MAY 2015

Examining the changing dynamics of the pension de-risking marketplace, as the pension risk transfer sector matures and alternatives to traditional liability-driven investment strategies come to the forefront.

PENSION PLAN DE-RISKING, NORTH AMERICA 2015

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SECTION 1DE-RISKING IN THE CURRENT ECONOMIC ENVIRONMENT

1.1 INTERVIEW 5The road to recovery – what have been the after effects of the Great Recession?

Interviewer:• Hubert Danso, Chief Executive Officer and Vice Chairman, Africa Investor

Interviewee:• Mark Schweitzer, Senior Vice President, External Outreach and Regional Analytics,

Federal Reserve Bank of Cleveland

1.2 INTERVIEW 7De-risking in a divergent world – is the current economic environment making some strategies obsolete?

Interviewer:• Hubert Danso, Chief Executive Officer and Vice Chairman, Africa Investor

Interviewee:• Fabio Savoldelli, Adjunct Professor, Columbia University

1.3 INTERVIEW 11Examining the outlook for interest rates and whether this could be a game changer for the de-risking market in 2015

Interviewer:• Noel Hillmann, Managing Director, Clear Path Analysis

Interviewee:• Susan Slocum, Treasurer, Childrens Hospitals and Clinics of Minnesota

SECTION 2LDI UNDER THE MICROSCOPE

2.1 INTERVIEW 14What alternatives to traditional LDI should funds consider in order to meet pension liabilities?

Interviewer:• Noel Hillmann, Managing Director, Clear Path Analysis

Interviewee:• Patrick Baumann, Assistant Treasurer, Harris Corporation

SECTION 3PENSION PLAN DE-RISKING USER SURVEY

3.1 FOREWORD 17• Rohit Mathur, Senior Vice President, Global Product & Market Solutions, Pension

& Structured Solutions, Prudential

3.2 SURVEY RESULTS 20

3.3 ROUNDTABLE DEBATE 25Survey Analysis

Moderator:• Noel Hillmann, Managing Director, Clear Path Analysis

Panellists:• Robert O’Keef, Corporate Vice President & Treasurer, Motorola Solutions • Margaret G. McDonald, Senior Vice President & Actuary, Pension & Structured

Solutions, Prudential• Amy Kessler, Senior Vice President and Head of Longevity Reinsurance, Prudential• Ian Aley, Head of Transactions, Towers Watson UK

CONTENTS

Pension Plan De-Risking, North America 2015

Robert O’Keef Corporate Vice President & Treasurer, Motorola Solutions

Margaret G. McDonald Senior Vice President & Actuary, Pension & Structured Solutions, Prudential

Patrick Baumann Assistant Treasurer, Harris Corporation

Susan Slocum Treasurer, Childrens Hospitals and Clinics of Minnesota

Mark Schweitzer Senior Vice President, External Outreach and Regional Analytics, Federal Reserve Bank of Cleveland

Rohit Mathur Senior Vice President, Global Product & Market Solutions, Pension & Structured Solutions, Prudential

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Libby BritcherMarketing & Operations Manager

Jim AllenSenior Digital Producer

Noel HillmannManaging Director & Head of Publishing

Jessica McGhieSenior Publishing & Strategy Manager

Jennifer MenoscalMarketing Assistant

FOR MORE INFORMATION: | W: www.clearpathanalysis.com | T: +44 (0) 203 102 4311 | E: marketing@clearpathanalysis.com

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www.prudential.com

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DE-RISKING IN THE CURRENT ECONOMIC ENVIRONMENT

SECTION 1

The road to recovery – what have been the after effects of the Great Recession? 1.1 INTERVIEW

De-risking in a divergent world – is the current economic environment making some strategies obsolete?

2.1 INTERVIEW

Examining the outlook for interest rates and whether this could be a game changer for the de-risking market in 2015

2.3 INTERVIEW

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Hubert Danso: Thank-you for joining me today.

I’d like to begin by asking, what is the current economic situation in the U.S?

Mark Schweitzer: The U.S economy continues to improve with occasional bumpiness. Growth has been a bit above what I would estimate to be potential and we are likely to see that continue in the coming year. That growth has led to steady progress in the labour markets and in many ways more progress than forecasters have anticipated, so that’s been a very sizeable benefit.

Also, inflation continues to temporarily be very low. That is temporary based on some of our indicators of underlying inflation and due to the relative steadiness of inflation expectations in the U.S.

Hubert: How would you describe the Great Recession?

Mark: I think about the very important role of the financial crisis which, combined with a larger recession than we’ve seen in a long time, has resulted in an extraordinarily slow recovery compared to prior recessions.

If I think about the 1982 recession, that had about as large of an impact on the U.S in terms of the unemployment rate and GDP reduction but the bounce back from it was much sharper. What we’ve seen in this case was a very sizeable recession with significant losses to output and very large losses to employment but then a more gradual recovery process.

Hubert: Specifically in terms of your views on what the after effects of the Great Recession have been, are you a strong believer that these are still felt quite deeply and heavily across the U.S today?

Mark: When you think about what the after effects of the Great Recession have been, much of the attention has been on consumers and households. We have seen fairly notable changes in their behaviour. One of the signs of that is, it’s not a great indicator, but the savings rate is more elevated now than it typically is in a recovery in the U.S. That has shown up in the form of a lower tendency for households to take risks in what they choose to purchase. It’s showing up in a slower housing market.

In many ways consumers have changed their behaviour, but not in others. At the same time the recovery of consumers is seen in the recovery of auto purchases. It is very much the case that there are lasting after effects - we have a slower and different sort of housing market recovery - but we are seeing recovery in consumers on the whole because they have adapted and are responding in a more conventional way in other products. That’s not the only after effect of the recession.

We definitely think about the international environment as one of the after effects of the recession. We and most countries in the world had some fiscal shock in the Great Recession and its aftermath and of course the international environment is one where it still has some challenges and businesses have also somewhat changed their behaviour. There

aren’t as many indicators for whether businesses are more or less cautious, but in our contact with business leaders in our district we do find them a bit more cautious now in their approaches than they were prior to the recession.

Hubert: From what I’m hearing about businesses being more cautious, research is suggesting that there is over $4 trillion of cash held by companies which is apparently a record number to any previous period after or during a recession. There appears to be indecision about deploying that capital even for their own growth. Do you see that in any form?

Mark: We do see that. There is a combination of businesses that are large and in reasonably good condition but unsure of what their outlook or prospects are. For example, businesses in our region who are involved in international trade are quite concerned about how the international environment will develop. Similarly, businesses that are involved in construction have been relatively cautious in this recovery for obvious reasons. They all have separate explanations but there is the sense in which businesses are broadly a little more cautious at this point than they would have been in a past recovery cycle.

Hubert: What are the Federal Reserve’s plans to counteract the lasting after effects, and how effective have their previous efforts been?

1.1 INTERVIEW

The road to recovery – what have been the after effects of the Great Recession?

Interviewer Interviewee

Mark Schweitzer Senior Vice President, External Outreach and Regional Analytics, Federal Reserve Bank of Cleveland

Hubert Danso Chief Executive Officer and Vice Chairman, Africa Investor

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The road to recovery – what have been the after effects of the Great Recession?

Mark: There was a recent speech by Fed Governor Stanley Fischer and it’s quite eloquent, walking through the recovery process from the ‘financial crisis’ as we tend to call it. On balance the policies that the Federal Reserve took were significant contributors to the recovery and to getting the economy back on a reasonable path. At this point though it’s still very much the case that monetary policy continues to be highly accommodative and the Federal Open Market Committee (FOMC) more broadly has certainly indicated that with their statements.

This is an environment where the Federal Reserve continues to be in a position where we’re supportive of quicker growth and that is continuing upwards to counteract the effects of the Great Recession.

Fed Chair Janet Yellen noted in her recent (March) press conference that most of the FOMC members are expecting a relatively slow increase in rates and that reflects continued headwinds as one of the explanations. Headwinds are things like consumers being reluctant to spend. I see that as part of why we are continuing to counteract the effects of the Great Recession.

Hubert: How do you typically respond to the practitioners and the observers in the market who look to the side of caution on the Central Bank interventions, running the risk of potentially creating a situation that doesn’t necessarily reflect the realities of the market?

Mark: There have been concerns about financial stability risk associated with the policy and that’s certainly something that the FOMC has commented on over many years and is something that the Federal Reserve continues to watch carefully. Some of those critics have been saying that for rather a long time. In general, today’s environment is one where we’re still looking for growth to pick up more than we’re looking for an

economy with some tremendous risk of a bubble.

Hubert: Over the next twelve months how do you anticipate the global economic environment and possible signs of recovery will impact on U.S pension liabilities?

Mark: When we’re thinking about liabilities of pensions one of the things which is going to impact them is the rising interest rate environment and that will change the discounting of future liabilities. In some sense that’s not really a change because the FOMC has been saying for a while that rates would increase and their expectations were that they would start to increase this year. That will change the environment but it’s not something that’s actually news; it’s really a response to the growing recovery and the effects of the recovery in the U.S.

There’ve been some questions recently about how the global environment is going to change or alter U.S policies. It’s something that we’re watching, in terms of does it affect the outlook that we at the Cleveland Federal Reserve feel is appropriate for the U.S economy; how are we altering our expectations for growth in the U.S and, at this point, will we still expect to see growth continuing in the U.S. We expect a little bit above trend growth. We will continue to see progress in the labour market. Again thinking about potential liabilities, one of the things that is interesting in that space is that the retirement age of individuals is an important contributor to the liabilities of pensions. As the U.S labour market continues to improve that may affect the choices that households make on their retirements. For example, we’ve seen that older workers are choosing to stay in the labour market for a little

longer and of course that will affect liabilities of pensions.

Hubert: On that note we can finish. Mark, thank-you for sharing your views, it’s greatly appreciated.

“We expect a little bit above trend growth”

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Hubert Danso: Thank-you for joining me for this debate Fabio.

I’d like to begin by asking, what are your views on the increasingly divergent world and the different paths that the U.S and Europe are heading down economically?

Fabio Savoldelli: Fundamentally, you have a tug of war which is at the heart of the debate amongst institutional investors. Either Europe drags the U.S. down, or the U.S. will help lead the world, either out of recession or at least it will be able to tread water while everyone else continues to flounder.

In comparison to Europe right now, the US could not be more divergent. In the US the only debate is whether or not the Federal Reserve will tighten. In Europe right now over a quarter of European sovereign debt is trading at negative yield. There are a couple of issues investors are looking at, where there may be an error or a variant opinion from the consensus. Within Europe you have three really key issues: dangerously low inflation, continued inability to address structural impediments to growth and one area that is least being looked at and will have one of the greatest impacts: the threat of rising populism within European politics. That populism will both stymie growth and slow, to a tremendous extent, the ability to restructure the impossibly high debt of certain countries, much less to address any of the structural issues that they have. As a result, low inflation and low growth are being baked in the cake to some degree by the natural German desire to not reward rising populism. The debt they want to repudiate was, in

large part, supplied by Germany. They won’t bend easily.

Hubert: Are you suggesting then that your rising populism theory is one of the ball just being kicked down the line to be taken on later?

Fabio: Greece and the Greek parties are threatening to leave the Eurozone. Their position is, ‘we want to stay but we don’t want to pay’. That’s nice but it’s a little bit like going to a restaurant and ordering dinner and saying, ‘loved the meal don’t particularly care for the bill’. It doesn’t work that way. On the 17th January 2014 the Podemos party in Spain was created. A year later on the 31st January 2015 they managed to pull together 150,000 people in the central Puerta del Sol square in Spain. If Greece can negotiate a departure from its debt, and remain in Europe, thereby fulfilling the populist Greek electoral promises, the numbers in the street in Madrid will double or triple.

Germany will take a hard line, but their message is not for the Greeks: I expect they don’t care about their commercial banks highly limited financial exposure to Greece, which is only around €700 million. This issue with them is that Greece is just a small part of a larger picture. The key issue is, if the Greeks can get away with not paying their debt, then Spain will walk away from its debt, then Italy and its leftist parties will come back out again, looking to walk away from theirs. Germany knows full well the dangers of allowing a small ‘necessary restructuring’ to be viewed as a precedent: vote in a hardcore, left wing, populous government that’s willing to stand up to the Troika and hey, you can walk away from your

debt! Since it is German money that the weaker European economies are walking away from, they cannot be allowed to do that without Germany demanding major repercussions, probably including expulsion from the Euro. The precedent risk is massive. This impasse is going to create a much more challenging environment to get rid of the structural impediments to growth, including restructuring an almost impossibly large debt on the part of some of these central bank governments. But they can’t let the Greeks walk away because it will simply be an advertisement for the Spanish left (Podemos), the Italian (PRC) left, Irish left (SinnFein) and all the other parties that simply will market a policy of, ‘We need not pay either, if they didn’t’.

Hubert: What would you do to address this issue of rising populism?

Fabio: From a geopolitical perspective there is almost no way that they can acquiesce to the Greek government demands, it’s not possible to establish that precedent, it will simply cause a giant continuing situation that will just widen out across Europe. It is possible to “kick the can down the road” and let the Greeks avoid a crisis. However, the position they will be taking is to say to the Greeks, ‘Alexis Tsipras and the Syriza party made completely unrealistic promises to the voters’. The Germans, the IMF and the European Central Bank (“ECB”) will stand shoulder to shoulder saying there is no way that the Troika can back down on its current position; they are in a corner and they can’t go backwards. Usually they are happy to kick the can down the road and if there weren’t populist others

1.2 INTERVIEW

De-risking in a divergent world – is the current economic environment making some strategies obsolete?Interviewer Interviewee

Hubert Danso Chief Executive Officer and Vice Chairman, Africa Investor

Fabio Savoldelli Adjunct Professor, Columbia University

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De-risking in a divergent world – is the current economic environment making some strategies obsolete?

waiting in the wings to do this in much larger economies, then they would happily kick that can down the road. But they’re in a corner. My expectation: the Germans will still push the issue down the road; they will find some way to keep the Greeks from actually exiting. But they cannot be seen to do so, simply to keep them in, by allowing some form of absolute debt forgiveness or money transfer. Other “net contributing” countries within Europe won’t put up with it, and the danger of this spreading to Italy, the third largest bond market in the world, is too great.

From the investors standpoint you can expect to continue to see the ECB being forced to fight off the resultant disinflation, and you can continue to expect to see European weakness. You are going to see some small bounces, particularly among the exporters as the Euro has fallen. You will see some small apparent light at the end of the tunnel but the actual structural impediments are not going to go away. You can continue to position yourself on the expectation of continued European weakness. In term of what that means, there will be the now traditional response of printing a lot more money and seeing the currency continue to either stay weak or decline. That means you’ll likely see European shares continue to rise on a flood of money. As a result the currency will go down. For non-euro based investors, currency hedged European stocks certainly do make some sense. If your plan is looking for capital appreciation in bonds, duration risk in Europe, despite the difficultly plans would have in buying negative yields, may well be profitable as yields in the core continue to decline a little further. Obviously if you’re looking for yields you’d be well advised to look somewhere else!

Hubert: Is it correct to assume that the current environment is making some of these more traditional de-risking strategies obsolete?

Fabio: Yes there is no doubt. The expression that we use over here is TINA – There Is No Alternative to stocks. Everyone seems to like them, so it’s nearly impossible to de-risk in some of the more traditional strategies other than to invest in cash and that is carrying continued negative yields. What is going to occur, particularly in Europe and in some U.S. pension plans, as they start to worry about the turn in rates, is risk transfers via annuities and lump sum distributions. For plans that are very well funded or ones that cause extraordinary balance sheet risk, you could see more of them saying, ‘we’ve had a heck of a run in the stocks, rates are as low as they’re going to go’. They may sell off the plan or immunize. Others, as a result of where we are in the cycle, will look to or expand their use of alternatives. This should be done with caution. For example, in an effort to reduce their equity market risk there has been a move to activist investment: it is the latest trend. The hedge funds in the space make the argument that their stock returns are so specific that you really don’t have much market exposure. The reality is that the correlation between the typical activist and the Standard & Poor’s (“S&P”) index is running at around 80%. Since 2008 the S&P has been down 36 months of the entire period, activists have only been up in 8 of those. Every time the S&P is down, the typical activist is also down. There is alpha to be obtained by activism and real event driven funds. What is unfortunately happening though is that this screaming bull market has allowed managers to hide ‘beta’ and call it ‘alpha’ by ascribing their predominantly beta returns to something they claim to be doing, and selling it as “alpha”. The reality is that the majority of returns have come from beta. When interest rates start to turn around and stocks start to go sideways,

a lot of the hedge fund strategies may find themselves to be revealed to have not been a lot more than very expensive beta.

Hubert: Is it still practical for institutional investors to pick global funds?

Fabio: Yes. You have two initial questions and a key long run question. The two initial questions are, are you going to go global indirectly via a consultant? If via a consultant then there are three issues that are worth digging into. One is, what is the experience of the consultant? Not of the firm itself, but of the individuals who are actually choosing the funds. What you’ll often find is that one of the challenges consultants face is the amount of employee turnover at the lower end. What is the median time period that your analysts have been reviewing any given fund? This staff turnover makes it very difficult to change the consultant “buy lists” and to upgrade funds on those lists.

The second resultant question for pension funds going via the consultant route is, what is the turnover of your suggested funds? How many times have you added a new fund and fired a new fund from your buy list? The consultants have a very real structural challenge that they need to deal with in that regard.

The third sub-question for consultant advised pensions is, “what sort of experience do they have from their portfolio perspective?”. Do you need advice on global funds in an asset

“the Germans will still push the issue down the road; they will find some way to keep the Greeks from actually exiting”

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De-risking in a divergent world – is the current economic environment making some strategies obsolete?

liability management context? Do you need this as a diversifier? That’s a very important consideration. You need to be shown and it needs to be conclusively proven that when they are looking at fund solutions it is not “one size fits all” but “one size that will fit your objectives”.

The second initial question is related to direct investing. The key question is, “how do you feel about foreign exchange risk”? A lot of consultants will tell you, “you don’t need to actively manage your foreign exchange risk: it does not matter in the long run”. This is true, in the long run it can be a wash, but in the words of John Maynard Keynes, “in the long run we’re all dead”. The middle term matters a lot, and foreign exchange will determine much of that outcome. When you look at the decline in foreign currency, and the decline of global investment funds in U.S. dollar term, you really do have to make a fundamental choice. Are you going to pay money to hedge the foreign exchange risk out and focus on the asset appreciation? Are you going to work with a manager who actively manages foreign exchange risk? Anyone who enters into global funds is making a colossal error if they don’t have an understanding of how large a component of historical non-correlation and total returns is actually attributable to foreign exchange. Much of the returns you will be shown can simply be the movement of the currency, not the movement of the underlying asset. Fundamentally, you absolutely have to diversify from strictly U.S. dollar investments. It is completely possible to do so even through investments as simple as ETFs. Now almost every ETF offers a currency hedged share class. So it’s not rocket science but you really need to ask yourself some fundamental questions before taking the plunge. There’s no doubt in my mind you should diversify away from strictly U.S. dollar denominated investments.

Hubert: On the macro perspective, what’s your view in terms of the

impact this divergence will have on commodity prices?

Fabio: Some interesting studies have been done on commodity prices. A Turkish scholar named Saban Nazlioglu did some work on the link between oil and agricultural commodity prices. A lot of that impact only really starts to impact prices after the oil price has settled down, that’s when you start to see the impact on a greater level than you had before. Often you’ll see it in the form of a rebound. Right now, going back one year, grains are down 25% to 30%, while coffee, cocoa, all the other commodity investments along those lines are down as much as 55%. Ethanol, which is an oil substitute, is down 30%. To the exclusion of livestock there’s no question that oil has spilled all over the sector. When we look at it the winners will be those countries that are net oil importers: China, Japan, India and Korea. Also countries that produce oil but rely on huge domestic subsides: Indonesia and Brazil come to mind. One can look at what the primary imports are for those countries and you might find that actually, over time, there is a definite benefit to them.

One of the issues that has been forgotten is the wealth transfer that has been created by the decline in oil prices. What you’re seeing is a transfer in the order of 2% of the entire world’s GDP from oil producers to oil consumers. That is a colossal wealth transfer and that will impact commodity prices for those countries that now have more money. Eventually places like China, which while it’s slowing in the high-end, people will overestimate the breadth of the slowdown. It’s not going to necessarily reach the heart of Chinese growth, which is the middle class. Obviously, the super high-end consumer is

under pressure, as are some of the construction industries, but the overall Chinese growth story remains and the China slowdown is exaggerated.

Hubert: What advice would you give to pension plans when they are planning their asset allocation with all these different moving parts?

Fabio: At the macro level, pension funds and insurance companies do not necessarily win in a low interest rate environment. Quantitative Easing (“QE”) lifts a lot of boats but it does not necessarily make life easier for pension plans. In general, the duration risk in the U.S. pension sector is substantial and there they do have to be careful. But right now in Europe a lot of the plans are actually overfunded and they are in much better shape because of the rally; many with funding ratios of around 105% at the end of 2014. In the U.S. we don’t have as rosy a picture and for people that are looking for duration they may well be advised to take their risk allocations and consider taking them offshore.

The reality is, it is not realistic to bring all of your money into global investments. One issue investors have to look at is an alternative approach, for example hedge funds that can go long or short interest rates, long or short on currencies, as well as working within US rates. For example, an allocation may have made money over the last 10 years, and all the resultant models will indicate that is a robust allocation. Of course, it is predicated on rates getting more negative forever: at some point logic tells you that is going to

“Quantitative Easing (“QE”) lifts a lot of boats but it does not necessarily make life easier for pension plans”

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De-risking in a divergent world – is the current economic environment making some strategies obsolete?

be a bad idea. Anyone who has been going against a “long duration” posture has been proven wrong at every asset allocation meeting that’s occurred for the last decade. That does not mean that is the case going forwards. I believe I read somewhere that “past performance does not guarantee future results”. You will find that the prudent, intelligent pension investor is going to continue to take interest rate risk but with a global bent, and form the long or short perspective. The next macro cycle could be for flat interest rates, and then upward interest rates. It is unlikely that there is going to be another massive leg downwards, particularly in the United States treasuries, or global rates and investors should be positioned for the market ahead.

Hubert: We’ve been talking about de-risking in a divergent world in terms of the current environment making some strategies obsolete. What would be your top 5 strategies for investors to seriously consider putting in place, in no particular order of priority, taking into account that there is some form of new normal out there?

Fabio: My first choice of investment may be counter intuitive. One of the worst performing strategies over the last few years has been global, fundamental, macro-economic based investing. It did poorly in 2014, losing around 58 basis points. In 2013 it made barely 6% and in 2012 it made 3.5%: global macro has done very poorly over time. One has to look at the reasons behind that, to look for opportunity going forward. The root cause was that global interest rates and foreign exchange markets were quite simply manipulated by the central banks. That hand is slowly but surely going to come off at least in the U.S. Slowly but surely it is also likely to do so in other markets once they start to turn. When we talk about divergence, it is the same as saying opportunity for macro managers. No question in my mind that would be one of my top strategies.

Another top strategy would be to look at global rates, U.S. mortgage backed debt or global rate funds that are able to go long and short. There is likely to be a substantial movement in interest rates coming up and that movement may not be as it’s been previously: straight down. That’s another area where profitable allocations could be made.

There is opportunity in funds that, in a market neutral, truly hedged fashion, seek to profit from corporate events As I mentioned earlier much of the recent return in activist funds has been from beta, and the same applies for event driven funds. With diligent manager selection, however, plans can find funds with a diversified portfolio with very, very low correlations to the increasingly volatile equity markets. True alpha exists in the coming wave of corporate activity, and skilled managers can capture it.

On a global scale, India and other oil consuming countries could end up in a much better condition than people think. We don’t view the oil decline as the typical cyclical situation. What you have seen here is a fundamental change in the supply dynamics within the supply demand framework. When that supply curve has moved as much up as it has, it will permanently, or at least for quite a long time, alter the oil dynamic. People are making a mistake. They say these wells will stop, these companies will go bust and that is true; a lot of these high-debt drillers will go bankrupt. But you know full well what happens when an oil driller goes bankrupt: you don’t fill in the hole. What happens is someone else says, ‘great, you paid $100 to drill this hole, guess what? It’s only profitable when you sell it to me for $20’, and that oil keeps pumping because drilling is all about fixed costs. At the right price

investors are not losing money on a variable cost (and, again, oil wells are predominantly a fixed cost) so the oil production is going to keep going, just under new ownership.

People who think crude production is going to slowdown to bring prices back to where they were before are quite simply wrong. It is a structural change that is going to be long enough that countries such as India, South Korea, even Japan will find themselves benefitting from lower energy costs. That said, after years of brutal oil prices, the sensitively of these countries to oil prices should not be over estimated. It will not reverse Japan’s dismal demography, for example. Europe, which is fighting deflation, will find its headline inflation going even lower, adding that factor to the challenge facing the European Central Bank. Again it’s going to be a challenge for investment in Europe, except on a currency hedged basis. There you’re more likely to see just good old fashioned Euros being printed, the currency tanking, but the asset prices rising simply on the face of more money chasing the same or fewer goods and assets.

Hubert: On that note we can finish. Thank-you Fabio for sharing your thoughts.

“Anyone who has been going against a “long duration” posture has been proven wrong at every asset allocation meeting”

11

Noel Hillmann: Thank-you for joining me for this interview.

Let’s begin with the question, what effect has the interest rate outlook had on the de-risking market in the U.S?

Susan Slocum: There are two elements there. One is the interest rate anticipation. It has also had an effect on the value of the dollar, so there are two components which come into play. In spite of facing higher interest rates people wanting to accept interest rate risk is on the surface not going to change. The expectation of a slower rise in interest rates is fairly helpful in that perspective. The strength of the dollar is going to affect asset allocation in the pension market.

Noel: How will the strength of the dollar affect it? What do you think is going to happen and how will that change asset allocation strategies?

Susan: You have to focus on the economics of where you are investing and in what currency you want to hold that asset, de-coupling the investment opportunity and the currency.

Noel: So you believe that there could be a greater bias towards domestic investing if there is a significant move in the U.S. dollar and there may well be a pull-out from emerging markets and other developed country allocations?

Susan: No, I’m saying that there are some great opportunities to invest off the shores of the U.S. but people will likely hedge back to the dollar and

de-couple the investment opportunity from the currency decision.

Noel: So they will keep as much of their investments as possible dollar denominated even if that may mean investing overseas.

Susan: Right.

Noel: How could this affect institutional investment decisions going forward and to what extent? Do you feel there is going to be a greater move towards diversification in asset allocations made, that there may be more asset classes that come into play as a result of any change in interest rates?

Susan: For the last 2 years I have used unconstrained bond managers. I have proactively outsourced the decision made about the portfolios duration, so what I am looking at now is going into more traditional core fixed income products and hedging out the duration myself. This means bringing the hedging of rising interest rates back to me and not leaving it at the manager level.

Noel: Are you finding that there is a significant pull-back of assets in-house from investing externally? Do you find that there is a great desire to handle investment decisions much more with an in-house team that you can speak to on a daily basis? Is there a great tendency when such changes happen to bring it in-house or do you see the external market place and expertise that is available more advantageous?

Susan: I’m not sure what others are doing but we are certainly bringing the decisions more in-house, fully understanding the triggered risks we are taking. At the moment I can call my managers up and say, ‘where do you have duration today’ but I have no control over where they are going to put the duration tomorrow. So understanding your risk management requires a certain amount of decisions to be made in-house.

Noel: Is that in both the active and the passive parts to your allocations or is that simply just on the passive side?

Susan: I don’t really run a lot in passive so it’s more the active.

Noel: So you’re pulling a lot of the active mandates back in-house to be able to take to the market call decisions?

Susan: Yes

Noel: Are you finding there has been a greater emphasis on cost management internally now? Are you finding new suppliers coming into play such as technology providers, custodians? How is that changing as you make the shift in-house?

Susan: The key is getting value for what you spend money on so it’s a balancing act. What you do well you bring in-house and you outsource the things you don’t do well. It is cheaper to bring a lot of things in-house but it isn’t necessary for a better outcome.

Noel: Are you finding that your hedging strategies have become a lot more active and that you’re placing

1.3 INTERVIEW

Examining the outlook for interest rates and whether this could be a game changer for the de-risking market in 2015Interviewer Interviewee

Susan Slocum Treasurer, Childrens Hospitals and Clinics of Minnesota

Noel Hillmann Managing Director, Clear Path Analysis

12

Examining the outlook for interest rates and whether this could be a game changer for the de-risking market in 2015

more two-way bets in order to minimise the risk that you’re likely to face when interest rates rise?

Susan: Definitely. We have a global bond mandate which speaks to what I was saying earlier which is getting hedged back in dollar terms. I would call that a two-way bet.

Noel: Could it create a complete overhaul of the de-risking market or will pension plans stick to their current strategies?

Susan: If we were to enter a trending up market in interest rates then there is going to be a lot of re-thinking because of matching assets and liabilities, a lot of fundamental thought has developed in the business over an incredible bull market in bonds. There’s a lot of fury that’s going to keep people on their paths until it becomes painful. It’s going to depend on how interest rates rise. If they very slowly move up then there’s some space saving that’s going to go on. There is this other element of the dollar’s strength which is going to come up within the portfolio.

Noel: Finally, in light of these interest rate changes, should plan managers be more global in their outlook if they want to understand how to manage their North American portfolios?

Susan: Most definitely. If they’re not already running global portfolios I really think that this will force the hand of asset allocators to move towards a global portfolio.

Noel: Thank-you Susan for your time, it is greatly appreciated.

“What you do well you bring in-house and you outsource the things you don’t do well.”

13

LDI UNDER THE MICROSCOPE

SECTION 2

What alternatives to traditional LDI should funds consider in order to meet pension liabilities?

2.1 INTERVIEW

14

Noel Hillmann: Thank-you for taking time to join me today Patrick.

I’d like to begin by asking, what trends have you seen in how North American based pension plans have approached their de-risking strategies and does Liability Driven Investing (“LDI”) play a part in that?

Patrick Baumann: We have seen plans align the duration of plan assets more closely with the liability duration, diversify equity and increase the fixed income allocation with corporate and inflation indexed funds.

Noel: How are organizations like Harris coming to these decisions in terms of how you set up your de-risking strategy?

Patrick: We generally analyze market trends and assess several scenarios with plan consultants and our plan actuary. We also consider synthetic derivatives for better liability management, as well as commodities and managed futures.

Noel: Do you use or have you considered alternatives to traditional LDI in order to meet pension liabilities?

Patrick: We believe the traditional LDI approach that we have adopted meets our needs of reducing surplus volatility. With that said, there is potentially a place for alternative investments within an LDI framework. Of course it all depends on the company’s investment policy and without a doubt that should always be the starting point as well as considering the risk tolerance and plan profile. We work with our actuary

and outside consultants to assess the different strategies. I would assume that most companies would start by determining their current funding ratio and understand the workforce characteristics while also factoring in the company’s financial position.

In a situation where the plan is over funded and the pension liability small relative to the overall risk and size of the company, the plan may have greater ability to assume additional risk and therefore be able to invest in asset classes such as private equity within the growth asset allocation. Alternatively, plan sponsors could diversify and further reduce the overall portfolio volatility by potentially combining a market neutral long/short fund or global macro fund with more traditional return-seeking asset classes.

Noel: Do you see alternatives as higher risk than traditional LDI? Are the benefits of this asset class still enough despite the risks?

Patrick: There are trade-offs associated with using non-traditional asset classes, including relative illiquidity, potentially higher due diligence costs and monthly performance evaluation challenges. Depending on the plan objectives, alternatives could be a source of diversification and additional alpha within the return-seeking allocation for plans with a long term horizon and high risk tolerance.

Noel: What would you expect the employee benefit group to be able to provide you with?

Patrick: The investment committee, supported by the finance group, will

assess the various risks, volatility correlation within the portfolio and work with the employee benefit group to communicate the strategy and plan description. We have a website that provides investment results and fund descriptions. The employee benefit group works with our record keeper and are responsible for informing the plan participants and designing communication to support the initiatives taking place.

Noel: Are the benefits of alternatives still enough despite the inherent risks there are in using them?

Patrick: It depends on the situation. Numerous factors should be considered, including the plan funding, workforce characteristics, size of the plan and profitability of the company. For example, a relatively young plan (such as a start-up company) with employees still accruing benefits may be more interested in a total return strategy, including alternatives. Such companies have a longer time horizon and would be less concerned about liquidity. Contrast that situation with a company having a fully funded plan, a frozen plan in which case they may opt to immunize the plan.

There are benefits and drawbacks to using alternative investments, such as hedge funds or private equity. Some of these investments could have liquidity restrictions in the earlier years.

Noel: When adopting perceived higher risk strategies, what measures do you take in order to gain the trust of employers, trustees and finance directors?

2.1 INTERVIEW

What alternatives to traditional LDI should funds consider in order to meet pension liabilities?Interviewer Interviewee

Patrick Baumann Assistant Treasurer, Harris Corporation

Noel Hillmann Managing Director, Clear Path Analysis

15

What alternatives to traditional LDI should funds consider in order to meet pension liabilities?

Patrick: It starts with a fair understanding of assessing the main risks, including interest rate, exchange rate, counterparty, tax and accounting risks. Then it is important to determine whether such strategies are allowed under the investment policy. In addition, plan sponsors may decide to retain an outside investment consultant to assist in understanding non-traditional asset classes.

The corporate finance group would take the lead in managing capital market risk and assessing the most suitable solution to immunize the plan liabilities.

Noel: Do you feel LDI strategies need to somewhat evolve in order to keep up and compete with the newer investment strategies entering the market, such as multi-asset funds?

Patrick: That is a tough question as ultimately it is up to each plan sponsor to determine the best portfolio composition for their needs. For well-funded, frozen plans, the traditional LDI approach of reducing equity exposure and better matching asset and liability duration can be very effective. Several providers are changing their marketing approach in promoting non-traditional asset classes and demonstrating how these strategies can be used in an LDI framework, either within the hedging or return-seeking allocations. For instance, having exposure only to macro or long/short market neutral may not have the diversification benefit that perhaps a plan sponsor is looking for. However, adding those asset classes to a traditional portfolio could in fact reduce the overall risk exposure and volatility.

Noel: Over the next 12 months where will the opportunities be in the pension de-risking marketplace and how can pension plans continue to use their investment strategies to alleviate risk and command the greatest absolute returns?

Patrick: Given the current interest rate environment combined with the overall equity market performance, companies may be re-assessing their objectives and asset allocations. Plan sponsors may consider establishing a strategy based on an anticipated interest rate increase which could translate into a decrease in liabilities and improved funding ratio. Investment committees will be tasked with establishing a journey towards an asset liability management style and matching the duration.

Noel: We can finish there, thank you for sharing your thoughts on this topic.

“There are trade-offs associated with using non-traditional asset classes…”

16

PENSION PLAN DE-RISKING USER SURVEY

SECTION 3

3.1 FOREWORD

3.2 SURVEY RESULTS

Survey Analysis3.3 ROUNDTABLE DEBATE

17

3.1 FOREWORD

In recent years pension plan sponsors across North America have endeavored to more effectively identify, evaluate

and alleviate the risks inherent to their defined benefit plans. The marketplace disruptions of the past decade and a half have laid bare the significant risks caused by pensions and highlighted its negative impact on shareholder value.

Pension Plan De-Risking, North America 2015, an industry insight report and survey commissioned by Clear Path Analysis and sponsored by Prudential Retirement®, closely examines the views of 51 senior finance, pension and treasury professionals in the private sector to better understand their perspectives on de-risking pension plans in the current marketplace environment.

The survey confirmed that pension risk management remains a principal concern for many plan sponsors. Escalating longevity, ongoing market volatility, unpredictable funding requirements and asset/liability mismatch are all contributing to significant risk over the long term. In response, scores of plan sponsors are exploring de-risking options. In fact, nearly a quarter of private plan sponsors queried are either considering transferring or are very likely to transfer pension risk in 2015.

Moreover, 50% of private pension plan professionals either partially or fully disagree with the belief that companies are better off delaying the implementation of risk-management solutions to benefit from further improvements in the financial markets. 64% percent of these same professionals either partially or fully disagree with the notion that risk transfer solutions can only be executed once a plan reaches or exceeds full funding. These responses hold great promise that plan sponsors are likely to take action in the near term to address pension risk.

Another significant trend identified in the survey is the heightening awareness of longevity risk and its effect on pension liabilities. 80% of private plan sponsors have either a very high or high awareness of the impact longevity risk is having on their pension liabilities. A point of interest: 63% of plan sponsors with $5 billion to $15 billion in assets under management indicated they have a very high awareness of the impact of longevity risk, while just 25% of those sponsors of plans in the $1 billion to $5 billion assets-under-management range felt they have a very high awareness of such risk.

With new, more precise mortality tables recently introduced into the U.S. marketplace, plan sponsors were asked what action they would take if their plan’s liabilities increased due to

the implementation of these updated mortality calculations. 12% of private plan sponsors said they would transfer risk to an insurer, 22% said they’d offer lump sums, 25% indicated they would implement a liability driven investment strategy, and 23% indicated they would allow additional voluntary pension contributions. Just 8% said they would close or freeze their plans, and 10% responded that they would take no action at all.

The belief that transferring defined benefit risk to an insurer is cost-prohibitive was also contradicted by the survey, with 54% of private plan sponsors fully disagreeing, partially disagreeing, or neither agreeing nor disagreeing with that statement. Additionally, when presented with the statement, “reducing defined benefit risk, though prudent, reduces shareholder value,” private plan sponsors replied emphatically, with 49% partially disagreeing and 20% completely disagreeing.

The movement of interest rates, however, continues to be a factor in the decision to de-risk through liability driven investing or a bulk annuity transaction. Evidence exists in the fact that 76% of private plans indicated that interest rate movements either greatly impact or slightly increase their decision to de-risk.

Consider this particularly significant observation that emerged from the survey: 38% of plan sponsors who said they would transfer pension risk to a third-party insurer represented plans with between $500 million and $1 billion in assets under management. No plans in the same assets-under-management category said they would initiate a lump sum program for their participants.

Highlights of the Survey

Included among the survey’s key findings:

• Twenty-five percent of private plans are either currently transferring risk, or considering, or are very likely to consider, transferring risk to a third party insurer in 2015.

• 80% of private plan sponsors have either a very high or high awareness of the impact longevity risk is having on their pension liabilities. Larger plans have a much higher level of longevity risk awareness than smaller plans.

• 50% of private pension plan professionals either partially or fully disagree with the belief that companies are better off delaying the implementation of risk-management solutions to benefit from further improvements in the financial markets.

Rohit Mathur Senior Vice President, Global Product & Market Solutions, Pension & Structured Solutions, Prudential

18

• 76% of private plan sponsors surveyed believe that movement in interest rates will impact their decisions to implement a liability driven investment strategy, or to execute a bulk annuity transaction.

Taken as a whole, the survey is indicative of senior finance executives moving toward a more palatable level of risk. Notwithstanding some respondents’ diffidence to de-risk, an opportunity remains for plan sponsors to recognize and re-think their pension risk management practices.

For further information about the misconceptions precluding plan sponsors from de-risking their plans, see Prudential’s white paper titled Reducing Pension Risk: The Five Myths Hold Back Plan Sponsors.

This information should not be considered an offer or solicitation of securities or

insurance products or services. No offer is intended nor should this material be

construed as an offer of any product.

Insurance products are issued by Prudential Retirement Insurance and Annuity

Company (PRIAC), Hartford, CT, or The Prudential Insurance Company of America

(PICA), Newark, NJ. Retirement products and services are provided by PRIAC.

Both are Prudential Financial companies. Each company is solely responsible for

its financial condition and contractual obligations. Prudential Retirement is a

Prudential Financial business.

Guarantees are based on the claims-paying ability of the insurance company and

are subject to certain limitations, terms and conditions.

© 2015 Prudential Financial, Inc. and its related entities. Prudential, the Prudential

logo, the Rock symbol and Bring Your Challenges are service marks of Prudential

Financial, Inc., and its related entities, registered in many jurisdictions worldwide.

0276048-00001-00 PRTWR008

“80% of private plan sponsors have either a very high or high awareness of the impact longevity risk”

Pension Plan De-Risking revised.indd

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Prudential Advertising973-802-7361

PRUDENTIAL RETIREMENT

Twice since 2000, corporate pension plans have lost over 30% of their funded status in market downturns.1

Will it happen again? No one can predict the market’s future direction.

Now, when markets are recovering and business confi dence is relatively high, might be a smart time to de-risk.

In a recent survey,2 over 50% of fi nance executives said they will seriously consider transferring their defi ned benefi t plan risk to a third-party insurer over the next two years.

Prudential can design a pension risk transfer solution to help mitigate your future risks, allowing you to focus on your core business.

We have nearly 90 years of de-risking experience, grounded in sound risk management and core strengths in asset management and insurance.

To learn more, contact Glenn O’Brien, Managing Director, Pension & Structured Solutions Group, at 860-534-2440. Or visit prudential.com/smarttime

REMEMBER THE LAST TWO DOWNTURNS? YOUR PENSION PLAN CERTAINLY DOES.

WHY NOW IS A SMART TIME TOADDRESS PENSION PLAN RISK.

1Milliman Pension 100 Funding Index, as of December 31, 2014. 2“Managing Financial Risk in Retirement and Benefits Programs: Translating Awareness into Action,” CFO Publishing LLC, 2014. Guarantees are based on the claims-paying ability of the insurance company and are subject to certain limitations, terms and conditions.

Insurance products and services are issued by The Prudential Insurance Company of America (PICA), Newark, NJ 07102. © 2015 Prudential Financial, Inc. and its related entities. Prudential, the Prudential logo, the Rock symbol and Bring Your Challenges are service marks of Prudential Financial, Inc. and its related entities, registered in many jurisdictions worldwide. 0264494 0264494-00003-00

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Pension Plan De-Risking revised.indd 1 4/28/15 1:38 PM

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3.2 SURVEY RESULTS

Responses were received from 51 individuals from across North America and Canada who represent Private Pension Plans and answered the survey in full.

About those who responded to the survey

10% Treasurers

60%Pension PlanManager/Director

8%FinanceDirector

20%PensionTrustee

2%Chief InvestmentO�cer

US

80%

Canada

20%

<$500 million:

>$15 billion:

$1 billion – $5 billion: $5 billion – $15 billion:

$500 million – $1 billion:

39%

16%

6%

25%

14%

47%Open to all employees

53%Closed tonew entrants

Job Title Country

AUM What is the status of your plan?

21

1. How does the movement of interest rates impact your decision to de-risk through LDI or a bulk annuity transaction?

Greatly impact my decision

Slightly increase my decision

Rates don’t a�ect my decision either way

27%

24%49%

2. Please select your level of agreement with the following statements about defined benefit pension de-risking.

Greatly impact my decision

Slightly increase my decision

Rates don’t a�ect my decision either way

27%

24%49%

2.1 Please select your level of agreement with the following statements about defined benefit pension de-risking.

2.2 Companies are better off delaying the implementation of DB risk management solutions to benefit from further improvements in the financial markets

Fully agree

Partially agree

Neither agree or disagree

Partially disagree

Fully disagree

6%

18%

23%29%

21%

Fully agree

Partially agree

Neither agree or disagree

Partially disagree

Fully disagree

10%15%

31%22%

22%

2.4 Transferring DB risk to an insurer is too expensive

Fully agree

Partially agree

Neither agree or disagree

Partially disagree

Fully disagree

2%

6%

23%

49%

20%

2.5 Reducing DB risk, though prudent, reduces shareholder value

Fully agree

Partially agree

Neither agree or disagree

Partially disagree

Fully disagree

8%

12%

33%

16%31%

2.3 Risk transfer solutions can only be executed once a DB plan reaches or exceeds full funding

22

3. How would you rate your level of awareness of the impact longevity risk has on the size of your pension liabilities?

Very high

High

Moderate

Low

Very low20%

35%

45%0%

0%

4. If or when proposed new mortality tables are put into effect in the United States, what level of increase in liabilities will your defined benefit plan see or experience?

0

5

10

15

20

25

30

35

No Change

1 – 3%

3 – 5%

5 – 10%

10%+

27%

16%

33%

22%

2%

5. If your plan’s liabilities increase due to the implementation of new mortality tables, what actions would your company take? (can choose more than one)

12% Transfer risk within your DB plan to a third-party insurer

22% Lump-sum program for DB participants25% Implement liability-driven investing (LDI) strategies

8% Close or freeze plans23% Additional voluntary pension contributions

10% No action

23

6. How successful have your LDI strategies been in reducing DB pension volatility?

25% 24%

37%

12%

2% 0% Very UnsuccessfulSomewhatunsuccessful

Somewhatsuccessful

Very Successful Neither successfulor unsuccessful

We don’t utilizeLDI strategies

7. Do you use alternatives in your portfolio and would you consider decreasing/stay the same/increasing your use of them?

2% Looking to introduce

4% Do currently use and looking to decrease

20% Not looking to introduce

14% Do currently use and looking to increase

27% Don’t currently use

33% Do currently use

8. Do you utilize real assets, and if so are you looking to allocate more over the next 12 months to:

53%Don’t currently utilize

16%Real Estate 25%

Infrastructure

2%Timber

22%Utilize, but not lookingto allocate more to any

0%Trade �nance 2%

Farmland/agriculture

2%Project �nance

24

9. In 2015, how likely is your company to do the following:

2%

71%4%

Very likely

Considering

Not at all likely

PRT transaction already completed or in progress

23%

9.1 Transfer risk within your DB plan to a third-party insurer?

Very likely

Considering

Not at all likely

Lump sum o�ering complete or in progress

14%

12%47% 27%

9.2 Implement a lump-sum program for DB participants?

Very likely

Considering

Not at all likely

LDI strategy implemented or in progress

23%

32%

18%

37%

9.3 Utilize or increase the usage of LDI strategies?

25

Noel Hillmann: Thank-you for joining me on this call today. I’d like to begin by discussing the recent buy-out transaction Motorola completed with Prudential.

Robert, can you please talk about why Motorola transacted, what the process was like, and the outcome?

Robert O’Keef: Motorola had been an outlier for some time in terms of the sheer scale of its global pension liabilities relative to the size of the company. Over the past 15 or 20 years Motorola has divested six or seven major businesses and reduced its footprint from around 150,000 employees to around 15,000 with the latest divestiture last year. As the company became smaller, it retained the pension liabilities related to the businesses it has divested. As of last year we had about $10 billion in global pension liabilities and around 95,000 participants with about 15,000 active employees effectively supporting those liabilities. So the scale of the liability was far outsized relative to the scale of the sponsor and the sponsors’ ability to withstand the volatility and uncertainty associated with the liabilities.

The real call to action came when we divested our last non-core business last year for $3.5 billion. We moved that off the balance sheet and it became very clear to the senior leadership

and board that we needed to do something. We’d been looking at pension alternatives for some time and that divestiture was the catalyst for action. Once we’d decided to move we moved very quickly; we’d spent some time developing the play book and waiting for a catalyst for action. Once we had the catalyst we very quickly assembled our advisory team. Needless to say, in the time frame from starting the process to closing at the end of the year it was a period of very significant market uncertainty and volatility. Therefore we wanted to move quickly to lock in the economics we had negotiated.

We ended up having our U.S. pension liability, which was marked to market in the middle of last year at around $8.5 billion, cut in half with an annuitization of about $3.1 billion related to our retiree population and a billion dollar lump sum to our term vested population, in total taking about $4.3 billion out of the liability.

We’re very happy with the outcome. The scale of the liability is much more manageable from our perspective and we’re much more comfortable with our risk profile.

Noel Hillmann: How did Motorola think about the interest rate environment when deciding to transact?

Robert: There’s no question it was an important consideration and a subject of quite a lot of debate given the interest rate environment that we’re in.

I’d make three points on this subject. First, in our situation, given the sheer scale of the liability relative to the size of the sponsor and the sponsor’s ability to withstand the volatility associated with the pension liability, we simply couldn’t afford to make a bet that interest rates were going to move one way or the other. We had to take action on the gross liability.

Secondly, we’re not in the business of taking views and managing capital markets risk. The way we look at it, at any given time there is a 50% chance rates will move higher than the market expects and 50% chance that they don’t. There are businesses and balance sheets more equipped to managing those risks than ours.

Lastly, it’s really not just about interest rates. If and when rates do rise, and some day rates will rise, we also need to understand where risk assets land. Clearly there’s a lot of uncertainty and volatility around outcomes related to the portfolio of assets that support the liability. Understanding that range of outcomes and the risk around those is important too.

In the end interest rates were an important consideration but we

3.3 ROUNDTABLE DEBATE

Moderator

Survey Analysis

Amy Kessler Senior Vice President and Head of Longevity Reinsurance, Prudential

Ian Aley Head of Transactions, Towers Watson UK

Noel Hillmann Managing Director, Clear Path Analysis

Robert O’Keef Corporate Vice President & Treasurer, Motorola Solutions

Margaret G. McDonald Senior Vice President & Actuary, Pension & Structured Solutions, Prudential

Panellists

26

Survey Analysis

did feel compelled to act and felt comfortable acting in the interest rate environment we’re in.

Noel: If you had held off transacting and you had moved into a slightly higher interest rate environment do you think that would have made the transaction more difficult for you to justify and made it less affordable for you to go ahead?

Robert: It would depend on what happens to all the other variables in that equation: risk asset prices, what happens in the insurance market and so forth. We were in a place last year where we felt we had the assets and the overall plan in a place to transact. The sponsor was in a place where we could access debt markets; we did borrow a billion dollars of long-term debt to fund up the plan in order to facilitate this transaction. So the capital markets were conducive to us borrowing, our balance sheet was able to take on the funded debt and the company was willing to make the contribution so our business was able to support it at the time.

It has to be highlighted, the insurance markets were in a place where they were able and willing to consider a large scale transaction. Looking at interest rates in isolation is very difficult. All those variables came together to support the transaction and we couldn’t be certain, regardless of where interest rates go, that all the variables would be in place again.

Noel: Margaret, what for you stood out about this transaction as the insurance partner to it?

Margaret G. McDonald: I would focus on two things. The first, as Rob alluded to, is that the speed of the transaction itself was less than four months from the time insurers got involved to the time the agreement was reached. It was a very efficient process following some of the precedent transactions in 2012.

As far as the general framework, there are of course a few unique aspects about every single transaction. We had those here but the process itself went very smoothly and very quickly.

Second, this transaction really pointed out the efficiency of a retiree buy-out transaction where a plan sponsor has updated their view of mortality to be more in line with the insurer’s view. If you look at what’s happening with U.S. plan sponsors right now, they are at a place where they tend to be every 10 years, where they’re marking up their mortality assumptions to account for improved longevity. Once plan sponsors make that update, a sponsor’s view of mortality and longevity should be very similar to the insurers view. Once that update is made, we see transactions closing at something much closer to GAAP liability than they were just a year or two ago. That is the new math of pension risk transfer, where a plan sponsor can transfer retiree liability for a fairly minimal amount above GAAP liability.

There was some concern by plan sponsors that as they marked up their mortality insurers would also be marking up mortality, but that is not the case. Insurers are continuously updating their mortality and that’s what gives rise to the new math.

Noel: It’s of course easy to say we are in a window of opportunity to do transactions at this current time but could you expand on the justification that there is truly a general window of opportunity and it’s based on particular factors?

Margaret: We were certainly last year in an environment where there had been some of these transactions, so there was a framework, and there are advisers and insurance companies looking to take part. The first movers have already moved and the first four or five jumbo transactions have all gone smoothly. That has set a precedent for future transactions and we expect the market to remain active.

Noel: Ian, talking about the UK market. How much more activity are you seeing and what other solutions are sponsors pursuing?

Ian Aley: The UK market for pension de-risking is very active. It’s been active for the last few years. Last year was a record year in terms of the volume of risk transferred with some £35 billion of liabilities transferred or hedged through insurance solutions. This has been really driven in the UK by defined benefit pension schemes increasingly becoming a legacy issue for plan sponsors. Over the last decade the plans have been closed to new entrants and in many instances to accrual, so the membership of the funds is increasingly detached from the sponsor creating this legacy position, resulting in the funds maturing quickly. Therefore sponsors in particular, but also trustees, are very keen to de-risk the pension fund and ultimately to remove the liability from their balance sheet to the extent that they can.

In terms of the second part of your question on what other solutions sponsors are pursuing, in the insurance space we’re seeing a lot of activity in buy-ins, where the risk is transferred to an insurer but remaining within the trust and governance framework of the pension plan. We’re also seeing a shift towards buy-outs, where the entire or part of the pension plan is transferred to an insurer, both in terms of the risk and the relationship becomes one between the insurer and the individual members of the plan. The sponsor is no longer a party to that relationship, and the fund is removed from their balance sheet.

Then the other solution that we’re seeing, and there is a great deal of activity in, is the hedging of longevity risk. Whilst many plans have de-risked their assets through moving from return seeking assets to matching assets they of course still hold demographic risks. We’re seeing a great deal of activity in that space to

27

Survey Analysis

hedge the demographic risk through longevity swaps or insurance.

Amy Kessler: One of the most interesting aspects about the UK market today is the fact that buy-ins, buy-outs and longevity risk transfer transactions are all happening side by side so that the pension funds in the UK are really choosing the solution that best suits them. The people who are moving to buy-in and buy-outs are the ones who are looking for a holistic solution for all of their asset and liability risks, like Motorola who are looking for a smaller pension obligation going forward because that’s how the buy-in and the buy-out can best be used.

Those in the UK who are looking at longevity solutions are doing so because they are more comfortable on a path to hibernate their pension plan on the balance sheet. Here in the U.S. we’re starting to hear a lot of plans talk about and be focused on hibernation. However, in the U.S. it’s a new idea or a new concept to hibernate your pension plan on the balance sheet with a fairly high degree of fixed income and longevity insurance alongside it.

The UK has pioneered the approach to longevity re-insurance, the first complete and holistic hibernation strategy that addresses both asset and liability risk with LDI and longevity hedging. We’re now seeing for the first time interest in this de-risking strategy in the U.S. The interest is driven by the release of the new mortality tables in the U.S. which have brought a renewed focus on liability risks and the substantial impact longer life is having on pension obligations. U.S plans are now considering holistic hibernation strategies where you could combine a high fixed income allocation, call it 70% or more, with a longevity reinsurance product and have both your assets and your liabilities managed. This approach, pioneered in the UK means your volatility is managed and you can hibernate that pension risk safely.

Noel: What did we learn from this market about hibernation strategies, and how do you use longevity risk transfer to complement those strategies?

Ian: What we’re learning is quite simple in many respects. An insurer that provides an annuity for a group of plan members will adopt, due to the regulation and efficient risk management required, a relatively low risk investment strategy that is probably exposed to corporate credit in some degree. They’ll hedge their interest rate and inflation risk and may well hedge through reinsurance their longevity risk. They will then apply, driven by the regulation, a capital support model on top of that portfolio of assets to provide their clients with the security of the insurance regulation.

What a number of the larger pensions funds in the UK have considered is, do they wish to follow a buyout strategy and pay the insurer to support the transaction with their capital or do they want to ‘hibernate’ their pension liabilities, use a similar investment strategy, the same techniques but use their own sponsor’s balance sheet as support for the member security? Thereby if the future turns out as they anticipate, they will have achieved the same economic effect at a lower cost because they are not being asked to pay the return on the capital that’s employed by the insurer. However, until the last few years, that strategy could only be concluded in part as there wasn’t a viable market for hedging the demographic risk, predominantly the longevity risk. Now though there is a longevity insurance or swap market and a number of funds are either undertaking those strategies or have journey plans in place towards such a strategy.

Noel: How did the BT transaction change the shape of the longevity risk transfer market?

Amy: It’s really opened a new avenue for the largest pension plans anywhere in the world to proactively manage their longevity risk. Many of the largest pension funds in the world are wonderful, world class asset managers, as BT is. They have the capability together with their advisory teams, at scale and in a very sophisticated way, to manage their asset risks. As they consider hibernating a very large pension plan on the corporate balance sheet they know that they really need to address longevity risk as well.

Up until the BT transaction, the largest deal in the longevity risk transfer space had been in the $5 billion range. For the very largest pension plans, which need an efficient and cost effective structure to manage longevity risk at scale, the $27.7 billion BT transaction has demonstrated a viable path forward. In addition, because of the use of a wholly owned captive that’s owned by the BT Pension Scheme, the ability to go to the very deep liquid and competitive global reinsurance market using that captive solution has now taken hold. This is because it is a more cost effective and more efficient way to go to market. We’re now seeing smaller pension funds also approach the longevity risk market with a captive solution. That has really made a very big impact on the way the longevity market is transacting. Within nine months of the BT transaction closing, we’re seeing many many more longevity risk transfers coming in the same framework and format.

Noel: Many may look at the BT transaction and say they have these resources available to them to pursue such a transaction. Do you feel that those pension plans that are not even close to similar size can learn a lot from the BT transaction?

Ian: In terms of what was unique, the BT transaction was the first UK corporate pension plan to use a captive insurance company to act as a conduit between the pension scheme and the global reinsurance market.

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In the UK pension schemes cannot directly transact with reinsurers and it’s reinsurers that have the appetite for longevity risk as opposed to insurers per se. At the time of the transaction that was a unique feature.

The BT scheme, as Amy has already touched on, has a very sophisticated asset investment manager in place and hence it was able to deal with the complexity of such a transaction. What we’ve seen more recently is solutions which enable that complexity to be managed on behalf of smaller pension plans. This is achieved through the use of similar structures, whereby a pension plan owns the insurance cell but has some of the services around operating a longevity hedge, such as the calculation agent, in a ready packaged form.

We saw at the end of last year the first transaction complete in this structure which has made longevity hedging more accessible for smaller pension plans.

Noel: Margaret, would you have any follow up comments?

Margaret: We have spent time talking about the speed and efficiency with which the transaction happened once it came to market but I know that Rob had to do some very important internal work at Motorola to set the ground work. That was important to the overall success of the transaction and is something other plans should be aware of.

Doing the pre-work before a transaction is extremely important. It gives the plan sponsor the flexibility to transact when the market is right and Rob alluded to the importance of that earlier. It also helps the transaction move more smoothly For example, Motorola worked on cleaning their data and refining their data file for some time before they came to us, and that helped tremendously in moving our transaction along quickly and efficiently. If you don’t have the

pre-work done you don’t have the flexibility that Motorola had and the ability to strike when they wanted to.

Robert: We spent a lot of time internally prior to the transaction educating our leadership and our board around the issues they needed to be aware of: the risk profile, how to restructure our capital structures, and as such we’d zeroed in on which tools we wanted to access, how and why. So when we had a catalyst for action the company as the plan sponsor was lined up and ready to move.

We also knew that regardless of what we were going to do with the liability, cleansing the data, understanding the liability, and being ready to transact was going to be important. Therefore we started that process sooner than most, well before we actually decided to transact.

Understanding your liability structure and what you’re dealing with regardless of which tool you want to use is going to be important. It’s a relatively low cost investment and it will have you prepared to access whatever tool you decide to access.

We also had a team in place that was familiar with the process and the players and we assembled an advisory team that had run large scale transactions before and was able to partner with us, Prudential Retirement. All the other constituents moved the process along very quickly.

We were very well positioned from the very beginning to move quickly once we decided to hit the button.

Margaret: I’m often asked about the importance of hiring an adviser. Rob do you have any comments about how hiring an adviser that was helpful to the transaction?

Robert: We were in an unusual position in that we already had people in-house who knew how to run the play. We still hired an adviser and the advantage

was that they did add value, most notably they kept the process moving and kept it moving quickly. They knew exactly how to access resources, assets, and interact with all the constituents including the Prudential Retirement team. That allowed us to move very quickly.

As I mentioned earlier, as markets are moving and sometimes moving violently, once you’ve decided to transact on certain economic terms moving quickly is critical. That becomes difficult if you don’t have advisers and difficult if you don’t have advisers that have been down the path before. In that sense having the right advisers was mission critical.

Noel: On that point we’ll bring the debate to close. Thank-you to all our panellists for being so open in your views.

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