2008 General Meeting Assemblée générale 2008 Toronto, Ontario 2008 General Meeting Assemblée générale 2008 Toronto, Ontario Canadian Institute of Actuaries Canadian Institute of Actuaries L’Institut canadien des actuaires L’Institut canadien des actuaires

Consulting to Closed DB Plans – An Investment Strategy Michel Rhéaume November 13, 2008

2008 General Meeting Assemblée générale General Meeting Assemblée générale 2008 Investment Management in an Asset/Liability Framework Particularities of Closed DB Plans Developing an Investment Strategy Benchmarking and Portfolio Tracking Conclusion Agenda

2008 General Meeting Assemblée générale General Meeting Assemblée générale 2008 Pension assets exist in order to pay future benefits Importance of building a portfolio that tracks the liability growth –High positive correlation between assets and liabilities would be ideal –Investment returns in excess of liability growth are desirable –Risks should be assessed in relation to expected return opportunities On-going pension plans have long investment horizons –Ability to take risk Investment Management in an Asset/Liability Framework

2008 General Meeting Assemblée générale General Meeting Assemblée générale 2008 Depends on ability and willingness to take risk – “Ability” to take risk Funded status Ability to raise contributions Ability to reduce benefits – Willingness to take risk General attitude towards risk Strength of risk beliefs Willingness to deliver bad news to members / Board How Much Risk?

2008 General Meeting Assemblée générale General Meeting Assemblée générale 2008 Pension liabilities may still be very long – Benefit payment obligations extending for 75 years or more Particularities of Closed DB Plans Annual Benefit Payments

2008 General Meeting Assemblée générale General Meeting Assemblée générale 2008 Past and future obligations of closed plans are better known than for on-going plans – Easier to design an adequate investment strategy – Easier to monitor and benchmark against Investment horizon could be short – What is the ultimate goal – Annuitization strategy – Ability and willingness to take risk – Investment losses more difficult to recoup For mature plans, mortality could be a predominant risk – Cannot be hedged through the investment strategy Particularities of Closed DB Plans

2008 General Meeting Assemblée générale General Meeting Assemblée générale 2008 Developing an Investment Strategy Wide range of risk/return tradeoff opportunities – Risk defined as the mismatch between assets and liabilities Cash flow matching with Government of Canada bonds would be a low risk strategy – Difficulties to implement – Potential shortfall in returns Duration matching – Not protected against non parallel shifts in the yield curve Traditional balanced portfolios – Are you exposed to too much risk?

2008 General Meeting Assemblée générale General Meeting Assemblée générale 2008 Developing an Investment Strategy Opportunities for Higher Returns Through Investment Risk Interest Rate Risk – Policy decision to mismatch based on interest-rate decision – Strategic versus tactical decisions – Active management of bond portfolio Credit Risk – High quality corporate bonds – Provincial bonds Illiquidity Risk – Mortgages – Zero coupon/strip bond Equity Risk – High yield equities – Core equities

2008 General Meeting Assemblée générale General Meeting Assemblée générale Obtain estimated benefit and expense cash flows from actuary 2.Discount cash flows using Government of Canada or provincial spot rates to determine market value of liabilities 3.Define the MRP (Minimum Risk Portfolio) for this set of cash flows using Government of Canada and provincial securities 4.Determine client’s risk budget or value-added objective relative to the MRP 5.Add risky assets/strategies to the MRP until the risk budget and/or value-added objective is reached 6.Monitor performance of portfolio relative to liability benchmark to assess the success of the investment strategy and execution Developing an Investment Strategy Six Steps to Portfolio Construction

2008 General Meeting Assemblée générale General Meeting Assemblée générale 2008 Possible MinTarget AllocationMaxComments Significant proportion in provincial bonds Preferably long Provincials Benchmark:Pension Plan liability cash flows Interest rate management: ± 0.5 year of benchmark Value Added Expectation: basis points per year over a cycle Focus on shorter-term issues Minimum A or BBB-rating Focus on shorter-term issues Attractive yield advantage Potential Portfolio Structure Government Bonds Corporate Bonds Mortgages

2008 General Meeting Assemblée générale General Meeting Assemblée générale 2008 Benchmarking and Portfolio Tracking Presumably annuitization is the end objective for most plans – Asymmetric risks for plan sponsors – Mortality risk Pension assets should be compared to actuarial liabilities – Absolute rates of return are irrelevant – Returns vs broad market indices are secondary Ideal scenario is to benchmark against cost of buying annuities – Custom liability benchmark – Asset/liability ratio

2008 General Meeting Assemblée générale General Meeting Assemblée générale 2008 Cash flow mismatch (Yield curve & duration) 2-13 Yield Advantage & Spread Change from: Corporate Bonds517 Mortgage512 Government Bonds1538 Total Investment Strategies Three MthsOne Yr Value added relative to the customized benchmark in basis points basis points Performance Monitoring Attribution Analysis - Example

2008 General Meeting Assemblée générale General Meeting Assemblée générale 2008 Annuitization Benefit of establishing a relationship with one or several annuity providers – Understanding pricing – Ability to transfer securities in kind – Composition of appropriate benchmark – Faster implementation

2008 General Meeting Assemblée générale General Meeting Assemblée générale 2008 Conclusion Closed DB plans are facing many similar factors as on-going plans Investment horizon is likely very shorter As active members disappear, the economic objective becomes more obvious Annuitization should be the end result