defined benefit plans amid market volatility

© 2008 Towers Perrin

Defined Benefit Plansamid Market Volatility

Sam KnoxVP and Director of ResearchCFO Research ServicesBoston, MA

Sylvia PozezanacManaging PrincipalRetirement Risk SolutionsTowers PerrinNew York, NY

Monica McIntoshManaging PrincipalAsset ConsultingTowers PerrinToronto, Canada

Highlights of the 2nd Annual Towers Perrin —CFO Research Services Pension Plan Study

September 18, 2008

1© 2008 Towers Perrin

Today’s agenda

Review findings from the report, Defined Benefit Plans amid Market Volatility

Towers Perrin’s point of view on the research and the broader business challenge of pension risk

Open dialogue with our panel, including audience Q&A


Research methodology

The Survey: 214 senior finance executives in U.S. and Canada All respondents have defined benefit (DB) plansBroad industry representation with more than half of respondentsfrom $1B+ companies

The Interviews: 12 senior finance executivesExplore the broader business context for pension decision-making

The opinion/performance analysis: Linked data on respondents’opinions to their companies’ financial and pension performance

Publicly available data collected from filings of 65 public companies that participated in the survey


A solid majority of companiesfocus on eradicating risk from theirpension portfolios, as opposed to increasing returns

76%

24%

Company will reduce risk more than seek higher returns in its pension portfoliosCompany will seek higher returns more than reduce risk in its pension portfolios

Percentage of all respondents

In your opinion, is your company more likely to focus on increasing the return on, or managing the risk in, its pension portfolios in the next several years?

Asset intensive: 85%Labor intensive: 67%

Equity %: Hi 83% Low 68%Assets/cap: Hi 85% Low 68%

Asset intensive: 15%Labor intensive: 33%

Source: CFO Research Services.


Why? Concerns about cash and compliance top the list of reasons


Note: Respondents were asked to select up to two.

What aspects of your DB plan do you expect senior management to be most concerned about over the next 24 months?

Cash & CompliancePlan sponsors must be sure they have the cash they need to run their business —especially at a time when credit is not always readily available. A return-focused investment strategy could result in needing to make contributions at a time when they can least afford it

3%

6%

8%

12%

20%

21%

27%

35%

38%

0% 10% 20% 30% 40%

Other

Impact on public perception of our company

Impact on our credit rating

Impact on recruitment and retention

Impact on our balance sheet

Impact on our current employees

Impact on our income statement

Conforming to regulatory requirements

Impact on our cash flow



While a sizeable number of respondents have closed or frozen their plans, very few have terminated them

Percentage of all respondentsNote: Respondents were asked to select all that apply.

In what ways, if any, has your company changed its DB plan design or offerings since 2000?

How likely is your company to take any of the following actions over the next 24 months with respect to your DB plan?

22%

4%

15%

19%

22%

28%

36%

None of the above

We terminated DB plans for anongoing line of business

We converted DB plans to hybridplans such as cash balance plans

We closed existing DB plans forall employees and froze benefit

accruals

We offered new DB plans tocurrent employees

We replaced DB plans withdefined-contribution (DC) plansor shifted contributions from DB

to DC plans

We closed existing DB plans tonew employees while continuing

benefit accruals for current employees

0% 20% 40%

18%

20%

24%

23%

31%

10%

11%

9%

20%

20%

Terminate some or all plans

Close plans and cease benefitaccruals for all employees

Convert to hybrid plans (e.g.,cash balance)

Close plans to new employees,but continue benefit accruals for

current employees

Replace DB plans with definedcontribution (DC) plans, cash-

outs or other alternatives

0% 20% 40% 60%

Somewhat likely Very likelySource: CFO Research Services.


It’s portfolio management — notsettlement or risk transfer—that provesthe most common approach to managing risk


In your opinion, how likely is your company to adopt the following methods for managing pension risk?

Likely

Ongoing Management

Respondents have a clear preference today

for managing the risk as opposed to

transferring or settling the risk

6%

7%

7%

12%

15%

17%

20%

21%

30%

30%

18%

20%

22%

32%

20%

52%

46%

45%

20%

28%

8%

7%

6%

7%

7%

0% 25% 50% 75% 100%

Captive insurancesolutions

Settlement with lifeinsurer

Transfer of plan tothird party

Decrease equityexposure in pension

portfolio

Liability-based assetmanagement

Very likely Somewhat likely Somewhat unlikely Very unlikely Don't knowSource: CFO Research Services.


Market/economic performance, competitorsand regulation have driven change in plan design

Which of the following external events contributed most materially to the decisions your company has made in DB plan design since 2000?

Note: Respondents were asked to select up to three.


11%

17%

18%

37%

40%

45%

0% 5% 10% 15% 20% 25% 30% 35% 40% 45% 50%

Other

Increased scrutiny of risk management practices

Increased investor demand forprofits and financial strength

Changes in retirement program regulations

Competitors' pension policies and offerings

Performance of the economy or financial markets



Some takeaways and insights

Companies intend to focus more on risk reduction than on higher return generation over the next few yearsMost companies have adopted an incremental approach to pension plan design. However, the next step for a plan that is completely frozen is a full termination, which respondents say is not in the cards Companies indicate they are trying to coordinate their pension risk strategy with a broader enterprise framework — but find this a challengeThere is strong interest in LDI — which is in line with companies having stated a clear preference for risk management over generating returnAgreeing on a pension risk management strategy is often difficult because it involves trade-offs


On the issue of risk —key risks in a defined benefit program

Type of Risk Source

Market risk

Market risk posed by investments held in pension trust (equity volatility, credit risk, currency risk, etc.)Market risk can be compensated: Greater returns are expected in the long run for greater risk undertaken

Interest rate risk

Risk posed by inflation rate changes, changes in spreads and yield curve shapes, pension asset/liability mismatchInterest rate risk is not compensated: Greater returns are generally NOT expected from interest sensitivity mismatches

Operational risk

Plan governancePlan administration

Demographic risk

Risk posed by participant longevity and embedded design options (e.g., lump sums, early retirement subsidies)

These risks can be managed!

Regulatory risk

Risk from regulatory changesAsymmetric risk of surplus rules


Plans are taking an incrementalapproach to plan design change

Once a plan is in a hard freeze, the decision to exit has been made —it’s only a question of when, at what pace, and through what tactics

Ongoing DB Plan

Soft Freeze for New Entrants

Hard Freeze + DC Plan

Hybrid DB for All

Ongoing DB Plan

Hard Freeze + DC Plan


Managing pension risk within an enterprise context means assessing both pension plan and company performance under a range of economic scenarios

High Growth

Low Growth

High inflation / High interest rates

Low inflation / Low interest rates

Good times Overdrive

Perfect Storm Stagflation

Pension

Business

Pension

Business

Pension

Business

Pension

Business

?

+

-

-

+

+

-

?


What do market and interest rate risk really mean?

Assets

$1,000M

Fully Funded

A typical defined benefit plan has:Assets. An asset allocation of 60% equities/40% fixed incomeLiability. 60% of its liability is for “inactive” participants; liability duration of 12 years

$60M Deficit

$1,000M

$940M

$1,120M

$1,018M

$102M Deficit

$1,120M

Fully Funded

Liabilities

10% decrease in

Equities

1% decrease in discount

rates

Invest in portfolio whose

movements mirror those of the liabilities

3 Ways to Decrease Interest Rate Risk

Increase fixed income allocationIncrease fixed income durationUse derivatives


With the risks identified andobjectives set, the strategy starts to fall into place


Panel discussion

Q&A

Our Panelists

Sam KnoxVP and Director ofResearch

CFO Research ServicesBoston, MA(617) 345-9700, Ext. [email protected]

Sylvia PozezanacManaging PrincipalRetirement Risk SolutionsTowers PerrinNew York, NY(212) [email protected]

Monica McIntoshManaging PrincipalAsset ConsultingTowers PerrinToronto, Canada(416) [email protected]