Despite this backdrop, most DB pension trustee boards are only able to meet a handful of times throughout the year and rarely have the ability to come together in response to specific market events. The limited resources that can be devoted to investment decision making make many trustee boards unable to respond effectively to rapidly changing economic conditions. This leaves schemes liable to miss out on valuable opportunities to lock in improved funding ratios during the good times and unable to manage downside risks during periods of market adversity.

The economic costs of long-term pension benefits have become increasingly apparent to trustees, sponsors and investors as strengthened regulation has upgraded the “pensions promise” to a “guarantee”, and as accounting changes have marked these guarantees to market. Cost pressures have prompted schemes to close to new members, thereby reducing cash inflows and shortening investment horizons. Some schemes have looked to bonds to boost their cash flow and

CONTEXT

2

ThE DE-RISKING OpTIONS …

Substantial losses from the recent market turbulence demonstrate that pension schemes might benefit from a more dynamic long-term approach to investment decisions. Through Mercer Dynamic De-risking Solution (MDDS) trustees and scheme sponsors can achieve this by delegating responsibility to a third party that can monitor funding levels on a daily basis and react more responsively to changes in market conditions.

Many pension schemes are seeking to take risk out of their portfolios when they can afford to do so, and to do that efficiently requires a dedicated commitment to managing investment strategies on a real time and dynamic basis.

Until now trustees have been faced with limited choice and flexibility when attempting to deal with the challenge of de-risking their portfolio.

OPTIONS PROS CONS

•Regular re-balancing

•Simple•Can be cheap to implement

•May not take full account of transaction charges• Often a manual process• Timing of changes may not be favourable• Limited risk reduction benefits• Does not work as well in very volatile markets

•Progressive asset allocation changes

•Clear and disciplined approach

• Activity may not reflect scheme funding position

•Liability-driven investment approach

•Reduces unrewarded investment risks

•Requires a significant investment in governance structures and trustee training

•Significant implementation time may be required

•Buy-ins •Good match for liabilities•Benefits from FSA regulatory

regime

•Typically focused on pensioner liabilities only•May limit options for future efficient risk

management approaches for actives and deferred liabilities

• Irrevocable commitment•Significant lead time•Counter-party risk•Cost implications

•Buyouts •Minimal counter-party risk•Benefits from FSA regulatory

regime•Liability extinguished for

company and trustees

• Irrevocable commitment•Significant lead time•Cost implications•Counter-party risk transfers to individuals

TyPICALLy THE OPTIONS HAVE INCLUDED THE FOLLOWING:

3

MDDS AN INTRODUCTIONMDDS is an entirely new solution for UK Db pension schemes attempting to cope with their funding arrangements and underlying investment strategy. It is designed to bring order, discipline and new operational capabilities to Db fund management – transforming the way schemes develop and manage their risk reduction plans.

by bringing together Mercer’s renowned retirement and investment consulting experience, with its proven, established and highly successful investment implementation capability, Mercer is uniquely positioned to provide scheme sponsors and trustees with a real and practical solution to their pension funding challenges.

4

The following steps are taken:

1. Long-term funding target is established

2. Time horizon and risk appetite are specified

3. Based on this, Mercer calculates the expected funding path and recommends a series of funding level bands crossed by this trajectory

4. Each band has an associated: — Target growth portfolio allocation

— Downside protection level beyond which asset falls are minimised

5. The funding level is monitored daily by Mercer and is regularly reported via secure web access

MDDS hOW IT WORKS

Mercer works closely with trustees/sponsors over a series of meetings to agree the overall funding objectives and to calibrate an affordable de-risking path.

6. If the funding level crosses upwards into a new band, this triggers actions implemented automatically by Mercer:

— Reducing the growth portfolio allocation in line with the allocation of the new band

— Increasing the downside protection level to the higher level associated with the new band

7. If the funding level falls to the downside protection level, this also triggers automatic actions by Mercer:

— Downside protection implemented to reduce further losses

— Protection maintained until funding level rises back into the previous band

The following chart illustrates how this works.

Starting point End goal

Funding level (%)

Time

100%5%

10%

20%

25%

30%

40%

50%

95%

90%

85%

80%

75%

70%

65%

Desiredtrajectory

5thpercentile

95thpercentile

Percentage growth portfolio allocation

Actual fundinglevel

Downsideprotection level

Step up inthe downsideprotection level

Gradualde-risking

5

A key feature of MDDS is the robust and disciplined way in which Mercer will work with you to help oversee the strategy and accomplish the desired level of de-risking. A number of components in the MDDS approach help to make this happen:

A design that reflects existing best practice and pensions governance throughout the process

1

Upfront agreement to a long-term strategy for the evolution of the risk profile of the pension scheme. A focus on the longer-term view and the adoption of a strategic plan are critical elements of the MDDS process and its ultimate success

2

An approach to de-risking that is rigorous and rules-based:

• Clear targets and rules across assets and liabilities are agreed upfront:

— Integrated with funding target — Best practice risk budgeting — Rules then set to give best chance

of meeting funding targets

• Hedging discipline: — Hedging of inflation and interest

rate risk — “First loss” protection against falls

below floor level while preserving ability to recover

• Targets and rules are reviewed regularly

3

Integrated asset and liability management:

• The best of Mercer’s ideas for active managers, alternative strategies and liability matching opportunities

• A bespoke hedging portfolio to match the profile of your scheme’s liabilities

• Downside equity market risk protection

4

Frequent monitoring, execution and reporting:

• Monitoring against triggers: — Frequent monitoring against assets

and liabilities — Monitoring of de-risking and hedging

opportunities

• Execution of transactions: — Asset rebalancing — Implement downside risk protection

• Reporting: — Frequent and transparent web-based

reporting

5

Access to Mercer’s market-leading intellectual capital:

• Experience of dynamic rules, funding level targets and trigger points

• Expert view on liability hedging and timing, as well as market-leading Mercer investment manager selection

• Mercer’s “best ideas” growth portfolio

6

666

MDDS IN ACTION

Initial meeting explains principles and main components and discusses main objectives including:

•Funding target•Time horizon•Risk preferences (including attitude to downside protection)

Mercer uses DDS strategy tool to:

•Determine investment strategy to target required funding improvement• Propose a series of funding level triggers (and associated downside

protection level) consistent with the desired time horizon and risk preferences

•Propose an allocation to matching and growth assets for each funding band

•Mercer presents recommended asset allocation and funding bands•DDS path is agreed or refined based on feedback

• Investment beliefs are discussed (i.e. passive vs. active management) • Based on these preferences, the main objectives and other

constraints,1 Mercer uses the portfolio allocation tool to specify a matrix of allocations to each growth portfolio and matching asset classes and proportion of liabilities to be hedged

INITIAL MEETING bETWEEN

MERCER AND TRUSTEES

ASSET AND LIAbILITY

MODELLING STUDY

GROWTh pORTfOLIO

ASSET ALLOCATION

fINAL AGREEMENT

1 For example, minimum allocation to liquid assets

TYpICAL “ON-bOARDING” pROCESS

7

The MDDS approach allows you to oversee your strategy and de-risk your pension fund in a robust and disciplined manner, realising the following important benefits to you:

SOLUTION BENEFIT TO yOU

Timely, rules-based de-risking under an integrated asset and liability approach

•you make the decisions in advance regarding funding objectives and your appetite for risk

•you then delegate monitoring and implementation according to specified rules

•The approach narrows the range of future funding levels by gradually de-risking when funding levels improve and limiting downside risk along the journey

De-risking philosophy •Hedge unrewarded risk upfront

•Reduce your exposure to growth assets as funding improves, locking in gains

•Achieve dynamic downside protection through an options strategy

Upside potential •Mercer’s “best ideas” growth portfolio

•Diversified growth assets with exposure to alternatives

•Market-leading manager selection

Best practice governance •Daily monitoring of funding levels and actions within agreed parameters

•Efficient and reliable execution of all transactions

•Transparent and regular reporting (web based, where appropriate)

•Regular opportunity to re-calibrate (both annually and event-driven)

8

fREQUENT MONITORING, EXECUTION AND REpORTING

MDDS – WhAT hAppENS WhEN A “TRIGGER” IS bREAChED?

• When an upside trigger is breached, growth assets are sold and the proceeds invested into matching assets.

UPSIDE BREACH

DAILy

•Funding level will be calculated at close of each London business day, based on information regarding:

— Asset values

— Market interest rates

— Liability cash flows

— Major changes in cash flows

•Rebalance between growth and hedging assets, based on changes to funded status

•Adjustment of downside protection

•Management of investment of contributions and cash withdrawals

•Trading times may be less frequent than daily

•Funding level may differ from your own methodology and need to translate scheme’s funding basis to a MDDS economic basis

ANNUALLy

•At the end of each year, a review is held between Mercer and you

•you have the opportunity to change your objectives/recalibrate

•Technical structure of liabilities is reviewed and recalibrated

QUARTERLy

•The growth portfolio is rebalanced to ensure allocations stay close to the targets set out in the calibration stage

•Rebalancing will only take place when the actual allocation significantly differs from the target

•Rebalancing occurs by selling and buying appropriate portions of each asset class, net of cash flow

• If Mercer’s best ideas regarding relative asset returns have changed, asset allocation will be revised

• Downside protection is triggered if the scheme’s funding level falls below a pre-agreed trigger.

• A fraction of the scheme’s equity holdings will be sold to buy units in a protection fund to mitigate the impact of further equity loses.

DOWNSIDE BREACH

9

COMMONLY ASKED QUESTIONS

We are happy with our existing investment managers and we don’t want to change, so why would we move to MDDS?

MDDS provides a total framework enabling your investment strategy to change with movements in your funding level. Mercer will take care of strategic asset allocation and manager selection and then monitor performance constantly, with the capacity to react quickly and make immediate changes where necessary.

How easily can trustees delegate this level of responsibility to Mercer?

Delegation of risk management is made easier and will be underpinned by Investment Management Agreements and Terms and Conditions documents. By passing control of the risk management strategy to Mercer, trustees can focus on overall scheme governance.

Overall responsibility for the scheme remains with the trustees. However, better implementation of risk management objectives is achieved by delegating this element to experienced experts with dedicated resources and information.

What is the legal framework?

Mercer carries out the initial strategy formulation under the terms of a standard Letter of Engagement, which then leads to a formal Investment Manager Agreement to cover the operation of MDDS.

Why can I trust Mercer to provide this solution?

We are completely transparent in our approach and we have a proven track record in the UK defined benefit market. Our interests are also aligned with our clients’ in our desire to improve scheme funding levels.

What sets this Mercer solution apart from the competition?

No one else in the market offers such frequent and dynamic asset management and decision making. Nobody in the market has an equivalent track record in managing pension fund assets or overseeing the managers of those assets, and no provider has the depth of expertise in constructing the underlying portfolios or the LDI hedges that go in them.

Q.A.

How can Mercer efficiently time the market?

MDDS is not about timing the markets. The solution is designed to take action to lock in improvements in scheme funding levels as they happen, and to protect against certain aspects of downside losses should markets fall. MDDS is about bringing a more disciplined approach to pension fund management.

Q.A.

Q.

A.

How transparent is the Mercer approach?

MDDS provides regular quarterly reporting and you can access information at any time via the website. Whenever MDDS implements an action you will be notified promptly. Additionally, MDDS operates full transparency of all underlying fee structures.

Q.A.

Q.

A.

Q.

A.

Q.A.

10

IMpORTANT NOTICES

© 2012 Mercer Limited. All rights reserved. Mercer Limited is authorised and regulated by the Financial Services Authority. Registered in England with number 984275. Registered Office: 1 Tower Place West, London EC3R 5BU. www.mercer.com

This presentation is only intended for companies establishing UK defined benefit occupational pension schemes and the trustees of UK defined benefit occupational pension schemes.

This presentation has been prepared solely for information purposes and is not an offer to buy or sell or solicitation of an offer to buy or sell any investment.

This presentation contains information on investment management firms that has been obtained from those investment management firms and other sources. Mercer research documents and opinions on investment products (including product ratings) are based on information that has been obtained from the investment management firms and other sources. Mercer gives no representations or warranties as to the accuracy of such information, and accepts no responsibility or liability (including for indirect, consequential or incidental damages) for any error, omission or inaccuracy in such information other than in relation to information which Mercer would be expected to have verified based on generally accepted industry practices.

This presentation does not contain investment advice relating to your particular circumstances. No investment decision should be made based on this information without first obtaining appropriate professional advice and considering your circumstances.

Any opinions on or ratings of investment products contained herein are the intellectual property of Mercer and are subject to change without notice and are not intended to convey any guarantees as to the future investment performance of these products. In addition:

• Past performance cannot be relied upon as a guide to future performance and Mercer offers no guarantee that the scheme’s Technical Provisions or any other specified funding levels will be met nor that the scheme’s assets will meet any investment performance objectives

• The value of stocks and shares, including unit trusts, can go down as well as up and you may not get back the amount you have invested

• The value of gilts, bonds, and other fixed income investments including unit trusts can go down as well as up and you may not get back the amount you have invested

• Investments denominated in a foreign currency will fluctuate with the value of the currency

• The value of investments in real property can go down as well as up, and you may not get back the amount you have invested. Valuation is generally a matter of a valuer’s opinion, rather than fact. It may be difficult or impossible to realise an investment because the property concerned may not be readily saleable

• When there is no recognised market for investments, it may be difficult for you to obtain reliable information about their values or the extent of the risk to which they are exposed or to be able to deal in the investments

• When investments carry a contingent liability, you may lose more than the amount of your original investment

• A change in investment strategy will incur transaction costs

For further information, please contact your local Mercer office or visit our website at:www.mercer.com

Argentina

Australia

Austria

Belgium

Brazil

Canada

Chile

China

Colombia

Czech Republic

Denmark

Finland

France

Germany

Hong Kong

India

Indonesia

Ireland

Italy

Japan

Malaysia

Mexico

Netherlands

New Zealand

Norway

Peru

Philippines

Poland

Portugal

Saudi Arabia

Singapore

South Korea

Spain

Sweden

Switzerland

Taiwan

Thailand

Turkey

United Arab Emirates

United Kingdom

United States

Venezuela

Argentina

Australia

Austria

Belgium

Brazil

Canada

Chile

China

Colombia

Czech Republic

Denmark

Finland

France

Germany

Hong Kong

India

Indonesia

Ireland

Italy

Japan

Malaysia

Mexico

Netherlands

New Zealand

Norway

Peru

Philippines

Poland

For further information, please contact your local Mercer office or visit our website at:www.mercer.com

Copyright 2012 Mercer LLC. All rights reserved. 11136-MG

Mercer

Tower Place

London

EC3R 5BU

Tel +44 (0)20 7626 6000

Fax +44 (0)20 7929 7445

Issued in the United Kingdom by Mercer Limited, which is authorised and regulated by the

Financial Services Authority. Registered in England No. 984275. Registered Office:

1 Tower Place West, Tower Place, London EC3R 5BU.

Portugal

Saudi Arabia

Singapore

South Korea

Spain

Sweden

Switzerland

Taiwan

Thailand

Turkey

United Arab Emirates

United Kingdom

United States

Venezuela