retirement and investment webinar series

Aon HewittRetirement and Investment

Investment advice and consulting services provided by Aon Hewitt Investment Consulting, Inc., an Aon company.Nothing in this document should be construed as legal or investment advice. Please consult with your independent professional for any such advice. To protect the confidential and proprietary information included in this material, it may not be disclosed or provided to any third parties without the approval of Aon Hewitt.

Retirement and Investment Webinar SeriesAugust 26, 2015

Aon HewittRetirement and Investment

Investment advice and consulting services provided by Aon Hewitt Investment Consulting, Inc., an Aon company.Nothing in this document should be construed as legal or investment advice. Please consult with your independent professional for any such advice. To protect the confidential and proprietary information included in this material, it may not be disclosed or provided to any third parties without the approval of Aon Hewitt.

The Next Generation of Pension Risk Management Strategies• Bryan Ward• Joe McDonald• Eric Friedman• Bob Penter

Aon Hewitt | Retirement and InvestmentProprietary & Confidential | 2015Investment advice and consulting services provided by Aon Hewitt Investment Consulting, Inc., an Aon company. 3

Agenda

Section 1 Environment for U.S. Pension Plans in the Private Sector Three levels of plan governance and circumstances influences approach to

risk managementSection 2 Level 1: Strict Funded Ratio-BasedSection 3 Level 2: Market-AwareSection 4 Level 3: Opportunistic

Appendix A Additional Materials


Agenda Tracker

Section 1 Environment for U.S. Pension Plans in the Private SectorSection 2 Level 1: Strict Funded Ratio-BasedSection 3 Level 2: Market-AwareSection 4 Level 3: Opportunistic


Funded Statuses Ended about Where they Started Over Five Years

Source for funded status and discount rates: Aon Hewitt’s analysis of annual data from the 10-K reports of companies in the S&P 500 with 12/31 fiscal year ends and reporting U.S. pension financials.Source for S&P 500 levels: S&P 500, levels shown at each year-end. Source for expected returns: Aon Hewitt’s capital market assumptions


Forward-Looking Investment Prospects Have Weakened

10-Year Expected Return as of

January 1, 2010

10-Year Expected Return as of July 1, 2015

Change

U.S. Large Cap Equity 8.1% 6.5% -1.6%Non-U.S. Developed Equity 8.2% 6.9% -1.3%U.S. Long Credit Fixed Income 5.7% 4.4% -1.3%U.S. Core Bonds 4.4% 2.9% -1.5%

Source for S&P 500 levels: S&P 500, levels shown at each year-end. Source for expected returns: Aon Hewitt’s capital market assumptions

Drivers of Past and Future Pension Challenges


Regulatory and Demographic Changes Pose Headwinds to Improving Funded Statuses

Drivers of Past and Future Pension Challenges

• The RP-2014 mortality table update increased liabilities by about 7% for the average plan3

Mortality Updated

• Legislated funding relief in 2012 and 2014 reducing required contributions, thus slowing increases to funded status1

Funding Relief

• PBGC premiums roughly doubled since 2011, proving further headwinds in increasing funded statuses2

PBGC Premium Increases

1Highway and Transportation Funding Act of 2014 (HATFA) and Moving Ahead for Progress in the 21st Century Act of 2012 (MAP-21)2PBGC premiums were increased by both the Moving Ahead for Progress in the 21st Century Act of 2012 (MAP-21) and the Bipartisan Budget Act of 2013 (BBA), Between 2012 and 2016, the flat rate premium increased from $35 to $64/participant and the variable rate premium increased from 0.9% to 3.0% of the unfunded liability. 3Based on an internal Aon Hewitt analysis using a generic final average pay pension plan with average demographic characteristics.


Strict Funded Ratio-Based

Description: Simplest approach

Governance needed: Monitoring funded status and execute de-risking triggers

Market Aware

Description: May opportunistically allocate if there are meaningful changes to markets

Governance needed: Monitor markets to tilt implementation within a risk-controlled framework

Opportunistic Description: Broadens opportunity set to include alternative assets

Governance needed: Most sophisticated governance structure needed to allow strategies outside the standard policy benchmarks

Potential Solutions are Based on Governance Sophistication: 3 Levels


Toolkits for Each Level of Governance Sophistication

OPPORTUNISTIC3a. Embrace Alternatives3b. Opportunity Allocation

3c. Option strategies

MARKET AWARE 2a. Hedge path

2b. Credit flexibility2c. Medium-Term Views on Asset

Allocation

STRICT FUNDED RATIO-BASED1a. Basic de-risking glide path

1b. Custom liability-hedging portfolio


Agenda Tracker



Strict Funded Ratio-Based Tool 1a: De-risking Glide Path (Illustrative)

Surplus Volatility defined as the variability in funded ratio assuming a one standard deviation event over a one year period and a “beginning of year” funded ratio consistent with the various glide path funded ratio stepsChart represents a hypothetical situation, and is presented for illustrative purposes only

1


Strict Funded Ratio-Based Tool 1b: Custom Liability-Hedging Portfolio

Description AHIC View

None Standard long duration benchmarks Simplest solution Causes mismatch between the fixed

income and liabilities

Standard approach Custom blend of standard indices. Combines long, ultra-long, and intermediate duration credit and government bond indices

Simple to implement Significantly reduces mismatch between

assets and liabilities

Partial customization Utilizes one customized “completion” manager to wrap around other managers with standard benchmarks to make sure the total portfolio exposures are desirable

Increases complexity, incorporating derivatives and custom benchmarks Fees are typically similar to active

managers, but the benefits are in risk-reduction rather than return-enhancement Risk-reduction is not always sufficient to

justify the added cost and complexity

Full customization Give each manager a customized benchmark that matches the liabilities

Highest level of complexity Risk-reduction is not typically sufficient to

justify the added cost and complexity


Strict Funded Ratio-Based Tool 1b: Custom Liability-Hedging Portfolio

No customization

Standard approach

Partial customization

Full customization

Standard long duration benchmark

Customized blend of standard fixed income indices

One customized “completion”

manager wraps around managers

with standard benchmarks

All managers have customized benchmarks

The appropriate level and type of customized liability hedging portfolio depends on many factors: – Allocation to fixed income– Plan size– Liability duration– Market views


Strict Funded Ratio-Based Tool 1b: Custom Liability-Hedging PortfolioEnd-State Structure of Fixed Income May Differ from Current (Illustrative)

Current Potential End-State

Public Equity: # of managers $ of assets

4 managers$800mm in assets

1 manager$300mm in assets

Public Equity: Benchmarks Region and capitalization specialists

Broader mandates

Public Equity: Active/Passive All active Consider passive management

Fixed Income: # of managers $ of assets

2 managers$500mm in assets

4 managers$1.1bn in assets

Fixed Income: Duration Same as BC Long Credit benchmark

Blend of BC Long and Intermediate Credit

Fixed Income: Credit Quality Same as BC Long Credit benchmark

Customized to have some govtsand less BBB than the indices

Fixed Income: Active/Passive Active Active

Alternative Assets Private equity, real estate, hedge funds

No new commitments to illiquidalternatives, maintain liquid hedge funds and core real estate

Chart represents a hypothetical situation, and is presented for illustrative purposes only


Agenda Tracker



Market Aware Tool 2a: Hedge Path

Two-dimensional dynamic investment program (Glide Path + Hedge Path)

First Dimension – Glide Path

Funded Ratio

ReturnNeeds

Return-SeekingAllocation

Hedge RatioInterestRate Level

DesiredDuration

Second Dimension – Hedge Path

How much to allocate to

Return-Seeking and Liability-

Hedging Assets

How to invest Liability-Hedging

Assets


Market Aware Tool 2a: Hedge Path (Illustrative)

Funded RatioL/H Allocation < -100bps -80bps -60bps -40bps -20bps Target

75% 41% 30% 36% 42% 48% 54% 60%80% 52% 43% 49% 54% 59% 64% 69%85% 61% 56% 60% 64% 69% 73% 77%90% 70% 70% 73% 76% 79% 82% 85%95% 79% 85% 87% 89% 91% 93% 95%

100% 90% 100% 100% 100% 100% 100% 100%

Glide Path Hedge Path (Liability-Hedging Portfolio Custom Mandates)

How Much to Invest in Liability Hedging Assets How to Invest the Liability Hedging Assets



Market Aware Tool 2b: Credit FlexibilityC

redi

t Spr

ead

Hed

ge R

atio

Funded Ratio



Market Aware Tool 2c: Medium-Term Views on Asset AllocationStrong Academic Support for Market Aware Asset Allocation

“There is no way to predict the price of stocks and bonds over the next few days or weeks. But it is quite possible to foresee the broad course of these prices over longer periods, such as the next three to five years. These findings, which might seem both surprising and contradictory, were made and analyzed by this year’s Laureates, Eugene Fama, Lars Peter Hansen and Robert Shiller.”

– The Royal Swedish Academy of Sciences, describing the research basis for the 2013 Nobel Prize in Economics


Market Aware Tool 2c: Medium-Term Views on Asset AllocationExample of Historical Valuation Measures Influencing Excess Returns

0%

2%

4%

6%

8%

10%

12%

14%

16%

18%

Below 2% 2-3% 3-4% 4-5% 5%+

Average Future Risk Premiums for Different Levels of Dividend Yields

There has been a clear relationship between average realized equity risk premiums and simple valuation measures

Rather than hugging their target strategic asset allocation, long-term investors would have been better off tilting their portfolios based on market conditions

Expensive CheapDividend Yields

Exc

ess

Ret

urn

of S

&P

500

ove

r 1-

Mon

th T

-Bills

for t

he N

ext 1

2 M

onth

s

Source: Aon Hewitt white paper: “Asset Allocation through Changing Market Environments.” Available at http://www.aon.com/attachments/human-capital-consulting/2015_Asset-Allocation-through-Changing-Market-Environments_WP.pdf


Market Aware Tool 2c: Medium-Term Views on Asset AllocationAon Hewitt’s Framework for Medium-Term Views

Fundamental

Analyze the core economic and underlying drivers of an asset class. For example:

Economic Growth Earnings Growth Default Risk

Valuation

Establish if the asset class is cheap or expensive given our fundamental outlook. For example: P/E Ratio Credit Spreads Yield Levels

Sentiment

Establish if near-term divers for the asset class are positive or negative. For example:

Technical Indicators Sentiment Surveys Futures/Options Positioning

Medium-Term View Framework

Aon Hewitt’s Medium Term Views (MTVs) have been developed to help investors change their asset allocation over varying market conditions.


Aon Hewitt’s MTV Track Record Over Time – Inception to 06/30/2015

Model Portfolio* – from February 2013:From February 1 2013, the Medium Term View value add has been tracked through the performance of a model portfolio relative to a strategic benchmark.

Model Portfolio since inception (2/1/2013 – 06/30/2015)Performance (annualized) 0.42%

Expected Tracking Error 0.50%

IR Adjusted1 0.84

1Adjusted Information Ratio is calculated using historical performance, but expected tracking error as the historical time series of returns understates volatility of actual asset volatility. True information ratio likely lies in between realized and adjusted IR.

See MTV Track Record Disclosures and Disclaimers slides in appendix for additional information.

1.13%

-0.20%

0.00%

0.20%

0.40%

0.60%

0.80%

1.00%

1.20%

1.40%

Feb13

Apr13

Jun13

Aug13

Oct13

Dec13

Feb14

Apr14

Jun14

Aug14

Oct14

Dec14

Feb15

Apr15

Jun15

Cumulative Outperformance vs. Benchmark

* Hypothetical Performance


Agenda Tracker



Opportunistic Tool 3a: Embrace AlternativesThe Case for Alternatives

Portfolio growth through high expected returns Efficiency improvement through strong risk-adjusted returns Diversification and risk reduction without return drag Part of a complete set of market exposures

– Across spectrum of ownership and maturity– Beyond economic growth, inflation and interest rates– Into “exotic market exposures” not available in traditional stock and bond investments


Opportunistic Tool 3a: Embrace Alternatives Flexibility

Focus resources where the impact is greatest

Spread Between Top and Bottom Quartile Performance, 10 Years

U.S

. Equ

ity

Non

-U.S

. Equ

ity

Fixe

d In

com

e

Valu

e A

dded

RE

Opp

ortu

nist

ic R

E

Vent

ure

Cap

ital

Buy

outs

Hed

ge F

unds

+10%

+20%

-10%

-20%

Source: eVestment Alliance, Thomson Reuters, NCREIF, The Townsend Group, HFR. Public equity, fixed income, and hedge fund data through March 31, 2013; real estate and private equity data through September 30, 2012.


Opportunistic Tool 3a: Embrace Alternatives Investor Characteristics and Choice Drives Portfolio Strategy

Governance Oversight resources Speed of action (Freedom from) scrutiny

Time Horizon Life span Cash flow Illiquidity tolerance

Portfolio Size Ability to diversify Market impact Potential for closet indexing

Investor characteristics and preferences help guide decisions about portfolio complexity


0%

10%

20%

30%

40%

50%

60%

2015

2016

2017

2018

2019

2020

2021

2022

2023

2024

Allo

catio

n to

Ret

urn-

Seek

ing

Asse

ts%

of T

otal

Ass

ets

Opportunistic Tool 3a: Embrace Alternatives Sample Liquidity Analysis

Max threshold for allocating to quasi-liquid assets like hedge funds

Max threshold for allocating to illiquid assets like private equity and closed-end private real estate

50th

95th

75th

25th

5th

Percentile

50th

95th

75th

25th

5th

Percentile

50th

95th

75th

25th

5th

Percentile

50th

95th

75th

25th

5th

Percentile



Opportunistic Tool 3b: Opportunity Allocation Overview

Asset allocation is the most important factor dictating long-term performance

Constraints of a formal asset allocation policy should not impede investors from investing in attractive or innovative opportunities

An Opportunity Allocation creates flexibility within the Investment Policy Statement to make investments that may not fit within a traditional asset allocation construct

– Strategies considered should offer a compelling return enhancement and/or diversification benefits (risk reduction)

– Optimal for investors with existing well-diversified portfolios that encompass both traditional and alternative classes and who are seeking additional flexibility

An Opportunity Allocation provides maximum flexibility to access such interesting and attractive opportunities by removing constraints of a formal asset allocation


Design as a maximum allocation as opposed to a target

Suggest an allowable range of 0% to no more than 10%

Opportunity Allocation policy target should ‘float’ to be generally in line with the actual allocation to the category over time

Source of funds should be liquid public securities and linked to the role of the investment

Opportunistic Tool 3b: Opportunity Allocation Implementation


Opportunistic Tool 3c: Option Strategies The Equity Insurance Risk Premium: Why Selling Options Wins Over Time

There is a persistent equity insurance risk premium (“EIRP”) inherent in the price of equity options

Options are a form of insurance; similar to conventional insurance underwriters, sellers of options require excess premiums to compensate for risk, and investors are willing to overpay

-5.0%

0.0%

5.0%

10.0%

15.0%

20.0%

25.0%

30.0%

35.0%

40.0%

Equity Insurance Risk Premium (EIRP)Calendar Years 1990-2013

Realized Volatility (20-Day Avg) EIRP (Implied Volatility - Realized Volatility) Average

Source: Aon Hewitt analysis. Realized volatility based on the average 20-day realized volatility of the S&P 500 and implied volatility is based on the average daily VIX.


Opportunistic Tool 3c: Option Strategies Performance Analysis and Expectations

Adding equity insurance risk premium strategies (BuyWrite and PutWrite) improve the risk/return profile of an equity portfolio through diversification

Source: Aon Hewitt white paper: “Harvesting the Equity Insurance Risk Premium: Know Your Options.” Available at https://retirementandinvestmentblog.aon.com/getattachment/fa29fef3-3767-48af-878f-0e906e8671a9/Harvesting_the_Equity_Insurance_Risk_Premium_White_Paper-final.pdf.aspx


Summary

Prevalence Frequency of Review/Action

Needed

Discretionary / Rules-Based

Consulting Support

Approaches

Impact on Investment

Performance

1a. Basic de-risking glide path

High Daily / monthly Rules-based Advisory or Delegated

High

1b. Custom liability-hedging portfolio

Occasional, but increasing

Quarterly or less

Rules-based Advisory or Delegated

Moderate

2a. Hedge path Moderate/High Daily / monthly Rules-based Advisory or Delegated

High

2b. Credit flexibility Occasional, but increasing

Daily / monthly Discretionary(policy controlled)

Advisory or Delegated

Moderate

2c. Medium-Term Views on Asset Allocation

Moderate Monthly / Quarterly

Discretionary(policy controlled)


Varies based on risk budget

3a. Embrace Alternatives

Moderate/High Quarterly or less

Discretionary(policy controlled)


Moderate / High

3b. Opportunity Allocation

Occasional, but increasing

Quarterly Discretionary(policy controlled)


Moderate

3c. Option strategies Occasional, but increasing

Quarterly or less

Rules-based or Discretionary

(policy controlled)


Moderate


Possible Next Steps for Plan Sponsors

Read the white paper1

Schedule a discussion with Aon Hewitt Investment Consulting

Consider possible strategy modifications

Implement

“Back to the Future: How the Future of Pension Risk Management Will Differ from the Past.” Available at: http://www.aon.com/attachments/human-capital-consulting/back-to-the-future-how-the-future-of-pension-risk-management-will-differ-from-the-past.pdf


Contact List

Bryan WardPartnerAon Hewitt Investment [email protected]

Joe McDonaldSenior PartnerAon [email protected]

Eric FriedmanAssociate PartnerAon Hewitt Investment [email protected]

Bob PenterPartnerAon Hewitt Investment [email protected]


Questions and Answers


MTV Hypothetical Track Record Disclosures and Disclaimers – Page 1This presentation is intended to document Aon Hewitt Investment Consulting, Inc.’s forward-looking expected returns for asset classes on a one to three year time horizon. The views expected in this report are AHIC’s forward-looking expectations based on informed historical results. There can be no guarantee that any of these expectations will become actual results.

As depicted in this presentation, we highlight the returns of our Medium Term Views (MTVs) model portfolio in excess of their respective benchmarks (i.e., alpha generation) for asset class view. The benchmark is based on the target asset allocation for a generic asset allocation representative of a typical institutional investor with a well-diversified portfolio, and our model MTV portfolio is based on our recommended positioning relative to the benchmark. These calculations assume rebalancing to target monthly, and updating our recommended positioning on the first of the month following when our MTVs are issued.

We realize that measuring past performance of our MTVs offers some insight into performance. Having said that, we believe that our ability to allocate assets for a specific role within a portfolio and monitor those views to ensure fit is one of our core competencies. Therefore, our measure of success is often customized to the client’s risk budget and accounts for various factors such as out-of-favor styles, market conditions, style drift, etc.

The MTV Model Portfolio is shown for illustrative purposes only. The return analysis presented does not represent actual performance generated for only managed strategies of AHIC. The MTV Model Portfolio analysis is intended to present an approximation of past aggregate performance that might have been generated had assets in a particular strategy been allocated in the relative proportions recommended by AHIC Medium Term Views, vis a vis a static asset allocation. THE BLENDED MTV MODEL PORTFOLIO DOES NOT REPRESENT THE HISTORICAL PERFORMANCE OF ANY FUND OR ANY ACTUAL ACCOUNT BUT INSTEAD REPRESENTS “SIMULATED” RESULTS CALCULATED BY MEANS OF A RETROACTIVE APPLICATION OF THE METHODOLOGY UTILIZED FOR ALLOCATION SELECTION. ACTUAL PERFORMANCE MAY VARY SUBSTANTIALLY FROM PERFORMANCE PRESENTED.


MTV Hypothetical Track Record Disclosures and Disclaimers – Page 2The hypothetical model portfolio cannot be invested in and does not consider any advisory fees, expenses related to trading, or other expenses incurred by a client. Future results based upon past performance, including hypothetical returns, cannot be guaranteed and a loss of principal may occur. Aon Hewitt Investment Consulting does not guarantee any minimum level of investment performance or the success of any portfolio or investment strategy. All investment involved risk and investment recommendations will not always be profitable.

Actual returns from live portfolios may differ materially from hypothetical returns which could be lower than actual performance. Hypothetical performance has inherent limitations. These hypothetical returns are developed with the benefit of hindsight and represent our recommendations chosen with the benefit of hindsight based on historical returns and therefore will invariably have the propensity to produce favorable returns. Hypothetical returns should not be relied upon to predict future performance. Since hypothetical models theoretically may be changed from time to time, the resultant effect on performance could be either favorable or unfavorable. Hypothetical returns may not accurately reflect the impact of any material market or economic factors might have on an investment adviser’s decision making process if the adviser were actually managing client assets and cannot account for the impact of financial risk in actual trading.

The time horizon included in the analysis begins the full month following when the target portfolio was approved by AHIC management. Performance figures do not include fees of any kind; performance results assume the reinvestment of dividends and capital gains.


Legal Disclosures and Disclaimers

Investment advice and consulting services provided by Aon Hewitt Investment Consulting, Inc. (“AHIC”). The information contained herein is given as of the date hereof and does not purport to give information as of any other date. The delivery at any time shall not, under any circumstances, create any implication that there has been a change in the information set forth herein since the date hereof or any obligation to update or provide amendments hereto.

This document and presentation is not intended to provide, and shall not be relied upon for, accounting, legal or tax advice or investment recommendations. Any accounting, legal, or taxation position described in this presentation is a general statement and shall only be used as a guide. It does not constitute accounting, legal, and tax advice and is based on AHIC’s understanding of current laws and interpretation.

This document and presentation is intended for general information purposes only and should not be construed as advice or opinions on any specific facts or circumstances. The comments in this summary are based upon AHIC’s preliminary analysis of publicly available information. The content of this document and presentation is made available on an “as is” basis, without warranty of any kind. AHIC disclaims any legal liability to any person or organization for loss or damage caused by or resulting from any reliance placed on that content. AHIC reserves all rights to the content of this document. No part of this document may be reproduced, stored, or transmitted by any means without the express written consent of AHIC.

© Aon plc 2015. All rights reserved.


About Aon Hewitt

Aon Hewitt empowers organizations and individuals to secure a better future through innovative talent, retirement and health solutions. We advise, design and execute a wide range of solutions that enable clients to cultivate talent to drive organizational and personal performance and growth, navigate retirement risk while providing new levels of financial security, and redefine health solutions for greater choice, affordability and wellness. Aon Hewitt is the global leader in human resource solutions, with over 30,000 professionals in 90 countries serving more than 20,000 clients worldwide. For more information, please visit aonhewitt.com.

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