1 Historical Perspective While investments recovered nicely in - - PDF document

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Rescue Strategies for Defined Benefit Plans

Presented by:

Chip Hunt, AIF Tom Bowler, QPFC, AIF Principal Chief Investment Strategist

(864) 627-4015 (864) 213-4015

chunt@primetrustadvisors.com tbowler@primetrustadvisors.com

Challenges for Pension Plans

• Pension plans are underfunded
• Asset values are down
• Liability values are up
• PPA 2006 changes in plan funding rules
• FAS changes in accounting rules
• “At-Risk” Status
• Traditional investment solutions may pose

unexpected risks to the Plan Sponsor Opportunities for Advisors

• The need is urgent!
• The impact is significant!
• CFOs need competent advisors
• Separate yourself from the crowd
• Manage the entire process
• “Value-added” service equals “value-added”

fees to your firm

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Historical Perspective

Data provided by Ryan Labs While investments recovered nicely in 2009, increases in pension liability values dampened the anticipated improvement in funded status for most plans.

Contributions on the Rise

Since the “tech bubble” pension contributions have increased and are on the rise again in the aftermath of the 2008 global economic crisis.

Time to Re-evaluate

Pension portfolios’ allocation to equities are reducing… accidentally or otherwise.

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Source: Mercer Human Resource Consulting

Source of US Pension Funding Volatility

Risk Budgeting Sources

• Keeping it real
• There are no silver bullets
• Closing the funding gap…
• Evaluating the trade-off between growth through

increased contributions or investment returns

• Negative leverage has to factor into the decision

Defining the Central Issues Impact of Negative Leverage

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Defining the Central Issues

• Cash flow impact
• Financial statements

– Balance Sheet – Income Statement – Shareholder equity

• Existing debt covenants

The issues can not be defined in isolation! They must be defined in terms of the financial impact upon the plan sponsor

Corporate Finance Approach 1. Emergence of the CFA 2. Integrate ALM and LDI results into financial statements 3. Identify key pension metrics as they relate to financial statements 4. Size does matter 5. Separate yourself from the crowd 6. Manage the process

Today: Plan 100% Funded Future: Plan 75% Funded Today: Plan 100% Funded Future: Plan 75% Funded Current Liabilities 1,900 $ 1,900 $ 190 $ 190 $ Liabilities for pension benefits

• 500
• 500

Deferred income taxes 800 600 80

• 120

Other long-term liabilities 16,750 16,750 1675 1675 Total liabilities 19,450 $ 19,750 $ 1,945 $ 2,245 $ Common Stock 1,500 $ 1,500 $ 150 $ 150 $ Retained earnings 14,500 14,500 1450 1450 Accumulated Other Comprehensive Income 7,250 6,950 725 425 Total shareholders' equity 23,250 $ 22,950 $ 2,325 $ 2,025 $ Total liabilities and shareholders' equity 42,700 $ 42,700 $ 4,270 $ 4,270 $ Reduction in shareholder equity

• 1.30%
• 13.00%

Financial Leverage Ratio 1.84% 1.86% 1.84% 2.11% Company A Company B

The impact of a drop on plan funded status on the sponsoring company’s balance sheet

Corporate Finance Approach Size Matters

Source: Vanguard Investment Counseling & Research

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Source: Vanguard Investment Counseling & Research

Metric Description Purpose

Balance Sheet Probability of pension deficit exceeding threshold For any given investment policy and/or funding policy, the probability that the deficit will exceed a level acceptable to the Plan Sponsor Access the downside risk of Balance Sheet vulnerability Expected downside impact to Shareholder Equity An estimate of expected downside changes in the plan's funded status and how these affect company estimates of shareholder equity Measure shareholder equity at risk Income Statement Expected downside impact on

• perating income

Estimates of downside changes in pension earnings and how these affect company estimates

• f operating income

Measure operating earnings at risk Standard deviation of pension expense Varibility of pension expense, measured as dispersion from the mean Assess the potential impact on earnings volatility Mixed Ratios Return on Assets (ROA) An estimate of change in pension expense or funding status and its influence on company ROA Assess potential impact on a company's profitability ratio Other Contributions & corporate cash flow Estimates of expected and downside contribution requirements and the potential impact on company cash flow Measure risk to company cash flow Expected and downside impact on planned capital expenditures Estimates of expected and downside contribution requirements and the potential impact on plans for projects Assess impact on capital budgeting

Key Metrics Corporate Finance Approach 1. Identify Plan Goals & Objectives 2. Establish finance risk control parameters 3. Perform asset-liability modeling (ALM) 4. Model impact of alternative funding policies 5. Integrate the results into financial statements 6. Choose the scenario best meeting company’s risk tolerance Corporate Finance Approach The Process 7. Establish Investment Policy 8. Establish Funding Policy 9. Measure, evaluate and monitor results

• 10. Make tactical adjustments, as necessary

Corporate Finance Approach The Process

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A Case Study The Goal Get the Plan fully funded! The company wants to terminate the plan and distribute benefits to the participants as soon as practical.

• US manufacturing company; subsidiary of European parent

company

• US pension deficit big concern for balance sheet impact
• Frozen pension plan
• Plan Assets as of 12-31-08: $47,539,000
• Plan Liabilities as of 12-31-08: $73,048,000
• Balance sheet funded status: - $25,509,000
• Target allocation as of 12-31-08: 65% LDI and 35% Equities
• Duration of plan liabilities: approx. 11.7
• Min. Req. Cont. for 2008: $2,064,000
• Min. Req. Cont. for 2009: $4,000,000

A Case Study The Facts A Case Study

• CFO is focused on pension funding deficit on the

balance sheet (IAS 19)

• Highly leveraged company very sensitive to

impact of additional liabilities hitting the balance sheet

• Focus of the ALM, Investments and funding

policy on variability of pension deficit

• Very little tolerance for downside pension deficit

results

• European CFO predisposed to 100%

Government Bond portfolio

Risk Parameters

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1. 65% LDI and 35% equities 2. 75% LDI and 25% equities 3. 85% LDI and 15% equities 4. 100% LDI A Case Study The ALM Study focused on the results expected from 4 Asset Allocation Models…

ALM Study

• Sampled Investment Mixes -

1. Minimum Required Contribution (approx $4 mil) 2. Minimum Required Contribution, plus $1 million 3. Minimum Required Contribution, plus $1 million, plus one-time addt’l $5 million in 2009 4. $ 6 million annually A Case Study And the ALM Study focused on the results expected from 4 alternative funding policies as an

• verlay to the investment policies…

ALM Study

• Sampled Funding Policies -
• 30,000,000
• 20,000,000
• 10,000,000

10,000,000 20,000,000 30,000,000 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 5th - 25th 25th - 50th 50th-75th 75th-95th

Balance Sheet Funded Status

Bars Left to Right Increase LDI Allocation: 65% (Leftmost), 75%, 85% and 100% (Rightmost) 21

Funding: Minimum Contribution

IAS 19 Balance Sheet Liability is eliminated Funded Status in not achieved

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• 30,000,000
• 20,000,000
• 10,000,000

10,000,000 20,000,000 30,000,000 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 5th - 25th 25th - 50th 50th-75th 75th-95th

Balance Sheet Funded Status

Bars Left to Right Increase LDI Allocation: 65% (Leftmost), 75%, 85% and 100% (Rightmost) 22

Funding: Minimum + $1 Million

IAS 19 Balance Sheet Liability is eliminated

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Observations

• Investment mixes with more than 35% equities

violate the company’s balance sheet liability threshold

• 100% LDI strategy never reaches fully funded

status without increased contributions

• Contributions above MRC in combination with a

25% - 35% equity portfolio appear most efficient within the company’s tolerance bands

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Conclusions

• The Board approved the 35% equity portfolio

and is evaluating the level of additional contributions

• The recommendation is MRC plus $1 mil

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Monitoring the Results IPS Scorecard

“” indicates IPS criteria have been met. “” indicates that IPS criteria have not been met. “-” indicates that data or IPS criteria are not applicable. Total Plan Performance Performance Risk-Adjusted Risk Investment Organization Investment Performance Discipline Issues Management Fees Simpsonville Pension Plan

• Washougal Pension Plan
• Fixed Income

Ryan Labs Simpsonville

• Ryan Labs Washougal
• US Equity

Eaton Vance Lg Cap Val

• Vanguard Index 500
• Aletheia Growth
• Columbia Marsico 21st Cent
• Rainier Small Mid
• Keeley Small Cap Value
• Real Estate

Cohen & Steers Realty

• Non-US Equity

Dodge & Cox Intern'l

• Artisan International
• Absolute returns, Alpha, Beta, R-squared, or the Net Expense ratio highlighted in red represent values not in line with Investment Policy Statement (IPS) criteria. Absolute returns for the three-

month or year-to-date periods highlighted in red lag their benchmark indexes by more than the threshold allowed for a one-year period as stated in the IPS. Category ranks highlighted in red indicate a fourth quartile ranking and category ranks highlighted in orange indicate a third quartile ranking. Total Plan Performance Alpha Beta R-Sq Net Exp YTD 3 Mo 1 Yr 3 Yr 5 Yr 3 Yr 3 Yr 3 Yr Average Longest Ratio (1) Simpsonville Pension Plan (4) 6.08%

• 0.12%

6.08%

• 2.81%

1.02 96.09%

• Simpsonville Blended Index (2)

0.48% 0.27% 0.48%

• Washougal Pension Plan (4)

8.38% 1.07% 8.38%

• 1.71%

1.01 97.26%

• Washougal Blended Index (3)

2.46%

• 0.20%

2.46%

• Fixed Income

Ryan Labs Simpsonville (4)

• 8.40%
• 4.00%
• 8.40%
• 2.09%

0.93 92.75% 16.0 16.0 0.26% Ryan Labs Simpsonville Index

• 13.62%
• 3.03%
• 13.62%
• Cat: Long Government / Corporate (4)

3.91%

• 2.07%

3.91%

• 0.44%

0.57 58.10% 3.2

• 0.67%

Ryan Labs Washougal (4)

• 5.76%
• 2.46%
• 5.76%
• 1.98%

0.94 95.04% 16.0 16.0 0.26% Ryan Labs Washougal Index

• 10.52%
• 3.82%
• 10.52%
• Cat: Long Government / Corporate (4)

3.91%

• 2.07%

3.91%

• 0.02%

0.69 61.90% 3.2

• 0.67%

US Equity Eaton Vance Lg Cap Val 17.01% 5.54% 17.01%

• 5.52%

2.24% 2.12% 0.88 94.87% 2.5 10.0 0.75% Category Percentile Rank 85 29 85 25 12 Idx: Russell 1000 Value TR 19.69% 4.22% 19.69%

• 8.96%
• 0.25%
• Cat: Large Value

24.13% 4.83% 24.13%

• 7.32%

0.02% 1.04% 0.95 95.44% 5.4

• 0.94%

Vanguard Index 500 26.61% 6.06% 26.61%

• 5.58%

0.40% 0.05% 1.00 100.00% 4.7 4.7 0.09% Category Percentile Rank 52 26 52 49 49 Idx: S&P 500 TR 26.46% 6.04% 26.46%

• 5.63%

0.42%

• Cat: Large Blend

28.17% 5.49% 28.17%

• 5.53%

0.46%

• 0.06%

1.00 96.63% 5.0

• 0.93%

Aletheia Growth (5) 33.88% 1.68% 33.88%

• 3.84%

7.14% 0.17% 1.20 80.84% 12.0 12.0 1.00% Idx: Russell 1000 Growth TR 37.21% 7.94% 37.21%

• 1.89%

1.63%

• Cat: Large Growth

35.68% 6.68% 35.68%

• 2.89%

1.21%

• 0.84%

1.01 94.50% 5.2

• 1.03%

Columbia Marsico 21st Cent 27.84% 5.71% 27.84%

• 5.18%

1.86%

• 2.22%

1.12 87.09% 6.9 6.9 1.04% Category Percentile Rank 80 72 80 79 33 Idx: Russell 1000 Growth TR 37.21% 7.94% 37.21%

• 1.89%

1.63%

• Cat: Large Growth

35.68% 6.68% 35.68%

• 2.89%

1.21%

• 0.84%

1.01 94.50% 5.2

• 1.03%

Annualized Returns / Category Ranking Manager Tenure

Monitoring the Results

Investment Performance

Monitoring the Results

Investment Performance

Absolute returns, Alpha, Beta, R-squared, or the Net Expense ratio highlighted in red represent values not in line with Investment Policy Statement (IPS) criteria. Absolute returns for the three- month or year-to-date periods highlighted in red lag their benchmark indexes by more than the threshold allowed for a one-year period as stated in the IPS. Category ranks highlighted in red indicate a fourth quartile ranking and category ranks highlighted in orange indicate a third quartile ranking. US Equity Alpha Beta R-Sq Net Exp YTD 3 Mo 1 Yr 3 Yr 5 Yr 3 Yr 3 Yr 3 Yr Average Longest Ratio (1) Rainier Small Mid 30.19% 6.11% 30.19%

• 6.65%

1.96%

• 3.11%

1.03 95.15% 9.5 15.7 0.91% Category Percentile Rank (6) 80 41 80 83 51 Idx: Russell 2500 Growth TR 41.66% 5.57% 41.66%

• 3.13%

2.00%

• Cat: Small / Mid Growth

36.60% 5.20% 36.60%

• 3.53%

1.48%

• 1.32%

0.93 92.97% 4.9

• 1.22%

Keeley Small Cap Value 21.67% 3.85% 21.67%

• 7.95%

1.61%

• 0.47%

1.07 86.39% 16.3 16.3 1.11% Category Percentile Rank 88 70 88 70 35 Idx: Russell 2000 TR 27.17% 3.88% 27.17%

• 6.07%

0.51%

• Cat: Small Blend

31.80% 4.64% 31.80%

• 6.11%

0.47%

• 0.16%

0.97 95.70% 5.2

• 1.15%

Real Estate Cohen & Steers Realty 32.50% 8.92% 32.50%

• 11.11%

2.05% 1.14% 0.93 99.31% 10.7 18.5 1.00% Category Percentile Rank 21 51 21 13 7 Idx: DJ Wilshire REIT TR 28.46% 9.18% 28.46%

• 13.65%
• 0.07%
• Cat: Real Estate

31.26% 8.76% 31.26%

• 13.42%
• 0.81%
• 0.52%

0.94 99.02% 6.0

• 1.16%

Non-US Equity Dodge & Cox Intern'l 47.46% 2.13% 47.46%

• 4.24%

5.59% 4.68% 1.09 96.72% 6.5 8.7 0.64% Category Percentile Rank 6 29 6 19 6 Idx: MSCI EAFE Value NR USD 34.23% 0.28% 34.23%

• 7.35%

3.36%

• Cat: Foreign Large Value

30.33% 1.42% 30.33%

• 6.62%

2.91% 0.73% 0.95 95.29% 4.7

• 1.12%

Artisan International 39.78% 3.72% 39.78%

• 3.90%

5.32% 2.45% 1.13 95.05% 14.0 14.0 1.22% Category Percentile Rank 30 74 30 36 31 Idx: MSCI EAFE Growth NR 29.36% 4.17% 29.36%

• 4.78%

3.65%

• Cat: Foreign Large Growth

38.02% 4.48% 38.02%

• 4.93%

4.25% 0.99% 1.09 95.12% 4.8

• 1.23%

Annualized Returns / Category Ranking Manager Tenure

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Funded Status Monitoring the Results

* Asset values based on Trust Statements as of December 31, 2009 2008 2009 2010 (Q1) Discount Rate 6.20% 5.80% 5.85% Simpsonville Assets 37,221,867 $ 37,227,052 $ 38,093,336 $ Liabilities 55,971,694 $ 59,473,505 $ 58,685,754 $ Funded Status (18,749,827) $ (22,246,453) $ (20,592,418) $ Funded % 66.50% 62.59% 64.91% Washougal Assets 10,316,852 $ 10,552,595 $ 10,828,904 $ Liabilities 17,075,777 $ 16,800,673 $ 16,459,848 $ Funded Status (6,758,925) $ (6,248,078) $ (5,630,944) $ Funded % 60.42% 62.81% 65.79% Combined Plans Assets 47,538,719 $ 47,779,647 $ 48,922,240 $ Liabilities 73,047,471 $ 76,274,178 $ 75,145,602 $ Funded Status (25,508,752) $ (28,494,531) $ (26,223,362) $ Funded % 65.08% 62.64% 65.10% Pension Plan Funded Status Sources of Funded Status Change for the Quarter $1,142,593 $(1,128,576) $2,271,169 $(1,500,000) $(1,000,000) $(500,000) $- $500,000 $1,000,000 $1,500,000 $2,000,000 $2,500,000 Change in Assets Change in Liabilities Change in Funded Status

Time a Tactical Shift?

Measuring Interest Rate Risk

Time a Tactical Shift?

Conventional thinking holds that plans may be over-hedged and an active interest rate bet could result in an improved funded status