CAPTRUST Strategic Research Report Q3 2012 Plan Sponsor Edition

PLAN SPONSOR | Q3 12

Strategic research report Pay Now or Pay Later?

MAP-21 Implications for Defined Benefit Funding Strategies Grant D. Verhaeghe Director, CAPTRUST Investment Research

In July, President Obama signed the Moving Ahead for Progress for the 21st Century Act (MAP-21) — formerly known as the Highway Bill — into law.

While the law’s primary function is to provide for highway and transportation funding, it also contains provisions that impact qualified defined benefit plans.

More specifically, one of the new law’s provisions affects the discount rates used to determine minimum required contributions to pension plans.

By way of background, pension plans use discount rates to determine the present value of future payments to retirees. Since the enactment of the Pension Protection Act of 2006, these discount rates have been based upon the yields of high-quality (AA-rated) corporate bonds. Since 2008, falling yields on these bonds have forced plan sponsors to contribute painfully high cash amounts to maintain funding levels. Lower yields (and, therefore, discount rates) mean a higher present value of liabilities and, thus, require a larger cash outlay to maintain or improve a plan’s funding status. This is analogous to the predicament faced by an individual investor who expects to receive a lower rate of return on his retirement assets: all things being equal, he will need to save more today to accomplish his financial objectives.

Plan Sponsor Highlights

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Investment Strategy

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Index Returns

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Investment Asset Classes

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CAPTRUST in the News

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Figure 1: Pension Discounting Curves as of July 2012 8%

6%

4% MAP-21 Segment Rates July 2012 HQ 24-Month Segment Rates July 2012 HQ Corporate Full Yield Curve

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http://www.irs.gov/Retirement-Plans/FundingYield-Curve-Segment-Rates

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Sources: http://www.irs.gov/Retirement-Plans/ Monthly-Yield-Curve-Tables

Letter from the Editor

Discount Rate (%)

In This Issue

With MAP-21’s passage, actuaries are now able to use discount rates based on a corridor around the 25-year average yield of high-quality corporate bond interest rates to determine minimum required contributions — rather than the 2-year average that was primarily used under previous regulations. Minimum discount rates for those plan sponsors electing to apply MAP-21 rates will be effectively 90% of the 25-year average in 2012 as shown in Figure 1. The law then gradually reduces the corridor to 70% by 2016. Figure 1 also demonstrates the difference between the published 2-year and 25-year average segment rates as of July 2012.

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Maturity (Years)

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LETTER FROM THE EDITOR

“ALL THE NEWS THAT’S FIT TO PRINT” That very tagline first appeared 115 years ago in the New York Times’ upper-left corner.

While the proverbial content “bar” is always high, we found this quarter especially challenging given the fourth quarter’s pending events with far-reaching implications.

The U.S. election season, change in Chinese leadership, ongoing European issues, and a volatile economic picture leave us with plenty of eligible contemporary topics.

We try to avoid the “news” aspect given how much financial narration has permeated mainstream media since the onset of the financial crisis, but this quarter we felt we would be remiss if we did not cover what we see as the most important issue over the next 18 months: the U.S. “fiscal cliff ” and its implications for institutional clients.

Eric J. Freedman

Our cover story provides a timely summary of the Highway Bill and its implications, while Phyllis Klein shares participant advice trends gleaned from CAPTRUST education meetings across the country in “Talking Walls.” We continue to innovate on the nonqualified deferred compensation side of our business this quarter, and to that end we preview some forthcoming primary research centered on nonqualified plan financing.

CAPTRUST Chief Investment Officer

On the capital markets front, we share some of our thinking on bond investing in the wake of recent Federal Reserve and European Central Bank policy changes, and the team and I spent some time with JP Morgan’s Dr. David Kelly, who provides an insightful look at the fiscal cliff and various potential scenarios that could emerge in coming weeks. To close, I summarize our thoughts across asset classes in my regular investment strategy piece.

A client once told me that we are all drowning in information but thirsting for knowledge.

That quote has stuck with me, and comes to mind particularly when thinking about topics to cover in this publication. As a long-time student of the global economy, I am well aware of the opportunity cost of you spending time reading this. We want to reach our readers with pieces that are understandable, actionable, and, ultimately, interesting, so if you decide any part of this quarter’s content was not “fit for print,” please don’t be bashful; my comment box is always open.

Have a great finish to 2012 — it promises to be action-packed.

Onward—

All Publication Rights Reserved. None of the

The opinions expressed in this report are subject to change without notice. This material has

material in this publication may be reproduced

been prepared or is distributed solely for informational purposes and is not a solicitation

in any form without the express written

or an offer to buy any security or instrument or to participate in any trading strategy. The

permission of CAPTRUST: 919.870.6822.

information and statistics in this report are from sources believed to be reliable, but are not warranted by CAPTRUST Financial Advisors to be accurate or complete. Performance

©2012 CAPTRUST Financial Advisors

data depicts historical performance and is not meant to predict future results. CAPTRUST Financial Advisors, Member FINRA/SIPC.

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PLAN SPONSOR | Q3 12

continued from page 1

SAMPLE PLAN DURATION (Years)

Figure 2: Comparison of Estimated MAP-21 Rate Impact on Plan Funding Ratios A

B

C

D

July 2012 HQ Corporate Full Yield Curve

July 2012 HQ 24-Month Segment Rates

MAP-21 Segment Rates

Estimated Current Annuitization Rates

Plan Funded Status*

Effective Interest Rate

Plan Funded Status

Effective Interest Rate

Plan Funded Status

Effective Interest Rate

Plan Funded Status

Effective Interest Rate**

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75.0%

3.74%

83.1%

4.71%

100.9%

6.82%

69.1%

3.00%

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75.0%

3.94%

84.8%

4.94%

105.7%

6.95%

66.9%

3.06%

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75.0%

4.07%

86.8%

5.09%

111.3%

7.03%

64.7%

3.11%

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75.0%

4.15%

89.0%

5.22%

117.1%

7.11%

63.4%

3.18%

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75.0%

4.23%

91.8%

5.32%

123.2%

7.17%

61.7%

3.23%

*Assumes 75% Initial Funding Status on a Full Yield Curve basis **Effective interest rate estimated based on current annuity rates and assumptions regarding demographic make-up of participant population Sources: http://www.irs.gov/Retirement-Plans/Monthly-Yield-Curve-Tables, http://www.irs.gov/Retirement-Plans/Funding-Yield-Curve-Segment-Rates, CAPTRUST Research

By allowing plan sponsors to calculate their contributions using the higher (as of this writing) 25-year average rate, MAP-21 provides a form of temporary funding relief.

The new law will likely result in higher tax revenue for the government, since plan sponsors that contribute less to qualified retirement plans will also not be taking the associated deduction. These revenues will help to offset the expense associated with other provisions of the bill.

Determining contributions based on the new rates, relative to previous calculations, can lead to materially lower contributions.

As an example, a $100 million plan with a 15-year duration (a measure of price sensitivity due to interest rate changes) would experience a $15 million decrease in the present value of liabilities for every 1% increase in the discount rate. Given that plan sponsors generally contribute normal costs plus one-seventh of the amount they are underfunded in a given year — absent asset smoothing, other funding relief measures, and actuarial chicanery — using the 25-year average rate could have a dramatic impact on annual funding requirements.

In Figure 2, we have taken an anonymous sample of representative client pension plans to estimate the impact of funding levels based on these new rates (using a bit more detailed calculation than described above) relative to other

measures of funding. The intent of this analysis is to estimate the impact of higher discount rates used to determine pension liabilities on funding ratios, and it does not account for many other tools that actuaries can use in official calculations. Plan sponsors should engage in a more formal conversation with their actuary, and the results will almost certainly vary from these estimates.

In the above exhibit, the full yield curve estimate in column A reflects liabilities discounted at today’s current rate—which provides an economic view of funding. The annuitization rates in column D estimate the additional cost of purchasing an annuity to settle the liability. The two segment rate scenarios (in columns B and C) demonstrate the impact to funding ratios when smoothing of interest rates is applied.

As you can see from this analysis, the change in interest rates has a materially higher impact on funding levels — especially when plan liabilities have longer duration. Focusing on the difference between the new MAP-21 rates and the true economic cost of settling the liability demonstrates how dramatically understated liabilities are under the new rule set. continued on page 4

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Figure 3: Market Participant Expectations for Future Interest Rates 3.5%

3.0%

2.0%

1.5% Source: Bloomberg as of 9/25/2012

Discount Rate (%)

2.5%

1.0% Sept 25, 2012 U.S. Treasury Actives Curve 3-Year Forward Rates

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At first glance, this legislation looks like a good deal for plan sponsors, so why the title? The answer lies in the fact that it would take a material increase in spot (current) interest rate levels by 2015-2016 to make up for the gradual widening of the corridor around the MAP-21 25-year average rate. This widening effectively “wears away” the new law’s funding relief. More plainly said, if rates don’t increase by several percentage points across the yield curve in the near term and plan sponsors elect to forgo contribution strategies, funding measures will likely return to lower levels, requiring higher future contributions.

How likely is that? Certainly, there are many paths that interest rates may follow. However, the forward curve (shown in Figure 3) — which reflects market participants’ expectations for interest rates in the future, along with recent Fed guidance that it intends to keep rates low through 2015, suggests that markets do not anticipate a rate scenario that will materially impact the 25-year average by 2015.

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It would take a material increase in spot (current) interest rate levels by 2015-2016 to make up for the gradual widening of the corridor around the MAP-21 25-year average rate.

PLAN SPONSOR | Q3 12

So if the relief is temporary and market expectations do not imply a materially rising rate environment before 2015-2016, what should plan sponsors do?

• Consider continuing your current contribution strategy given today’s business climate relative to the potential for higher contributions in future years in an unknown business environment.

• Consult with your actuary on contribution strategies and interest rate expectations — and perform a stress test to ensure that your organization can withstand possible future contribution scenarios.

• Evaluate the other implications of this new law (this article only addresses funding, but there are many other implications of this legislation).

• Continue to use spot measures for estimating liabilities when determining and measuring success of liability-driven investment strategies.

We encourage our plan sponsor clients to evaluate their specific objectives related to their ability to improve funding levels through contributions. While the path you choose may be different based on the factors discussed above, we continue to think that the road to improved funding levels includes some combination of contributions, interest rate changes, and market performance. Only one of those is directly controllable by the plan sponsor. So the question remains: “Pay Now or Pay Later?” Should you have any questions on how this rule set may impact your decision making, please do not hesitate to ask us.

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PLAN SPONSOR HIGHLIGHTS

A THREE-STEP APPROACH TO NONQUALIFIED PLAN FINANCING NOW IS THE TIME TO REVIEW YOUR STRATEGY Jason Stephens Director, CAPTRUST Nonqualified Executive Benefits

Employers that sponsor nonqualified deferred compensation plans understand that these plans can be a powerful tool to attract and retain valuable employees and independent contractors. At the same time, nonqualified plan adoption also introduces financial risk to the employer, as amounts deferred generate an unfunded corporate liability that can potentially grow at unpredictable rates. Therefore, it is important for nonqualified plan sponsors to consider how to effectively manage their plan’s eventual liquidity needs while also recognizing the potential for financial statement volatility due to the growth of participant account balances.

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Fortunately, nonqualified plan sponsors have a number of tools at their disposal to help manage those issues mentioned above that essentially boil down to one thing: the plan’s financing strategy. A well-thought-out financing strategy, involving a combination of an appropriate financing method, hedging strategy, and funding level, while taking several company-specific variables into account, can better manage plan financing volatility and liquidity and help plan sponsors feel more confident about the optimization of their plan’s financing. In our experience, plan sponsors generally select among four primary financing method options.

The most common methods today include: • unfinanced, where the plan sponsor leaves the benefit liability unfunded, • financing with mutual funds or other taxable securities, • financing with life insurance, or • use of a total return swap.

The unfinanced approach, which suggests that no assets are set aside to informally fund the nonqualified liability, may make sense if a company has a high return on capital indicating a better alternative for available funds, while the use of taxable securities like

PLAN SPONSOR | Q3 12

mutual funds is a common approach favored for simplicity and flexibility despite potential negative tax and cash flow consequences. Financing with life insurance offers tax advantages, yet can be relatively complex to understand and manage. Finally, a relatively new concept, the total return swap, involves transferring liability hedging risk to a third party for a fee. Each of these methods offers certain advantages and disadvantages depending upon numerous plan sponsorspecific goals and economic variables.

plans via total return swap have a contractual hedge against liability earnings growth that is offered by the swap provider.

Each of these hedging strategy options offers advantages and disadvantages that depend on a plan’s financing method and the plan sponsor’s level of risk tolerance.

A nonqualified plan’s hedging strategy is also an important element that contributes to the plan’s overall economic success. A close correlation between the movement of assets and plan liabilities generates a smaller possibility of difference developing between assets and liabilities, which helps minimize financial statement impact. Sponsors that elect to finance their plan’s benefit liability must additionally decide among three hedging strategies.

Traditional options for funding include:

The three approaches to hedging include: • a mirror strategy where assets and liability investment options are identical, • a mapping strategy where liability investment options are mapped to different asset investment options, and • a discretion strategy where the plan sponsor invests the assets independent of the plan liability or uses a total return swap.

Utilizing a mirror strategy is the most common approach. A mapping strategy is generally selected when it is impractical or impossible to mirror participant liability choices due to investment or administrative constraints. As an alternative, the plan sponsor selects similar — but not identical — investments.

The disadvantage with both of these strategies is that corporate assets are directed by plan participants — who often have neither the time, knowledge, nor desire to effectively manage their nonqualified plan account. With a discretion strategy, plan assets are managed to maximize their return, independent of how plan liabilities are directed. Sponsors that finance their

A third element controlled by the plan sponsor is the plan’s funding level, the degree to which nonqualified plan liabilities are offset by a corresponding asset portfolio.

• a pre-tax benefit funding level, • an after-tax funding level, and • a death benefit cost recovery level.

Targeting a pre-tax funding level, the plan sponsor manages an asset portfolio that is equivalent to 100% of the liability portfolio. An after-tax funding level takes into account the future tax deduction benefit associated with the eventual payment of plan liabilities, and the plan sponsor manages an asset portfolio equivalent to its after-tax benefit liability.

Death benefit cost recovery is an available option for plans financed with life insurance — where plan sponsors intend for the present value of the expected future death benefits to equal the plan liability value.

In a soon-to-be-published white paper titled A Three-Step Approach to Nonqualified Plan Financing, CAPTRUST more closely examines the three elements we consider central to creating an effective nonqualified plan financing strategy. Our paper makes the case that these elements can and should be tailored — based upon each plan sponsor’s specific economic needs — to provide a cost-efficient long-term financing solution. In addition, we also examine several key economic variables that influence this analysis, including the plan sponsor’s marginal income tax rate, the selected discount rate, return on capital, nonqualified plan earnings assumptions, and liquidity needs.

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TALKING WALLS A GLIMPSE INSIDE OUR RECENT CONVERSATIONS WITH PLAN PARTICIPANTS Phyllis Klein Senior Director, CAPTRUST Consulting Research Group

CAPTRUST has always taken an interest in the people who are trying to balance the economies of managing their life while saving for retirement: namely, plan participants. So far this year, we have met with over 8,800 participants across the country, including over 2,300 one-on-one meetings.

And we never stop learning from the conversations we have. Given all that has happened over the past couple of years, we thought it might be interesting to share some of our insights gathered from the individuals we have spoken with most recently.

Not surprisingly, we hear the same three main questions during almost every individual participant meeting: • Am I saving enough?

• Am I invested correctly?

• Am I on track for retirement? In other words, will I be OK?

In addition to these frequent questions, participant discussions about retirement savings definitely have a life-cycle aspect — with a range of concerns and issues that vary by age group.

Likely the most notable change in tone comes from younger savers, who expect access to a retirement plan but, at the same time, are skeptical about the stock market. Conversations are centered on the budgets they are trying to establish against key financial goals, including paying off college loans or other accumulated debt. This group is not used to handling financial decisions for themselves and may even ask to have their parents involved in our discussions with them. This attitude seems to have made the younger cohort comfortable with plan features such as auto-enrollment.

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PLAN SPONSOR | Q3 12

Here are a few interesting observations from our interactions with savers in their 20s: • This group saw parents suffer large losses during 2002 and 2008 and have been affected by those events.

• They are much more comfortable in individual or smallgroup discussions and disdain in large-group sessions.

• They rely heavily on the internet, their peers, or social media for information—making paper materials, like enrollment books, less effective.

• Frequently asked questions include: How much is the match? What investment options should I pick? What happens when I leave this job?

Participants in their 30s also have a distinct identity. I recently attended an Employee Benefit Research Institutesponsored retirement policy discussion in Washington, D.C., that provided insight into this unique group. The meeting was focused on U.S. retirement security, including the ability for people to accumulate adequate savings. Some of the conference content focused on the notion that retirement savings timeframes are shrinking. We see this issue affecting the “young family” savers through the discussions we are having with this group.

As individuals choose to marry later and may not start families until their early 30s, this group struggles with carving out adequate retirement savings. As a result, they are losing saving years due to other economic demands. Advice typically concerns how to increase savings gradually over time, how much savings is enough, and reiterating the need for continuous saving. The shortened retirement saving time horizon will have a long-term impact on these participants and their ability to accumulate enough money for retirement.

We are having similar conversations with people in their 40s and are starting to see an increase in questions about how an individual’s account balance compares with co-workers’. As previously mentioned, because people are marrying and having children later than previous generations, those in their mid-40s

regularly have children preparing for college and other money demands that interfere with retirement savings. Conversations with this group are often directed toward how much retirement income their account balance might provide and how an increase in savings may help make up for lost time.

Employees in their 50s provide an interesting conundrum.

Many surveys claim this group wants to work past normal retirement age, but our interactions suggest otherwise. Most of the people we see plan to retire on time or even early.

Perhaps we are meeting with individuals who have taken an active interest in saving; nonetheless, our experience coincides closely with what we see from the Bureau of Labor Statistics, where less than 20% of people are reported to be working past their normal retirement age. However, the same data shows that the group of workers over age 65 continues to expand and is expected to increase with the onslaught of the baby boomers. We often are asked by this age group for help with diversification and advice on how to protect their money. These employees are beginning to craft their desired retirement experience and want to understand if they are saving enough to meet their needs.

Finally, those who are close to retirement, in the 60-plus age group, often have already talked to a financial advisor, since many in this demographic have accumulated retirement dollars with rollover potential. Often those in this age group do not understand what type of income level their account balances may provide, so we spend time discussing longevity, income, and spending patterns. Since home ownership is a key variable for this group, we find ourselves discussing the need to pay off debt before going onto a fixed income in retirement.

While the nature of the conversation varies from one individual to another, participant advice is very much in demand across all economic and age groups. As advisors we find the kind of “feet on the street” insights we receive from these meetings to be very valuable and rewarding. As always, we will continue to use what clients are asking us to help create relevant solutions for employees working toward a successful retirement.

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NAVIGATING BONDS IN TODAY’S LOW-RATE ENVIRONMENT Hunter Brackett, CFA Senior Manager, CAPTRUST Investment Research

Under these circumstances, it may be an appropriate time for investors to reassess their portfolios and return expectations, particularly for fixed income assets. Going forward, we expect subdued returns in lower-yielding assets such as certificates of deposit, money market accounts, and fixed income securities for a number of reasons. The Fed actions discussed provide an incentive for investors to move away from lower-yielding assets and toward traditionally riskier areas such as equities. This is one of the reasons why the S&P 500 has rebounded so strongly off its March 2009 lows, recently approaching the all-time-high index level set in October 2007. In addition, many investors are concerned that interest rates can only go higher from today’s historically low levels. While the Fed will likely keep short-term rates anchored in the near term, it has less direct control over longer-term rates.

Nearly four years ago, the Federal Reserve cut its target interest rate to the lower bounds of its policy, where the rate remains today. While low interest rates are not a new phenomenon, two recent events have brought this issue back to the forefront of investors’ minds. First, the 10-Year U.S. Treasury — a useful proxy for interest rates — hit an alltime-low yield of 1.39% on July 24 amidst concerns about Europe’s debt crisis. Second, in September the Federal Reserve stated that it was willing to keep short-term interest rates at the present low levels through at least mid-2015 compared with the previous timeframe of 2014.

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The biggest risk for bond returns is a sharp rise in interest rates, but several factors could prevent this scenario. Despite accommodative monetary policy from both the Fed and European Central Bank in recent months, economic fundamentals still appear weak and risks to global growth remain a concern.

In addition, demographic factors in the United States and a lack of viable substitutes for U.S. Treasurys as a safe haven asset could provide support even as rates rise.

The forward curve, which represents market participants’ expectations for future interest rates, suggests a gradual rise in interest rates over the coming years. We also note that interest rates — which move in the opposite direction of bond prices — have staged short-lived rallies over the past few years, but in each instance have fallen as global

PLAN SPONSOR | Q3 12

this action is supportive of the MBS market, we note that some of the impact may have been priced into the market before the Fed announcement.

While the housing market remains at a depressed level, fundamentals have started to improve, which could also aid the MBS market. growth concerns reemerged. For example, the yield on the 10-Year U.S. Treasury rose to 2.38% in March on stronger economic data, only to fall sharply and reach the previously cited all-time low in July.

We continue to encourage investors to diversify their allocations across subsectors of the bond market. Our research has shown that fixed income returns can remain positive, even during periods of gradually rising rates, although subsectors may behave slightly differently. Given the prospect of higher long-term rates, investors may want to reduce interest rate risk while taking on a modest amount of credit risk.

Credit-sensitive areas such as high-yield and emerging market debt may perform better than rate-sensitive subsectors such as Treasurys and investment-grade corporate bonds that tend to be more vulnerable to rising rates.

While credit-sensitive subsectors tend to be more volatile, we believe that their

fundamentals are supportive. Corporate balance sheets are much improved, as companies reduced costs during the recession and took advantage of low rates to refinance their debt. Thus, default rates on high-yield debt are currently below their historical averages and are expected to rise at a modest pace going forward. It may also be useful to look outside of the U.S. market for bond exposure. Emerging market debt benefits from a stronger fiscal position relative to developed economies and favorable demographics, so exposure to this subsector may be appropriate depending on investor risk tolerance.

Another fixed income subsector that has received attention recently is mortgage-backed securities (MBS).

The Fed recently announced another round of quantitative easing in which it will purchase $40 billion of MBS in the open market every month. Importantly, this program is open-ended and will continue until the labor market shows sustained improvement. Although

Following a multi-decade bull market in bonds and facing the prospect of rising interest rates, it may be tempting for investors to abandon this asset class.

However, we continue to believe that bonds have an important role to play in client portfolios. They have historically been a less-volatile asset and provided a cushion during times of economic stress. Nevertheless, we expect subdued returns for fixed income going forward, so investors will need to be more selective with their asset allocation decisions. We also stress the value that active management can play in a more challenging fixed income backdrop.

Having skilled portfolio managers who can profitably source the subsectors mentioned earlier can be additive.

We are constantly reviewing and assessing bond portfolios and money manager talent. If you have specific questions we can answer given these historic times, please do not hesitate to let us know. „

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JUST A SPOONFUL OF SUGAR Eric J. Freedman CAPTRUST Chief Investment Officer

It is always dangerous to write about a topic that could go in a different direction before your content reaches readers. While we endeavor to get this publication out to readers as soon as possible, paper-and-ink publishing necessarily drives a “time wedge” between when we write and when your eyes hit this page. I recall a period early in my CAPTRUST career when I dutifully penned a 1,500-word article a week before deadline, only to have the Federal Reserve announce an unexpected policy change that rendered my missive, as they say in the business, old hat. “Rookie move,” as the kids say.

The topic of the fiscal cliff presents a similar authorship risk. As I write in early October to a readership that will see this article in late October at the earliest about an event that will occur on December 31, I risk that said “time wedge” may include critical developments that render this article old hat. However, my editorial staff and I agreed that the probability of this

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event being resolved before publication was extremely limited, and since resolution would likely be a positive development, we rolled the dice.

Before we delve into specifics, let’s start with what the fiscal cliff actually is. While the mainstream media has affixed this catchphrase onto potential year-end events, we do not want to presuppose that what the phrase embodies has been well-explained. The fiscal cliff represents tax cut expirations, Medicare tax increases, unemployment benefit program extension terminations, and two rounds of discretionary spending cuts resulting from the 2011 Budget Control Act that are all slated to become effective on December 31, 2012. These various programs clearly represent some political sensitivities, with parties deeply entrenched as we approach year-end.

The fiscal cliff has clear economic implications from a directional standpoint. Economic textbooks

suggest that U.S. government spending as a percentage of Gross Domestic Product (GDP) is normalized in the 15-20% range (while more skeptical sources say the range is highly volatile, more like 10% to 40% over time), so any government spending decreases would impact growth in the very near term. Effective tax increases also impact growth, as less discretionary spending means less available consumption dollars. This year, National Bureau of Economic Research economist Valerie Ramey concluded that — even if higher taxes translate into more government spending — the government spending GDP “multiplier effect” (how a dollar of increased spending reverberates in the economy) has a very wide range of potential outcomes and most likely decreases private (non-governmental) spending.1 In aggregate, the fiscal cliff ’s directional economic impact is clearly negative.

The order of negative magnitude, however, is unclear and a major point of debate among economists.

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Figure 1: Federal Debt Held by Public, Actual and Projected (CBO) 140% Actual

Projected

120%

Alternative Fiscal Scenario

80%

60% CBO's Baseline Projection

40%

20%

0% 1940

1945

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1995

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2015

Source: Congressional Budget Office3

Percentage of GDP (%)

100%

2020

Years If current laws governing taxes and spending remain in effect (CBO's baseline projection), debt held by the public will fall from 73% of GDP in fiscal year 2012 to 58% of GDP in 2022. If policymakers altered those laws to maintain many policies that have been in effect in recent years (CBO's alternative fiscal scenario), debt would climb to 90% of GDP by 2022. In either case, debt would be relatively high by historical standards.

So why do we need to go through this? The answer rests on America’s increased reliance on debt financing, within both the public and the private sectors. In prior Strategic Research Reports, we have analyzed consumer debt growth and how that has correlated with economic output. Government debt, however, has become a more topical discussion, particularly given the political climate.

Cumulative deficits (when government expenditures exceed revenues) have brought our debt picture to untenable long-term levels, and both political parties agree that high debt levels are not conducive to economic growth. In a comprehensive analysis that included both developed and developing countries, economists Carmen Reinhart and Kenneth Rogoff noted that median growth rates fall by 1% and average growth rates fall more than that for countries saddled with debt-to-GDP ratios above 90%.2 We have to go through it because, just as Mary Poppins prescribed to Jane and Michael Banks, we need to take our collective medicine, and investors are trying to see how much “sugar” will be included, as the list of policy changes could come all at once (representing sugarless castor oil in the form of a potential downward GDP shock) or in a more piecemeal fashion

(attenuated castor oil that the economy could more easily stomach) should Washington decide to compromise.

Figure 1 shows the non-partisan Congressional Budget Office’s (CBO’s) late August estimates of federal debt held by the public over time (a slightly different debt measure than that cited by Reinhart and Rogoff, but instructive nonetheless) as well as forecasts from fiscal year 2013 (which started on October 1) through 2020.3 As Figure 1 displays, the dotted line represents a figurative fork in the road for the U.S. debt-toGDP ratio. If the full fiscal cliff occurs in early 2013, the CBO projects a drop in debt to GDP to more favorable long-term levels under its baseline scenario. However, should a spoonful of sugar dilute this tough medicine, the “alternative” fiscal scenario shows debt to GDP drift higher and into the 90% of GDP red zone. So the tradeoff is clear when assessing the CBO’s projections: Should the economy endure the “full” fiscal cliff, our debt-to-GDP ratio improves, but the economy likely suffers. If instead Washington compromises and we delay parts of the tax increases or sequestration (a term that encompasses the budget cuts), the economy may experience some shortterm relief at the expense of longer-term debt considerations. continued on page 14

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Given a wide range of potential outcomes and pending the political horse trading in coming weeks, we caught up with Dr. David Kelly, JP Morgan Asset Management’s chief global strategist and head of the Global Market Insights Strategy Team. David and his colleagues penned a lucid piece, describing several scenarios that may play out, and we wanted to share a few takeaways from our conversation with Dr. Kelly.

Dr. Kelly and team do not anticipate any legislation prior to the election, but instead anticipate the balance of power after presidential and congressional elections to drive further action.4 Based on election outcomes, Kelly sees one of four scenarios playing out: a Democratic sweep of Congress where the Bush-era tax cuts end for wealthy households, a Republican sweep with a focus on spending cuts, a divided government that induces the fiscal “ledge,” or a divided government that results in a fiscal “ladder.” Let’s look at each scenario and JP Morgan Asset Management’s investment conclusions for each scenario.

THE DEMOCRATIC SWEEP

THE REPUBLICAN SWEEP

If this scenario occurs, Kelly assumes that:

Assumptions for this scenario include:

• the Bush-era tax cuts would be extended

• extension of all Bush-era tax cuts, along with

only for those households earning less than $250,000/year, • top dividend and capital gains tax rates rise from 15% to 20%, • the payroll tax cut is phased down and eventually eliminated, • extended unemployment benefits expire on

a fix for the Alternative Minimum Tax, • expiration of the payroll tax cut and extended unemployment benefits on schedule, and • no increase in Medicare taxes.

Similar to the Democratic sweep scenario, only the first round of spending cuts takes place and the second does not take effect.7

schedule, and • higher Medicare taxes ensue.

In terms of sequestration, he assumes that only the first round of spending cuts takes effect.5

Kelly sees this scenario as a negative for equities given their diminished after-tax cash flows but potentially positive for municipal bonds. The overall GDP impact would be a one percentage point drop in GDP from current levels if no tax increases or sequestration events happened.6

14

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Investment implications include a positive impact on equities but the opposite for municipal bonds.

Kelly and team note further that, in this scenario, a Romney administration may seek additional tax and entitlement reform.8

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DIVIDED GOVERNMENT — THE FISCAL LEDGE

DIVIDED GOVERNMENT — THE FISCAL LADDER

If we see some split at the executive and

This would be a better economic scenario with a

legislative branches of government, JP Morgan

more gradual deficit reduction, with:

anticipates a combination of spending cut

• full extension of the Bush-era tax cuts in 2013

compromises and some higher tax rates that

and for households earning less than $250,000

could include the following:

from 2014 onwards,

• extension of the Bush-era tax cuts only for

• top dividend and capital gains tax rates rise

households earning less than $250,000/year,

from 15% to 20%,

• top dividend and capital gains tax rates rise

• the payroll tax cut is maintained in 2012, phased

from 15% to 20%,

down in 2013, and eliminated in 2014,

• expiration of the payroll tax cut on schedule,

• unemployment benefits expire on schedule,

• higher Medicare taxes to pay for President

• higher Medicare taxes to pay for President

Obama’s healthcare plan, and

Obama’s healthcare plan, and

• both sets of spending cuts are implemented.9

• only the first set of spending cuts is implemented.11

Kelly and team expect that outside of a full fiscal cliff realization, this scenario would have the worst impact on the economy and stocks and would have an uncertain impact on Treasury bonds.10

In our follow-up conversation with Dr. Kelly, we asked him what he was seeing investors do to prepare for this range of outcomes, and David responded that retail investors appear to be voting with their feet, as mutual fund flows out of stocks and into bonds have occurred at the fastest rate in the last five years, a curious development in light of recent equity market performance. He was also seeing some taxable investors take steps to realize some gains this year across asset classes in light of higher anticipated taxes. In summary, though, Dr. Kelly argued that investors who are properly diversified do not need to take action ahead of the uncertain outcomes that await us this year-end. Our view — a solid asset allocation, and a spoonful of sugar, may be the best combination for investors heading into 2013.

Kelly and team see this as a potential positive for equities. Even though tax rates would move higher, GDP would expand and the fiscal deficit would simultaneously decline, potentially boosting investor confidence.12

Sources: 1

Ramey, Valerie A., and NBER (2012). “Government Spending and Private Activity.” http://econ.ucsd.edu/~vramey/research/NBER_Fiscal.pdf

2

Reinhart, Carmen M. and Kenneth S. Rogoff (2010). “Growth in a Time of Debt,” American Economic Review, May. (Revised from NBER working paper 15639, January 2010.)

3

http://www.cbo.gov/publication/43539

4

Kelly, David et al. “The Fiscal Choice: Cliff, Ledge or Ladder.” JP Morgan Asset Management Market Insights, 2012, page 5.

5

Kelly, David et al. “The Fiscal Choice: Cliff, Ledge or Ladder.” JP Morgan Asset Management Market Insights, 2012, page 6

6

Ibid

7

Ibid, page 8

8

Ibid

9

Kelly, David et al. “The Fiscal Choice: Cliff, Ledge or Ladder.” JP Morgan Asset Management Market Insights, 2012, page 10

10

Ibid

11

Ibid, page 12

12

Ibid

15

investment strategy

HASTE YE BACK Eric J. Freedman CAPTRUST Chief Investment Officer

This summer, I was fortunate enough to travel to Scotland with my dad, brother, and a good family friend, Neal Greenfield.

It was a trip I had delayed for too long — new babies, business school, and the financial crisis all contributed to its postponement, each with good reason. At last, on August 18, I found myself in Ayrshire, weary from a redeye flight and devoid of sleep (compliments of a fellow passenger’s cackle at every line from the recent movie version of The Three Stooges; my dad — affectionately referred to as the “Commish” for his selfless event planning — and I marveling at Curly’s enduring comedic prowess at 30,000 feet) but happily teeing up a new and soon-to-be-lost Titleist alongside the Ailsa Craig on Scotland’s southwest shore. I could only hope that the trip would match my long-built expectations and was determined to live every moment to the fullest. Especially considering that my honey-do account would be at an all-time surplus upon returning home. Our day at the Turnberry Golf Resort inaugurated a journey across the beautiful Scottish countryside, with my brother skillfully maneuvering a standardshift passenger van to eight different links courses.

Leaving Turnberry and reflecting on my par on 18 not being good enough to bring the youngsters (my brother and me) a victory over the seasoned veterans (thanks to Neal’s clutch birdie), we passed a sign with the message “Haste Ye Back,” which the Beverly Hillbillies may loosely translate into “Ya’ll come back now, ya hear?” It left us with a warm feeling every time we saw signs donning those three words, succinctly capturing the genuine Scottish hospitality no matter where we went. Caddies, waitresses, passers-by on the street; it didn’t matter whom we encountered, the Scots made us feel at home, except, of course, when an errant golf shot landed in the rough — a rough thickened by the second-wettest quarter in the United Kingdom since recorded history began in 1910.1 While we enjoyed excellent weather, the record spring rains lengthened what was already brutally high grass, causing us to export more golf balls than we would have liked.

The U.S. witnessed its own record in the third quarter, with the 10-Year Treasury hitting an all-time low in late July, touching 1.39% intraday. Uncertainty over Europe, the

16

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Chinese slowdown’s extent, as well as a consistent thirst for yield in any form, drove up bond prices and, by definition, drove down bond yields. My colleague Hunter Brackett covers this development’s implications for fixed income in this Strategic Research Report, but low bond yields also carry a significant impact across portfolios.

The most important consideration is total return expectations; since most asset allocations, ranging from insurance companies, pension funds, and individual investors to sovereign countries, have notable bond allocations, all else equal, lower nominal (or non-inflation-adjusted) interest rates imply lower total returns.

We don’t rule out a rise in bond prices given major events unfolding over coming months — U.S. election season, the fiscal cliff, a more subdued corporate profit tone, and ongoing European deliberations — but should the global economy “muddle through” or even surprise with growth exceeding expectations, bonds will not enjoy much of a yield cushion.

Figure 1 compares 10-Year U.S. Treasury yields to their equivalents in Germany, Japan, and Switzerland, demonstrating two important points. First, one can see that the yield cushion for all four sovereign countries’ bonds has contracted materially in recent years, with only the U.S. 10-Year above 1.50% at September’s end. Second, precedent exists wherein bond prices could move higher despite historically low yields.

However, since nominal bond yields are bound by zero, at some point, total return expectations must come down as bond yields approach this absolute zero boundary.

While no one can know definitively when bond yields will bottom, the closer we approach zero, the faster investors need to “haste back” their total portfolio return expectations. If bonds move lower in yield (and higher in price), investment theory suggests that a more muted total return expectation should be applied to all asset classes. The theory is best explained by the great Warren Buffett in a 1999 Fortune magazine article, which 13 years later remains one of the most popular media investing interviews of all time. (Please realize how clichéd it is to quote Mr. Buffett in this industry, so you know it’s gotta be good.) Mr. Buffett said that “interest

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the same maturity. This difference, by definition, provides investors with a realtime gauge of inflation expectations. The rates are for 5- and 10-year breakeven rates; in other words, where the market sees inflation 5 and 10 years from now.

Figure 1: Select 10-Year Government Bond Yields, Sept 2007 – Sept 2012 5.0% United States Japan

4.5% 4.0%

Switzerland Germany

2.5% 2.0% Source: Bloomberg

Yield (in %)

3.5% 3.0%

1.5% 1.0% 0.5% 9/1/2012

6/1/2012

3/1/2012

9/1/2011

12/1/2011

6/1/2011

3/1/2011

9/1/2010

12/1/2010

6/1/2010

3/1/2010

12/1/2009

9/1/2009

3/1/2009

6/1/2009

12/1/2008

9/1/2008

6/1/2008

3/1/2008

12/1/2007

9/1/2007

0.0%

Figure 2: Weekly U.S. Breakdown Inflation Expectations, 5 and 10 Years Forward, Jan 2002 – Oct 2012 3.0%

1.5% 1.0%

Source: Bloomberg

0.5% 0.0% 5-Year Breakevens 10-Year Breakevens

-0.5%

rates… act on financial valuations the way gravity acts on matter. The higher the rate, the greater the downward pull… so if the government rate rises, the prices of all other investments must adjust downward, to a level that brings their expected rates of return in line.” 2 Of course, investment theory and reality can diverge over time, so it is not a given that all other asset classes will sell off if interest rates move higher. We have been adamant — in these pages and other client communications — that bond yields will remain low and sticky for some time. While we hear periodic

1/11/2012

1/11/2011

1/11/2010

1/11/2009

1/11/2008

1/11/2007

1/11/2006

1/11/2005

1/11/2004

1/11/2003

-1.0% 1/11/2002

Breakdown Rate (in %)

2.5% 2.0%

inflationary cries (and have for five years), we continue to see the global economy as being too weak in the short term to stoke sustainable inflationary pressures, although we do see it as a potential risk should central banks continue accommodative monetary policy in the form of ongoing bond buying. Even given recent central bank activity, inflation expectations remain subdued.

Figure 2 shows inflation expectations as measured by breakeven inflation rates, calculated as the difference between nominal and real (inflation-adjusted) yields for bonds from the same issuer and

As Figure 2 details, inflationary expectations have risen from the depths of the financial crisis in 2008 and 2009, but current rates are well within the long-term average of 2.5 to 3.0% and are still below pre-crisis levels. Also, while it’s hard to see on the chart, inflation expectations have reversed from the period immediately preceding the Fed’s September policy announcement of open-ended bond purchases. So while inflation could cause bond yields to move higher in a more rapid fashion, for now, we retain our view that inflation is a “high class problem.” We will be watching developments that may cause us to shift this long-standing belief.

We see bond yields as being sticky at current levels, with downside risk to yields in the form of a marketunfriendly election, a failure to reach compromise on the fiscal cliff, a sharp global slowdown, and a variety of other negative catalysts and upside in the form of unforeseen inflation, quicker-than-expected growth, or asset allocation trends reversing from prior years’ bond-market dominance over stocks (see Figure 3 on the next page). Given consistent demand for fixed income assets, the potential for an asset allocation shift out of bonds is real, although U.S. demographics and memories of 2008’s woes would suggest that such a shift would be gradual. continued on page 18

17

continued from page 17

Figure 3: Investment Company Institute: Monthly Net New Flows into Stock and Bond Funds, Jan 2007 – Aug 2012

$40,000 $20,000 $0 -$20,000 -$40,000 Total Equity Total Bond

-$60,000

Given three possible scenarios, 1) a “muddle through” economy where bond yields hover at current levels with a bias for moving higher, 2) a “risk off” scenario where bond yields fall further, approaching the zero bound as investors seek safety, or 3) a “risk on” scenario where bonds are shunned in favor of stocks and traditionally riskier asset classes, portfolio returns could follow very different patterns, depending on their relative allocations. Regardless, only the second scenario would see bond prices head higher, which — despite economic and Buffett theory — may not result in all other asset classes moving higher as well based on recent relationships. While fixed income portfolios may get one last hurrah higher, they get closer and closer to the zero bound.

Please do not read this as me writing the bond market’s epitaph; quite the opposite. We still see a lot of risks in the global economy, including some in the very near term that cause us to recommend and retain a healthy exposure to parts of the bond market that run counter to current consensus views. My main message is that return expectations, for both bond-heavy and bond-light investors, need to be more subdued, given a lower nominal return world. Credit Suisse’s David Zion noted earlier this year that S&P 500 companies’

5/1/2012

1/1/2012

9/1/2011

5/1/2011

1/1/2011

9/1/2010

5/1/2010

1/1/2010

9/1/2009

5/1/2009

1/1/2009

9/1/2008

5/1/2008

1/1/2008

9/1/2007

5/1/2007

1/1/2007

-$80,000

Source: ICI

Net New Cash Flow (in $ Millions)

$60,000

median pension return expectation was 7.79% at the end of 2011, in an environment where U.S. nominal bond yields stood at historically low rates.3 While we don’t think this is an unchallenging return assumption over a long period of time, shorter term it may be difficult to achieve depending on asset allocation and liquidity needs.

Our last round fittingly took place at St. Andrews’ majestic Old Course, golf ’s birthplace. After a memorable day, Neal once again birdied 18 in front of a small crowd to give the old-timers a much-deserved multi-round, carry-over win following a solid finish from the Commish that morning — leaving the youngsters to ponder what could have been (and pick up the evening’s check). On top of the epic loss, I developed elbow tendonitis from having played too many rounds in too short a period (read: I am getting old), but that injury has neither garnered sympathy from my wife, Jamie, nor shortened the honey-do list. Still, the feeling standing on the Old Course’s first tee, playing Muirfield before the Open Championship next year, birdieing 18 at Troon, the jokes, the blinding rain, the non-conceded putts, eccentric caddies, driving on the wrong side of the road, the Scotts’ warm smiles, and a nip or two on the 19th hole will stay with me: Haste Us Back, indeed.

Sources:

18

1

http://www.bbc.co.uk/news/uk-18653274

2

http://money.cnn.com/magazines/fortune/fortune_archive/1999/11/22/269071/

3

https://doc.research-and-analytics.csfb.com/docView?sourceid=em&document_id=x430358&serialid=4SZAPm5ppWs68p7uGa6zSSuWzTQo2UkuZfyb20q%2F9pk%3D, page 9

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index returns

2012 3RD QUARTER ASSET CLASS RETURNS 2000

2001

2002

2003

2004

2007

2008

2009

2010

2011

YTD

Mid Cap Growth

Small Cap Value

Small Cap Value

Fixed Income

Small Cap Growth

Mid Cap Value

Large Cap Growth

Fixed Income

Mid Cap Growth

Small Cap Growth

Fixed Income

Large Cap Growth

51.29%

22.83%

14.02%

9.84%

48.54%

23.70%

14.02%

26.86%

11.81%

5.08%

46.29%

29.09%

7.84%

16.80%

Small Cap Growth

Mid Cap Value

Fixed Income

Cash

Small Cap Value

Small Cap Value

Mid Cap Value

Small Cap Value

International Equities

Cash

Large Cap Growth

Mid Cap Growth

Large Cap Growth

Large Cap Value

43.09%

19.18%

8.96%

46.03%

22.25%

12.65%

23.48%

11.63%

37.21%

26.38%

2.64%

15.75%

Large Cap Growth

Fixed Income

Mid Cap Value

Mid Cap Growth

International Equities

Mid Cap Growth

Large Cap Value

Mid Cap Growth

Small Cap Value

Small Cap Growth

Mid Cap Value

Large Cap Value

Small Cap Value

-9.64%

42.71%

20.70%

12.10%

22.25%

11.43%

-28.92%

34.47%

24.75%

0.39%

14.37%

Cash

Small Cap Growth

1.68%

Cash 3.64%

2005

2006

International International Equities Equities

1.51%

33.16%

10.12%

International Equities

Large Cap Value

Mid Cap Value

Small Cap Value

International Equities

Large Cap Value

Large Cap Value

Mid Cap Value

Fixed Income

Large Cap Value

Mid Cap Value

Small Cap Value

27.37%

7.02%

2.33%

-11.42%

39.17%

16.49%

7.05%

20.22%

7.39%

-36.85%

34.21%

24.50%

Cash

Large Cap Value

Large Cap Value

Mid Cap Value

Mid Cap Growth

Large Cap Growth

Small Cap Growth

Small Cap Growth

Mid Cap Value

International Equities

Large Cap Growth

Mid Cap Value

Mid Cap Value

-5.59%

-15.52%

38.07%

15.48%

5.26%

13.35%

7.05%

-38.44%

32.46%

16.71%

-1.38%

14.03%

Mid Cap Growth

Small Cap Growth

International Equities

Large Cap Value

Small Cap Growth

Small Cap Value

Mid Cap Growth

Cash

Large Cap Growth

Small Cap Value

Large Cap Value

Mid Cap Growth

Mid Cap Growth

-11.75%

-9.23%

-15.66%

30.03%

14.31%

4.71%

10.66%

-38.44%

20.58%

15.51%

-1.65%

13.88%

Fixed Income

International Equities

Mid Cap Growth

Mid Cap Growth

Large Cap Growth

Large Cap Growth

Small Cap Growth

Large Cap Growth

Large Cap Value

Small Cap Growth

Large Cap Value

International Equities

Small Cap Growth

International Equities

0.39%

-13.96%

-20.15%

-27.41%

29.75%

6.30%

4.15%

9.07%

-0.17%

-38.54%

19.69%

8.21%

-2.91%

10.59%

Mid Cap Value

Large Cap Growth

Large Cap Growth

Large Cap Growth

Fixed Income

Fixed Income

Cash

Cash

Mid Cap Value

International Equities

Fixed Income

Fixed Income

Small Cap Value

Fixed Income

-0.11%

-22.42%

-20.42%

-27.88%

4.31%

3.04%

3.35%

5.08%

-1.42%

-43.06%

5.24%

5.89%

-5.50%

3.99%

Small Cap Value

Small Cap Growth

International Equities

Small Cap Growth

Fixed Income

Fixed Income

Small Cap Value

Mid Cap Growth

Cash

Cash

International Equities

0.21%

0.13%

Large Cap Value

6.36%

7.35%

Cash 5.01%

-1.49%

-22.43%

-21.21%

-30.26%

Cash

Cash

1.05%

1.44%

1.58%

4.08%

4.71%

-9.78%

-44.32%

0.10%

-11.73%

14.08%

Cash 0.07%

Small Cap Value Stocks (Russell 2000 Value)

Large Cap Value Stocks (Russell 1000 Value)

International Equities (EAFE)

Small Cap Growth Stocks (Russell 2000 Growth)

Mid Cap Growth Stocks (Russell Mid Cap Growth Index)

Fixed Income (Barclay’s Capital U.S. Intermediate Govt./Credit)

Large Cap Growth Stocks (Russell 1000 Growth)

Mid Cap Value Stocks (Russell Mid Cap Value Index)

Cash (Merrill Lynch 3-Month Treasury Bill)

Sources: Markov Processes Inc., Bloomberg, Mobius

1999

2012 3RD QUARTER INDEX PERFORMANCE Q3 12

2012

2011

2010

2009

2008

2007

1-YEAR

3-YEAR

5-YEAR

S&P 500

6.35%

16.44%

2.11%

15.06%

26.46%

-37.00%

5.49%

30.20%

13.20%

1.05%

8.01%

Dow Jones Industrial Average

5.02%

12.19%

8.38%

14.06%

22.68%

-31.93%

8.88%

26.52%

14.45%

2.16%

8.60%

NASDAQ Composite

6.17%

19.62%

-1.80%

16.91%

43.89%

-40.54%

9.81%

29.02%

13.66%

2.90%

10.27%

Russell 1000

6.31%

16.28%

1.50%

16.10%

28.43%

-37.60%

5.77%

30.06%

13.27%

1.22%

8.35%

6.11%

16.80%

2.64%

16.71%

37.21%

-38.44%

11.81%

29.19%

14.73%

3.24%

8.41%

Russell 1000 Value

6.51%

15.75%

0.39%

15.51%

19.69%

-36.85%

-0.17%

30.92%

11.84%

-0.90%

8.17%

Russell Mid Cap Index

5.59%

14.00%

-1.55%

25.48%

40.48%

-41.46%

5.60%

28.03%

14.26%

2.24%

11.18%

Russell 1000 Growth

10-YEAR

Russell 2000

5.25%

14.23%

-4.18%

26.85%

27.17%

-33.79%

-1.57%

31.91%

12.99%

2.21%

10.17%

Russell 2000 Growth

4.84%

14.08%

-2.91%

29.09%

34.47%

-38.54%

7.05%

31.18%

14.19%

2.96%

10.55% 9.68%

Russell 2000 Value

5.67%

14.37%

-5.50%

24.50%

20.58%

-28.92%

-9.78%

32.63%

11.72%

1.35%

MSSCI Europe, Australia, Far East

6.98%

10.59%

-11.73%

8.21%

32.46%

-43.06%

11.63%

14.33%

2.59%

-4.77%

8.69%

Wilshire REIT Index

-0.15%

14.74%

9.24%

28.60%

28.60%

-39.20%

-17.55%

32.43%

20.72%

1.73%

11.35%

Barclays Govt. Intermediate Bond

0.62%

1.70%

6.08%

4.98%

-0.32%

10.43%

8.47%

2.39%

4.09%

5.20%

4.20%

Barclays Corporate IG Bond

3.83%

8.66%

8.15%

9.00%

18.68%

-4.94%

4.56%

10.76%

9.09%

8.06%

6.56%

Barclays Aggregate Bond

1.59%

3.99%

7.84%

6.54%

5.93%

5.24%

6.97%

5.16%

6.19%

6.53%

5.32%

Barclays Intermediate Govt./Credit

1.40%

3.53%

5.80%

5.89%

5.24%

5.08%

7.39%

4.40%

5.18%

5.71%

4.76% 10.98%

Barclays High Yield

4.53%

12.13%

4.98%

15.12%

58.21%

-26.16%

1.87%

19.37%

12.90%

9.34%

90-Day U.S. Treasury

0.03%

0.07%

0.10%

0.13%

0.21%

2.06%

5.00%

0.07%

0.11%

0.72%

1.82%

Consumer Price Index (Inflation)

0.59%

2.29%

2.96%

1.50%

2.72%

0.09%

4.08%

1.74%

2.24%

2.06%

2.46%

Sources: Morningstar, Mobius, MPI

INDICES

The information contained in this report is from sources believed to be reliable, but not warranted by CAPTRUST Financial Advisors to be accurate or complete. Index performance depicts historical performance and is not meant to predict future results.

19

investment asset classes

U.S. EQUITIES Market Performance, 3rd Quarter 2012

• U.S. equities recorded their third positive quarter in the last four with the S&P 500 rising 6.4%, outpacing both small- and mid-cap stocks in the third quarter.

Q3 12

2012

Large Value (R1000 Value)

6.51%

15.75%

Large Blend (S&P 500)

6.35%

16.44%

the third quarter, with utilities being the sole negative

6.11%

16.80%

performer, falling a modest 0.5%. Energy (+10.1%) and

Mid Value (Russell)

5.80%

14.03%

telecom (+8.1%) were the strongest sectors, with the

Mid Blend (Russell)

5.59%

14.00%

latter leading all S&P 500 sectors year to date with an

Mid Growth (Russell)

5.35%

13.88%

Small Value (R2000 Value)

5.67%

14.37%

Small Blend (R2000 Blend)

5.25%

14.23%

Small Growth (R2000 Growth)

4.84%

14.08%

impressive 26% gain.

Source: MPI Stylus Pro

Large Growth (R1000 Growth)

• Nine of the 10 major S&P 500 sectors were positive in

• Since the U.S. equity market peaked in October 2007, the only investment style that has not fully recovered from the two-and-a-half-year market malaise (after incorporating reinvested dividends) is large-cap value, due to its large weighting in the financial sector.

INTERNATIONAL EQUITIES Market Performance, 3rd Quarter 2012

• Developed and emerging international equities both rallied in the third quarter and have been higher 11 out of Q3 12

2012

the last 14, and 11 out of the last 15 quarters, respectively.

International Equities (MSCI EAFE)

6.98%

10.59%

Pacific Stocks (MSCI Pacific Ex-Japan)

11.03%

17.58%

and 4.7% in local currency terms, led by Germany (+13.9%

European Stocks (MSCI Europe Ex-UK)

9.73%

12.79%

in dollars). Japan was a laggard, falling 3.2% in local

-0.77%

2.43%

UK Stocks (MSCI UK)

7.06%

10.67%

Emerging Markets (MSCI EME)

7.89%

12.33%

Source: MPI Stylus Pro

Japanese Stocks (MSCI Japan)

• Developed international equities rose 7% in dollar terms

currency terms but down just 0.8% in dollar terms thanks to yen appreciation.

• Emerging markets finished up 6% in local terms and up 7.9% in dollars due to relative currency strength. China and Brazil were up 4.7 and 4.8%, respectively, but recently weak India posted a +15.4% dollar return after a strong rally in both stocks and the rupee.

20

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FIXED INCOME Market Performance, 3rd Quarter 2012

• The Barclays Aggregate Bond Index had its 15th positive quarter in its past 16, closing up 1.6% in the third quarter of 2012. The index was up every quarter in 2011.

Q3 12

2012

Broad Market (Barclays Capital U.S. Aggregate)

1.59%

3.99%

Barclays Capital U.S. Treasurys

0.57%

2.08%

parts of the bond market were stronger this past quarter,

1.13%

2.80%

with emerging market debt (+6.8%), high yield (+4.5%), and

Barclays Capital Municipals

2.31%

6.06%

Barclays Capital Intermediate Corporates

3.18%

7.69%

4.53%

12.13%

Barclays Capital High Yield

Source: MPI Stylus Pro

Barclays Capital Mortgage Backed Securities

• Within the broad fixed income space, historically riskier

investment-grade corporates (+3.8%) all marking strong returns. Mortgages and Treasurys lagged in the quarter.

• Despite relentless calls for interest rates to rise, 10-Year Treasury rates hit an all-time intraday low on July 24, touching 1.39% and closing at 1.64% for the quarter.

HEDGE FUNDS / PRIVATE EQUITY Market Performance, 3rd Quarter 2012

• Hedge fund strategies continue to post lackluster returns, and the third quarter was no exception. The HFRX Global Q3 12

2012

Hedge Fund index was up 0.39% in September after a

HFRI Fund Weighted Composite Index

2.86%

4.65%

+0.51% August, bringing the index to just over 2.6% for

HFRI Equity Hedge Index

3.47%

5.51%

HFRI Relative Value Index

3.68%

8.08%

• The weakest sub-categories include global macro and

HFRI Fund of Funds Composite Index

2.34%

3.33%

relative value strategies, while event driven is up close

HFRI Fund of Funds Conservative Index

1.65%

2.36%

Source: HFRI

the year.

to 5% through September and equity hedged strategies have meaningfully underperformed their long-only peers.

• Alternatives research firm Prequin reported that, based on preliminary data for the quarter, private equity had a slow sequential quarter capital-raising season (but better than the comparable quarter in 2011), as did infrastructure and venture capital despite an otherwise strong year.

21

COMMODITIES Market Performance, 3rd Quarter 2012

• The Dow Jones UBS Commodity Index rallied 9.7% in the third quarter after falling 4.6% in the second quarter, 2012

Dow Jones UBS Index

9.69%

5.63%

S&P GSCI Commodity Index

11.54%

3.47%

10.94%

13.33%

Natural Gas (U.S. Spot Henry Hub)

11.68%

2.68%

Crude Oil (U.S. Spot, WTI Cushing)

8.51%

-6.72%

Gold (Spot, $/oz)

moving to positive territory for the year-to-date period.

Source: MPI Stylus Pro, Bloomberg

Q3 12

• Several subsectors demonstrated considerable strength.

Metals were strong across the board, with lead up 28.1% and silver +25.4%. Sugar and cotton were the only weak agricultural components, and the energy complex demonstrated its typical volatility; WTI and Brent Crude returns were both positive yet highly divergent, and gasoline was up for the quarter.

• Commodities continue to show more elevated correlations to other asset classes than in most periods before the financial crisis, and those correlations did not abate in the third quarter.

REAL ESTATE Market Performance, 3rd Quarter 2012

Wilshire REIT Index

Q3 12

2012

0.01%

14.89%

-0.15%

14.74%

Source: MPI Stylus Pro

MSCI U.S. REIT Index

• Public real estate, as measured by the NAREIT Equity REIT Index, increased a modest 1% in the third quarter, but REITs have still outperformed U.S. equities four out of the last six quarters. REITs were up a whopping 164.2% cumulative over the past 10 years, ending September 30.

• Capital raising continues to be easy for REITs, with NAREIT data showing that REITs have raised just shy of $45 billion as of the end of August 2012, which is 88% of what the industry raised in a record-setting 2011.

• Several REIT subsectors sport attractive fundamentals based on changes in buyer behavior. NAREIT research suggests that apartment REIT supply lags demand by some four million units despite early signs of stabilizing housing demand.

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WWW.CAPTRUSTADVISORS.COM

PLAN SPONSOR | Q3 12

captrust in the news

CAPTRUST GROWTH The CAPTRUST team grew in the third quarter with the addition of four new financial advisors and new offices in Boston and New York City.

Boston Office Bob Auditore joined the firm in August 2012 as Vice President, Financial Advisor with over 24 years of experience in design, implementation, and administration of qualified retirement plans for corporate fiduciaries. Previously, Bob was one of the founding principals of Bay Colony Partners, a group of specialists focused on qualified and nonqualified corporate retirement plans and individual wealth management, located in Boston, Massachusetts. There, Bob served as managing partner of the firm’s retirement plan practice. Prior to the formation of Bay Colony Partners, Bob was a principal of L&M Securities, Inc. A recognized leader in the industry, Bob frequently serves as a speaker to professional groups and was named to 401k Wire’s “300 Most Influential DC Plan Advisors” in 2010. Bob is a graduate of Tufts University with a bachelor’s degree in economics.

Gary Cowles joined our team in August 2012 as Vice President, Financial Advisor with over 21 years of experience in retirement investment advisory services in the area of nonqualified deferred compensation plans. Previously, Gary was one of the founding principals of Bay Colony Partners and served as managing partner of the firm’s executive benefits practice. Gary also previously held executive-level positions with a large benefits consulting firm, John Hancock and Scudder, Stevens & Clark. Gary is a graduate of the University of New Hampshire with a bachelor’s degree in mathematics and performed graduate studies in taxation at Bentley College.

He has obtained the Chartered Life Underwriter (CLU®) and Chartered Financial Consultant (ChFC®) designations from the American College and is a member of the Association for Advanced Life Underwriting in Washington D.C., and the Society of Financial Services Professionals.

New York City Office

Los Angeles Office

John Davenport joined CAPTRUST in 2012 from Barclays Capital, where he was responsible for analysis and approval of over $11 billion of the bank’s balance sheet exposure to U.S. industrial, healthcare, consumer, and retail companies. He currently provides investment advisory services to fiduciaries of corporate retirement plans. John received top honors from the University of North Carolina Wilmington’s Cameron School of Business, where he graduated summa cum laude with a Bachelor of Science degree in finance and economics and was awarded the 2008 E.M. West Award for most outstanding graduate. John is a CFA charter holder.

Debbie Basch joined us as a Financial Advisor Relationship Manager and will be responsible for providing investment management and consulting services to institutional investors and corporate retirement plan fiduciaries. Debbie joins CAPTRUST from Diversified Investment Advisors, where she managed a diverse client base of corporate and not-for-profit retirement plans. Prior to that, she was a vice president, relationship manager at Union Bank of California and director of institutional retirement consulting at Fidelity Investments.

Debbie is a graduate of the University of Massachusetts with a bachelor’s degree in communication studies. continued on page 24

23

PLAN SPONSOR | Q3 12

continued from page 23

RECENT NEWS

INDUSTRY INVOLVEMENT

In the third quarter of 2012, CAPTRUST launched captrustnonqualified.com, a website that offers an objective and holistic perspective on best practices for nonqualified deferred compensation plans. The website offers a concise overview of what CAPTRUST calls the “Five Components of a Successful Nonqualified Plan Strategy.” In addition to providing a rare unbiased perspective, the site offers nonqualified plan sponsors a number of interactive tools.

The following is a list of topical discussions led by CAPTRUST at industry events in the fourth quarter.

One highlight of the website is the Benchmark My Plan feature, an interactive tool that allows nonqualified plan sponsors to see how their plan stacks up against others. Built using a combination of CAPTRUST proprietary and non-proprietary databases, this tool provides valuable insight not easily available elsewhere.

The website also offers the NQIQuiz, a test to gauge a plan sponsor’s knowledge of nonqualified plans, and a Plan Review tool that allows plan sponsors to upload plan-related documents and receive a complimentary nonqualified plan due diligence review.

UNDERSTANDING THE FIVE COMPONENTS OF A SUCCESSFUL NONQUALIFIED DEFERRED COMPENSATION PLAN October 3, 2012 | Portland, ME (Cumberland Club) October 10, 2012 | Chicago, IL (University Club of Chicago) October 11, 2012 | Des Moines, IA (Sheraton West Des Moines) November 28, 2012 | Washington, D.C. (National Press Club) Presented by Mike Curran, SVP, CAPTRUST Nonqualified Executive Benefits “ASK THE EXPERTS” WORKSHOP October 2, 2012 | Atlanta, GA Southern Employee Benefits Conference Presented by Vic Bell, SVP, CAPTRUST Financial Advisor FIDUCIARY OVERVIEW November 12, 2012 | Troy, NY (Emma Willard School) Association of Business Officers of Private Schools (ABOPS) Presented by Patrick Marlatt, VP, CAPTRUST Financial Advisor, and Phyllis Klein, Senior Director, CAPTRUST Consulting Research Group

CONGRATULATIONS FirstEnergy Repeats Honor of Top Utility for Economic Development For the ninth time in the past 11 years, Site Selection magazine has named FirstEnergy Corp. one of the top utilities in the country for promoting economic development. FirstEnergy is a diversified energy company dedicated to safety, reliability, and operational excellence. In 2011, the company helped attract more than $1.7 billion in capital investment to its Ohio, Pennsylvania, New Jersey, West Virginia, and Maryland service areas that is expected to create more than 7,400 new jobs.

GIVING BACK CAPTRUST continued its charitable efforts this past quarter through the CAPCommunity Foundation’s involvement with the following organizations and causes: • North Carolina Food Bank • The Salvation Army • Raleigh Rescue Mission • 519 Heart Haiti • Ronald McDonald House • Variety—The Children’s Charity • JOA, Inc.

The designation recognizes utility companies that complement reliable power delivery to their customers with a hands-on approach to encouraging business development in their operational areas. Using 2011 data, the award is based on a mix of objective and subjective criteria, including what the utility does to help create jobs and facilitate investment in its area, available website tools and data that can be used to help business development, and survey input from corporate end users and site consultants.

24

WWW.CAPTRUSTADVISORS.COM

• Habitat for Humanity of Summit County • Jonathan Brookins Memorial Scholarship • Special Olympics NC • Foundation of Hope • Super Cooper’s Little Red Wagon