1

Often, unhedged discount rate risk associated with the liabilities’market value is a major source of this surplus volatility. The unhedged risk can lead to low correlations of returns between assets and liabilities. This was the case for the representativepension plan shown in Figure 1, where assets and liabilities hada correlation of only 34% over the period shown.2

Figure 2 illustrates net surplus exposures for a “typical” pension plan. The net exposure to long corporate yields (liability exposure less long fixed income assets) is pronounced. The overall investment portfolio can be summarized as a combination of ‘long’ equities and a substantial ‘short’ position to long bonds.

Special Report

Figure 1: Estimated funding ratio changes for a US corporate pension plan

Figure 2: “Typical” pension plan asset & liability exposures for a plan that is 82% funded

Corresponding net surplus exposures: “Typical” net surplus exposures (illustrative)

42.5%

7.5%

-112%

10% 20%

-102%-120%

-90%

-60%

-30%

0%

30%

60%

Publicequity

Privateequity

Real estate

alternatives

Bondsaggregate

Longrates

Creditspreads

Bonds - aggregate

Bonds long duration

Real estate & alternatives

Public equity

Private equity

Source: Pension & Investments, BlackRock

March 2011

122%

Liability

For use with Institutional and Professional Investors Only - Proprietary and ConfidentialThe opinions expressed are as of 24 March 2011 and may change as subsequent conditions vary.

by Matthew Nili, BlackRock Multi-Asset Client Solutions

Fund

ed ra

tio (A

/L)

Dec

199

6

Dec

199

8

Dec

200

0

Dec

200

2

Dec

200

4

Dec

200

6

Dec

200

8

Dec

201

0

150%140%130%120%110%100%90%80%70%60%

1 Source: BlackRock, “Estimated Funding Ratio Changes for a US Corporate Pension Plan”

2 Using monthly estimates for sample plan asset and liability returns

Capital Efficiency Matters

“Pension plan funded ratios have rebounded from the depths of thefinancial crisis, yet most plans remain considerably underfunded.”

Dual-beta strategies can help solve the lower risk, high return challenge faced by many defined benefit plan sponsors

IntroductionMany pension plan sponsors struggle with conflicting objectives.These sponsors wish to invest in return-seeking assets (e.g. equities) to improve their plans’ funded position. They also wish to invest in liability-matching assets (e.g. long duration fixed income) to reduce surplus risk. A finite capital pool, often exacerbated by a low funded position, makes it challenging to achieve these dual objectives. Synthetic instruments, however, provide an opportunity to gain capital efficiency, allowing plansponsors to alleviate the conflict and achieve both of the desired exposures. In this paper we discuss plan objectives and the importance of considering exposures and capital separately. In addition, we illustrate how a “dual-beta” strategy provides the necessary capital efficiency to help achieve these objectives and discuss certain investment considerations for practical implementation.

The issue: unmet dual objectivesPension plan funded ratios have rebounded from the depths of the financial crisis, yet most plans remain considerably underfunded. Regulatory, reporting, investors, and market pressures have left plan sponsors in a difficult situation. Manysponsors would like to maintain return-seeking assets that they expect should provide incremental return over their plan’s liabilities. They also strive to manage high surplus volatility―theyare all too aware that plan funded ratios fluctuated dramatically over the past decade.1

2

Root causes for the asset-liability mismatch?In short―running the risk of over simplification―pension plan funding and accounting standards of the past essentially encouraged pension plans to consider themselves as asset-only investors. As a result, the natural and somewhat justifiable response from plan sponsors was to build what they considered well diversified total return portfolios, (i.e. the classic 60/40 stock/bond portfolios). While investment theory has evolved, with a growing realization that capital efficiency and alternative assets contribute to diversification of growth portfolios (often referred to as optimal beta or similar), the traditional asset-only approach was both easy to adopt and used broadly by plan sponsors.

Overtime, however, there have been changes to the accounting and pension funding rules governing corporate pension plans. Investors are now focusing much more on the risks and consequences to plan sponsors of changes in pension plan surpluses. The result is that investment risks and risk budgets need to be reappraised. This process will naturally take some time as it requires unlearning past practices and adopting new ones. One of such practices is using leverage to help manage asset-liability portfolios effectively. Leverage is a very useful toolfor many plans and can be vital for certain plans.

Hedging the liability discount rateWe have established that a significant source of risk, in many cases, can be attributed to very low levels of liability discount rate hedging seen in plans. In the United States, corporate bonds tend to drive liability discount rates. This means that there are two components of the liability discount rate to hedge: i) long Treasury interest rates and ii) long credit spreads3. Figure 3 shows the liability hedge ratios for our ”typical” pension plan, as depicted in Figure 2.4

The low interest rate and credit spread hedge ratio implies thatthere is likely to be a negligible sympathetic asset return when a plan’s liability value changes due to market forces. This dynamic represents a key contributor to surplus risk.

Building more efficient asset-liability portfolios-Gaining investment efficiency through capital efficiencyInvestment efficiency (i.e. expected return per unit of surplus risk) can be achieved by improving the liability matching characteristics of the assets. There are many ways in which thiscan potentially be done, all of which seek to extract more out of the same finite pool of assets. We would like to focus on two straightforward portfolio choices that can increase capital efficiency and reduce surplus volatility. These are: i) an interest rate duration extension using a treasury futures overlay (or using a similar substitute), and ii) a hybrid equity and bond investment, which we refer to as “dual-beta.”

i) Extending interest rate durationOur model pension plan could implement an interest rate duration extension via a Treasury futures (or interest rate swap) overlay. This strategy better matches asset and liability exposure to interest rates as shown on the x-axis of Figure 4. As an example, we will assume the interest rate hedge ratio is increased to 70% via a sufficient quantity of Treasury futures.

3 We note that the interest rates of importance here are not short term rates, but instead long term rates, particularly 10 year and over rates. This is because of the very long term nature of pension plan liabilities. This comment also applies to credit spreads. Any reference to credit spreads implicitly refers to high quality corporate credit spreads of terms equal to the liabilities

4 Assumes no credit spread duration from investments other than fixed income spread assets. In reality this is a simplification as there is a reasonable link between equities and credit spreads

0%

20%

40%

60%

80%

100%

0% 20% 40% 60% 80% 100%

Cre

dit s

prea

d he

dge

ratio

Current portfolio

Client liability

Interest rate hedge ratio

Source: BlackRock

0%

20%

40%

60%

80%

100%

0% 20% 40% 60% 80% 100%

Cre

dit s

prea

d he

dge

ratio

Current portfolio

Client liability

Interest rate hedge ratio

Current portfolio +Treasury futures overlay

Source: BlackRock

Figure 3: Interest rate and credit spread hedge ratios

Figure ４: Interest rate and credit spread hedge ratios

In this suggested strategy, the credit spread hedge is not increased because Treasury-based instruments are used to gain additional duration. This overlay, which represents more capitalefficient interest rate exposure, is therefore a major improvement in managing asset-liability risk. However, more can be done to enhance capital efficiency.

3

Figure 6 shows the hedge ratios for the example plan if the planimplemented this dual-beta strategy to achieve the same overall duration as the previously examined “simple” Treasury futures strategy.

The dual-beta allocation provides the desired capital efficiency that improves the pension plan’s exposures to liability hedging assets, without reducing exposure to return-seeking assets (equities). It also scores an improvement over the interest rateoverlay strategy in that it achieves exposure to long physical credit which offers favorable liability matching characteristics.

Benefits of dual-beta strategiesTo illustrate the benefits of capital efficiency contained in this dual-beta approach more broadly, Figure 7 shows two example efficient frontiers. The “Long FI/Equity” frontier (in blue) simply allocates between physical long duration fixed income and equities while the other frontier (in orange) adds a dual-beta fund into the eligible investment universe.

ii) Using the ‘dual-beta’ approach For a more complete hedge of the liability, greater credit exposure is required to cover both interest rate and credit spread movements (move further north and east in our hedge ratio illustration, Figure 4). Purchasing physical credit securities is the “natural” choice to accomplish this, but requires additional capital to be secured from elsewhere in the portfolio.5

A dual-beta approach seeks the additional capital for bond investing from equities within the plan’s asset allocation. Equity exposure can be readily attained synthetically, with little give up versus passive physical equities. As such, equity securities provide an effective alternative for capital release to fund harder-to-replicate credit exposure.

Understanding the dual-beta structure To illustrate how this works, consider an initial $100 capital allocation to a passive equity strategy. Under the dual-beta approach, the $100 could instead be redeployed with $50 invested in physical long credit securities and the remaining $50 used as collateral to fund $100 equity and $50 Treasury futures.The structure of the portfolio exposures is outlined below. The end result is exposures to $100 in passive equity and $100 in a combination of long treasury and long credit bonds.

Figure 5 provides a graphic representation of the example above, consisting of a $100 capital pool

Figure 5: Outline of dual-beta structure

5 An alternative is to get credit spread exposure synthetically via credit default swaps (CDS), but a ‘basis’ exists whereby these spreads can be significantly lower than physical bond spreads which are used to inform many liability discount curves. CDS portfolios also tend to be less diversified than physical credit portfolios

6 Assumes 82% funded status and Liability duration of 13.5 years. Volatility and correlations based on historical returns for representative indices. Expected returns are based on BlackRock long-term forecasts

Dual beta exposuresExisting capital

Dual betacapital

$100 of equity futures

$50 of long treasury futures$100 of

equities

$100 equity

exposure

$100 long gov/ credit exposure

$50 of long credit bonds

$50cash

$50cash

Source: BlackRock

Figure 7: Efficient frontiers: with and without dual beta

40% Long FI/60% Equity

4.6%

5.0%

5.4%

5.8%

6.2%

6.6%

7.0%

7.4%

8% 10% 12% 14% 16% 18% 20%

Surplus volatility (% of assets)

Expe

cted

retu

rn o

n as

sets

40% Core FI/ 60% Equity

40% Long FI/30% Equity/

30% Dual beta

Long FI / Equity Long FI / Equity + dual beta

Source: BlackRock

“The dual-beta allocation provides the desired capital efficiency that improves the pension plan’s exposures to liability hedging assets, without reducing exposure to return-seeking assets”

Figure 6: Interest rate and credit spread hedge ratios

0%

20%

40%

60%

80%

100%

0% 20% 40% 60% 80% 100%

Cre

dit s

prea

d he

dge

ratio

Current portfolio

Client liability

Interest rate hedge ratio

Current portfolio +Treasuryfutures overlay

Current portfolio +Dual Beta

Source: BlackRock

4

As shown, the addition of the capital efficient dual-beta exposure shifts the frontier to the upper left portion of the graph. Withgreater ability to hedge liability interest rate risk, this change has increased efficiency by reducing surplus risk per unit of expected return6. For example, the above addition of the dual-beta investment in place of 30% of the equity assets reduces surplus volatility by approximately 15% (over 2% absolute), while benefitting expected return.

Referring back to the funded ratio chart we examined earlier (Figure 1), including a 30% capital allocation to a dual-beta investment would benefit from similar reductions in surplus volatility.

In the chart below, we show how this sample plan’s funded ratio might have changed by year, if it started each year fully funded(i.e. assets equal liabilities).

Figure 8: Change from fully funded by year

Although funded status continues to be sensitive to equity markets, as intended, there is a greater degree of control of the plan’s funded ratio. This is due to the increased match between asset and liability exposures to long corporate yields.

It is also interesting to note that in years where equity markets performed very poorly, and in turn funded ratios were negativelyimpacted, the dual beta investment helped mitigate some of decline in funded ratio by hedging simultaneously falling interest rates.

ConclusionPension plan sponsors face difficult challenges. The dual objectives of maintaining expected return and simultaneously reducing surplus risk, while common among defined benefit plans, are hard to achieve via traditional allocations.

Many plan sponsors have started to embrace liability-driven investing (LDI) as a way to reduce surplus risk. In the absence of capital efficient strategies, however, the sponsors often find that they are not able to achieve both the return-seeking and liability-hedging exposures they desire.

Fortunately, simple structures exist that can increase capital efficiency (i.e., strategies that make the same plan assets workharder). In addition, there are collective funds that provide operationally simple execution.

For many pension plans, the dual-beta strategies outlined in this paper can help them move closer toward achieving their objectives.

Source: BlackRock

-35%

-25%

-15%

-5%

5%

15%

25%

35%

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

Cha

nge

in fu

nded

ratio

With dual-beta Without dual-beta

5

AppendixA) Implementation considerations in capital efficient dual-beta strategies

As with all investment decisions, there are certain considerations to bear in mind.

i. Collateral adequacy

Collateral is required in all overlays to support the synthetic exposures. In the dual-beta strategy, the initial value of cash set aside for collateral needs to support two sets of futures – treasury futures and equity futures. The amount of collateral and hence the amount of leverage used needs to be considered and judged appropriately. A key determinant is the level of market shock that can be tolerated, and the mechanism through which the leverage in the portfolio is managed and reset over time.

In the context of dual-beta there are diversification benefits for the collateral pool. The combination of long Treasury and equity exposures into a single collateral pool significantly stabilizes the structure against adverse market movements. This can be seen in the data below which shows few historical observations where poor treasury and equity returns occur together.7

7 Returns source: Bloomberg, Barclays Capital. Based on 4706 observations rolling 21 days between June 30, 1991 and October 31, 20108 A slight cost reduction might be afforded by entering into a “reverse EFP,” where one gives a broker S&P physicals in exchange for futures and cash

Figure 9: Negative index return observations (rolling 21 business days)

Combined Equity & Long Treasury (2:1 ratio) negative return observations (rolling 21 business days)

27

195

810

100

200

300

400

-30% -25% -20% -15% -10% -5%

Returns

Obs

erva

tions

SPX

Occurred in October 2008

4 8 2474

1

156

389

1 1740

100

200

300

400

-30% -25% -20% -15% -10% -5%

Returns

Obs

erva

tions

SPX Long Treasury

Source: BlackRock, Bloomberg, Barclays Capital

In Figure 9, the chart to the left shows historical downside observances for the standalone components of the collateral pool, with 17 total occurrences of returns below -20%. On the chart to the right, the equity and Long Treasury components are combined in a 2:1 ratio, as would be for the dual-beta investment collateral pool. There is only one occurrence of returns below -20%.

To be sure, a scenario where equities were stressed and interest rates rose would be painful from an asset-only perspective. The dual-beta approach would suffer sharp capital losses. In the context of the pension plan, however, one could expect that liability values would also decrease significantly due to a rise in liability discount rates, and so the overall surplus position would not be as problematic. This less-than-ideal occurrence also needs to be considered in the context of the much improved surplus risk performance that the pension plan would enjoy in many other more likely scenarios.

ii. Transaction costs

Applying a dual-beta strategy would incur transaction costs due to the sale of the physical equity assets, purchase of Treasury and equity futures, and purchase of the physical credit bonds. These costs could be on the order of 0.5% on the capital used8, but it is important to note the relationship of cost to potential benefit. A relatively small move in rates or spreads could translate into significant surplus changes as liability durations are very long.

iii. Active management

Given that the equity allocation for the dual-beta investment is achieved through futures, this exposure does not provide a direct substitute for actively managed equities. However, the strategy is a more or less direct replacement for existing passive equity exposure, and generally speaking alpha can often be maintained on existing assets through the removal of constraints, such as long-only constraints.

6

9 Charts are illustrative

With negative credit spread exposure as sizable as rates, if not larger, the dual-beta investment is particularly useful in helping to reduce both surplus risks.

Figure 10: Net surplus exposures: “Typical” net surplus exposures – Pre dual beta

Net surplus exposures: "Typical" net surplus exposures – Post 30% allocation to dual Beta

-72%

20%10%7.5%

42.5%

-97%-120.0%

-90.0%

-60.0%

-30.0%

0.0%

30.0%

60.0%

Publicequity

Privateequity

Real estate

alternatives

Bondsaggregate

Longrates

Creditspreads

-102%

20%10%7.5%

42.5%

-112%-120.0%

-90.0%

-60.0%

-30.0%

0.0%

30.0%

60.0%

Publicequity

Privateequity

Real estate

alternatives

Bondsaggregate

Longrates

Creditspreads

Source: BlackRock, Bloomberg, Barclays Capital

This material is for distribution only to those types of recipients as provided below and should not be relied upon by any other persons. This material is provided for informational purposes only and does not constitute a solicitation in any jurisdiction in which such solicitation is unlawful or to any person to whom it is unlawful. Moreover, it neither constitutes an offer to enter into an investment agreement with the recipient of this document nor an invitation to respond to it by making an offer to enter into an investment agreement.

This material may contain “forward-looking” information that is not purely historical in nature. Such information may include, among other things, projections, forecasts, estimates of yields or returns, and proposed or expected portfolio composition. Moreover, certain historical performance information of other investment vehicles or composite accounts managed by BlackRock, Inc. and/or its subsidiaries (together, “BlackRock”) has been included in this material and such performance information is presented by way of example only. No representation is made that the performance presented will be achieved, or that every assumption made in achieving, calculating or presenting either the forward-looking information or the historical performance information herein has been considered or stated in preparing this material. Any changes to assumptions that may have been made in preparing this material could have a material impact on the investment returns that are presented herein by way of example.

This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of 24 March 2011 and may change as subsequent conditions vary. The information and opinions contained in this material are derived from proprietary and nonproprietary sources deemed by BlackRock to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. There is no guarantee that any forecasts made will come to pass. Any investments named within this material may not necessarily be held in any accounts managed by BlackRock. Reliance upon information in this material is at the sole discretion of the reader. Past performance is no guarantee of future results.

In the UK issued by BlackRock Investment Management (UK) Limited (authorised and regulated by the Financial Services Authority). Registered office: 33 King William Street, London, EC4R 9AS. Registered in England No. 2020394. Tel: 020 7743 3000. For your protection, telephone calls are usually recorded. BlackRock is a trading name of BlackRock Investment Management (UK) Limited. In Hong Kong, the information provided is issued by BlackRock (Hong Kong) Limited. In Singapore, the information provided is distributed by BlackRock Investment Management (Singapore) Limited and is for distribution to institutional investors (as defined in section 4A of the Securities and Futures Act, Chapter 289 of Singapore (the "SFA") and accredited investors (as defined in section 4A of the SFA) only. For distribution in EMEA, Korea, and Taiwan for Professional Investors only (or “professional clients”, as such term may apply in relevant jurisdictions). In Japan, not for use with individual investors. In Canada, this material is intended for accredited investors only. This material is being distributed/issued in Australia and New Zealand by BlackRock Financial Management, Inc. ("BFM"), which is a United States domiciled entity and is exempted under Australian CO 03/1100 from the requirement to hold an Australian Financial Services License and is regulated by the Securities and Exchange Commission under US laws which differ from Australian laws. In Australia this product is only offered to "wholesale" and "professional" investors within the meaning of the Australian Corporations Act). In New Zealand, this presentation is offered to institutional and wholesale clients only. It does not constitute an offer of securities to the public in New Zealand for the purpose of New Zealand securities law. BFM believes that the information in this document is correct at the time of compilation, but no warranty of accuracy or reliability is given and no responsibility arising in any other way for errors and omissions (including responsibility to any person by reason of negligence) is accepted by BFM, its officers, employees or agents. This document contains general information only and is not intended to represent general or specific investment advice. The information does not take into account your financial circumstances. An assessment should be made as to whether the information is appropriate for you having regard to your objectives, financial situation and needs.

THIS MATERIAL IS HIGHLY CONFIDENTIAL AND IS NOT TO BE REPRODUCED OR DISTRIBUTED TO PERSONS OTHER THAN THE RECIPIENT.

© 2011 BlackRock, Inc., All Rights Reserved.

Appendix (cont.)B) Change in Net Surplus Exposures

Figure 10 shows changes in net surplus exposures for the “typical” plan examined earlier when 30% of equity capital is used to fund a dual-beta investment9: