Problem: Pension Crisis Solution: Portable Alpha Ryan ALM, Inc. - The Solutions Company RyanALM

2 Ryan ALM, Inc. The Solutions Company Ryan-ALM Index Returns YTD 2009 Estimated Weights Liabilities : Market (Tsy STRIPS) FAS 158 (AA Corporates) PPA (3 Segment) PPA (Spot Rates) GASB /ASOP (8% ROA) % % Assets : Ryan Cash Lehman Aggregate S&P 500 MSCI EAFE Int’l Asset Allocation Model 0.53 % % % 100 % Assets – Liabilities Market FAS 158 PPA (3 Segment) PPA (Spot Rates) GGASB/ASOP (8% ROA) 38.95% Total Returns Assets Liabilities Difference: Annual Cumulative The Ryan Letter December 2009 (Copyright Ryan ALM, Inc …All Rights Reserved)

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6 Ryan ALM, Inc. The Solutions Company Ryan-ALM Funding Ratio ____________ RatioMarket Value of Assets / MV of Liabilities Requires Custom Liability Index 1990sMost Pensions had Surpluses Didn’t change their Asset Allocation 2000sFunding Ratios eroded by 40% to 60% ProblemFocus on ROA instead of Funding Ratio

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8 Ryan ALM, Inc. The Solutions Company Ryan-ALM Pension Plan Objective ____________________

9 Ryan ALM, Inc. The Solutions Company Ryan-ALM Risk ____ TraditionVolatility of Total Returns Ryan ALM NOT Meeting the Client Objective (Uncertainty) Objective Liability Driven Sharpe Ratio Based on 3 month T-Bill New Ratio Based on Objective (Information Ratio)

10 Ryan ALM, Inc. The Solutions Company Ryan-ALM Risk Management ________________ TraditionReduce Volatility of Total Returns Ryan ALMIncrease Certainity of Meeting Objective Objective = Liability Driven Requires Objective Index Objective IndexCustom Liability Index

11 Ryan ALM, Inc. The Solutions Company Ryan-ALM Problem : Liability Valuation _________________________ Single Discount Rate Not market interest rates (ASOP = ROA, PPA = 2 year weighted average) Present Value calculated annually/triennially (Months delinquent) Liability Term Structure not transparent (Short, Intermediate, Long, Very Long)

12 Ryan ALM, Inc. The Solutions Company Ryan-ALM Problem : Generic Indexes _______________________ Represent the market not client liability schedule Generic Indexes do NOT represent clients’ true objective Client liability schedule is unique to each client (snowflakes) Confucius : Given Wrong Index … Get Wrong Risk/Reward

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16 Asset Allocation ________________ Should be based on “Funding Ratio” (Market Value of Assets / MV of Liabilities) Requires Custom Liability Index to Measure MV of Liabilities Large Deficit = Different Asset Allocation than Small Deficit Should be Dynamic (Tactical) Ryan ALM, Inc. The Solutions Company Ryan-ALM

17 Ryan ALM, Inc. The Solutions Company Ryan-ALM Solution: Contributions ____________________ Enhances Funding Ratio Contributions are a Future Asset Usually pay Liability Benefit Payments CLI will be recalculated to reflect this (Net Liability) Current Assets should fund Net Liabilities

18 Portable Alpha ________________ Transfer (Porting) of Excess Returns above Objective Index from Alpha Portfolio(s) to Beta Portfolio Requires Custom Liability Index = Liability Objective Alpha Portfolio = non-bonds to outgrow Liabilities Beta Portfolio = bonds to match Liabilities Ryan ALM, Inc. The Solutions Company Ryan-ALM

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22 Ryan ALM, Inc. The Solutions Company Ryan-ALM Portable Alpha (Benefits) ___________ As Portable Alpha Transfers Excess Returns above Liability Index Beta Portfolio grows and grows… creating 4 Major Benefits : 1. Reduces Contribution Costs (Fully Funds Liabilities) 2. Reduces Interest Rate Risks (Hedges Liabilities) 3.Increases Funded Ratio (Client Objective) 4.Increases Certainty of Meeting Objective

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24 Asset Allocation ______________ Should be based on “Funding Ratio” and “Time” Deficit / Time (Average Life of Liabilities) = Alpha Needed 30% Deficit / 15 years = 2% per year Larger the Deficit > Requires More Alpha Estimated Alpha = ROA – YTM of Liabilities ROA = 8% YTM = 5% Alpha E = 3% 2% / 3% = 67% allocation to Alpha Ryan ALM, Inc. The Solutions Company Ryan-ALM

25 Ryan ALM 5-year Scenario _______________________________________ Liabilities: Interest Rates go up 30-yr U.S. Treasury = 4.50% >> 8.50% Growth Rate = ( 5.00%) Annual Note: Liabilities behave like long bonds Annual Growth Rate Assets 5% 6% 7% 8% 9% Liabilities - 5% -5% - 5% - 5% - 5% Alpha (Annual) 10% 11% 12% 13% 14% Funding Ratio = 50% > 82% 89% 94% 98% 103% = 60% > 99% 104% 109% 115% 120% Ryan ALM, Inc. The Solutions Company Ryan-ALM

26 Ryan ALM, Inc. The Solutions Company Ryan-ALM Bond Management ________________ Mission Best Value in Bonds = Defeasance Match + Fund Liabilities Chronologically Liability Index Fund (Requires CLI) Benefits Reduces Cost (Contributions) Reduces Risk (Interest Rate Risk) Reduces Volatility of Funded Ratio

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28 Ryan ALM, Inc. The Solutions Company Ryan-ALM PIPER Study of Bond Managers ____________________________ Annual Total Returns (Periods Ending 12/31/08) 5 yrs. 10 yrs. 1 st Quartile 4.67% 5.75% Median 3.84% 5.22% Lehman Aggregate 4.64% 5.63% Median Manager loses to Lehman Aggregate 1 st Quartile loses to Lehman Aggregate (after fees)

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30 Ryan ALM, Inc. The Solutions Company Ryan-ALM Problem: No Alpha in Bonds ________________________ Total Returns (Periods Ending 12/31/09) Indexes 10 yrs. 20 yrs. Lehman Aggregate 6.33% 7.01% Ryan 5-year STRIPS 7.21% 7.57% Difference % % Lehman Agg Duration 5 year Intrinsic Value of any investment = vs. Risk-Free Treasury

31 Ryan ALM, Inc. The Solutions Company Ryan-ALM No Generic Index has same Cash Flow as Clients Liabilities Lehman Aggregate (12/31/06) 1-3 years 24.58% 3-5 years years years years08.96 Lehman Aggregate = 40% in Securitized instruments Cash flow behavior tends to move in wrong direction Rates go up = duration gets longer Cash flow gets reduced Cash Flow ________

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34 Performance Measurement _______________________ Compares Assets vs. Objective Objective = Custom Liability Index Beta Portfolio = Liability Index Fund Alpha Portfolios = Portfolios that Beat Liabilities Requires CLI to Measure Alpha and Manage Beta Portfolio Ryan ALM, Inc. The Solutions Company Ryan-ALM

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