pension risk in a new era

Pension Risk in a New EraTowers Watson-Forbes 2010 Pension Risk Survey

November 10, 2010

© 2010 Towers Watson. All rights reserved.

Matt Herrmann, Leader – Retirement Risk Management GroupMark Ruloff, Director of Asset Allocation – Towers Watson Investment Services

2towerswatson.com © 2010 Towers Watson. All rights reserved. Proprietary and Confidential. For Towers Watson and Towers Watson client use only.

About the Pension Risk Survey

Fielded from September 8, 2010 – October 8, 2010Seeks to gain insight into how leading organizations are approaching DB plan risk and related financial issuesProvides new insights about the current trends and practices of pension plansIncludes responses more than 304 U.S. executives in charge of pension finance at large companies


9%

11%

12%

13%

16%

25%

26%

41%

47%

56%

0% 10% 20% 30% 40% 50% 60%Percentage of Respondents in the U.S.

Companies are most concerned about theDB plan’s impact on cash flow over the next five years

Top Concerns of DB plan sponsors over next five years

Impact on our cash flow

Conforming to regulatory requirements

Impact on investors perception of our company

Impact on our credit rating

Orderly exit of older workers

Lack of appreciation from employees

Impact on attraction and retention of workers

Impact on public perception of company

Impact on our balance sheet

Impact on our income statement


Pension funded status has declined materiallyover the past 10 years with significant volatility along the path

Towers Watson Pension Index

60

70

80

90

100

110

120

130

140

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

Rising discount rates and strong investment performance during September and October increased benchmark funded ratio by 8% since August lows

68.3 as of 10/31/10


As financial conditions decline,ability to act decreases, yet desire to act increases

60%

65%

70%

75%

80%

85%

90%

95%

100%

105%

Funded Status

When funded status is low (typically following a period of poor market conditions), Desire to reduce pension risk is high, but cost to de-risk often results in Abilitybeing low

As funded status improves, so does the Ability to implement de-risking solutions. However, the memory of the “pain” has diminished, and Desire often falls

Abilityincreases

Desire increases


19%

22%

4%

5%

22%

42%

58%

61%

50%

13%

28%

57%

69%

34%

17%

16%

19%

41%

54%

4%

5%

7%

4%

5%

6%

11%

2%

5%

2%

2%

12%

5%

16%

33%

35%

1%

2%

2%

3%

7%

0% 20% 40% 60% 80% 100%

Effect of Financial Crisis

Financial crisis reduced sponsors’commitment to DB plans, despite higher employee appreciation

Strongly Negative Effect

Slightly Negative Effect

No Effect

Slightly Positive Effect

Strongly Positive Effect

Impact of DB Plan on cash flow

Impact of DB Plan on financial statements

Investors’ concern about your DB plan

Company’s long-term commitment to its DB plan

Impact of DB Plan on ability to raise capital through debt or equity

The financial strength of your company's DB plan

Employee appreciation of the DB plan

Retirement pattern of older workers


Over half of plan sponsors expectto change the DB promise in the future

49%

47%

29%

16%

15%

22%

1%

7%

6%

8%

0% 20% 40% 60% 80% 100%

Open Plans

Closed Plans

Percentage of Respondents in the U.S.

Maintain DB, but Change Future Design

No Changes Planned

Seeking Alternatives to DB

Seeking to Terminate the Plan

Other

Sponsors who have already taken the step to close the plan expect to seek alternatives to DB in the future

Sponsors with plans that are currently open to new entrants as likely to change future DB design


Hybrid regulations may alsolead to further changes down the way

The IRS released final and proposed Hybrid regulations in OctoberFinal regulations may provide another design opportunity for plan sponsors with traditional defined benefit plan designsIn addition, sponsors of existing plans may review their Hybrid plans for compliance, especially around the interest crediting rate for cash balance plans related to the proposed regulations


Sponsors’ cash flow concernsprompting some to change funding policy

Contribute the amount that ensures the plan is fully funded

Contribute enough to achieve explicit funding targets

Contribute the maximum tax-deductible amount

Make ad hoc decisions on pension funding without a formal funding policy

Contribute the legal or negotiated minimum payment

0% 10% 20% 30% 40%

Defined Benefit plan funding policy prior to the crisis and today

Policy Today

Policy Prior to Crisis


Majority of companies focused onaligning plan assets with liabilities to reduce risk

26%

16%

8%

5%

22%

16%

15%

6%

21%

32%

26%

19%

17%

23%

30%

31%

6%

9%

14%

35%

8%

3%

6%

3%

0% 20% 40% 60% 80% 100%

How likely is your company to use the following strategies to reduce risk in its DB plan over the next five years?

Very Unlikely

Somewhat Unlikely

Equally Likely/ Unlikely

Somewhat Likely

Very Likely Don’t Know

Capital market innovations (e.g., moving benefits to captive insurance vehicles)

Governance structure redesign (e.g., more formal decision-making structures for the plan

to enable better decision making)

Greater focus on dynamism (e.g., to capture long-term investment opportunities when

extreme market pricing moves in your favor)

Better alignment of assets with liabilities(e.g., buy-ins, liability-driven investment)


Asymmetric risk is driving plansponsors to reduce risk as plans become better funded

100% LDI (100% DD)

90% LDI (1

00% D

D)

80% LDI (1

00% D

D)

70% LDI (1

00% D

D)

60% LDI (1

00% D

D)

50% LDI (1

00% D

D)

40% LDI (1

00% D

D)

30% LDI (1

00% D

D)

20% LDI (1

00% D

D)

10% LDI (1

00% D

D)

0% LDI (1

00% D

D)

100% LB

90% LB

80% LB 70% LB 60% LB50% LB

40% LB30% LB

20% LB10% LB

100% AB

90% AB

80% AB

70% AB60% AB

50% A

BCurre

nt30

% AB

20% A

B

10% A

B

0% A

B

$0

$2,500

$5,000

$7,500

$10,000$0 $25 $50 $75 $100

PV Contributions plus Deficits (PBO) ($M)95th Percentile

PV

Con

tribu

tions

plu

s D

efic

its (P

BO

) ($0

00)

50th

Per

cent

ile

Desirable

Duration Matching strategies are attractive under this measure to manage both the expected and worse casesLDI portfolios 60% – 90% have no expected contributions (50th percentile)

Well-Funded Frozen Plan


Interest rate risk is the primary focus forcompanies who use financial instruments to manage risk

Financial instruments used to manage risks in DB plans

14%

26%

30%

31%

39%

39%

0% 10% 20% 30% 40% 50%

Option-based Strategies

Interest-rate Futures

Interest-rate Swaps

Currency Forwards

Mortality Swaps

Credit Derivatives


Explicit assumptions regarding future plan administration costs and taxes payable by plan on contributions and benefit payments

Disaggregate components of costExpanded disclosures to provide insight about nature of plan and risks

Interest cost and expected return on plan assets replaced with net interest income/expense

Immediate recognition of all changes in funded positionBalance Sheet & Comprehensive Income

Potential accounting changes may also impact behavior

Comprehensive Income (P&L + OCI)

Balance Sheet& P&L

Financial Reporting & Disclosure


Current accounting rules encouragerisk taking and the proposed rules may not

Desirable

CurrentProposed

$125

$0

$25

$25

$75

($50) $0 $50 $100 $150 $200PV of Cumulative IAS 19 Pension Expense ($M)

95th Percentile

PV o

f Cum

ulat

ive

LAS

19 P

ensi

on E

xpen

se ($

M)

50th

Perc

entil

e

100% Equities

50% Equities/50% Long Bonds

100% Long Bonds

100% Equities

100% Long Bonds

Asset/Liability Frontier – Year 2019


Private equity is the most common alternative investment for pensions, but more companies are holding company stock

23%

26%

38%

43%

62%

0% 10% 20% 30% 40% 50% 60% 70%

Percentage of Respondents in the U.S.

Private Infrastructure

Alpha-seeking strategies that utilize short-selling or derivatives

Company stock

Private Real-Estate

Private-Equity

Of the companies who reported holding Company Stock, almost 60% said they have contributed stock to the pension fund in lieu of cash


Dynamic strategies are being considered tohelp organizations take action as funded status improvesFu

nded

Rat

ioBond A

lloca

tion

One-Way Dynamic

Fund

ed R

atioBon

d Allo

catio

n

Two-Way Dynamic

Standard Approach

Funded Ratio

Bond Allocation


Lump Sums / Dynamic

AllocationsAnnuity

Products / LDI Partial Settlement Termination/

Immunization

Connecting funded status to market activity

Funded Status > 80 % > 90% > 100% > 110%

EOY 2007 95% 80% 53% 30%

EOY 2008 31% 14% 6% 3%

EOY 2009 47% 14% 6% 5%

General Trends Connecting Funded Status to Market Activities

Distribution of Funded Status of Large Plans by Year


Prevalence of lump sums and annuitypurchases expected to increase in the future

How Likely Are You to Do the Following to Reduce Pension Obligations?

24%

42%

28%

28%

26%

31%

13%

13%

14%

21%

22%

26%

27%

26%

28%

25%

12%

22%

17%

20%

14%

6%

4%

15%

8%

6%

5%

8%

8%

8%

6%

8%

8%

16%

12%

14%

0% 20% 40% 60% 80% 100%

Offer lump sum to terminated vested participants next year

Add lump sum option for current active participants next 2 to 5 years

Add lump sum option for current active participants next year

Purchase annuities for pension plan next year

Purchase annuities for pension plan next 2 to 5 years

Offer lump sum to terminated vested participants next 2 to 5 years

Very Unlikely

Somewhat Unlikely

Equally Likely/ Unlikely

Somewhat Likely

Very Likely Don’t Know


The changing lump sum rules make transfer ofthe obligation to participants more attractive for most plans

$0

($1,000)

($1,000)

Liability (Savings)/

Cost

($2,500)

($3,500)

($4,000)

Additional Operational (Savings)

$126,000

$83,000

$56,000

Historical Lump Sum

Basis

$109,000

$56,000

$32,000

PPA Lump Sum Costs

(2012)

$109,00060

$57,00050

$33,00040

Accounting LiabilityAge

Illustrative lump sum values for $1,000 monthly benefit*:

* Analysis shown above for deferred to 65 annuities, payable as a life option.

Historically, lump sum pay-outs were based on 30-year Treasury bond ratesUnder PPA, interest rates for minimum lump sum value calculations are based on bonds rated from A to AaaSavings also exist due to the elimination of future operating expenses but additional considerations (opportunity costs, accounting issues, PPA threshold issues, etc.) will have a significant influence on viability of approach


Significant effort and planning will be required to act

JOINT TEAM

HR/LEGAL TEAM

Q4 2010 – Q1 2011

Feasibility and Design

Q1 – Q3 2011

Preparation

Project Coordination

Implementation

Q4 2011 – 2012

Economic feasibility analysis:Cash funding requirementsOne-time and ongoing P&L costsOperational costsInvestment strategy

Operational Feasibility AssessmentAdministrative Feasibility AssessmentData Quality AssessmentProcess overview and steps

Legal and Bargaining Assessment

Design decisions on:Temporary vs. permanent provisionGroups to includeEarly retirement subsidiesLump sum value basis

FINANCIAL TEAM

JOINT TEAM

HR/LEGAL TEAM

Desired timing/triggersMonitor economic conditions and plan funded statusInterim investment strategy

Participant communication strategyDC provider/rollover opportunitiesConfirm trustee interaction

Data cleanupMissing participantsPlan document/SPDsElection packetsCalculation process

FINANCIAL TEAM FINANCIAL TEAM

JOINT TEAM

HR/LEGAL TEAM

Prepare and send calculations and election packetsProcess election formsCall centerParticipant follow-up

Final determination of P&L impactCash funding projectionsLiquidity and investment strategy implementation

Plan amendments enactedMonitor acceptance rate and impact on plan funded status


Towers Watson – Equity Analyst SurveyHow do Equity Analysts view Pension Risk?


About the Analyst Survey

32%

2%

53%

5%8%

Domestic plans onlyInternational plans onlyDomestic and international plansNone of the aboveDon't know

8%Don't know

25%More than $10 billion

10%$5 billion to $10 billion

39%$1 billion to $5 billion

18%Less than $1 billion

0%None

Types of defined benefit pension plans Total amount of pension liabilities held by the company with the largest plan(s)


Most important factors analystsconsider in their performance assessments

Notes: Respondents were asked to consider all companies they cover that sponsor defined benefit pension plans. Percentages indicate responses of “To a great extent” or “To a very great extent.”

49%

49%

38%

32%

28%

18%

Size of pension deficit (surplus) relative to sizeof the organization

Size of pension plan cash funding requirements

Size of pension obligations relative to size of theorganization

Size of earnings impact from pension plans

Volatility in pension plan cash fundingrequirements

Volatility in earnings impact from pension plans


2%

6%

10%

10%

14%

27%

33%

45%

49%

% %Changes to Pension Investment StrategyPension Risk Reduction Strategies

None of the above

Other

Partial pension obligation settlement by transferring obligations to a third party (annuity option)

Partial pension obligation settlement by transferring obligations to participants (lump sum option)

Changing the pension investment strategy to better match pension obligations

Complete wind-up of pension plan

Freezing the plan for all employees

Closing the plan to new hires

Plan design changes, e.g., converting the pension plan to a hybrid (cash balance) plan

0%Other

16%Increasing equity exposure

18%Increasing fixed income exposure

24%None of the above

27%Using alternative investments (such as swaps) to better match the pension liability profile

39%Using alternative investments to improve diversification and/or lower the volatility of the equity profile

45%Extending the duration of fixed income assets to better match the pension liability profile

Notes: Respondents were asked to consider the company they cover that has the largest defined benefit pension plan.

Analysts’ view hybrid conversions and matching duration ofassets to liability profile as top strategies to boost performance…


Notes: Respondents were asked to consider the company they cover that has the largest defined benefit pension plan. Percentages indicate responses of “To a great extent” or “To a very great extent.”

…although nearly two in five indicate that afull wind-up of the plan would boost the company’s valuation

38%

35%

16%

8%

100% from current level(full wind-up)

75% from current level




Summary

Survey results demonstrated that highest concerns for both plan sponsors and outside analysts are DB Plan funded status and cash flow

Desire to take action to reduce risk is high today, but often ability is lowSponsors are re-evaluating funding policy, design and investment strategy in the near-term to manage risk

Investment strategy decisions continue to shift towards a liability-focused risk reduction strategy

Currently implemented through liability-hedging strategies and dynamic allocation strategiesAnticipate this shift continuing as potential accounting changes may reduce the incentive for risk taking

As plan funded status improves, more companies anticipate transferring the pension obligations to reduce the overall size and risk of the DB Plan

These transfers will require significant up-front planning to implement when both economic conditions and sponsor ability align


Contact Details

Matt [email protected]

Mark [email protected]


Disclaimer

The information included in this presentation is general information only and should not be relied upon without further review by the appropriate professional advisors. Towers Watson is not a law firm nor an accounting firm, and we are not providing legal, accounting or tax services or advice. Some of the information included in this presentation might involve the application of law; accordingly, we strongly recommend that audience members consult with and involve their legal counsel and other professional advisors as appropriate to ensure that they are fully advised concerning such matters. Additionally, material developments may occur subsequent to this presentation rendering it incomplete and inaccurate. Towers Watson assumes no obligation to advise you of any such developments or to update the presentation to reflect such developments

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