LDI for Public Funds?

Drew Carrington, CFASenior US Fixed Income Portfolio Manager

December 4, 2006

US-INot intended for public distribution. For important additional information, please see the Additional Disclosures at the end of the presentation.

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What I’m NOT going to do

Argue in favor of Defined Contribution over Defined Benefit plans

Argue in favor of freezing or closing existing DB plans

Sensationalize the risks associated with underfunded public DB plans

Tell you to invest your entire plan in long duration bonds

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What I am going to cover

What is LDI?

Why is Corporate America focused on this?

Does LDI apply to public funds?

If not, can public funds apply lessons learned from LDI?

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What is LDI?

Liability Driven Investing (LDI), simply put, means designing asset allocation with liabilities in mind

LDI is also commonly referred to as Asset Liability Management (ALM) and has applications in not only pension investing but also in banking, insurance, lottery, trust funds – any obligation whose cash flows can be forecasted

Phenomenon not just limited to US; has global roots

LDI benchmarks must incorporate liability characteristics including cash flow profile, duration, embedded credit spreads, etc.

Extreme proponents of LDI prescribe investing in a portfolio that precisely matches liability cash flows

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Measuring risk and return vs. the liability

Source: UBS Global Asset ManagementFor illustrative purposes only.

Funding ratio risk/return characteristics

Source: UBS Global Asset ManagementFor illustrative purposes only.

-1.5%

-0.5%

0.5%

1.5%

2.5%

3.5%

4.5%

2% 4% 6% 8% 10% 12% 14% 16%Funding ratio risk

Fund

ing

ratio

retu

rn

Long Gov’t/Credit

Equities

Traditional 65/35 policy

Asset-o

nly fron

tier

Aggregate Bonds

Cash

Funding ratio frontier

Liability matching strategy

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The case for liability-driven investing

Funding levels reduced during the “perfect storm” of 2000-2002

Drop in equity markets lowered plan asset levels

Falling interest rates increased plan liabilities Large drop in funding ratios

Pension reform increases attention to funding ratio volatility

Increased short-term volatility Greater incentive for sponsors to

reduce pension funding volatility

Increased focus on funding ratio Growing interest in the relationship

between liability structure and market value of plan assets

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Why is Corporate America so focused on this?

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The asset-liability mismatch

Source: UBS Global Asset Management, BloombergNote: Typical Asset Return represents 40% S&P 500 Index//10% Russell 2500 Index/10% MSCI EAFE Index/35% Lehman Brothers Aggregate Index/5% 3 Month T-Bills. Typical Liability Return represents the PBO of a typical pay-related defined benefit plan. Discount rate is the yield on the Moody’s Aa Corporate Bond Index. Assumes no contributions. Benefit payments and service cost are excluded from each year’s annual growth.

-20%-10%

0%10%20%30%40%

1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005

Asset ReturnLiability return

Market-related Asset and Liability Returns 1994-2005

A good year or a bad year?

“Perfect storm”

-30%-20%-10%

0%10%20%30%

1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005

Funding ratio returns

Asset-liability mismatch risk causes funding ratio volatility

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Anticipating effects of pension reformPension reform may unsmooth the impact of A-L mismatch risk

Funding reform Accounting reform

August 17, 2006 Phase 1: End of 2006 Phase 2: 2008-2009

Reduce smoothing of assets and liabilities

Severe penalties for falling below funding ratio thresholds (80% and 60%)

PBGC premiums required for all underfunded plans

Mark-to-market balance sheet

Immediate recognition of gains/losses

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Why doesn’t LDI apply to public funds?

Driver

PPA 2006

FASB accounting changes

PBGC (Pension Benefit Guaranty Corp.)

Voluntary plan terminations / purchase of annuities

Equity analyst focus

Expanded derivative availability allows for liability hedging

Mismatch

Public funds not governed by ERISA, DOL, IRS funding rules

Public fund accounting governed by GASB

No federal pension insurance

Pension benefits irrevocable; no reasonable termination option

No stock to evaluate

Not required to mark liabilities to market

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Yes, but…

Driver

PPA 2006

FASB accounting changes

PBGC (Pension Benefit Guaranty Corp.)

Voluntary plan terminations / purchase of annuities

Equity analyst focus

Expanded derivative availability allows for liability hedging

Relevance

Congress holding hearings on public plan funding

GASB reviewing potential changes to pension accounting

Concern by tax payers regarding “funder of last resort” for DB plans

COLA’s add liability complexity

Rating agencies incorporating pension funding in debt rating analysis

Economics vs. accounting; hedging unacceptable investment outcomes

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Can public plans learn anything from LDI?

Focus first on the liability

Equities are not the only way to increase return

Learn to love derivatives

Key take-aways

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Constructing a plan-specific liability based benchmark1. Develop the “typical” liability cash flow

profile

Typical active member liability profile

0 10 20 30 40 50 60 70Year

Expe

cted c

ash fl

ow

Typical retired member liability profile

0 10 20 30 40 50 60 70Year

Expe

cted c

ash fl

ow

Typical aggregate liability profile

0 10 20 30 40 50 60 70Year

Expe

cted c

ash fl

ow

+

=

2. Select the discount curve to calculate the present value of the cash flow profile

Typical aggregate liability profile

0 10 20 30 40 50 60 70Year

Expe

cted

cash

flow

Source: Lehman, Hewitt Associates

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Selecting the risk budget

Key question: How much investment return is required to meet the liability?

— a function of funding ratio, liability growth, and expected contributions

Higher the funding ratio, the lower the required return

Minimize funding ratio risk for the given required return

Source: UBS Global Asset ManagementPlease see additional disclosures at the end of the presentation

Alternative investment policies

Funding ratio risk budget

Fund

ing

ratio

retu

rnRequired return A

B

C

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Investing implications of COLA’s

Many public plans contain cost of living provisions which are directly linked to published inflation indices

Nominal bonds are an exceptionally poor hedge for inflation

Using TIPs (Treasury Inflation Protected Securities) to hedge inflation risk embedded in COLA’s is LDI in its purest form

Consider adding TIPs as a stand-alone asset class in your plan to hedge COLA risk

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Equities aren’t the only way to generate returns

Traditional view: linear relationship between equity allocation and increasing return

Modern investment tools allow for separation of alpha and beta

Proliferation of alternative asset classes

Endowments & Foundations manage state-of-the-art portfolios

Source: UBS Global Asset ManagementFor illustrative purposes only.

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-1.5%

-0.5%

0.5%

1.5%

2.5%

3.5%

4.5%

2% 4% 6% 8% 10% 12% 14% 16%Funding ratio risk

Fund

ing

ratio

retu

rn

Equities

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Return generation: Absolute return strategies

Focus on improving risk/return trade off by— less reliance on equity market return— better balance between alpha and

beta

Driver of absolute return based strategies is to improve consistency

Typically this means— less equity market risk— more diversified sources of return— more active management of risks and

returns

UBS Global Asset Management Capabilities— Dynamic Alpha Strategy (DAS)— Absolute Return Bond (ARB)

Desired distribution

Probability

Real return (% p.a.)

0%

Absolute return strategies seek to improve on risk/return tradeoff

For illustrative purposes only.        

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Derivatives: Learn to love them

Many alternative asset categories make extensive use of derivative strategies

Derivative markets are better regulated, more liquid and more complete than ever before

Widespread use has increased general public comfort with derivatives

Derivatives not inherently dangerous: can be used to reduce risk

Direct use of derivatives allow investors to custom design range of portfolio risk/return outcomes

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Impact of duration mismatch on funding ratio

The value of the liabilities increases faster than the value of the assets do

Falling interest rates create a deficit

The value of the liabilities decreases faster than the value of the assets do

Rising interest rates create a surplus

AssetsLiabilities

DeficitValu

e

AssetsLiabilities

SurplusValu

e

Currently, interest rate changes cause funding ratio changes

For illustrative purposes only.

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Impact of swap overlay

Funding level reduced: liabilities increase relative to assets

Swap has a positive value which precisely offsets the reduction in funding level

Swap overlay immunizes funding ratio from interest rate changes

Falling interest rates: positive swap value

AssetsLiabilities

Swap

Valu

e

AssetsLiabilities

SwapValu

e Rising interest rates: negative swap value Funding level increased: assets

increase relative to liabilities Swap has a negative value which

balances the funding level once again

For illustrative purposes only.

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Managing derivative transaction risks

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Liquidity risk Counterparty risk

“Headline” risk Collateral risk

Low degree of control

High degree

of control

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Summary

LDI is here to stay

Direct application of Corporate LDI approaches may not fit for public plans but …… relevance of LDI to public plans is increasing

Three key take-aways— consider TIPS for fixed income allocation— look beyond equities for return generation— learn to love derivatives

Appendix

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Benefiting from a heritage of innovation

UBS predecessor First Chicagomanages assets

Equity

Real Estate

Dynamic Alpha Strategy

Asset Liability Investments Solutions Private REITGlobal & regional 130/30 strategiesUnconstrained global tactical asset allocation strategies: currency/marketJapan opportunitiesAgriVest Farmland

Core Plus Property

US Equity 130/30

Long/Short equity opportunities

Mid Cap Growth

1970s:Total return

1990s:Specialization

2000s & beyond: Alpha & beta integration

Growth Investors prede-cessor joins UBS

Third-party Manager Program

Short Duration

Emerging Markets Equity and Debt

Single- andMulti-Manager Hedge Funds

SBC merges with UBSDSI joins; enhanced indexing

1991 1995 1998

Swiss Bank Corporation (SBC) acquires O’Connor

SBC acquires Brinson Partners

Hedge Fund ManagerO'Connor launched

1992Systematic AlphaAbsolute Return Bond

1974 1978

1980s:Globalization & asset allocation

Global Multi-Asset Portfolio –

Integrated SolutionsAsset class specialists Global and Core EquityRegional portfolios

19812003 2004 2005 2006 Forward2000

Integrated alternative solutionsPension risk managementRetirement income solutions

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Liability Hedging: One UBS Global Asset Management solution

Long duration commingled vehicles

Interest rate derivative overlay

(single manager)

Interest rate risk coordinator(multi-managers)

Passively managed to a duration target Actively managed versus duration

target

Manages duration position of overall plan across several managers

Can be passive or active

Active Member with 18 year duration1

Retired Member with 8 year duration1

1 As of October 2006

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Our solution fills in gaps: Customized indicesModular, allowing blended construction of a customized liability index

iBoxx US Pension Liability Index – Retired Member, which will mimic the performance of a retired member liability profile for a model traditional defined benefit plan in the US, taking into consideration a plan’s estimated future liability cash flows for retired members, the passage of time and changes in the term structure of interest rates.

iBoxx US Pension Liability Index – Active Member, which mimics the performance of an active (i.e., non-retired) member liability profile for a model traditional defined benefit plan in the US taking into consideration a plan’s estimated future liability cash flows for active members, the passage of time and changes in the term structure of interest rates.

iBoxx US Pension Liability Index – Aggregate, which mimics the performance of a model (or typical) traditional defined benefit plan in the US, taking into consideration such a plan’s estimated future liability cash flows, the passage of time and changes in the term structure of interest rates.

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iBoxx US Pension Liability indices incorporate two important features:

Other currently published indices lack one or both of these important criteria

Pooled funds: Appropriate benchmarks

Mimic the sensitivity of the liabilities to changes in interest rates, as well as the slope and shape of the yield curve

Provide an extremely liquid, long-dated and high-quality yield curve representative of a pension plan’s interest rate exposure to the corporate bond yield curve

Reflect the actual liability profile of a plan

Are investable via LIBOR interest rate swaps

1 2

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Drew Carrington, CFA

Drew Carrington is a member of the US Core/Core Plus and Emerging Market Debt strategy teams, focusing on fixed income strategy and development of the portfolios. Drew is also responsible for communicating the firm's full range of fixed income strategies to clients and consultants.

Additionally, Drew works with the firm's GIS (Global Investment Strategy) team on the development of asset/liability solutions for clients.

Prior to joining the firm in early 2005, Drew was a principal at Mercer Investment Consulting, serving an array of institutional clients. Drew was also a member of Mercer's manager review committee and the strategic research committee. Prior to joining UBS, Drew's entire 16 years of professional experience was in the institutional investment consulting field.

Drew is a long-time member of the Atlanta Society of Financial Analysts.

Senior US Fixed Income Portfolio ManagerExecutive DirectorYears of investment industry experience: 16Education: Harvard University (US), BA

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Additional disclosures

Past performance is no guarantee of future results. There is no guarantee that investment objectives, risk or return targets discussed in this presentation will be achieved.The opinions expressed in this presentation are those of the UBS Global Asset Management Business Group of UBS AG and are subject to change. No part of this presentation may be reproduced or redistributed in any form, or referred to in any publication, without express written permission of UBS Global Asset Management. This material supports the presentation(s) given on the specific date(s) noted. It is not intended to be read in isolation and may not provide a full explanation of all the topics that were presented and discussed. Information contained in this presentation has been obtained from sources believed to be reliable, but not guaranteed. Furthermore, there can be no assurance that any trends described in this presentation will continue or that forecasts will occur because economic and market conditions change frequently.The information contained in this presentation should not be considered a recommendation to purchase or sell any particular security. There is no assurance that any securities discussed herein will remain in an account’s portfolio at the time you receive this information or that securities sold have not been repurchased. The securities discussed do not represent an account’s entire portfolio over the course of a full market cycle.It should not be assumed that any of the securities transactions or holdings referred to herein were or will prove to be profitable, or that the investment recommendations or decisions we make in the future will be profitable or will equal the investment performance of the securities referred to in this presentation.A client's returns will be reduced by advisory fees and other expenses incurred by the client. Advisory fees are described in Part II of Form ADV for UBS Global Asset Management (Americas) Inc.This presentation does not constitute an offer to sell or a solicitation to offer to buy any securities and nothing in this presentation shall limit or restrict the particular terms of any specific offering. Offers will be made only to qualified investors by means of a prospectus or confidential private placement memorandum providing information as to the specifics of the offering. No offer of any interest in any product will be made in any jurisdiction in which the offer, solicitation or sale is not permitted, or to any person to whom it is unlawful to make such offer, solicitation or sale.Any statements made regarding investment performance expectations, risk and/or return targets shall not constitute a representation or warranty that such investment objectives or expectations will be achieved. The achievement of a targeted ex-ante tracking error does not imply the achievement of an equal ex-post tracking error or actual specified return. According to independent studies, ex-ante tracking error can underestimate realized risk (ex-post tracking error), particularly in times of above-average market volatility and increased momentum. Different models for the calculation of ex-ante tracking error may lead to different results. There is no guarantee that the models used provide the same results as other available models.

Copyright © 2006 UBS Global Asset Management (Americas) Inc.

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