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»A Pe r s p e c t i ve O n F i n a n c i a l To p i c s Fo r O u r I nve s t o r s

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Issue No. 111 Spring 2011

A New Era of Internet InvestingNot since the Internet craze of the late ’90s have technology investors shown the ardor generated by the latest wave of social media, e-commerce, and other digital companies blooming on the increasingly ubiquitous Internet.

Sparked by the introduction of Apple’s iPhone four years ago, the convergence of computing and communications—enabling wireless Internet access virtually anytime, anywhere—is not only changing lifestyles and spawning dynamic new companies, but also providing new growth opportunities for estab-lished industry leaders.

This Internet boom is different than that of the latter 1990s, when many companies with no earnings or prospect of earnings went public at stratospheric valuations and their businesses proved unsustainable.

Unlike that dot-com bubble, which burst in March 2000, these new trendsetters generally have far more viable business models, and some have grown rapidly. They are capitalizing on the growing capacity of wireless networks to support expanding mobile communications—trends that have enabled a new era of innovation.

Though still private companies, the upstarts are attracting lots of attention and investor interest. They include social media firms (Facebook, Twitter, and LinkedIn) that are fostering huge Internet communities, location-based e-commerce companies (Groupon and Living Social) that bring local

businesses and consumers together online, such social gaming developers as Zynga, and online consumer refer-ral companies like Angie’s List.

In contrast to the last Internet boom, “the profitability or potential for profitability is already there,” says David Eiswert, manager of the Global Technology Fund. “It’s not like they are burning cash. They have scaled their revenue and they were able to keep growing despite the massive global recession.

“Also, the first Internet bubble was a lot about conceptualizing connectivity—what it would be like to have a phone in your pocket that gives you Internet access from anywhere,” Mr. Eiswert says. “We got that in 2007 with the iPhone. Now, there are 3G [third genera-tion] networks all around the world. So the infrastructure has caught up with the business models.”

Ken Allen, manager of the Science & Technology Fund, adds that the rapid ascent of Facebook and Twitter simply would not have been possible with just desktop computers and laptops. “The value of such social media firms is tremendously enhanced when people can access them from anywhere on portable computing devices, which

InsIde ThIs Issue

5 Performance Spotlight: Emerging Europe: Standout Returns But Often Overlooked

6 Can Mid-Cap Stocks Sustain Their Outperformance?

8 U.S. Industrials Stage a Strong Comeback

10 Perspectives: Inflation Outlook Moderate Despite Spike in Energy Prices

12 Investment Viewpoint: A More Challenging Year for Fixed Income Investing

14 Municipal Bonds: In-Depth Credit Research Is Critical

16 Personal Finance: Delaying Retirement But Not Your Retirement Dreams

18 Taking Stock of the Market: Are We There Yet?

19 Performance Update • Equity Market Review • Fixed Income Market Review • Fund Performance Tables

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The Rapid Rise of the InternetGlobal Number of Internet Users

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*EstimatedThe global number of Internet users has doubled since 2005. It is expected that the total number of Internet users last year passed the 2 billion mark, including 1.2 billion in developing countries. While 71% of the population in developed countries is online, only 21% of those in developing countries are online. With more than 420 million Internet users, China is the largest Internet market in the world.Source: ITU World Telecommunication/ICT Indicators database.

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they could not have done just a few years ago,” he says.

Fulfilling the PotentialIndeed, the sudden success of these companies is fulfilling the early promises of the Internet. “What we’re seeing now is what fueled much of the optimism and ultimately much of the speculation in the 1990s,” says Robert Sharps, a large-cap growth manager. “And now there are compa-nies with sustainable business models and solid financial characteristics.

“The way businesses reach consumers and the way consumers reach each other is changing so quickly and the magnitude of the change is so different that whole business models are being turned over and new ones are being cre-ated. Change creates opportunity.”

Adds Mr. Eiswert: “The rate of change is on steroids. If you have a good idea or new product, you now have a very rapid rate of adoption around the globe.”

Mr. Sharps cites Blockbuster, a video store chain that went from large profits to bankruptcy in just three years as consumers shifted

to downloading videos. Borders, a bookstore chain, is exploring bank-ruptcy as consumers shift to down-loading e-books. “Three years ago there were no e-readers,” he notes, “and now Amazon.com is selling more e-books than paperbacks.”

Another indication of the pace of change, Mr. Sharps says, is that Apple is expected to derive 60% to 70% of its earnings this year from products that it had not even intro-duced before 2007—principally the iPhone and the iPad tablet computer.

The new media have already marked some impressive milestones:

• In just seven years, Facebook has amassed more than 600 million users and was valued at $50 billion in a private financing in January. It has surpassed Google as the most popular site on the Internet in terms of “time spent.”

• Twitter, an online messaging service and microblogging company, has accumulated 175 million registered users in just four years.

• Groupon is among the fastest-growing companies in Web history, according to Forbes.com.

• Apple’s iPhone has sold roughly 100 million units in four years, and Google’s Android operat-ing system for mobile phones is activating users at a rate of 300,000 per day.

• Apple has sold more than 15 million iPad tablets since their introduction in April 2010.

• There are now some 350,000 software applications on the Apple App Store that can be accessed with an Apple product.

Internet Bubble 2.0?

With some of these companies expected to go public within the next year or two, there already are concerns about another potential Internet bubble.

“Not all of these companies are going to be winners,” cautions Anna Dopkin, co-director of T. Rowe Price’s North America equity research. “However, with extensive research and analysis, you can increase the likelihood of deter-mining which ones will be successful and which ones will likely fall short.”

Mr. Sharps adds: “We can’t say whether the valuations of these private companies are reasonable or not. Some may be overvalued based on the hype surrounding all this. But based on the strength of positioning of some of these firms, there is a reasonable chance that they can become much larger companies over time.”

Paul Greene, a T. Rowe Price media and Internet analyst, cautions that some companies “are getting a lot of venture capital funding and don’t have a lot to show yet. But some of these companies have real business models, are growing very fast, and their valuations don’t seem anywhere near what some compa-nies reached in the 1990s.”

To illustrate the point, he notes

Internet InvestingContinued from page 1

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*Smartphones reflect iOS (Apple) and Android (Google) operating systems. Tablets reflect Apple’s iPad. 2010 results are estimates. Smartphones are expected to garner a 28% market share of the mobile handset market this year.Source: Stifel Nicolaus.

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that Priceline.com in 1999 had a $19 billion market capitalization with just $58 million in gross profit. After the dot-com crash, the company did not attain that market cap again until November 2010, but its gross profit last year was $1.9 billion.

“The fact that Priceline’s valuation is roughly the same now as it was 11 years ago but its profits are 33 times higher shows how excessive the valu-ation was then,” Mr. Greene says.

Portfolio managers also note that companies with dynamic growth opportunities can grow into what seem to be excessive valuations at the time. Mr. Greene observes that the market cap of Google at the end of 2004, the year it went public, was about $52 billion with only $2 billion in net revenue. That valuation seemed excessive, but a year later Google was valued at $121 billion. It is almost $200 billion today, and net revenue last year totaled $22 billion.

“The question is, what is the potential for these companies longer term,” says Dan Martino, manager of the Media & Telecommunications Fund. “Good growth investors stick with companies that are well positioned even when the valuation

appears to be full, and that takes a lot of courage, research, and experience.”

Growth stocks tend to be more volatile and can have sharp price declines due to earnings shortfalls.

Sticking With Leaders

Some T. Rowe Price funds have made small investments in a few of these private, new media companies, recognizing their potential growth. The firm’s technology strategy, however, remains focused on such industry stalwarts as Apple, Google, and Amazon, which are all driving change and benefiting from new opportunities.

Apple, of course, has been at the forefront of the shift from fixed to mobile computing. Its explosive growth has driven its market capi-talization to $321 billion, second in size only to ExxonMobil.

With an 80% market share, Google dominates search on the Internet globally and has been successful with its Android operating system for mobile phones, introduced in 2008, which is driving more traffic—and advertising revenue—to its site.

“In the Internet bubble, stocks traded at 40 to 50 times expected

earnings or more, and today you have companies like Google and Apple that trade at less than 20 times forecasted 2011 earnings,” Mr. Sharps says.

“These are real businesses that are well positioned to take advantage of substantial changes in how we live, and they are trading at valuations that we believe are not onerous at all given their current growth rates and the opportunities they should have over a long period of time.”

Mr. Martino says both Apple and Google potentially could reap more benefits as “interest in connectivity continues to grow, especially with the advent of fourth generation (4G) networks. With 4G, data transmis-sion speeds are faster, and software developers will come out with even more exciting applications.”

Mr. Martino expects that Apple’s share of the global mobile computing market will increase over its present level of just 5% and that Google “could be the leader in the mobile ecosystem in terms of software.”

Mr. Eiswert adds: “Investors have underestimated the revenue potential of Apple’s iPad, and in the years ahead we expect to see mass adoption of the Apple platform of products by businesses, the government, and private and public education arenas.”

Amazon also is well positioned to benefit from the continuing global migration to online commerce, fund managers say.

Moreover, Amazon, along with Google and Microsoft, is also positioning itself to become a key player in the nascent field of cloud computing, in which businesses out-source their data centers to a central network that stores and delivers data over the Internet, Mr. Greene says.

Mr. Allen believes that cloud computing and mobile communica-tions are the two dominant trends in

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technology today. “Cloud computing is more about companies and mobile communications is more about individuals,” he says, “but they tie together because a lot of what we do on smartphones and tablets relies on cloud computing. Without these data centers in the cloud, you could not do as much on your smartphone.”

T. Rowe Price managers are also finding attractive opportunities in a range of infrastructure companies and component manufacturers that serve the wireless community.

These include such companies as Juniper Networks (networking and switching equipment), Qualcomm (semiconductor chips for mobile devices), American Tower (cellular towers), Corning (the damage- resistant “Gorilla Glass” for all high-end tablets and smartphones), and several software business devel-opers that stand to benefit from the growth in mobile connectivity.

And then there are even more opportunities in emerging markets, especially Asia, to invest in such companies, because of the rapid growth of consumer classes in India and China. “Valuations are compel-ling among many companies in the region that have strong exposure to mobile computing, including Digital China, Baidu.com, China Unicom, and Tencent,” Mr. Eiswert says.

Investments in emerging markets are subject to abrupt and severe price declines and should be regarded as speculative.

Threats and Opportunities

The changing technology landscape is unfolding at such speed that fund managers say vigilance is in order. While closely tracking these new digital companies for potential opportunities, they also are watch-ing out for possible threats to established leaders.

“For Apple, Google’s Android is a threat,” Mr. Sharps says. “For Google, Facebook is a threat because it could attract more advertising dol-lars as people spend more time on the site. So you have to be on the lookout for whatever threats could emerge from any of these new players.

“No one is immune to the effects of rapid change,” he adds. “The odds are that some of these leading compa-nies will continue to take advantage of the magnitude of this change, but the pace of change suggests they have to anticipate and be highly innovative. If Amazon had not invested in the Kindle and the iPad came along and e-books took off, Amazon would have been in trouble.”

Investing in technology companies involves special risks, including earnings disappointments and intense competition for market share that can result in sharp price declines. Of the stocks mentioned in this article, these funds had the following percentage of their assets invested in them as of March 31, 2011: Science & Technology Fund: 23.7%; Media & Telecommunications Fund: 25.7%; and Global Technology Fund: 28.6%. These companies were not owned by any of these funds as of that date: Twitter, LinkedIn, Groupon, Living Social, Zynga, Angie’s List, Blockbuster, Borders, and Digital China. The Science & Technology Fund did not hold Priceline, American Tower, Baidu, or Tencent. The Media & Telecommunications Fund did not hold Priceline, Microsoft, Juniper Networks, or Corning. The Global Technology Fund did not hold American Tower.

Internet InvestingContinued from page 3

Top 10 Public Internet Companies Ranked by Market Values as of March 31, 2011

Company Market Value (Billions) % Change

12/31/2005 3/31/2011

1. Apple $60.8 $321.1 428%

2. Google 121.6 188.7 55

3. Amazon.com 19.6 81.2 314

4. Baidu.com (China) 2.1 48.0 2,187

5. Tencent (China) 1.9 44.4 2,238

6. eBay 60.7 40.3 -34

7. Priceline.com 0.9 24.9 2,666

8. Yahoo! 56.0 21.8 -61

9. Yahoo! Japan 45.9 20.9 -55

10. Salesforce.com 3.5 17.8 407

Sources: Morgan Stanley and Capital IQ.

Managers expect a stream of other dynamic companies to come to the fore. “The Goupon business model and the Twitter business model didn’t exist a couple of years ago,” Mr. Sharps says, “so it would be foolish of us to think we are going to go through this period of innovation right to maturity just riding existing companies.”

Mr. Eiswert concurs. “This is a great time to be a tech investor, considering the potential opportuni-ties,” he says. “Five years ago people thought tech was dead. And that may be true for some parts of it. But for other parts we’re just at the beginning.”


Emerging Europe Equities Versus Global MarketsTotal Return Indexed to 100, From December 31, 2000, Through March 31, 2011

Equity performance in Eastern Europe, emerging markets, and developed markets is represented, respectively, by the MSCI Emerging Markets Europe Index, MSCI Emerging Markets Index, and MSCI All Country World Index. Returns are in U.S. dollars.Source: MSCI RIMES.

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The growth in Asian and Latin American markets has been widely publicized, particularly because of their burgeoning ranks of middle-class consumers. By contrast, Europe’s developing markets have received little attention. Yet emerging Europe outperformed the global emerging markets index during much of the last decade. (See chart.)

Emerging Europe was particularly hard-hit by the financial crisis—losing 68% in 2008—only to rebound with equal velocity, returning 118% total in 2009 and 2010.

With Russia composing over 60% of the MSCI Emerging Markets Europe Index, the index’s perfor-mance has been significantly tied over the past decade to the heavy energy and utilities weightings within Russia’s stock market.

But Eastern Europe’s investment prospects also may hinge on the region’s continued ability to modern-ize and grow its consumption—a trend set in motion by the collapse of the Soviet Union 20 years ago.

Post-Soviet Transition

Russia and such former Eastern Bloc nations as Poland, Hungary, and the Czech Republic already have undergone “an astounding transition from communism toward capitalism,” says Leigh Innes, manager of the Emerging Europe & Mediterranean Fund.

“For example, there were only about 10 stocks we would look at in Russia about eight years ago, and today there are almost 70, as well as a strong pipeline of initial public offerings of stock,” Ms. Innes says.

However, she adds, there is still much catching up to be done.

Emerging Europe: Standout Returns But Often Overlooked

“Compared with Western Europe and even many other emerging markets, Eastern Europe is quite underdeveloped. Even though there have been large retailers throughout emerging economies in Asia for years, supermarkets and discount stores are actually new to Russia,” she says.

At the same time, she says, “It would be a mistake to think of Russia only as an oil and gas story.”

Ms. Innes believes that Russian consumer staples and discretionary stocks—such as X5 and Magnit supermarkets—are well positioned to capitalize on increasing economic growth and consumers with low debt and rising wages.

Nevertheless, problems persist. Russian companies continue to grapple with government interfer-ence, bureaucracy, and corruption.

The good news is that not all of Eastern Europe has governance and debt problems. “Investors shouldn’t think of this region as one mono-lithic group,” Ms. Innes says.

Poland, for example, was one of the few countries in the world to sidestep the recent recession, but its stocks are among the region’s more costly.

Such disparities can create oppor-tunities, however, for investors with greater risk appetites. Ms. Innes has been finding attractive investments in Turkey and such frontier markets as Ukraine, Kazakhstan, and Georgia.

“Volatility is no stranger to this sector, and I don’t expect that to change,” she says. “But the region’s unique history and growth pros-pects create compelling long-term opportunities.”

International investing is subject to market risk and risks associated with unfavorable currency exchange rates and political or economic uncertainty abroad. Investments in emerging markets are subject to the risk of abrupt and severe price declines. Stocks mentioned in this article made up 10.3% of the Emerging Europe & Mediterranean Fund as of March 31, 2011.

Performance Spotlight


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Mid-Caps Outperform Small- and Large-Cap StocksTotal Return Indexed to 100 From December 31, 1999, Through March 31, 2011

Mid-caps are represented by the Russell Midcap Index, large-caps by the S&P 500 Index, and small-caps by the Russell 2000 Index.Source: T. Rowe Price.


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For the stocks of medium-sized U.S. companies, there was no such thing as a “lost decade.”

While U.S. large-capitalization stocks had an annualized return of only 1.41% for the 10-year period ended December 2010, mid-cap equi-ties did far better with an annualized gain of 6.54%, which also modestly outperformed small-cap stocks.

Indeed, even as the S&P 500 Index of large-cap stocks remains short of its 2007 high, the S&P 400 Index of mid-caps broke its all-time record in January of this year.

Moreover, mid-caps continued their market leadership in the first quarter of this year, with the S&P 400 gaining 9.36% compared with 5.92% for the S&P 500.

While mid-cap stocks tend to be more volatile than those of larger companies, they have a long track record of outperformance.

With the exception of certain periods of large-cap leadership—the most recent being their vast gains from 1994 through 2000—mid-caps have consistently outpaced large- caps in almost every decade since the 1930s, based on studies by the University of Chicago’s Center for

Can Mid-Cap Stocks Sustain Their Outperformance?Research in Security Prices.

According to that center, cycles of mid-cap outperformance relative to large-caps have lasted more than six years on average and produced an average return 10.9 percentage points higher over those cycles.

Large-Caps Favored

But mid-caps may be challenged to sustain their dominance going forward, T. Rowe Price mid-cap portfolio managers say.

They note that mid-caps’ valua-tions, while still considered largely reasonable, are high relative to those of large-caps—a reversal of their relative valuations in 2000, when large-cap prices were in bubble ter-ritory and mid-caps were cheap and poised for the last decade’s rebound.

So T. Rowe Price’s current out-look favors large-caps, particularly those global players that can benefit from the higher growth rates in emerging markets.

As Brian Berghuis, manager of the Mid-Cap Growth Fund, puts it: “I expect reasonable returns over the next few years for mid-caps, but I expect large-cap stocks to do better.”

Don Peters, manager of the Diversified Mid-Cap Growth Fund, agrees. “Sustained periods of outper-formance are hard to keep going,” he says. “I’m a big believer in reversion to the mean, so I am certainly willing to say that large-caps now present a better risk-versus-reward play.”

He notes that the median stock in the fund was up more than 30% over the year ended in February. “It is extraordinarily unlikely that we will repeat that,” he says. “We anticipate solid returns, but a period of more normal returns wouldn’t surprise me.”

“Sweet Spot”

At the same time, many mid-caps historically have offered a key advan-tage, a “sweet spot” in the growth cycles of companies and the risk/reward trade-off, says Joe Milano, manager of the New America Growth Fund, which invests in both large- and mid-cap companies.

Over time, the capitalization range of mid-caps tends to drift upward with the economy. For the Russell Midcap Index, the capitalization range is reset annually; at its last reset in May 2010, the range was from $1.3 billion to $14.1 billion.

In general, that range tends to offer a potentially productive mix of characteristics, says David Wallack, manager of the Mid-Cap Value Fund—characteristics that boil down to “a lot of the benefits of larger-cap companies without some of the risks associated with small companies.

“They tend to be established. They have a brand, franchise, product, or service that’s stood the test of time, plus more seasoned managements. But they’re more nimble than larger companies, more dynamic, and they simply have delivered superior returns relative to risk over the long term.”


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Relative Valuations of Mid-Caps to Large-CapsRatio of Mid-Cap Price/Earnings Ratio to Large-Cap Price/Earnings Ratio December 31, 1991, Through March 31, 2011

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That’s evidenced by the Chicago center’s data showing that mid-caps have delivered comparable com-pounded annual returns to small-caps (11.03% versus 11.47%) from 1926 through 2010 with consistently much lower volatility. Both asset classes have outperformed large-cap stocks, which had an annualized return of 9.34% over this long time frame.

“With mid-caps, essentially you have ‘de-risked’ smaller-cap com-panies,” Mr. Peters says. “They’re small-cap companies that have made it to mid-cap size, validating their business models. They’re still rela-tively early in their growth cycle, but you have much more data about how their businesses have evolved.”

Another factor driving mid-caps’ relatively higher returns has been mergers and acquisitions, Mr. Peters says, which may accord some pre-mium pricing.

“Small-caps often may be too risky for acquisitions by larger com-panies and too small to make much of a difference for their acquirers,” he says. “And very few companies are large enough to take over another large company. But mid-caps may be considered a manageable, bite-sized acquisition for a larger company.”

Evolving Stocks

Because T. Rowe Price funds span the market capitalization spectrum, managers believe they have an edge investing in mid-cap companies as the firm’s analysts may have covered certain stocks for years before they grew to that size.

For example, ask Mr. Berghuis where he has found many of the best ideas for his fund, and he answers without hesitation: two of T. Rowe Price’s small-cap funds, the Small-Cap Value Fund and the growth-oriented New Horizons Fund.

“Within the several hundred companies in those funds, there are certain companies that over time will grow in size,” Mr. Berghuis says. “They’ve consistently provided us with great ideas. Particularly when you get a company that goes from small-cap value to small-cap growth to mid-cap, you can get sizable stock gains because of the expansion of its price-to-earnings ratio.”

As an example, Mr. Berghuis cites Whole Foods Market, the food chain, which, as an analyst, he recommended to the New Horizons Fund in 1992 when it had just 12 supermarkets and a market cap of $90 million.

“The thesis was that, while many viewed the company as a fringe con-cept, we believed that it would grow as baby boomers’ healthy food focus became more mainstream,” he says.

Whole Foods grew to the point that in 1998 it was large enough for its stock to be bought by the Mid-Cap Growth Fund, which still owns it. Today, the chain has 302 stores and a market cap of $10 billion.

Mr. Berghuis estimates that at least half of the stocks now owned in the fund similarly have “graduated” from

the firm’s small-cap funds, including Human Genome Sciences and FLIR Systems, a defense contractor.

Some companies—such as Amazon.com; Starbucks; and Danaher, a global manufacturing conglomerate—were first owned in T. Rowe Price’s small-cap funds, then in the Mid-Cap Growth Fund, and then in large-cap portfolios, with analyst coverage over several decades.

“Sometimes companies come in for meetings,” Mr. Berghuis says, “and we bring in the analyst who first covered them 25 years ago and all the other analysts who have covered them since.”

Earnings of mid-caps tend to fluctuate more than those of larger firms, and small-caps could offer greater growth potential. The stocks mentioned by Mr. Berghuis made up 2.7% of the Mid-Cap Growth Fund as of March 31, 2011. The fund did not own Amazon.com.


Since the stock market bottomed roughly two years ago, U.S. indus-trial stocks have sharply rebounded in a V-shaped recovery. And T. Rowe Price portfolio managers say more gains in this important sector could come.

While surging new orders and exports already have boosted the share prices of many manufacturers, managers say the U.S. economic expansion and increased sales to emerging markets could benefit many other industrials that tend to perform better later in the economic recovery.

Overall, as is typical after a severe recession, the industrials sector has outperformed the broader U.S. mar-ket since the March 2009 trough—with the sector gaining a cumulative 157.2% through March of this year versus the S&P 500’s 104.5% gain. Only the financials and consumer discretionary sectors performed better.

During this time, manufacturing production indexes have soared in the developed world—in February they reached their highest levels in almost seven years in the United States and more than 10 years in Europe—while cooling somewhat in China and other parts of Asia.

Even U.S. manufacturing employ-ment, which leaked jobs for more than a decade, has been gaining ground, becoming a relatively bright point in a bleak jobs outlook.

U.S. industrials encompass a wide range of companies, with some tending to respond more quickly at the start of an economic recovery and others much later.

The earliest recovering indus-trials—for example, producers of machinery, automated production lines, and equipment for construction services—have already seen strong returns, with some stocks more than doubling in value from their lows.

U.S. Industrials Stage a Strong ComebackWhile portfolio managers still

hold some of these positions for their continued potential, they say that the economy now has moved from the recovery to the expansion phase.

“The early cycle companies did well in 2009 and into 2010,” says Jeff Rottinghaus, manager of the U.S. Large-Cap Core Fund. “But we’re headed into the third year of a cycle, what we might call the middle innings of the economic recovery.”

As a result, managers have reduced holdings in some of these early recovery stocks and turned more toward stocks that may do well in the later stages of the economic cycle, such as aerospace, defense, and construction services stocks.

Two Trends

Two trends are at work here, portfolio managers say.

The first is the typical post- recession business uptick. Manufacturing is among the first sectors to suffer in a downturn, as customers deplete inventories and cut back on new orders and on capital spending. And the sector is among the first to pick up in recoveries.

“We had a dramatic drop in industrial production, and dramatic

declines are typically followed by dramatic upswings,” says Greg McCrickard, manager of the Small-Cap Stock Fund.

The second trend is that U.S. man-ufacturers are experiencing increasing demand from emerging markets, which portfolio managers believe will be an enduring—not cyclical—theme. Emerging markets now account for more than half of all U.S. exports.

In evidence long before the down-turn, emerging market demand has accelerated from the strong recoveries in China, India, Brazil, and elsewhere. Moreover, U.S. manufacturers, as well as those in Europe, have benefited from their weaker currencies, which supercharge exports.

Stock PickingSome portfolio managers say the U.S. economic expansion will continue to propel many industrial stocks, while others are more cau-tious because industrials already have had substantial gains.

“Industrials today are the most favored sector in the market and one of the most richly priced,” says David Giroux, manager of the Capital Appreciation Fund.

Another reason for caution is increasing commodity and raw

S&P Industrials Sector Outpaces S&P 500 in Market RecoveryTotal Return Indexed to 100 as of March 9, 2009, Through March 31, 2011


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1/31/1112/31/1011/30/1010/31/109/30/108/31/107/31/106/30/105/31/104/30/103/31/102/28/101/31/1012/31/0911/30/0910/31/099/30/098/31/097/31/096/30/095/31/094/30/093/31/09

3/09 6/09 9/09 12/09 3/10 6/10 9/10 12/10 3/11

Source: T. Rowe Price.


materials costs, which could impede industrials’ profit margins, adversely affecting stock prices.

As a result, managers agree that as the economic cycle matures, stock picking will become even more of a factor in driving potential returns.

Mr. Giroux and Mr. Rottinghaus both say this means that investing decisions are more complex than just determining industrial stocks’ position in the economic cycle.

With the recovery in its middle innings, Mr. Rottinghaus sees advan-tages to tilting toward companies that tend to benefit as the economy moves into the expansion phase.

He cites some examples of such late-cycle industrials: Honeywell; United Technologies; Boeing; and Cooper Industries, which manufactures electrical products for commercial construction, a sector that has not yet recovered.

At the same time, Mr. Rottinghaus holds a wide range of industrials that tend to perform well during more than one stage of the economic cycle. He cites, for example, 3M, a diversi-fied technology conglomerate that has more than doubled off its 2009 lows.

One potential driver of additional gains for early cycle industrials, Mr. Giroux says, could be if they

deploy their considerable cash toward acquisitions and mergers.

An example: industrials giant Danaher. While the firm is expected to grow sales at a reasonable pace over the long term, it could benefit strongly from its recent acquisition of medical test-maker Beckman Coulter. “Danaher is more of an early cycle company but creates more value through mergers and acquisitions,” Mr. Giroux says.

Manufacturing Abroad

A striking feature of the current manufacturing rebound is that, while capital spending on equipment and property has increased sig-nificantly, the labor market remains weak—contrary to most recoveries.

But portfolio managers say the lag in jobs is not reflective of the health of many larger U.S. companies that have transitioned to very lean, auto-mated domestic production or have moved their manufacturing overseas.

Mr. Rottinghaus notes that, among industrials in the U.S. Large-Cap Core Fund, “almost to a company the growth in manufacturing sales and jobs is not in the United States but overseas because they need to be closer to their customers and because of the expenses of U.S. workers.”

For example, he says, United Technologies’ Otis elevator division has a booming business in China that is competing with Chinese manufacturers, while producing far fewer elevators in the United States.

Similarly, Joe Fath, a large-cap portfolio manager, cites Emerson Electric, a diversified electrical equipment maker, which has moved some production and research and development to emerging markets. Emerson has about 30% of its sales in these markets, a figure that the company projects will swell to about 50% in just 10 years.

This trend also is evident among some smaller-cap U.S. companies. Mr. McCrickard cites General Cable, which makes communication, indus-trial, and utility products and recently opened new plants in Peru and India, and A.O. Smith, a U.S. producer of water heaters, which is doubling its manufacturing capacity in China and opening a new plant in India.

Partly due to the rise of offshore manufacturing, U.S. manufacturing accounts for just 10% of U.S. gross domestic product, compared with 13.5% in 1995, according to the U.S. Bureau of Economic Analysis.

A Peak in Outsourcing?

At the same time, Curt Organt, a T. Rowe Price industrials stock analyst, says, “the outsourcing trend may have peaked. Many jobs simply can’t be outsourced.”

Mr. Organt says that small U.S. manufacturers that produce bulky or high-end products are more likely to make them in the U.S. or Mexico.

Moreover, the continued weak-ness of the U.S. dollar, steadily rising wages in China, the surge in emerging market energy costs, and concerns over intellectual property favor keeping U.S. manufacturing

Industrial Production Index

move up 300 pts

80

85

90

95

105

100

12/101009080706050403020100

Recession Periods

The industrial production index is seasonally adjusted and indexed to 100 at the average of every month in 2007.

Sources: Federal Reserve Board and Strategas Research Partners.

Recovery

Recovery

Expansion

January 2000 Through February 2011

2/1110’09’08’07’06’05’04’03’02’01’’00

Shaded bars reflect recessions.

Continued on page 10


Perspectives

Inflation concerns have become more prominent since political unrest in Libya—a major oil producer—raised the specter of a 1970s-style oil supply shock. Indeed, the roughly 15% increase in crude oil prices during the second half of February translates into a rise in the pump price of gasoline of a bit less than half that magnitude.

Even as oil prices show signs of stabilizing, the full impact of the

late-winter runup will likely lift the retail price of a gallon of regular gasoline into a $3.75 to $4.00 range by midyear.

Yet the upward pressure on energy prices predates the fears of supply disruption related to political unrest in the Middle East and North Africa (MENA). Crude oil prices began to rise sharply in early September as better economic data dispelled fears

that last spring’s Greek debt crisis would spark a double-dip recession.

And oil had company in the commodities space. In the half year to mid-February, while the price of crude oil rose roughly 30%, indexes of raw industrial materials and raw food commodities prices advanced by roughly 25%.

In the past, swings in commodity prices—energy and food in partic-ular—were driven significantly by transitory changes in supply caused, for example, by geopolitical develop-ments or unanticipated weather patterns. More recently, however, the rise of fast-growing emerging countries in the global economy has injected a lasting increase in demand for a broad range of commodities.

The upshot is an upward shift in the degree of commodities-based inflation relative to the state of the U.S. economy.

These effects are greatest in the energy sector, where the crude input is a predominant component of the refined output. The pass-through is weaker in food production. Nonetheless, the consumer price index (CPI) for food has also acceler-ated in recent months, lifting the year-to-year inflation rate to 2.3% in February from -0.2% a year earlier.

Moderate But Rising

As the commodity content of domes-tic products declines, the available capacity in a particular industry—and associated labor, distribution, and other costs—becomes a more impor-tant determinant of price pressure.

Thus, apart from food and energy—in the so-called core infla-tion process—margins of available slack in labor and products play

production on U.S. soil.While some of the later-cycle

industrials in the Small-Cap Stock Fund produce and sell their goods in emerging markets, Mr. McCrickard’s holdings are more firmly positioned near their U.S. customers. Manufacturing more of their products overseas could cost them more, not less.

An example: Tennant, which makes industrial sweepers, scrub-bers, and other heavy equipment. Approximately 60% of the com-pany’s revenues are generated in North America. While the company produces and sells globally, it has kept 60% of its workers in North America, resisting the temptation to offshore more of its operations.

“They say that they can make things just as cheaply in Minneapolis as in China,” Mr. McCrickard says. “It may be unique to them. But there’s not as much of a disadvan-tage to being in the United States.”

Similarly, Acuity Brands, an electrical equipment manufacturer, keeps its manufacturing base close to its customers. With 97% of its sales in North America, 14 of its 16 manufacturing facilities are in the

United States and Mexico.Some of these kinds of holdings,

Mr. McCrickard cautions, have already been benefiting from the expectation of the economy moving into an expansion phase. But other industrials, particularly related to housing and construction, he says, “still have a long way to go.”

The prices of small companies tend to fluctuate more than larger firms. Growth-oriented stocks can have sharp price declines as the result of earnings disappointments, and value- oriented stocks carry the risk that the market will not recognize their intrinsic value for a long time or that they are already appropriately priced.

As of March 31, 2011, stocks mentioned by Mr. Rottinghaus made up 9.9% of the U.S. Large-Cap Core Fund; by Mr. McCrickard made up 2.5% of the Small-Cap Stock Fund; and by Mr. Giroux made up 3.6% of the Capital Appreciation Fund. Emerson Electric, mentioned by Mr. Fath, makes up 1.3% of the Institutional Large-Cap Growth Fund. It was not held by the other funds.

U.S. IndustrialsContinued from page 9

Inflation Outlook Moderate Despite Spike in Energy PricesBy Alan Levenson, T. Rowe Price Chief Economist


a more significant role. This is particularly the case in the United States, an advanced economy in which goods make up only 40% of the consumption basket, with services composing the rest.

On this score, industrial uti-lization rates have been low and unemployment rates high, speaking to ample potential supply that will hold measures of underlying infla-tion at low levels over the next two to three years.

In terms of the direction of infla-tion, however, the critical factor is that margins of slack are diminishing. For example, after drifting sideways for almost a year, the unemployment rate has begun a marked decline, fall-ing by nearly a full percentage point since November 2010.

Concurrently, manufacturing industry utilization rates, well off of their mid-2009 lows but making limited further progress after May of last year, quickened their cyclical ascent in recent months, surpassing August 2008 levels.

Finally, the rental vacancy rate, which peaked in mid-2009, began to fall sharply from the middle of last year. While still high by historical standards, the onset of a declining housing vacancy overhang signaled

an upturn in rents, which gained traction in mid-2010.

As a result of these develop-ments, the year-to-year rate of core CPI inflation (excluding food and energy) has risen from a trough of 0.6% during the final months of 2010 to 1.1% in February; we see it rising to 1.5% at the end of this year and to at least 1.75% by the end of next year.

With food and energy set for larger increases this year (2.5% and 7.0%, respectively), the overall headline CPI is set to rise by 2.3% this year and 2.5% next year.

Inflation Risks

Energy and food prices could fall back for a time, as is often the case after a sharp ascent, perhaps in response to monetary tightening and moderating growth in China or a cooling of political risks in the MENA region. If not, persistently elevated prices in these sectors could have an impact on the broader inflation outlook.

Higher energy costs could pass through to non-energy sectors that are intensive energy users, such as transportation services. In addi-tion, particularly as labor markets tighten, higher food and energy

costs could pass through more fully to wages. Because labor costs are a significant portion of total costs for most industries, this development would lead to price pressures for various industry sectors.

Finally, a weak dollar and elevated foreign inflation could boost import price inflation further, creating more leeway for domestic producers to raise prices.

Fed PolicyNone of this is to say that we are on the verge of a 1970s inflation outbreak. The Fed remains strongly committed to holding inflation near 2% over the long term, but it has been equally committed to raising inflation toward 2% in the near term.

In its willingness to allow core inflation to rise while the economy strengthens and global inflation pressures mount, the Fed may not be playing with fire. But it seems at any rate to be playing with matches.

It will be important for the Fed to start raising interest rates, beginning the gradual process of returning monetary policy to a broadly neutral setting, long before the unemploy-ment rate approaches a level that policymakers view as being consis-tent with a fully employed economy.

If the Fed waits too long, misjudging the persistence of commodities-based inflation or the levels of resource utilization at which broader inflation pressures intensify, an inflation dynamic could take hold that would require a more aggressive course of tightening—with risks to the economy.

Consumer Price Index


-2

-1

0

1

2

3

4

5

6CPI

CPI Excluding Food & Energy

1/111/101/091/081/071/061/051/041/031/021/011/00

— Consumer Price Index Excluding Food and Energy— Consumer Price Index

Source: Bureau of Labor Statistics.

-2

-1

0

1

2

3

4

5

6%

2/111/101/091/081/071/061/051/041/031/021/011/00

Perc

ent

Cha

nge,

Yea

r Ago


Q. Interest rates have risen modestly this year, but the average yield for investment-grade corporates was recently about 4.1% and junk bond yields fell to about 7%—near the all-time low in 2004. Do corporate yields adequately compensate investors for the credit risk?

A. While absolute yields are at historically low levels, yields relative to alternative sectors still look somewhat compelling. High yield bonds offer a 500-basis-point [five-percentage-point] spread over comparable Treasuries—still meaningful, though well below levels of the past two years. Credit sectors continue to benefit from the liquidity in the market, and corporate credit quality has improved significantly. Defaults in the high yield market have fallen dramatically, though we have seen some decline in the quality of new issues and early signs of specula-tive behavior in that market recently.

Q. What’s your perspective on the Treasury market?

A. Treasury yields also have risen this year, to about 3.50% recently on the 10-year bond. Yields are up largely because of increased inflation expectations, partly driven by the

Investment Viewpoint

A More Challenging Year for Fixed Income InvestingCorporate bond investors enjoyed back-to-back stellar returns during the past two years, but with interest rates likely to rise further, expectations are more subdued. Steve Huber, manager of the Stra-tegic Income Fund, which invests in multiple global bond sectors, discusses the outlook for fixed income investing.

Q. How do you view the general financial health of corporate borrow-ers and the state of the fixed income markets now—almost two years after the recession officially ended?

A. Corporations are in much better fundamental shape. The new issue markets allowed them to refinance their debt and extend their maturity profile, and they have relatively high levels of cash on their balance sheets, which should allow them to better navigate through a protracted economic recovery. We expect a slow-growing economy, and we’re focused on how topline revenue growth and profits hold up under these conditions.

As for the general state of the mar-kets, corporate credit has surprised us with the speed and magnitude in the tightening of yield spreads over Trea-suries. As long as the Fed is providing liquidity, these spreads should stay relatively contained at these lower levels and corporate credits should do well, at least for the first half of the year. But as we get closer to Fed tightening, perhaps in the second half, we would suggest that a more cautious approach to credit sectors could be warranted.

Fed’s QE2 [its second quantitative easing] program of buying Treasur-ies, which is supportive for yields as an additional source of demand but also adds to longer-term inflation concerns given the magnitude of liquidity injection.

We expect rates to trend higher longer term, as the Fed ends QE2 Treasury purchases in June, deficit levels remain high, and the economy continues to recover. Inflation could also trend modestly higher but is not a concern for the time being. The yield on the 10-year bond could reach 4.25% to 4.50% a year from now, but the path will likely be interrupted by periodic bouts of risk aversion such as we’ve recently experienced with events in the Middle East, Japan, and Europe. Shorter-term yields should also rise once the Fed signals its intention to remove policy accom-modation, which could begin in the second half of 2011.

Q. So has the 30-year secular decline in

interest rates finally come to an end?

A. I would say we reached the low in rates toward the end of 2008.

How Rising Interest Rates Affect Treasury Bond Prices

Bond Maturity Coupon Rates Increase By:

50 Basis Points 75 Basis Points 100 Basis PointsChange in Principal Value of Bonds With $1,000 Face Value

2 Years 0.75% -0.99% -1.49% -1.98%

5 Years 2.25 -2.40 -3.59 -4.79

10 Years 3.62 -4.28 -6.42 -8.56

30 Years 4.75 -8.31 -12.46 -16.61

Average coupons on Treasury securities provided as of 3/31/11. Price changes are apart from fluctuations caused by other market conditions or factors. 100 basis points equal one percentage point. The table may not be representative of price changes for mortgage-backed securities because of prepayments. This chart is shown for illustrative purposes only and does not represent the performance of any specific security.



Q. Do you see more opportunity in international bonds?

A. We have a negative view on the dollar, especially versus emerging economies, which are raising interest rates to combat inflation. I would emphasize that this is a longer-term view, though. Over the shorter term, we are more cautious on emerging market currencies because investors have built up large positions in them over time. As those positions

moderate, we expect to be increas-ingly bullish on emerging currencies.

In developed countries overseas, such as Europe, we would expect to see rates slowly trending upward, similar to the U.S.

Q. What is your current strategy?

A. We are overweight in high yield, specifically in bank loans, which represent the higher-quality part of the market and whose floating rate nature provides some protection if rates rise. We are also overweight in local currency emerging market bonds. We’re neutral on investment- grade credit and mortgage-backed securities, both in the U.S. and

Europe, and underweight agencies and asset-backed securities.

With yield spreads back to more normal levels or even tighter in some cases, it is a difficult environment to make money from fixed income sec-tor allocation, unlike during the past two years. Having said that, market volatility should provide plenty of tactical opportunities as the global economy works through numerous challenges.

Q. What are the keys risks now?

A. One is the inflation risk emerg-ing economies are contending with, which threatens growth. Second, as we get closer to Fed tightening, how will the Fed engineer its exit strategy, pulling liquidity out of the system quickly enough to contain inflation, yet slowly enough to allow the economic recovery to take hold?

Another risk is the economy in general. The housing market is still in the doldrums, and unemployment is high. We also are focused on potential event risk in the corporate bond market, as high corporate cash levels often lead to M&A [mergers and

acquisitions] activity. As investment- grade corporations engage in M&A, they typically take on more debt, which hurts their credit quality.

Global risks also extend beyond emerging market inflation concerns. Geopolitical risk, European sovereign debt risk, and rising commodity and oil prices are just some of the potential roadblocks on the path to economic recovery.

Q. What impact will the turmoil in the Middle East and rising oil prices have on the bond markets?

A. There are somewhat offsetting factors here. Typically global turmoil leads to lower rates because Treasuries are often seen as a safe haven, and that is what we’ve seen lately. On the other hand, rising oil and commodity prices are often associated with higher bond yields as inflation concerns rise. While lower rates have taken the lead thus far, as time goes on, rising com-modity prices could lead to upticks in headline inflation and pressure rates higher.

Q. What should investors expect in terms of bond market returns?

A. With interest rates rising and yield spreads tight, we do not expect returns anywhere near what we have seen in the last couple of years. We see a coupon-clipping environment as a good outcome, with even less return if rates rise as we expect.

It’s likely that the high yield market will outperform investment-grade corporates and Treasuries once again, assuming the economy continues to improve. But the outlook for credit sectors is more uncertain as we get closer to liquidity being pulled from the system, particularly as valuations become less compelling. It seems prudent here to reduce risk, stay liquid, and tactically allocate around market volatility.

Other5%

Europe CorporateBonds

11%

EmergingMarket Bonds

17.5%

Bank Debt15%

Strategic Income Fund Portfolio Diversification As of March 31, 2011

Other and Reserves

Euro Corporate Bonds

Emerging Market Bonds

Bank Debt

High Yield Bonds

U.S. Commercial Mortgage-Backed Securities

U.S. Mortgages

U.S. Corporate Bonds

Treasuries

Global Treasuries7.5%

U.S. Corporate Bonds14%

U.S. Mortgages15%

U.S. Commercial Mortgage-Backed Securities5%High Yield Bonds10%

[ “With interest rates rising and yield spreads tight, we do not expect returns anywhere near what we have seen in the last couple of years.”

]


Parking garages, as it turns out, are complex businesses, and Trish Deford has become steeped in their nuances.

Ms. Deford is a municipal bond analyst at T. Rowe Price, one of 43 credit analysts in the firm’s Fixed Income Division, eight of whom specialize in researching municipal bonds—collectively aiming to know every-thing they can about hundreds of bond issuers’ finances, operations, management, construction projects, and prospects.

Such independent credit research recently has become even more important to finding good values in the municipal bond market. While remaining a high-quality market, municipal bonds saw a sharp sell-off starting last fall and through the winter, with bond prices falling as a result of a glut of new issuance, credit concerns, and an overall rising interest rate environment.

Moreover, the municipal bond market has recently gone from mostly insured securities to 90% uninsured. And many investors don’t realize that the market is not just general obligation bonds based on state and local taxes but is mostly made up of bonds based on revenue generated by the tax-exempt projects they finance, such as parking garages, hospitals, and water and sewer systems.

No two municipal bond securities are alike, and so T. Rowe Price credit analysts examine every investment that the firm is considering and assign each security a rating. Managers make their investment decisions based on these internal ratings.

Analysts are assigned to and develop various specialties. Ms. Deford, a municipal credit ana-lyst since 1979 and at T. Rowe Price for 12 years, often focuses on bonds involving very complex matters, such as highly structured transactions—securitization of state tobacco settle-ment revenues, for example.

But even something seemingly as simple as parking garages has its complexities and often requires on-site visits as an essential part of the research. “I never thought I’d be spending so much time in parking garages, but to invest in that area, you have to,” Ms. Deford says.

In such visits, her goal is to assess the bond’s risk versus return. “My job is to really home in on that risk element and help the portfolio manager make a decision,” she says. “If we provide the funds to build the new garage by buying this bond, will customers switch to that garage and provide the revenue to pay the bond interest?”

She likes to drive into each garage as if she were a customer, examining its ease of access, rates, payment options, ticket machines’ functioning, and competition from other garages and mass transit. She talks with man-agement face to face, follows up with phone calls and more visits as needed, and files update notes and ratings.

“It’s hard for individual investors to do all that because it’s so specific and it requires so much attention to legwork and detail,” Ms. Deford

says. “But only by going out and getting in-depth understanding of the bonds and of the projects that secure them can we make good investment decisions.”

On the RoadMarcy Lash, a municipal bond credit analyst since 1992, including 13 years with T. Rowe Price, agrees. She stud-ies hospital bond issues across the

country and is on the road about once a month for site visits “to get a more complete picture.”

Sometimes, these trips are adven-tures. “I’ve traveled to some very out-of-the-way places, and some-times I find myself in the middle of cornfields, down some gravel road,” she says.

“It could be an hour between towns. You really gain an under-standing of different areas and cultures of this country. And some-times you find great investments where you least expect.”

In 2010, for example, T. Rowe Price bought additional bonds issued by a hospital system in Kentucky that is replacing its main facility, after a visit by Ms. Lash that began with a predawn flight from Baltimore and an hour drive through farmland.

Municipal Bonds: In-Depth Credit Research Is Critical

[ “…only by going out and getting in-depth understanding of the bonds…can we make good investment decisions.”

]


Once at the hospital, she met with managers for several hours, discussed their strategic planning and financial management, and walked the construction site for the new hospital, where she talked with the construction manager and sat in on one of his meetings.

She also analyzed the hospital’s market, taking into account popula-tion, income, and insurance data; competition from other health care providers; and the area’s employ-ment structure.

“I like looking at hospitals that operate in difficult environments, where you really have to get under the hood and figure out a story and put all the pieces of the puzzle together,” Ms. Lash says.

“Talking with managements is invaluable. From years of asking the same sorts of questions in different situations, you get an understanding of what the right answers should be and whether they have control over the issues they’re facing.

“Frankly, I’ve spoken with some management teams that completely had their heads in the sand as to what was going on around them, and you needed to be there to find that out.”

Getting InvolvedOn a few occa-sions, probing by T. Rowe Price municipal credit analysts lead to even greater involve-ment with the bond issuer.

One such case involved a 15-year-old public charter school in Colorado, which issued bonds in 2007 to finance a move from a warehouse-type space to a brand new facility.

Among analyst Jonathan Chirunga’s specialties is examining bonds issued by charter schools. He says buying bonds of such schools is somewhat like investing in a start-up company, and so initially he was impressed by the school’s superior student achievement record relative to its larger school district. That track record, not surprisingly, had parents clamoring to enroll their children.

But about nine months after the initial bond sale, Mr. Chirunga discovered that the school, which had been on sound financial footing at the start, was not managing its construction finances well.

“They just said we want this for the school, we want that, and the price for the project kept going higher and higher,” he says.

There were other management challenges, as Mr. Chirunga found out on multiple visits to Colorado. At the same time, he says, the school’s positive fundamentals—its teaching and learning and its paren-tal support—had not deteriorated.

So Mr. Chirunga, who had proj-ect management experience before joining T. Rowe Price 10 years ago, took the very unusual step of work-ing hand in hand with the school to repair its finances, improve man-agement, and get its construction project back on track.

With the support of the project’s other bondholders, he says, “We requested that the school bring in a consultant to get the budget under

control to where they had a manage-able cost structure.

“Nothing was mandated by us. Instead we rolled up our sleeves and partnered with this school to bring about positive changes. There’s no doubt this was highly unusual, but it really was just part of my job. It was our fiduciary duty, and it was worth it for the school and for us as investors.”

All this took four visits to Colorado by Mr. Chirunga over

a year and a half—and countless phone calls. As a result, the school’s new building was finished in 2008 and, in the fall of that year, students moved in. Student achievement has remained high. The school’s enroll-ment has grown from about 560 students in 2008 to 875 students.

And its financial condition has improved. Its bonds even have been rerated by Standard & Poor’s from noninvestment grade to investment grade and have been upgraded by the state of Colorado—resulting in principal gains that far exceeded the bonds’ original coupon rates.

Now the school is so successful, it is talking with Mr. Chirunga about how to finance construction of more classrooms.

“Initially, I didn’t expect to play such an involved role with this school,” he says. “There are a lot of other firms that invest in charter schools, but not everyone goes to the level of follow-up that we do. We dig a little deeper, we do follow-up visits, and we collaborate with managements in an effort to mitigate risk.”

[ “We dig a little deeper, we do follow-up visits, and we collaborate with managements… to mitigate risk.”

]

A Case Study

To illustrate how this new strategy could work, let’s consider the hypothetical couple John and Mary Smith. They are each 60 years old, have a combined income of $100,000, and have $500,000 in retirement savings. They have been saving 15% of their income ($15,000) each year in their 401(k) plans and want to retire in two years.

Here are some possible scenarios (as reflected in the chart below, assuming a 7% preretirement return on investments and a 6% post-retirement return).• Retire at 62 as planned: If the Smiths begin Social Security benefits at 62, they would receive $30,700 a year (plus assumed annual cost of living adjustments of about 2.8%). Additionally, they could expect appropriate annual withdrawals from their retirement savings of $21,100 (plus annual inflation

Personal Finance

Delaying Retirement But Not Your Retirement Dreams Many investors today who had planned to retire early at 62 when they became eligible for Social Security benefits—albeit at a reduced rate compared with normal retirement age—are discovering that those benefits, combined with their retirement savings, cannot support the lifestyle they expected or provide the financial cushion in retirement they desire.

Often, they are disappointed to realize they may have to continue working and saving for several more years to catch up. This strategy leaves preretirees in transition with a choice: retire early with insufficient savings and income in retirement or delay their retirement dreams until after they retire.

For some preretirees there may be another, more desirable option. An analysis by T. Rowe Price demonstrates that, even if those in their early 60s decide to keep

working but discontinue making contributions to their retirement plans—spending that money instead—they can start fulfilling some of their retirement dreams sooner and still be in a stronger financial position down the road.

“We advocate a new transitional strategy,” says Christine Fahlund, a senior financial planner for T. Rowe Price. “While this approach involves working longer, it can provide more discretionary income during these transition years to start seriously pursuing your retirement aspirations well before you thought you could.

“And by continuing to work and delay receiving Social Security benefits, you are positioning yourself to have potentially higher payments—adjusted annually for inflation—for the rest of your life. This strategy can be much more positive for those in transition.”

New Strategies For the Transition Years

Annual Income and Savings First Year of Full Retirement for Both Spouses

Strategies

Cumulative Income*

Age 62–69

Social Security + Savings

Withdrawals = Total Annual Income

Savings Balance at Retirement

Both Spouses Fully Retire at Age 62 $413,100 $30,700 + $21,100 = $51,800 $571,400



Both Spouses Work Part Time From Age 62 to Age 70

$400,000 $54,100 + $34,900 = $89,000 $775,000

*Sources of income include salary and/or Social Security plus savings withdrawals, in current dollars at age 60.

The table shows how much annual pretax income and savings at retirement this couple would have under various retirement scenarios. Each scenario assumes: the couple had $500,000 in retirement savings at age 60 and $100,000 in annual earnings ($60,000 plus $40,000) with 3% yearly inflation adjustments; 15% of earnings are contributed to a retirement plan annually until age 62 and no contributions thereafter; no Social Security benefits or savings withdrawals are drawn by either spouse until his/her retirement; savings earn 7% annu-ally before retirement and 6% annually after retirement; amounts represent current dollars at age 60, assuming a 3% discount rate; Social Security benefits rise 2.8% annually after initiation; savings are withdrawn at a rate of 3.7% for age 62, rising by 0.1% for each year retire-ment is delayed; the initial withdrawal increases yearly by 3% inflation. Social Security benefits are from the Social Security Administration website’s Quick Calculator (assuming 0% relative growth factor).

Sources: T. Rowe Price Associates and ssa.gov.


adjustments of 3%) from age 62 on. All dollar amounts are shown in current dollars.

However, their $51,800 (in current dollars) annual retirement income would be only 52% of their $100,000 preretirement combined earnings—much less than T. Rowe Price’s 75% general retirement income replacement guideline.

In addition, their savings of $500,000 at age 60 would only rise to $526,000 by age 70.

The Smiths conclude that retiring early will not support the retirement lifestyle they expected. So they decide to continue working a few more years and delay taking Social Security until they retire.

Stop Saving

At the same time, they want to enjoy their 60s to the fullest, so they decide to discontinue making contributions to their retirement plan after age 61. This provides them with an additional $15,000 a year to spend while they continue working. With this extra income to enjoy life, working longer may not seem as much of a burden—it may actually reenergize them.

One of the primary reasons that this new strategy is effective is that each year the Smiths work and delay taking Social Security benefits, their benefits increase about 8% (in today’s dollars)—almost doubling in purchasing power by age 70.

Since these increases are based on Social Security formulas and not on investment returns, preretirees have a level of assurance that, even if the markets take another turn downward, their Social Security benefits will not. • Retire at 66: If the Smiths both work full time until age 66, their retirement income (from savings and Social Security) would be

about $67,900, or 68% of their preretirement earnings—much closer to the 75% guideline.

Their retirement income is now 31% higher than if they had retired at 62—even though they discontinued making retirement contributions. Moreover, their retirement nest egg by 66 would have grown to $665,400 since they did not withdraw savings while working.

If they worked one more year to age 67, they would be very close to achieving their retirement income replacement rate of 75% and have a nest egg of $691,300. • Retire at 70: If the Smiths decide to continue working until 70, without making any additional contributions to their retirement accounts, they could withdraw $34,900 from their savings annually plus their initial Social Security benefits of $54,100 for a total annual retirement income of $89,000—an 89% replacement rate and significantly greater than the amount at 62. Moreover, their retirement nest egg would have grown to about $775,000 by age 70.

Making Trade-Offs

In these scenarios, the Smiths had more money to “play with” in their 60s, and they still put their retirement on sounder financial footing. On the other hand, since they were still working, they did not necessarily have as much extra time to pursue their interests as they would have liked.

If willing to trade money for time, they might consider working part time beyond age 62. This strategy might provide them with the extra income they need to pursue a semiretirement lifestyle while not jeopardizing their financial security when they fully retire.

For example, using the same

assumptions, if the Smiths both worked part time until 70, they would have less to spend in their 60s but their annual income and their retirement nest egg at age 70 would be the same as if they had both worked full time until then. This is because they were able to delay Social Security benefits and avoid making withdrawals from their savings, which continued to grow.

Some Caveats

Not everyone, of course, will be in a financial position to pursue this new strategy. Moreover, Ms. Fahlund stresses that those who do must avoid tapping their retirement nest egg and delay taking Social Security benefits while they continue working.

“They should also try to put their financial house in order before they fully retire by paying off their mortgage and other debts and purchasing any big-ticket items they expect to need in retirement,” she adds.

While these scenarios call for no further retirement savings to boost income, Ms. Fahlund says preretirees should strive to continue contributing at least enough to qualify for an employer match in their 401(k) plans, if available.

“Finding the right time/money balance, as well as the balance between spending and saving while working, will involve trade-offs,” Ms. Fahlund says. “But this new strategy is likely to give some investors more financial opportunities to pursue their lifelong dreams and enjoy their 60s while also building a stronger foundation for retirement.”

www.troweprice.com 1704779-23 106114 4/11


The U.S. stock market recovery is more than two years old, dating from the last low of the S&P 500 Index on March 9, 2009.

And Judith Ward, a T. Rowe Price financial planner, says the protracted rebound reminds her of those “long road trips with the kids in the back-seat” because some investors may have been repeatedly asking, “Are we there yet?”—while waiting to recoup their losses in the 2007–2009 market crash.

The S&P 500 Index gained 104% from the market low through the first quarter of 2011. Nevertheless, investors who had $100,000 invested in such a portfolio at its last high point on October 9, 2007, were still not “there yet” at the end of the first quarter of this year, with a portfolio value (including dividends) of $91,511.

But T. Rowe Price advises investors to diversify their portfolios consistent with the time horizons of their goals.

An 85% stock/15% bond portfo-lio, which the firm typically recom-mends for those about 20 years from retirement, fared better than a portfolio with 100% stocks, but also had not fully recovered.

Those with a 55% stock/45% bond retirement portfolio, generally appropriate for investors at retirement age, first recouped their losses by last October and have generally stayed above the $100,000 level since then.

And those with a 45% stock/55% bond retirement portfolio—generally appropriate for investors roughly five years into retirement—recovered even earlier, first crossing the thresh-old in April 2010 and remaining above it since last September.

Moreover, those who invested throughout the downturn and recovery fared better (see bottom chart). Contributing $416.67 each

Taking Stock of the Market: Are We There Yet?month—$5,000 a year—meant that all three portfolios, as well as the 100% stock portfolio, reached $100,000 even earlier.

Ms. Ward takes two key lessons from these data:

• Diversification can’t assure a profit or protect against a loss in a down market, but it can help investors ride out stock volatility.

• The greatest influence on meet-ing long-term financial goals

is saving—and the sooner the better. Moreover, saving in down markets enables investors to purchase more shares per dollar.

“It’s been a very bumpy ride,” Ms. Ward says. “But a successful journey hinges on setting an asset allocation appropriate to the time horizons of your goals and resisting the temptation to deviate because of short-term market events.”

Getting EvenThe Performance of Three Portfolios Since Last Market Peak (October 9, 2007, Through March 31, 2011)

These charts show that diversification and savings helped investors better weather the market crash of 2007–2009. In the top chart, investors started with $100,000 and did not add more savings. In the bottom chart, investors also started with $100,000 but added $416.67 a month, or $5,000 a year, to their portfolios.

In both cases, portfolios were rebalanced monthly to sustain the following stock/bond asset allocations for the three portfolios: 45%/55%, 55%/45%, 85%/15%. Stocks are represented by the S&P 500 Index and bonds by the Barclays Capital U.S. Aggregate Index. Past performance cannot guarantee future results. It is not possible to invest directly in an index.

$100,000 Portfolios With Additional Savings of $5,000 Annually

$100,000 Portfolios Without Additional Savings

40,000

60,000

80,000

100,000

120,000

$140,000 55 LBAGG

45 LBAGG

15 LBAGG

’10 3/11

3/11

’09’08’07

40,000

60,000

80,000

100,000

120,000

$140,000

55 LBAGG

45 LBAGG

15 LBAGG

’10’09’08’07

45% Stocks/55% Bonds55% Stocks/45% Bonds85% Stocks/15% Bonds

45% Stocks/55% Bonds55% Stocks/45% Bonds85% Stocks/15% Bonds

82

86

90

94

98

102


U.S. stocks extended last year’s brisk gains in the first quarter amid favorable economic and corporate profit growth. Market volatility increased significantly starting in late February due to political and social unrest in the Middle East and North Africa (MENA) region; a spike in oil prices; and a devastating earthquake, tsunami, and nuclear crisis in Japan. However, shares rallied in the final days of the quarter, lifting smaller-cap indexes to new bull market highs. Large-cap indexes finished the quarter slightly below their February highs.

U.S. Stocks Advance Despite Turmoil Overseas and Higher Oil Prices

Energy and Smaller-Cap U.S. Growth Stocks Outperform

Mid- and small-cap shares outper-formed their large-cap counterparts. As measured by Russell style indexes, value stocks fared better than growth stocks in the large-cap universe; the reverse was true among small- and mid-caps. Since bottoming in March 2009, the S&P 500 Index has returned slightly more than 100% through March 31, 2011. Various small- and mid-cap indexes have done even better.

In the U.S. equity market, as measured by the Wilshire 5000 Total Market Index, all sectors produced positive returns. Energy stocks fared best, lifted by a spike in oil prices in response to the unrest in the MENA region. Industrials and business ser-vices and health care stocks also out-performed, but other sectors lagged. The consumer staples and financials sectors recorded the smallest gains.

Non-U.S. equities generally advanced but lagged their domes-tic counterparts. Japanese stocks plummeted following the March 11 earthquake but recovered some of their losses by the end of March. Other Asian markets, such as South Korea, fared much better. MENA markets declined, while inflation and political uncertainties weighed on Latin American stocks. European stocks generated the best returns in U.S. dollar terms.

March 31, 2011T. Rowe Price Quarterly Performance Update

Equity Review


U.S. Stock Market Performance

Total Returns for Periods EndedMarch 31, 2011


S&P 500 Stock IndexS&P MidCap 400 IndexNasdaq Composite IndexRussell 2000 Index

0%

4%

8%

12%

16%

20%

24%

28%

Russell 2000 Index

Nasdaq Composite Index (Principal Return)

S & P Midcap 400 Index

S & P 500 Stock Index

1 Year3 Months

5.92

9.36

4.83

7.94

15.6

5

26.9

5

15.9

8

25.7

9

5.67

5.67

3 Months 1 YearS & P 500 Stock Index 11.29 10.16 S & P Midcap 400 Index 13.12 17.78Nasdaq Composite Index (Principal Return) 12.3 11.6Russell 2000 Index 11.29 13.35

1 Year3 Months0

4

8

12

16

20

24

28%

International Stock Market Performance



MSCI EAFE Index(Europe, Australasia, Far East)MSCI Emerging Markets Index

1 Year3 Months

3 Months 1 YearMSCI EAFE Index -13.75 6.38MSCI Emerging Markets Index -8.29 23.480.94 2.45

55.2 81.55

0

4

8

12

16

20

24%

10.9

0

18.7

8

2.103.

45

Performance of Wilshire 5000 Series

Total Returns for Periods Ended March 31, 2011,Ranked by Highest to Lowest Quarterly Return

1 Year3 Months

0 5 10 15 20 25 30 35 40 45

1 Year

3 Months

Financials

Consumer Staples

Consumer Discretionary

Utilities

Information Technology

Telecomm Services

Materials

Health Care

Industrials and Business Services

Energy

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

Performance of Wilshire 5000 Series 3 Months 1 YearInformation Technology 10.51 61.91Materials 8.90 55.73Consumer Discretionary 7.87 48.61Health Care 7.86 23.31Telecomm Services 7.54 12.78Utilities 6.85 13.12Energy 6.55 22.92Industrials and Business Services 5.53 22.55Consumer Staples 5.35 15.08Financials -2.30 14.68

0 5 10 15 20 25 30 35 40 45%

16.09

8.79

6.73

5.13

4.66

4.27

4.12

4.03

2.87

2.75

40.90

24.18

8.54

28.90

27.07

15.18

15.30

21.65

10.88

5.70Financials

Consumer Staples

Consumer Discretionary

Utilities

Information Technology

Telecommunication Services

Materials

Health Care

Industrials and Business Services

Energy


Fixed Income Review

Domestic High Yield and Non-U.S. Bonds Outperform

U.S. bond returns were mostly posi-tive. Despite the Federal Reserve’s ongoing Treasury purchases and a flight to safety triggered by overseas developments, yields were pressured higher by positive economic data and concerns that rising food and energy prices portended more widespread inflation. Investors in Treasury inflation protected securities (TIPS), however, benefited from heightened inflation expectations.

Other segments of the U.S. bond market fared well. High yield bonds did best as they continued to attract investors with relatively large coupons. Higher-quality corporate bond returns were more subdued. Municipal bonds produced modest gains amid muted issuance. Agency mortgage-backed securities also rose slightly.

Non-U.S. bond returns were posi-tive. Japanese bond yields rose amid concerns about rebuilding costs. The yen strengthened to post-World War II highs before falling sharply due to global central banks’ currency market intervention. Bond yields rose in large European economies, though a stronger euro and pound lifted returns to U.S. investors in dollar terms.

0

3

6

9

12

15%

1 Year3 Months

U.S. Bond Market Performance



Barclays Capital U.S. Aggregate IndexBarclays Capital Municipal Bond IndexCredit Suisse High Yield Index

0%

3%

6%

9%

12%

15%Credit Suisse High Yield Index

Barclays Capital Municipal Bond Index

Barclays Capital U.S. Aggregate Index

1 Year3 Months

0.51

3.77

5.12

1.63

13.6

4

5.67

5.67

3 Months 1 YearBarclays Capital U.S. Aggregate Index 3.49 9.5Barclays Capital Municipal Bond Index 2.03 9.61Credit Suisse High Yield Index 0.21 26.91

0.42

International Bond Market Performance



J.P. Morgan Emerging Markets Bond Index–Global

Barclays Capital Global Aggregate ex U.S. Dollar Bond Index

0%

2%

4%

6%

8%

10%

12%JP Morgan Emerging Markets Bond Index-Global

Barclays Capital Global Aggregate Ex-USD Index

1 Year3 Months

1 Year3 Months

5.67

5.67

1.80

8.63

Barclays Capital Global Aggregate Ex-USD Index JP Morgan Emerging Markets Bond Index-Global3 Months -2.43 1.161 Year 1.89 17.9

8.65

0

2

4

6

8

10

12%

1.02

-1.65 4.1611.84 29.15

Trends in Interest Rates


Credit Suisse High Yield Index*

Barclays Capital Municipal Bond Index*

90-Day Treasury Bills

Barclays Capital U.S. Aggregate Index*

6.96%

0.09%

3.06%3.85%

* Yield-to-worst

0%

3%

6%

9%

12%

15%

18%

21% Credit Suisse High Yield Index*

Barclays Capital Muni Bond*


90-day Treasury Bill

12/1012/0912/0812/0712/0612/0512/0412/0312/0212/01

0

3

6

9

12

15

18

21%

Credit Suisse High Yield Index*

Barclays Capital Muni Bond*


90-day Treasury Bill

9/103/109/093/099/083/089/073/079/063/06 3/11

-7%

0%

7%

14%

21%

28%Credit Suisse High Yield Index



MSCI EAFE Index

Russell 2000 Index

Nasdaq Composite Index (Principal Return)

S & P Midcap 400 Index

S & P 500 Stock Index1 Year3 Months

Stock and Bond Market Performance

Total Returns for Periods Ended March 31, 2011Unlike stocks, U.S. government bonds are guaranteed as to the timely payment of interest and principal.


S&P MidCap 400 Index

S&P 500 Stock Index

Russell 2000 Index

Nasdaq Composite Index


MSCI EAFE Index

Credit Suisse High Yield Index


1 Year3 Months

5.67

9.36

4.83

7.94

0.42 0.51

26.95

15.98

10.90

3.773.451.63

5.12

25.79

15.65

-7

0

7

14

21

28%

13.64

5.92

T. Rowe Price Mutual FundsPerformance Summary

The performance information presented here includes changes in principal value, reinvested dividends, and capital gain distributions. Current performance may be higher or lower than the quoted past performance, which cannot guarantee future results. Share price, principal value, yield, and return will vary, and you may have a gain or loss when you sell your shares. To obtain the most recent month-end performance, call us at 1-800-225-5132 or visit our website. The performance information shown does not reflect the deduction of redemption fees (if applicable); if it did, the performance would be lower. Call 1-800-225-5132 to request a prospectus or summary prospectus; each includes investment objectives, risks, fees, expenses, and other information that you should read and consider carefully before investing. Funds are placed in alphabetical order in each category. To learn more about each fund’s objective and risk/reward potential, visit troweprice.com/mutualfunds.

Past Quarter, Year, and Average Annual Total ReturnsPeriods Ended March 31, 2011

Ticker Symbol

3 Months 1 Year 3 Years 5 Years

10 Years or Since

InceptionInception

DateRedemp-tion Fee

Redemp-tion Fee Period

Expense Ratio

Expense Ratio

as of Date

STOCk fUnDS Domestic

Blue Chip Growth TRBCX 5.74% 18.03% 4.71% 3.94% 3.92% 6/30/93 0.77% 12/31/10Capital Appreciation PRWCX 4.58 12.71 6.34 5.89 8.68 6/30/86 0.73 12/31/10Capital Opportunity PRCOX 5.62 13.75 2.70 2.91 3.77 11/30/94 0.74 12/31/10Diversified Mid-Cap Growth PRDMX 7.79 28.70 8.60 5.60 8.06 12/31/03 1.12 12/31/10Diversified Small-Cap Growth PRDSX 11.44 36.56 13.82 6.12 7.53 6/30/97 1.0% 90 days 1.25 12/31/10Dividend Growth PRDGX 5.90 14.57 3.05 3.73 4.36 12/30/92 0.68 12/31/10Equity Income PRFDX 5.66 14.22 2.23 2.78 5.19 10/31/85 0.70 12/31/10Equity Index 500 PREIX 5.85 15.32 2.18 2.39 3.03 3/30/90 0.5 90 days 0.30 12/31/10Extended Equity Market Index PEXMX 8.50 27.28 8.72 5.06 8.68 1/30/98 0.5 90 days 0.42 12/31/10Financial Services PRISX 3.88 4.94 1.19 -2.13 3.83 9/30/96 0.96 12/31/10Growth & Income PRGIX 5.06 14.07 2.96 2.97 3.44 12/21/82 0.72 12/31/10Growth Stock PRGFX 5.19 17.94 5.11 4.26 4.89 4/11/50 0.70 12/31/10Health Sciences PRHSX 12.45 20.07 11.69 8.76 10.19 12/29/95 0.84 12/31/10Media & Telecommunications PRMTX 7.19 28.40 13.11 12.14 13.33 10/13/93 0.84 12/31/10Mid-Cap Growth1 RPMGX 8.71 28.48 11.00 7.63 9.99 6/30/92 0.80 12/31/10Mid-Cap Value1 TRMCX 5.78 16.07 8.13 6.17 10.82 6/28/96 0.81 12/31/10New America Growth PRWAX 6.30 19.81 8.64 6.64 5.24 9/30/85 0.83 12/31/10New Era PRNEX 10.18 31.29 1.33 8.28 13.01 1/20/69 0.67 12/31/10New Horizons PRNHX 10.24 35.54 14.31 5.97 9.70 6/3/60 0.81 12/31/10Real Estate TRREX 6.01 24.56 2.52 1.09 11.77 10/31/97 1.0 90 days 0.76 12/31/10Science & Technology PRSCX 6.82 21.91 11.48 6.89 2.61 9/30/87 0.92 12/31/10Small-Cap Stock OTCFX 9.12 31.94 14.37 5.88 9.71 6/1/56 0.92 12/31/10Small-Cap Value PRSVX 7.75 25.23 8.60 4.33 11.98 6/30/88 1.0 90 days 0.97 12/31/10Tax-Efficient Equity2 PREFXReturns before taxes 6.44 22.91 5.41 3.69 5.85 12/29/00 1.0 365 days 1.25 2/28/10Returns after taxes on distributions – 22.88 5.40 3.68 5.85 12/29/00

Returns after taxes on distribu-tions and sale of fund shares – 14.93 4.63 3.17 5.14 12/29/00

Total Equity Market Index POMIX 6.28 17.18 3.50 2.98 4.32 1/30/98 0.5 90 days 0.40 12/31/10U.S. Large-Cap Core TRULX 6.50 16.91 – – 24.36 6/26/09 2.21 12/31/10Value TRVLX 6.98 16.82 3.66 3.16 5.33 9/30/94 0.85 12/31/10

1 Closed to new investors except for a direct rollover from a retirement plan into a T. Rowe Price IRA invested in this fund.2 The returns presented reflect the return before taxes; the return after taxes on dividends and capital gain distributions; and the return after taxes on dividends, capital

gain distributions, and gains (or losses) from redemptions of shares held for 1-, 5-, and 10-year or since-inception periods, as applicable. After-tax returns reflect the highest federal income tax rate but exclude state and local taxes. The after-tax returns reflect the rates applicable to ordinary and qualified dividends and capital gains effective in 2003. During periods when a fund incurs a loss, the post-liquidation after-tax return may exceed the fund’s other returns because the loss generates a tax benefit that is factored into the result. An investor’s actual after-tax return will likely differ from those shown and depend on his or her tax situation. Past before- and after-tax returns do not necessarily indicate future performance.

BENcH- MARkS Domestic Stock

S&P 500 Index 5.92% 15.65% 2.35% 2.62% 3.29%S&P MidCap 400 Index 9.36 26.95 10.00 6.07 9.36Nasdaq Composite Index 4.83 15.98 6.86 3.52 4.22Russell 2000 Index 7.94 25.79 8.57 3.35 7.87Lipper IndexesLarge-Cap Core Funds 5.20 13.17 1.86 2.11 2.63Equity Income Funds 5.85 14.93 1.84 2.34 4.10Small-Cap Core Funds 7.65 25.72 8.89 4.01 8.60


T. Rowe Price Mutual FundsPerformance Summary Past Quarter, Year, and Average Annual Total ReturnsPeriods Ended March 31, 2011

Ticker Symbol


10 Years or Since

InceptionInception

DateRedemp-tion Fee


Expense Ratio

Expense Ratio

as of Date

STOCk fUnDS International/Global

Africa & Middle East TRAMX -6.24% -2.47% -14.27% – -5.80% 9/4/07 2.0% 90 days 1.47% 10/31/10Emerging Europe & Mediterranean TREMX 3.03 23.09 -5.57 2.93% 18.68 8/31/00 2.0 90 days 1.41 10/31/10

Emerging Markets Stock PRMSX 0.71 16.00 -0.18 8.12 15.81 3/31/95 2.0 90 days 1.27 10/31/10European Stock PRESX 7.13 16.52 -1.41 4.05 6.14 2/28/90 2.0 90 days 1.03 10/31/10Global Infrastructure TRGFX 3.69 9.75 – – 9.46 1/27/10 2.0 90 days † 10/31/10Global Large-Cap Stock RPGEX 4.59 14.16 – – 37.81 10/27/08 2.0 90 days †† 10/31/10Global Real Estate TRGRX 2.56 20.23 – – 28.11 10/27/08 2.0 90 days ‡ 12/31/10Global Stock PRGSX 4.04 12.87 -4.38 1.50 5.14 12/29/95 2.0 90 days 0.87 10/31/10Global Technology PRGTX 10.19 30.08 16.95 10.12 7.75 9/29/00 1.04 12/31/10International Discovery PRIDX 1.91 19.00 2.05 4.52 10.36 12/30/88 2.0 90 days 1.24 10/31/10International Equity Index PIEQX 3.81 11.38 -2.46 1.77 5.57 11/30/00 2.0 90 days 0.50 10/31/10International Growth & Income TRIGX 4.88 13.68 -1.73 1.92 7.18 12/21/98 2.0 90 days 0.89 10/31/10International Stock PRITX 2.18 12.94 0.59 3.12 5.09 5/9/80 2.0 90 days 0.87 10/31/10Japan PRJPX -3.34 3.70 -6.04 -7.73 -0.02 12/30/91 2.0 90 days 1.13 10/31/10Latin America PRLAX -1.85 14.24 5.16 16.29 22.03 12/29/93 2.0 90 days 1.24 10/31/10New Asia PRASX -0.83 16.11 6.93 13.72 15.91 9/28/90 2.0 90 days 0.96 10/31/10Overseas Stock TROSX 4.20 13.00 -1.34 – -1.28 12/29/06 2.0 90 days 0.90 10/31/10

BENcH- MARkS International/Global Stock

MSCI EAFE Index 3.45% 10.90% -2.53% 1.78% 5.83%Lipper AveragesEmerging Markets Funds 0.44 16.44 2.11 8.40 16.07International Large-Cap Core Funds 3.30 10.79 -3.45 0.91 4.56International Large-Cap Growth Funds 3.09 13.64 -1.35 2.78 5.87International Small-/Mid-Cap Growth Funds 1.85 22.02 0.93 3.51 11.09

BOnD fUnDS Domestic Tax-Free3

California Tax-Free Bond PRXCX -0.70% 0.01% 3.32% 3.20% 3.96% 9/15/86 0.51% 2/28/10Georgia Tax-Free Bond GTFBX -0.20 -0.39 3.56 3.09 3.91 3/31/93 0.57 2/28/10Maryland Short-Term Tax-Free Bond PRMDX 0.35 1.10 2.15 2.91 2.59 1/29/93 0.52 2/28/10

Maryland Tax-Free Bond MDXBX -0.37 0.36 4.10 3.52 4.17 3/31/87 0.47 2/28/10New Jersey Tax-Free Bond NJTFX -0.27 0.32 3.59 3.26 4.11 4/30/91 0.53 2/28/10New York Tax-Free Bond PRNYX 0.30 0.62 3.57 3.39 4.10 8/28/86 0.52 2/28/10Summit Municipal Income PRINX -0.22 0.36 4.08 3.53 4.57 10/29/93 0.50 10/31/10Summit Municipal Intermediate PRSMX 0.83 2.14 4.41 4.31 4.32 10/29/93 0.50 10/31/10

Tax-Free High Yield PRFHX -0.47 0.46 2.84 2.16 4.07 3/1/85 0.68 2/28/10Tax-Free Income PRTAX -0.13 0.13 3.75 3.53 4.26 10/26/76 0.53 2/28/10Tax-Free Short-Intermediate PRFSX 0.40 1.86 3.68 3.91 3.45 12/23/83 0.50 2/28/10Virginia Tax-Free Bond PRVAX 0.52 0.57 4.20 3.61 4.27 4/30/91 0.48 2/28/10

† As of its fiscal year ended 10/31/10, the Global Infrastructure Fund’s gross and net expense ratios were 1.32% and 1.10%, respectively. The fund operates under a 1.10% contractual expense limitation that expires on 2/29/12.

†† As of its fiscal year ended 10/31/10, the Global Large-Cap Stock Fund’s gross and net expense ratios were 1.61% and 1.00%, respectively. The fund operates under a 1.00% contractual expense limitation that expires on 2/28/13.

‡ As of its fiscal year ended 12/31/10, the Global Real Estate Fund’s gross and net expense ratios were 2.34% and 1.05%, respectively. The fund operates under a 1.05% contractual expense limitation that expires on 4/30/11.

3 Some income from the tax-free funds may be subject to state and local taxes and the federal alternative minimum tax.All mutual funds are subject to market risk, including possible loss of principal. Funds that invest overseas generally carry more risk than funds that invest strictly in U.S. assets due to factors such as currency risk, geographic risk, and emerging markets risk. Funds that invest in fixed income securities are subject to credit risk and liquidity risk, with high yield securities having a greater risk of default than higher-quality securities.



Ticker Symbol


10 Years or Since

InceptionInception

DateRedemp-tion Fee


Expense Ratio

Expense Ratio

as of Date

BOnD fUnDS Domestic Taxable

Corporate Income PRPIX 1.12% 7.96% 7.09% 6.00% 6.11% 10/31/95 0.65% 5/31/10GNMA4 PRGMX 0.39 5.14 5.69 5.89 5.19 11/26/85 0.66 5/31/10High Yield PRHYX 3.84 13.64 11.69 8.15 8.20 12/31/84 1.0% 90 days 0.76 5/31/10Inflation Protected Bond PRIPX 1.62 7.41 3.61 5.90 5.64 10/31/02 0.63 5/31/10New Income PRCIX 0.42 5.36 6.27 6.48 5.71 8/31/73 0.72 5/31/10Short-Term Bond PRWBX 0.38 2.40 3.95 4.63 4.09 3/2/84 0.59 5/31/10Strategic Income PRSNX 1.12 8.18 — — 15.18 12/15/08 1.04 5/31/10Summit GNMA4 PRSUX 0.50 5.24 5.76 6.00 5.23 10/29/93 0.67 10/31/10U.S. Bond Index PBDIX 0.27 4.84 5.40 6.03 5.40 11/30/00 0.5 90 days 0.30 10/31/10U.S. Treasury Intermediate4 PRTIX -0.19 5.56 4.30 6.61 5.16 9/29/89 0.52 5/31/10U.S. Treasury Long-Term4 PRULX -1.17 6.71 4.14 6.43 5.87 9/29/89 0.59 5/31/10

4 The market value of shares is not guaranteed by the U.S. government.

BENcH- MARkS Domestic Bond

Barclays Capital U.S. Aggregate Index 0.42% 5.12% 5.30% 6.03% 5.56%Barclays Capital Municipal Bond Index 0.51 1.63 4.47 4.14 4.66Credit Suisse High Yield Index 3.77 13.64 11.66 8.54 8.99Lipper AveragesShort Investment-Grade Debt 0.60 3.03 3.19 3.64 3.44Corporate Debt Funds A Rated 0.91 5.99 5.44 5.16 5.02GNMA 0.63 4.81 5.74 6.05 5.06High Current Yield 3.66 13.57 9.70 6.86 6.92Short Municipal Debt 0.41 1.33 2.12 2.52 2.59Intermediate Municipal Debt 0.62 2.08 3.74 3.60 3.76General Municipal Debt 0.07 0.41 2.96 2.52 3.50

BOnD fUnDS International/Global

Emerging Markets Bond PREMX 1.46% 9.82% 8.77% 8.00% 11.48% 12/30/94 2.0% 90 days 0.95% 12/31/10International Bond RPIBX 1.83 8.53 2.82 6.83 7.69 9/10/86 2.0 90 days 0.82 12/31/10

BENcH- MARkS International/Global Bond

Barclays Capital Global Aggregate ex U.S. Dollar Bond Index 1.80% 8.63% 3.14% 7.51% 8.15%

J.P. Morgan Emerging Markets Bond Index–Global 1.02 8.65 8.70 8.26 10.15

Lipper AveragesEmerging Markets Debt Funds 1.55 9.35 8.21 7.88 11.91International Income Funds 1.61 8.07 4.16 6.71 6.90

Ticker Symbol

7-Day Yield

7-Day Yield Without Waiver


10 Years or Since

InceptionInception

DateExpense

Ratio

Expense Ratio

as of Date

MOnEy MArkET Tax-Free5

California Tax-Free Money PCTXX 0.01% -0.22% 0.00% 0.01% 0.42% 1.42% 1.32% 9/15/86 0.60% 2/28/10Maryland Tax-Free Money TMDXX 0.01 -0.23 0.00 0.01 0.48 1.47 1.37 3/30/01 0.53 2/28/10New York Tax-Free Money NYTXX 0.01 -0.24 0.00 0.01 0.46 1.45 1.35 8/28/86 0.58 2/28/10Summit Municipal Money Market TRSXX 0.01 -0.10 0.00 0.01 0.55 1.57 1.51 10/29/93 0.45 10/31/10

Tax-Exempt Money PTEXX 0.01 -0.16 0.00 0.03 0.51 1.53 1.44 4/8/81 0.49 2/28/10

Taxable5

Prime Reserve PRRXX 0.01% -0.25% 0.00% 0.01% 0.63% 2.22% 2.01% 1/26/76 0.58% 5/31/10Summit Cash Reserves TSCXX 0.01 -0.12 0.00 0.01 0.69 2.31 2.14 10/29/93 0.45 10/31/10U.S. Treasury Money PRTXX 0.01 -0.29 0.00 0.01 0.31 1.81 1.75 6/28/82 0.45 5/31/10

An investment in the money market funds is not insured or guaranteed by the FDIC or any other government agency. Although the funds seek to preserve the value of your investment at $1.00 per share, it is possible to lose money by investing in the funds. Money fund yields more closely reflect current earnings than do total returns. 5 In an effort to maintain a zero or positive net yield for the fund, T. Rowe Price has voluntarily waived all or a portion of the management fee it is entitled to

receive from the fund. A fee waiver has the effect of increasing the fund’s net yield. The 7-day yield without waiver represents what the yield would have been if we were not waiving our management fee. This voluntary waiver is in addition to any contractual expense ratio limitation in effect for the fund and may be amended or terminated at any time without prior notice. Please see the prospectus for more details.



Editor: Steven E. Norwitz Associate Editor: Robert BenjaminStaff Writers: Brian Lewbart and Heather McDonoldEditorial Board: christine Fahlund, Alan Levenson, Brian Brennan, Darrell Riley, Tom Siedell, Brian Sullam, Jerome Tuccille

charts and examples in this issue showing investment performance (excluding those in the Performance Update section) are for illustrative purposes only and do not reflect the performance of any T. Rowe Price fund or security. A manager’s view of the attractiveness of a company may change, and the fund could sell the holding at any time. This material should not be deemed a recommendation to buy or sell shares of any of the securities discussed. Past performance cannot guarantee future results.

T. Rowe Price Investment Services, Inc., Distributor. copyright © 2011 by T. Rowe Price Associates, Inc. All Rights Reserved.

04779_UD 105568M00-066 5/11

Ticker Symbol

7-Day Yield


10 Years or Since

InceptionInception

DateRedemp-tion Fee


Expense Ratio

Expense Ratio

as of Date

ASSET ALLOCATIOn

Balanced RPBAX 4.04% 12.81% 4.52% 4.93% 5.55% 12/31/39 0.68% 12/31/10Personal Strategy Balanced TRPBX 4.26 14.17 5.81 5.29 6.62 7/29/94 0.86 5/31/10Personal Strategy Growth TRSGX 5.33 16.28 4.49 4.14 6.28 7/29/94 0.91 5/31/10Personal Strategy Income PRSIX 3.24 11.67 6.13 5.73 6.44 7/29/94 0.77 5/31/10Retirement 2005 TRRFX 3.35 11.20 5.30 5.12 5.91 2/27/04 0.61 5/31/10Retirement 2010 TRRAX 3.65 12.38 5.09 4.86 8.77 9/30/02 0.64 5/31/10Retirement 2015 TRRGX 4.12 13.68 5.11 4.78 6.18 2/27/04 0.68 5/31/10Retirement 2020 TRRBX 4.50 14.79 5.00 4.57 9.54 9/30/02 0.71 5/31/10Retirement 2025 TRRHX 4.82 15.59 4.82 4.38 6.29 2/27/04 0.74 5/31/10Retirement 2030 TRRCX 5.15 16.37 4.72 4.23 10.02 9/30/02 0.76 5/31/10Retirement 2035 TRRJX 5.40 16.91 4.66 4.12 6.30 2/27/04 0.77 5/31/10Retirement 2040 TRRDX 5.34 16.94 4.72 4.16 10.02 9/30/02 0.77 5/31/10Retirement 2045 TRRKX 5.34 16.87 4.72 4.16 6.19 5/31/05 0.77 5/31/10Retirement 2050 TRRMX 5.34 16.84 4.66 – 2.56 12/29/06 0.77 5/31/10Retirement 2055 TRRNX 5.40 16.98 4.65 – 2.55 12/29/06 0.77 5/31/10Retirement Income TRRIX 2.99 9.87 5.26 5.12 7.22 9/30/02 0.59 5/31/10Spectrum Growth PRSGX 5.65 17.41 4.36 3.86 6.21 6/29/90 0.80 12/31/10Spectrum Income RPSIX 2.14 8.95 6.81 6.77 7.00 6/29/90 0.70 12/31/10Spectrum International PSILX 3.26 14.25 0.24 3.51 6.78 12/31/96 2.0% 90 days 0.97 12/31/10

T. rOwE PrICE nO-LOAD VArIABLE AnnUITy6

Blue Chip Growth Portfolio 5.55% 17.37% 4.11% 3.28% 3.18% 12/29/00 0.85% 12/31/10Equity Income Portfolio 5.60 13.43 1.47 2.06 4.44 3/31/94 0.85 12/31/10Equity Index 500 Portfolio 5.69 14.59 1.32 1.64 2.37 12/29/00 0.40 12/31/10Health Sciences Portfolio 12.09 18.49 10.49 7.57 8.72 12/29/00 0.95 12/31/10International Stock Portfolio 2.11 12.36 -0.30 2.24 4.17 3/31/94 1.05 12/31/10Limited-Term Bond Portfolio 0.31 1.83 3.16 3.92 3.50 5/13/94 0.77 12/31/10Mid-Cap Growth Portfolio 8.52 27.64 10.41 7.01 9.34 12/31/96 0.85 12/31/10New America Growth Portfolio 6.32 19.74 8.32 6.26 4.76 3/31/94 0.85 12/31/10Personal Strategy Balanced Portfolio 4.16 13.45 4.77 4.43 5.96 12/30/94 1.00 12/31/10Prime Reserve Portfolio7 -0.55% -0.14 -0.49 0.21 1.75 1.53 12/31/96 0.55 12/31/10


An investment in the money market funds is not insured or guaranteed by the FDIC or any other government agency. Although the funds seek to preserve the value of your investment at $1.00 per share, it is possible to lose money by investing in the funds. Money fund yields more closely reflect current earnings than do total returns.6 �A prospectus is available to existing clients who are considering an exchange into a new portfolio. The prospectus includes investment objectives, risks, fees,

expenses, and other information that you should read and consider carefully before investing. The T. Rowe Price No-Load Variable Annuity (Variable Annuity) is issued by Security Benefit Life Insurance Company (Form V6021). In New York, it is issued by First Security Benefit Life Insurance and Annuity Company of New York, White Plains, New York (FSB201(11-96)). (Security Benefit Life is not licensed in New York and does not solicit business in New York.) The yields and performance figures are based on the accumulation unit value (AUM) of the Variable Annuity subaccounts. Variable Annuity subaccount performance reflects a hypothetical contract and includes the effects of a mortality and expense risk charge of 0.55% on an annualized basis. The inception date relates to the date the portfolios were available as investment options in the Variable Annuity. The Variable Annuity, which has been available since April 1995 and in New York since November 1995, has limitations; contact your representative. It is distributed by T. Rowe Price Investment Services, Inc.; T. Rowe Price Insurance Agency, Inc.; and T. Rowe Price Insurance Agency of Texas, Inc. The underlying portfolios are managed by T. Rowe Price Associates, Inc. The Security Benefit Group of companies and the T. Rowe Price companies are not affiliated. The Variable Annuity may not be available in all states.

7 The 7-day unsubsidized simple yield for the Prime Reserve Portfolio was -0.72% as of March 31, 2011. In an effort to maintain a zero or positive net yield for the underlying portfolio of the Variable Annuity subaccount, T. Rowe Price has voluntarily waived all or a portion of the management fee it is entitled to receive from the underlying portfolio. This voluntary waiver is in addition to any contractual expense ratio limitation in effect for the underlying portfolio and may be amended or terminated at any time without prior notice. A fee waiver has the effect of increasing the underlying portfolio’s and subaccount’s net yield; without it, the underlying portfolio’s and subaccount’s 7-day yield would have been lower.

Indexes included in this update track the following: S&P 500—500 large-company U.S. stocks; S&P MidCap 400—stocks of 400 mid-size U.S. companies; Nasdaq Composite (principal only)—U.S. stocks traded in the over-the-counter market; Russell 2000—stocks of 2,000 small U.S. companies; MSCI EAFE—the stocks of about 1,000 companies in Europe, Australasia, and the Far East; MSCI Emerging Markets—more than 850 stocks traded in over 20 emerging markets; Barclays Capital U.S. Aggregate—investment-grade corporate and government bonds; Barclays Capital Municipal Bond—tax-free investment-grade U.S. bonds; Credit Suisse High Yield—noninvestment-grade corporate U.S. bonds; Barclays Capital Global Aggregate ex U.S. Dollar Bond—tracks investment-grade government, corporate, agency, and mortgage-related bonds in markets outside the U.S.; J.P. Morgan Emerging Markets Bond–Global—U.S. dollar-denominated Brady Bonds, Eurobonds, traded loans, and local market debt instruments issued by sovereign and quasi-sovereign entities; Lipper averages—all funds in each investment objective category; and Lipper indexes—equally weighted indexes of typically the 30 largest mutual funds within their respective investment objective categories.

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