1. 2006 General Meeting Assemblée générale 2006 Chicago, Illinois 2006 General Meeting Assemblée générale 2006 Chicago, Illinois Canadian Institute of Actuaries Canadian Institute of Actuaries L’Institut canadien des actuaires L’Institut canadien des actuaires

2. 2006 General Meeting Assemblée générale 2006 2006 General Meeting Assemblée générale 2006 PD-3 Assumption Setting For Pension Plans What is a Reasonable Going Concern Discount Rate? Bill Watson Mercer Human Resource Consulting

3. 2006 General Meeting Assemblée générale 2006 2006 General Meeting Assemblée générale 2006 3 Assumption Setting For Pension Plans: What is Reasonable? Current challenges Mercer’s process for setting reasonable assumptions – Going-concern – Expected Return on Assets under CICA Wrap-up

4. 2006 General Meeting Assemblée générale 2006 2006 General Meeting Assemblée générale 2006 4 Current Challenges Pension costs matter Plans have matured Aging workforce and an increase in retiree liabilities Now a significant part of a corporation’s financial statements/cashflow requirements Relative to the size of the active operations Sharp rise in costs in recent years due to decreasing interest rates Increased volatility

5. 2006 General Meeting Assemblée générale 2006 2006 General Meeting Assemblée générale 2006 5 Current Challenges Heightened Scrutiny Plan sponsor Pension and corporate governance Finance area Auditors Regulators Business community

6. 2006 General Meeting Assemblée générale 2006 2006 General Meeting Assemblée générale 2006 6 Current Challenges Increased litigation Class actions Court decisions Fiduciary concerns What is the role of the actuary?

7. 2006 General Meeting Assemblée générale 2006 2006 General Meeting Assemblée générale 2006 7 5.72% 5.45% 5.15% 4.69% 4.22% Long Canada Benchmark Bonds 3% 4% 5% 6% 7% 20022003200420052006 January 1 st 6.78% 6.65%6.51% Going Concern Discount Rate (FSCO Stats) 6.84% Current Challenges Lower Bond Yields = 1.8% 1.1%=

8. 2006 General Meeting Assemblée générale 2006 2006 General Meeting Assemblée générale 2006 8 Current Challenges Financial Pressure + Heightened Scrutiny + Increased Litigation + Lower bond yields Actuaries must be able to justify their assumptions = Challenging Environment for Pension Actuaries

9. 2006 General Meeting Assemblée générale 2006 2006 General Meeting Assemblée générale 2006 9 Setting Reasonable Assumptions Going Concern Discount Rate What rate of return can we reasonably expect the pension fund to earn over the long-term? – Not a prediction – But as much as possible, a reading of the market

10. 2006 General Meeting Assemblée générale 2006 2006 General Meeting Assemblée générale 2006 10 Setting Reasonable Assumptions Going Concern Discount Rate Historically, the typical approach for a Mercer actuary was: Stable long term economic views – Based largely on empirical evidence Little emphasis placed on market rates

11. 2006 General Meeting Assemblée générale 2006 2006 General Meeting Assemblée générale 2006 11 Setting Reasonable Assumptions Going Concern Discount Rate Mercer’s current approach Provide actuaries with a market based model to assist in determining the going concern discount rate The actuary must assess the appropriateness of the assumptions for each valuation in the context of the particular case and the prevailing economic environment

12. 2006 General Meeting Assemblée générale 2006 2006 General Meeting Assemblée générale 2006 12 Setting Reasonable Assumptions Going Concern Discount Rate First Step: Establish long-term expected return for each asset class Bonds – Based on current market yields in effect on valuation date – Split by Universe, Long and Real Return Bonds

13. 2006 General Meeting Assemblée générale 2006 2006 General Meeting Assemblée générale 2006 13 Equities – Long bond yields plus equity risk premium – Equity risk premium considers expected GDP, dividend yield, growth in corporate earnings Model provides 3 equity risk premium scenarios Combine expected returns based on target policy mix Setting Reasonable Assumptions Going Concern Discount Rate

14. 2006 General Meeting Assemblée générale 2006 2006 General Meeting Assemblée générale 2006 14 Adjustments to expected return Provision for active management – Based on portion of fund that is actively managed Provision for expenses – Expenses charged to the fund not already explicitly included in the current service cost Setting Reasonable Assumptions Going Concern Discount Rate

15. 2006 General Meeting Assemblée générale 2006 2006 General Meeting Assemblée générale 2006 15 Adjustments to expected return Margin for adverse deviations – Based on portion of fund that is invested in equities and underlying equity risk premium – Consider any margins (positive or negative) inherent in other actuarial assumptions Setting Reasonable Assumptions Going Concern Discount Rate

16. 2006 General Meeting Assemblée générale 2006 2006 General Meeting Assemblée générale 2006 16 An example, Expected Return 6.98% Active Management 0.30% Expenses(0.50%) Margin for adverse deviation(0.68%) Going Concern Discount Rate 6.10% Setting Reasonable Assumptions Going Concern Discount Rate

17. 2006 General Meeting Assemblée générale 2006 2006 General Meeting Assemblée générale 2006 17 Setting Reasonable Assumptions Other Going Concern Assumptions Other assumptions Economic assumptions (inflation, YMPE, salary scale) – Based on market yields Demographic assumptions – Best estimate approach – Future mortality improvements Otherwise, further adjustments to the margin in the discount rate

18. 2006 General Meeting Assemblée générale 2006 2006 General Meeting Assemblée générale 2006 18 Setting Reasonable Assumptions Expected Return on Assets (CICA) Actuaries often asked to provide input on accounting assumptions including the Expected Return on Assets (EROA) Same approach as setting the going concern discount rate No margin for adverse deviations since it is a best estimate assumption

19. 2006 General Meeting Assemblée générale 2006 2006 General Meeting Assemblée générale 2006 19 5.72% 5.45% 5.15% 4.69% 4.22% Long Canada Benchmark Bonds 3% 4% 5% 6% 7% 20022003200420052006 January 1 st 6.78% 6.65%6.51% Going Concern Discount Rate (FSCO Stats) 6.84% Setting Reasonable Assumptions = 1.8% 1.1%= Is 6.5% still reasonable for a plan that is invested 40% bonds and 60% equities?

20. 2006 General Meeting Assemblée générale 2006 2006 General Meeting Assemblée générale 2006 20 Let’s assume, Discount rate is before expenses Margins for adverse deviation = 0.5% Yield on universe bonds = 4.6% Roughly speaking, Implies equity return of 8.6% [ (6.50% + 0.50%) - (40% times 4.6%) ]/ 60% Implies an equity risk premium of 4.4% (Assuming government bonds are 4.2%) Setting Reasonable Assumptions

21. 2006 General Meeting Assemblée générale 2006 2006 General Meeting Assemblée générale 2006 21 Wrap-up Challenging times for pension actuaries Actuaries must be able to justify their assumptions Leads to assumptions that are largely driven by observed market conditions Setting Reasonable Assumptions