Annual Meeting ● Assemblée annuelle 2009 Halifax, Nova Scotia ● Halifax (Nouvelle-Écosse) 2009 Annual Meeting ● Assemblée annuelle 2009 Halifax, Nova Scotia ● Halifax (Nouvelle-Écosse) Canadian Institute of Actuaries Canadian Institute of Actuaries L’Institut canadien des actuaires L’Institut canadien des actuaires

2 Can Pension Plans fit in an ERM framework? WS-24 Thursday June 25, 2:15PM André Choquet, FCIA, FSA Minaz Lalani, FCIA, FSA, CERA Enterprise Risk Management Applications Committee of the CIA

3 1.Review of Enterprise Risk Management (ERM) and ERM models 2.Pension Risk Management 3.Future of DB market 4.How can the pension plan be managed in an ERM model? 5.Case Study and discussion Today's discussion

4 Risk Management –Business discipline to protect assets and profits by reducing loss potential, mitigate impact or execute recovery after a loss –Involves risk identification, measurement, evaluation, reduction or elimination of exposures, risk reporting, risk transfer and/or loss financing –All organizations practice risk management Threat of damage to assets Use of hedging or derivative contracts to mitigate financial exposures 1-Risk Management versus Enterprise Risk Management

5 Enterprise Risk Management –Broadens the Risk Management scope to all significant business risks of the organization and it deals with risks comprehensively and systematically Strategic, human capital, operational, financial, hazard, demographic, etc –Manages risks and seizes opportunities to reduce uncertainty and achieve organizational objectives Risk Management versus Enterprise Risk Management

6 Generic Establish Goals Identify Quantify Solve Execute Communicate Monitor AS/NZ2 Establish Context Identify Analyze Evaluate Treat Communicate Monitor COSO Objective Setting Event Identification Risk Assessment Risk Response Control Activities Information / Communications Monitoring Integrated/Enterprise Risk Management Framework

7 Governance: Structure and reporting relationships Accountability: Roles and responsibilities Organization Scope of risks Risk assessment approach Key risks/controls/gaps Risk measurement and methodology Tools Risks and Processes Monitoring, Reporting, Managing Tools Goals and objectives Risk appetite Risk policy and guidelines Risk Strategy Source : Towers Perrin ERM Framework – All Companies

8 Governance: Pension Committee / Board of Trustees, HR Committee, Board Governance process and stakeholder roles and responsibilities Organization Identifying pension risks Evaluating and prioritizing risks at enterprise level Managing and measuring risk Risks and Processes Monitoring, Reporting, Managing Tools Plan Sponsor Philosophy and Goals Statement of Investment Beliefs Pension Objectives Statement of Investment Policy and Goals Funding Policy Risk tolerance, appetite and guidelines Risk Strategy ERM Framework Applied to Pension Plan

9 Financial Risks –Credit, liquidity, insurance, interest rates, equity prices, commodity prices and currency Strategic Risks –Risk of choosing strategic alternatives that do not generate the best return for the level of risk undertaken, risk of poorly executed strategies. Operational Risks –Risks of failure due to inadequate processes (e.g., business interruptions), and systems (e.g., technology), and people (e.g., fraud, accidents) Legal and Regulatory Risks –Risk of failing to satisfy regulatory compliance, changes in legal environment, ethics or code of conduct. Reputation Risks –Actions or events that can potentially damage or improve the standing or value of an organization in the eyes of third parties Hazard Risks –Insurable risks resulting from a general course of doing business (e.g., fire) not covered above. Main Sources of Enterprise Risk Source ERMAC booklet "ERM, should you be doing it?"

10 Identification Measurement Management DC risks: how do they differ? 2-Pension Risk Management

Longevity Demographic Salary Inflation Interest rate/ Inflation Actuarial cost method Design risk Surplus/Deficit asymmetry Indexation Funding Contributions + + = LiabilitiesDesign Structure E&O IT Administration Fiduciary liability Compliance Data Fees Liquidity Beta & Alpha Credit Interest rate/ inflation Currency Liability mismatch Assets Governance Financial RisksOperational Risks Pension Equation Investment Return Benefits Administrative Expenses (Governance) © 2009 Aon Consulting Inc. This slide contains information protected by copyrights owned by Aon Consulting Inc. No part of this slide may be disclosed to any third party or reproduced by any means without the prior written consent of Aon Consulting Inc.

How risk was viewed traditionally : Asset based © 2009 Aon Consulting Inc. This slide contains information protected by copyrights owned by Aon Consulting Inc. No part of this slide may be disclosed to any third party or reproduced by any means without the prior written consent of Aon Consulting Inc.

An integrated view of risk is needed (Asset and Liabilities) © 2009 Aon Consulting Inc. This slide contains information protected by copyrights owned by Aon Consulting Inc. No part of this slide may be disclosed to any third party or reproduced by any means without the prior written consent of Aon Consulting Inc.

14 Quantitative Tools (for Funding, Investment, Design Risks) –Standard deviation, correlation, regression –Stochastic Modeling of A & L –VaR, CTE Metrics: cash, accounting, funded ratio, contributions etc. –Market pricing (swaps, options, insurance) Qualitative Tools (Governance) –Stress testing –Delphi Studies –Heat Maps –Tree analysis –Scenario analysis –Simulation How are risk measured?

Traditional Asset Mix © 2009 Aon Consulting Inc. This slide contains information protected by copyrights owned by Aon Consulting Inc. No part of this slide may be disclosed to any third party or reproduced by any means without the prior written consent of Aon Consulting Inc.

Optimization Technique 1-Traditional ALM © 2009 Aon Consulting Inc. This slide contains information protected by copyrights owned by Aon Consulting Inc. No part of this slide may be disclosed to any third party or reproduced by any means without the prior written consent of Aon Consulting Inc.

Active management risk (Alpha VaR) Optimization Technique 2 - Risk Budgeting General Conclusions from Risk Budgeting: –High concentration of risk at the Beta level (eg: 80% vs 20% in Alpha) –Alpha activities provide a much better payoff than Beta activities © 2009 Aon Consulting Inc. This slide contains information protected by copyrights owned by Aon Consulting Inc. No part of this slide may be disclosed to any third party or reproduced by any means without the prior written consent of Aon Consulting Inc.

18 Asset only –Asset based benchmarks –Absolute return –Other competing funds Relative to Liability –Cash vs funding, solvency vs going concern Relative to others –Industry sector –Direct competitors –Pension Industry Relative to other Enterprise risks Measurement of performance Challenges of Risk Monitoring

19 DC Plan RisksDescription of Risk DesignRisk of providing less than the intended level of retirement income InvestmentRisk of not achieving desired / target level of investment return InflationRisk due to loss of purchasing power of retirement income LegalRisk of failing to meet explicit, or implied contractual commitments DC Plan Risks

20 DC Plan RisksDescription of Risk LongevityRisk of outliving retirement funds based on standard life expectation MarketRisk exposure to potential fall in asset value, or capital loss OperationalRisk due to inadequate processes, systems or ill-trained people StrategicRisk of failure to meet business objectives DC Plan Risks

21 DC Retirement VaR (Illustrative) Actuarial Perspective: What is the plan sponsor’s downside risk? 5% chance that the “shortfall” (RVaR) will be $1,606 Case Study – The portfolio has 4,500 employees; For each employee, the “shortfall” is the difference of the stochastic average less target account balance. Median= % RVaR = -1,606 1% RVaR = -1,972 5 th Percentile = ($1,606) Each portfolio consists of 4,500 employees (000’s)

22 McKinsey & Company 2006 study "The coming shakeout in the Defined Benefit market" The 5 types of plan sponsor segments The upcoming 3 way race between insurers investment banks and asset managers Future of DB market

Source: McKinsey & Company 5 Key Segments will drive the products and solutions

24 Priorities will vary by plan sponsor segment Source: McKinsey & Company

25 Starting capabilities in the 3-way race Source: McKinsey & Company

26 Process to integrate PRM with ERM Approaches to Management of Pension Plan Risks Pension plan in an economic capital model 4-How can pension plan risks be managed in an ERM framework?

27 1.Define and confirm pension and enterprise risks Key risk domains at enterprise level: Financial, Strategic, Operational, Legal and Regulatory Risks, Reputation, Hazard 2.Consolidate pension risks with other enterprise risks with similar risk characteristics Have a better understanding of exposure and risk correlations Look across risk silos to better evaluate risk / reward profile Process to integrate PRM with ERM

28 Process to integrate PRM with ERM (cont'd) 3.Identify risks that can be effectively and efficiently managed 4.Prioritize risks (opportunities) that the enterprise will exploit, finance, or mitigate Difficult to address all risks – implement incrementally 5.Implement risk strategies to optimize capital 6.Monitor risk polices and control procedures Establish sound governance and robust risk metrics

29 Approaches to Management of Pension Plan Risks 1.Standalone a)Pension plan risks are managed on a silo basis (current practice) b)Pension plan managed as a financial subsidiary / separate entity / enterprise using integrated / ERM framework (best practice – single plan sponsor) 2.Collaborative: Pension risks managed on Standalone basis (b) with coordination of specific risks at the parent enterprise level (emerging practice – single plan sponsor) 3.Integrated: Complete pension risk management at the parent enterprise level ( best and emerging practice – standalone multi- employer plans, investment managers)

30 The approach will depend on: –Form and structure of the Pension Plan ( single employer versus multi-employer) and governance –Size of pension plan relative to enterprise value –Disclosure to stakeholders of pension information on income statement and funded status on balance sheet –Impact of ‘mark to market’ accounting disclosure –Level of funding contributions relative to free cash flow –Impact of pension plan on enterprise earnings –Maturity of pension plan (ratio of active and inactive liabilities) Approaches to Management of Pension Plan Risks

31 Different definitions of Capital at Financial Institutions –Required: Capital to support the business –Regulatory: Capital Required by regulators to support the business –Economic: Capital to ensure that the business is solvent over a prescribed time horizon at a pre-determined likelihood "Capital" for Pension Plans –Surplus / Unfunded : Excess of Assets over Liabilities Going-concern, Solvency, Accounting, Target –Regulatory: 100% funded on going-concern, or solvency –Economic: Account for use of economic principles, variation in economic scenarios, asset performance, liability experience and margins for adverse deviations Pension plan in an economic capital model

32 EC is the capital that the firm needs to ensure that its balance sheet stays solvent over a certain time period with a pre-specified probability (different from regulatory capital) = Net assets on a going concern basis less net assets on a stressed basis Computed for the firm as a whole using VAR method and then allocated to lines of business Pension plan in an economic capital model

33 References ERMAC CIA 2008 ERM booklet "ERM should you be doing it?" m/208070e.pdf McKinsey & Company 2006 Study "The coming shakeout in the Defined Benefit market" s/pdf/coming_shakeout_in_defined_benefit_market.p df Pension Risk Management: Derivatives, Fiduciary Duty and Process by Susan Mangiero survey.pdf