billclark Dec 0704

TWO YEARS AFTER 9/11/01

IMPACT ON INSTITUTIONAL PLANS “RETHINKING THE PARADIGM" Bill Clark Deputy Director NJ Division of Investment

This Just About Sums It Up……

NJ Public Pension Plan Assets 6/30/01

6/30/03

Difference

$35,116

$29,346

$-5,770

International Equity

10,139

9,176

-963

Total Equity

45,255

38,522

-6,733

Fixed Income

23,796

20,018

-3,778

3,376

3,698

322

$72,427

$62,238

$-10,189

Domestic Equity

Cash Total

State Pension Plan Funding Is A Widespread Issue Financial Overview of State Retirement Systems ($ billions) 2000

2001

2002

$1,893

$1,917

$1,797

1,648

1,805

1,977

Difference

$245

$112

$(180)

Funding Ratio

115%

106%

91%

31%

51%

79%

Total Pension Assets Total Pension Liabilities

Underfunded Plans as % of all Plans Source: Wilshire Associates, Inc.

Corporate Plans Face Similar Funding Shortfalls Summary of S&P 500 Defined Benefit Plan Funding $300

40%

$200

30% 20%

$100

10%

$ Amt Over/Under Funded (billions)

0%

% Over/Under Funded

$0 -$100

-10%

-$200

-20%

-$300

-30% 95

96

97

98

99

00

01

02

Source: Lehman Brothers

According to the PBGC, total underfunding of single-employer defined benefit plans was over $400 billion as of December 31, 2002

Change In Funding Status Is Attributable to the Asset Allocation of Defined Benefit Plans Asset Allocation 12/31/02 Corporate Plans

Public Plans

2% 6%

Domestic Equity

4%

4% 4% 1%

International Equity

2% 41%

Domestic Bonds International Bonds

31%

1%

42% 35%

Real Estate/Mortgages 14%

Private Equity/Other Cash

Source: Pension & Investments, Wilshire Associates, Inc.

13%

What Has Led To Current Pension Plan Asset Allocation?  Pension Consulting “Conventional Wisdom” – – – –

Long-dated liabilities minimize need for immunization Focus on realizing equity risk premium (beta over alpha) Primary reliance on public equity/fixed income markets Risk = Volatility of Asset Returns Only

 Other “Structural” Factors – Accounting obscures reality – encourages excessive risktaking – Out-of-Date government regulation

Defined Benefit Pension Plan Participants & Vested Status

Thousands

1979 - 1998 42,000

80%

41,000

70%

40,000

60%

39,000

50%

38,000

40%

37,000

30%

36,000

20%

35,000

10%

34,000

0% 19 7 9

19 8 1

19 8 3

19 8 5

19 8 7

19 8 9

19 9 1

19 9 3

19 9 5

19 9 7

Source: US Department of Labor, Private Pension Plan Bulletin Abstract of 1998 Form 5500 Annual Reports

# Participants % Fully Vested

Volatility of a Typical Pension Portfolio Has Risen to Levels Not Seen Since the 1980s Rolling 3-Year Monthly Returns Volatility 1980 - 2003 4.0 3.5 3.0 2.5

Standard Deviation of Monthly Returns

2.0 1.5 1.0 0.5 Jan-02

Jan-00

Jan-98

Jan-96

Jan-94

Jan-92

Jan-90

Jan-88

Jan-86

Jan-84

Jan-82

Jan-80

0.0

Typical Portfolio: 50% S&P 500 15% MSCI EAFE 30% Lehman Govt/Credit 5% 30-day T-Bills

Why? The Volatility of Domestic Equities Has Increased, Along With the Correlation Between Domestic and International Equities Rolling 3-Year Monthly Volatility and Correlation 1980 - 2003 0.9

6.0

0.8

5.0

0.7 0.6

4.0

0.5

3.0

0.4 0.3

2.0

0.2

1.0

0.1 Jan-02

Jan-00

Jan-98

Jan-96

Jan-94

Jan-92

Jan-90

Jan-88

Jan-86

Jan-84

Jan-82

0.0 Jan-80

0.0

Correlation of Monthly Returns S&P 500 and MSCI EAFE (left)

Standard Deviation of Monthly Returns S&P 500 (right)

The “Black Box” of Pension Accounting Calculation of Pension Income/Expense Service Cost

- Increase in PV of benefits due to additional employment

+ Interest Cost

- Increase in PV of benefits due to passage of time

Assumed Return on Pension Assets

= Pension Income/Expense

- Assumed return on “marketrelated” value of assets

The “Black Box” of Pension Accounting The “Catch 22” of Pension Assumptions S&P 500 Defined Benefit Plan Assumptions 1995 - 2002 10.0 9.0 8.0 Return on Assets

7.0

Discount Rate

6.0 5.0 4.0 95

96

97

98

99

00

01

02

Plans make significant allocations to equities in order to justify a higher assumed investment return – because they desire a strong assumed investment return, they allocate funds to equities.

Source: Lehman Brothers

The “Black Box” of Pension Accounting Even Plan Sponsors Don’t Believe Their Own Assumed Rates of Return Corporate Plan Survey

12.0 10.0 8.0

2002

6.0

2001 4.0 2.0 0.0 Long-Term 90-day Rate-ofTreasury Return Bills Assumption

Actively Managed Bonds

Source: Greenwich Associates

S&P 500 Mean

Equity Real International Estate Equity

Private Equity

Expected Rate of Inflation

The “Black Box” of Pension Accounting What Would True “Market-to-Market” Accounting Look Like?

Hypothetical Pension Asset and Liability Market Value Returns 50

50

40

40

30

30

20

20

10

10

0

0

-10

-10

-20

-20

-30

-30

-40

-40 89 90 91 92 93 94 95 96 97 98 99 00 01 02

Source: Ryan Labs

Assets Return % (left) Liabilities Change % (left) Assets - Liabilities % Return (right)

Out-of-Date Government Regulation  PBGC Premiums - $19 per participant and 90 bp of

underfunding measured on a “current liability” basis  90 bp variable premium applies only if funding is less

than 90% of current liability  Premium not impacted by risk profile of investment

portfolio  Additional funding required only if funding ratio drops

below 90%; required funding not adjusted for creditworthiness of plan sponsor

What Is Causing Pension Plans to Rethink Asset Allocation?  Investor appreciation for the exposure/risks

associated with defined benefit pension plans  Changes in accounting – FRS17

FASB IAS  Potential changes in legislation due to PBGC financial health  Political pressures on Public Funds to stabilize

funding levels

Three Potential Models for Pension Fund Asset Allocation 1)

Immunized Model

2)

“Cutting Edge� Endowment Model

3)

Risk Control Model

Immunized Model Understanding The Underlying Nature of Defined Benefit Pension Liabilities Present Value of Hypothetical $100 Million Projected Benefit Obligation By “Source� of Liability Retirees

15% Terminated Vested

30% 5%

Active Vested Nonvested

20%

Effect of Future Salary Increase on Past Service Future Service

25%

5%

Source: Center for Retirement Research at Boston College

Immunized Model Long-Term Fixed Income Is Most Appropriate For Accumulated Benefits, but Lack of Issuance by U.S. Government and Corporations May Make This Difficult to Implement Composition of Lehman Govt/Credit Index by Maturity 1993 - 2003 33% 31% 29%

1-3 Years

27%

3-5 Years

25%

5-10 Years

23% 21%

Over 10 Years

19% 17%

Source: Lehman Brothers

Jun-03

Dec-02

Jun-02

Dec-01

Jun-01

Dec-00

Jun-00

Dec-99

Jun-99

Dec-98

Jun-98

Dec-97

Jun-97

Dec-96

Jun-96

Dec-95

Jun-95

Dec-94

Jun-94

Dec-93

15%

Immunized Model If Pension Funds Were to Implement This Approach, It Could Flatten the Slope of Yield Curve. It Happened in the UK. US vs UK Government Note/Bond Interest Rates 6/30/03

10.0 8.0 6.0

US

4.0

UK

2.0 0.0 2-YR

5-YR

10-YR

30-YR

Immunized Model Hedging Salary Growth on Future Liabilities  Investors assume equities are highly-correlated with

inflation, but data doesn’t support it (correlation coefficient of –0.15)  Many plans are looking at TIPS and other inflation-

indexed products as a separate asset class  But, lack of issuance and secondary-market liquidity

are a problem

“Cutting Edge� Endowment Model While Most College Endowments Have Asset Allocations Similar to Pension Funds, Several Universities Have Adopted Significantly Different Approaches Endowment Portfolio Asset Allocation June 30, 2002

Harvard

Yale

0%

18%

Absolute Return Foreign Equity *

19% 8% 12% 10%

0% 0% 10% 16%

Domestic Equity

9%

24%

* Includes Emerging Markets

Private Equity Real Assets Fixed Income

21% 26%

Cash TIPS

14% 13%

“Cutting Edge” Endowment Model Such Endowments Have Realized Superior Risk-Adjusted Returns Over the Past Five Years Compared to Pension Funds Total Returns 7/1/97 – 6/30/02 50 40 30

Harvard

20

Yale Median Pension Fund *

10 0 -10 98

99

00

01

Year Ended June 30 * Source: New England Pension Consultants

02

Risk Control Model Pension Funds Are Starting to Hedge Their Equity Exposure as a Means to Reduce Risk. The “Put Spread Collar” Is a Popular Approach Potential Equity Returns Sell Put Sell Call

Buy Put

-25%

-20%

-15%

-10%

-5%

Downside Protection

0%

+5%

+10%

+15%

+20%

Upside Give-Up

+25%

Conclusion  Plan sponsors are in process of reevaluating asset

allocation  Expect increased exposure to fixed income,

alternative asset classes and use of hedging strategies  Shift will impact financial markets  Changes in investor analysis of pension exposure

and PBGC regulation will drive portfolio changes over time