LDI from an Investment Actuarial Point of View · LDI CUSTOM SOLUTIONS – ALL PENSIONS NOT THE...

BARROW, HANLEY, MEWHINNEY & STRAUSS, LLC

February 24, 2015

Jeff Passmore, CFA, FSA – Client Portfolio Manager, LDI Strategist

LDI from an Investment Actuarial Point of View


QUESTIONS

Short Maturity

$1.0 Billion

Long Duration

Credit

$5.3 Billion

Core/Core Plus

$3.4 Billion

Credit/Other

Benchmarks

$2.4 Billion

Short Maturity $0.8 Billion

Long Duration

$6.5 Billion

Core/Core Plus

$3.2 Billion

Credit/Other

Benchmarks

$2.9 Billion

1

By a show of hands:

• Have you been involved with investing assets

for ERISA pension plans?

• Have you been involved in designing or

implementing a liability driven investment

(LDI) approach?

• Are you currently part of a group responsible

for implementing LDI?


LIABILITY DRIVEN INVESTING BACKGROUND AND (MY) DEFINITIONS

Short Maturity

$1.0 Billion

Long Duration

Credit

$5.3 Billion

Core/Core Plus

$3.4 Billion

Credit/Other

Benchmarks

$2.4 Billion


Long Duration

$6.5 Billion

Core/Core Plus

$3.2 Billion

Credit/Other

Benchmarks

$2.9 Billion

2

• Predominant approach to US corporate pension plan investing

• Maximizing risk adjusted returns (net of fees)

• Risk - funded status volatility (not asset volatility)

• Typically includes derisking (but not required)

• Acknowledges fundamental changes in pension accounting

and funding rules (around 2006)

• Has existed under different names for a long time

• Glidepath – plan to derisk based on funded status and/or rates

and/or timing


GLIDEPATHS – HYPOTHETICAL ILLUSTRATIONS OF TWO APPROACHES

Short Maturity

$1.0 Billion

Long Duration

Credit

$5.3 Billion

Core/Core Plus

$3.4 Billion

Credit/Other

Benchmarks

$2.4 Billion


Long Duration

$6.5 Billion

Core/Core Plus

$3.2 Billion

Credit/Other

Benchmarks

$2.9 Billion

3

Funded Status Hedge Ratio

111% (or more) 100%

100-110% 75%

91-100% 50%

81-90% 35%

80% (or less) 25%

One Dimensional Glidepath

• Funded status based Glidepath

• Most typical and straightforward

• Goal – excess return helps close funded status gap

Two Dimensional Glidepath

• Funded status and rates based Glidepath

• Increasingly common

• Goal – Rates exposure explicitly managed

• Hedgepath (rates) and Glidepath (asset alloc.)

Funded Status <2.5% 2.75% 3.00% 3.25% 3.5%+

111% (or more) 80% 80% 90% 95% 100%

100-110% 60% 70% 80% 90% 95%

91-100% 45% 55% 70% 85% 90%

81-90% 35% 45% 60% 80% 85%

80% (or less) 25% 35% 50% 75% 80%

UST 10 yr

Hedge Ratio


FUNDED STATUS RISK – ASSET ALLOCATION IMPLICATIONS

Short Maturity

$1.0 Billion

Long Duration

Credit

$5.3 Billion

Core/Core Plus

$3.4 Billion

Credit/Other

Benchmarks

$2.4 Billion


Long Duration

$6.5 Billion

Core/Core Plus

$3.2 Billion

Credit/Other

Benchmarks

$2.9 Billion

4

Ass

et E

xce

ss R

etu

rn

Funded Status Volatility

LDI Efficient Frontier

Feasible Investment Set

Long Duration Bonds

Core Bonds

Liability Adjusted Sharpe Ratio (LASR)

Asset Return - Liability Return

Funded Status Volatility

Implications

• Core bonds are not efficient

• Long bonds are usually the low risk (“risk free”) asset; not cash

• Risk is plan specific - each plan has opportunities relative to market due to unique risk profile

• Liability noise and discount curve risk is present

Source: BHMS

This sample is intended to illustrate a quantitative risk analysis technique and not intended to represent or recommend any strategy.


FUNDED STATUS RISK – ASSET ALLOCATION IMPLICATIONS

RISK BUDGET ILLUSTRATION

5

Implications

• Liability creates a short position in rates (and spreads)

• LDI risk is greater than asset only risk

• Risk spend should be proportional to strength of convictions

Rates

$55M

45%

Dev Mkt Eq

$31M

26%

EM Eq/Debt

$17M

14%

Alts

$18M

15%

Risk Budget

Core Bonds

VaR5 $121M

This sample is intended to illustrate a quantitative risk analysis technique and not intended to represent or recommend any strategy.

Rates

$39M

38%

Dev Mkt Eq

$30M

29%

EM Eq/Debt

$17M

16%

Alts

$18M

17%

Risk Budget

Long Duration Bonds

VaR5 $104M


LDI CUSTOM SOLUTIONS – ALL PENSIONS NOT THE SAME

LDI solutions are evolving to

become more customized

Each plan has unique liability

benefit projected cash flows

These cash flows sometimes

require different solutions based

on differences in benefit

structures, e.g. as a result of

acquisitions, plan redesigns, etc.

The relative importance of

benefit structures can change

over time, e.g. through spinoffs,

lump sum windows and ongoing

benefit accruals

Plan sponsors are becoming

more aware of LDI “gotchas”

like embedded interest rate

options and solutions are

available to help hedge these

risks

Cash Balance Projected Benefit Cash Flows; Source: Barrow Hanley

Typical (Non Cash Balance) Projected Benefit Cash Flows; Source: Barrow Hanley

20

40

60

80

100

120

140

2015 2025 2035 2045 2055 2065 2075 2085

Traditional Pension ($M)

2

4

6

8

10

12

14

16

18

20

2015 2025 2035 2045 2055 2065 2075 2085

Cash Balance ($M)


LIABILITY DRIVEN MEANS KNOWING VOLATILITY SOURCES

Cash Balance Projected Benefit Cash Flows; Source: Barrow Hanley

Pension Liabilities Generally Have Three

Sources of Hedgeable Volatility: Rates,

Spreads and Curve

Rates-based Volatility Can Be Measured and

Managed Mostly With Duration Matching

Techniques

Spread Volatility Is Also Important When

Hedging Pension Liabilities (Pension Cash

Flows Are Discounted Using Corporate

Bond Yields)

Curve Volatility Not Hedged Through

Duration Matching Is Small And Can Be

Managed Through Key-rate Duration

Matching

Different Benefit Cash Flows Have Different

Sensitivities To Each Source

Embedded Options Can Have a Significant

Impact On Liability Volatility And Hedge

Effectiveness


ASSUMPTIONS AND DISCLOSURES

We have used typical pension benefit projections, based on our experience working with corporate pension plans implementing

LDI mandates. These are typical of benefit projections prepared on a projected benefit obligation (PBO) basis by the plan

actuary. Cash Balance benefits represent a blend of Active and Terminated Vested participants. Traditional benefits represent

Active, Terminated Vested and retired participants.

We calculated the plan liability as of November 30, 2004 using the Citigroup Pension Discount Curve in effect on that date and

downloaded from the Society of Actuaries website (www.soa.org). We also calculated the liability for each future month end

through October 2014 using the curve as of each date. Citigroup changed the method used to determine their pension discount

curve and for a period of time provided both curves determined using the old and new method. We used the new approach

beginning December 31, 2009.

We then calculated the change in liability by moving the curve in a parallel fashion in the amount of the month over month

change in yield of the 10 year US Treasury Note for each month end beginning with December 31, 2004 through October 31,

2014. The resulting change in liability is the monthly change series for which we calculated the Rates Volatility statistics. We

obtained these yields from the Federal Reserve website (http://www.federalreserve.gov/releases/h15/update/) and used the

series: “Market yield on U.S. Treasury securities at 10-year constant maturity, quoted on investment basis” selecting those

yields at the end of the month or the day next following the end of the month if a month end did not have a quoted yield (e.g. if

it fell on a weekend).

We then developed a yield curve for each month end. To construct this yield curve we used yields from the above Federal

Reserve website using Treasury securities with maturities of one year, two years, three years, five years, 10 years, 20 years and

30 years. We used linear interpolation to determine yields for years in between these maturity dates. During the period between

February 2002 and February 2006, the 30 year US Treasury bond was not issued. On those dates that we needed for our

analysis, we used the extrapolation technique and factors published by the US Treasury to estimate an 30 year long bond

yield. For each month, we determined the change in yield curve for each annual point along the yield curve. We then applied

these changes to the Citigroup pension curve as of each prior month to determine the liability. The change in liability from this

series was used to calculate the Curve Volatility statistics.

Finally, we determined the residual change in liability, that is the amount remaining of the total liability change using the

Citigroup discount curve after subtracting those changes attributable to the change in rates and change in curve. This series of

changes in liability was used to calculate the Spread Volatility statistics.

http://www.soa.org/

http://www.federalreserve.gov/releases/h15/update/


APPENDIX


MARKET TRENDS

New Pension Mortality Tables

Society of Actuaries Formally Released an Updated Mortality Table (RP-2014) and Projection Scale (MP-2014) in October 2014

Last Pension Mortality Table was Prepared in 2000; Improvements Since then Have Been Estimated

New Study Found Life Expectancy Has Improved Faster than Expected

New Tables Both Catch Up with Past Improvements and Are Designed to Do a Better Job Keeping Up in the Future

Lump Sum Payments Will Be More Expensive Once New Tables Are Used – Possibly in 2016

Gap Between Accounting Liabilities and Annuity Purchase Price Will Be Reduced

Impacting Impact Expected

Accounting Liability 3%-10% 2014 (EOY)

Funding, Liability, Lump-Sums 3%-10% 2016

Duration 3/4-1 Year 2014 (EOY)

LDI Considerations Include: Changes to Glidepaths and LDI Benchmarks, Re-risking Based on Decreased Funded Status, Lump Sum Windows And annuity Settlements


MARKET TRENDS

Pension Funding Relief

Highway And Transportation Funding Act of 2014 (HATFA) Extends MAP-21 Pension Funding Relief

MAP-21 placed a floor of 90% on the 25-year Average of Corporate Bond Yields in 2012, then Decreasing to 70% in 2016

HAFTA Keeps 90% Floor through 2017

Due to the Funding Relief, We Estimate Significant Benefits for a Sample Plan1

There would be a 74 Basis Point Higher Effective Interest Rate Used For 2014 Pension Minimum Contributions (6.66% Vs. 5.92%)

Without MAP-21 Relief, the Discount Rate Would Have Been 210 Basis Points Lower (4.56%)

No Required Contributions Under HATFA for a Frozen Pension Plan that was 80% Funded

MAP-21 Reduced Contributions by Two-Thirds, i.e. 67% Reduction

1 Our analysis uses a four-month look back for the 2014 plan year and as a rule of thumb, assumes that the effective interest rate is the average of the second and third segment rates. The frozen plan is assumed to have no normal cost

component of the minimum required contribution calculation, a liability effective duration of 10 years, and ignores plan specific information such as pre-funding balances and shortfall amortization bases.

2 See “Utilization of MAP-21 Pension Funding Stabilization in 2012,”, published April 28, 2014 by the Society of Actuaries and available at: https://www.soa.org/research/research-projects/pension/default.aspx.

48%

33%

19%

Survey of MAP-21 Pension 2012 Funding Relief Elections and

Contributions

Relief but voluntary

contributions

Relief and minimum

contributions

No Relief

Source: Society of Actuaries

MAP-21 And HATFA Funding Relief

Optional

81% of Plan Sponsors Are Electing

Funding Relief 2

48% of Plan Sponsors Are Making

Voluntary Contributions


MARKET TRENDS

Pension PBGC Premiums

PBGC Premium Rates Have Been Increasing as a Result Of Recent Legislation

MAP-21 Increased Premium Rates and Tied Future Premium Rates to Wage Inflation

The Bipartisan Budget Act (BBA) Was Enacted in December 2013

It Increased PBGC Premium Rates for Both Flat Rate Premiums and Variable Rate Premiums

1 See Russell (“Do PBGC Premiums Incent Sponsors to Borrow to Fund Their Pension Plans?”, December, 2013); this paper listed a range of breakeven debt costs depending on a number of factors. 7% is our conservative summary figure.

2 See, for example, discussion of NCR’s pension de-risking strategy which included a $500M bond issuance and contribution in September 2012 at http://www.ncr.com/newsroom/resources/lump-sum-pension and $1.4B Motorola issuance

announced September 2014 and described on next slide, and Northrup Grumman’s $600M issuance in February 2015..

Higher PBGC Premiums Encourage Funding

Borrowing to Fund a Pension Deficit Can Be Accretive to Earnings If Cost of Debt Is 7% Or Less1

Some Have, in Fact Borrowed to Fund their Pension Plan and Have De-Risked Their Asset Allocation Strategy to

Lock in These Funded Status Improvements2.

*Indexed to Increase with National Average Wages

Year

Prior Law MAP-21 BBA Prior Law MAP-21 BBA

2012 35 35 35 90 90 90

2013 35 42 42 90 90 90

2014 35 49* 49 90 130* 140

2015 35 49* 57 90 180* 240

2016 35 49* 64 90 180* 290

2017 35 49* 64* 90 180* 290*

Flat Rate Premium

(Per Participant in Dollar

Amount)

Variable Rate Premium

(Based on Unfunded Liabilites

in Basis Points)

Significant increases coming


MARKET TRENDS

Pension Risk Transfer: Annuity Purchases and Lump Sum Windows

Motorola Solutions Announced In September 2014 a Three Pronged Pension De-risking Initiative:

Annuity Purchased to Settle Motorola’s Pension Obligations to Certain Retirees

Lump Sum Window for Another 32,000 Vested and Terminated Employees, for Another $1b in Offered Lump Sum Value

Borrow-to-Fund Implementation: $1.4B In New Bonds Issued August 12, 2014, with $1B Planned to be Used as a Pension Contribution

Context: There Were Three Other Significant Pension Settlements Announced in 2012

GM: Announced a Two Pronged Settlement: an Annuity Purchase and a Lump Sum Window for 42,000 Retirees; Those Who Declined the Lump Sum Offer Will Be Included in the Annuity

Verizon: Announced an Annuity Purchase

Ford: Announced a Lump Sum Window to 98,000 Retirees, Along with Vested and Terminated Participants

Annuity Transactions Year

Liability

Transferred

Purchase

Price

Retirees

Covered

GM 2012 $26B $29B 76,000

Verizon 2012 $7.5B $8.5B 41,000

Motorola 2014 $3.1B $3.1B 30,000


MARKET TRENDS

40-Year Plus Issuance

Twelve Issuers Totaling $10.6 Billion Have Come to Market Year-To-Date, with Maturities of 40 Years or Longer Versus the Issuers Totaling $700 Million in 2013

Companies Want to Extend Average Maturity Debt Profiles and Take Advantage of Low Rates and Tight Credit Spreads

These Longer Dated Bonds Provide LDI Participants Better Cash Flow Matching Characteristics Beyond 30 Years, with Additional Yield and Convexity.

30 Year vs 50 Year Illustration

Date of Issue Issuer Sector CPN Maturity Issue Size ($M) MDY S&P FITCH Spread @ Issue

1/13/2014 Electricite De France SA Utilities 6.000 100 yrs $700M Aa3 A+ A+ 240.0

5/5/2014 Caterpillar Industrials 4.750 50 yrs $500M A2 A A 137.5

5/20/2014 South Carolina E&G Utilities 4.500 50 yrs $300M A3 A A 120.0

6/10/2014 Johnson Controls Vehicle Parts 4.950 50 yrs $450M Baa2 BBB+ NR 150.0

6/16/2014 Guardian Life Financials 4.875 50 yrs $450M A1 AA- AA- 150.0

6/26/2014 Monsanto Materials 4.700 50 yrs $750M A3 BBB+ A- 140.0

7/16/2014 CSX Corp. Industrials 4.500 40 yrs $450M Baa1 BBB+ NR 120.0

7/24/2014 Verizon Communications Communications 5.012 40 yrs $5500M Baa1 BBB+ A- 167.0

9/2/2014 Marathon Petroleum Energy 5.000 40 yrs $400M Baa2 BBB NR 190.0

9/3/2014 Cleveland Clinic Healthcare 4.858 100 yrs $400M Aa2 AA- NR 160.0

10/2/2014 Enterprise Products Oper. Energy 4.950 40 yrs $400M Baa1 BBB+ BBB+ 190.0

10/7/2014 Dignity Health Healthcare 5.267 50 yrs $300M A3 A A 220.0

Date of Issue Issuer Sector CPN Maturity Issue Size ($M) Spread @ Issue Mod. Duration Convexity

6/10/2014 Johnson Controls Industrial 4.625 7/2/1944 $450M 120 16.08 3.75

6/10/2014 Johnson Controls Industrial 4.95 7/2/1964 $450M 150 18.52 5.76

Increase +30 2.44 2.02

Source Bloomberg


MARKET TRENDS

An Ultra-Long Credit Custom Index – Is It A Viable Alternative To STRIPS For Longer Dated Cashflows?

These Longer Dated Cash Flows May Provide an Alternative to 20+ Year Strips for LDI Custom Benchmarks

Longer Dated Cash Flows Will Become More Important to LDI with New Mortality Tables

Source Barclays 10/31/2014

Ultra-Long Credit Bonds Have Become 5.7% of Long Credit Index Market Value

Yield Pickup Of 23 bps Compared to the Long Credit Index

Duration Pickup is 3.1 Years

Long Credit US STRIPS (20+ Yrs)

Barclays Index "Index" vs. Long Credit Index

Mkt Value $1,514.3 B $86.4 B 5.70% $91.9B

Issuers 1,900 97 68 (Issues)

Yield 4.51% 4.74% +23 bps 3.14%

Duration 13.5 Yrs 16.6 Yrs +3.1 Yrs 27.3 Yrs

Sector Weights

Finance 16.0% 4.0%

Industrials 53.0% 36.0%

Utilities 10.0% 2.0%

Non-Corporate 21.0% 58.0%

Total 100.0% 100.0%

Ultra Long Credit (30+ Yrs)


2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

(1.0)

(0.5)

0.0

0.5

1.0

Ex

cess

Ret

urn

Corporate

Outperforms Credit

Credit Outperforms

Corporate

PPA Segment Rates are More Like the Barclays Corporate Index

-- Rolling 3-Year Excess Returns (Barclays Long Credit Vs. Barclays Long Corporate)

LONG CREDIT VS. LONG CORPORATE COMPARISON

Build America Bonds

Sovereign Risk

Rolling 3-Year Excess Returns as of 12/31/14

16

STRICTLY PRIVATE/CONFIDENTIAL

Liability Driven Investment

J.P. Morgan Asset ManagementLiability Driven Investment

February 24th, 2015

Prashant Lamba, CFA, Client Portfolio Manager Michael Buchenholz, CFA, FSA, Associate, Client Portfolio Managerg212.648.0414, [email protected]

, , , , g212.648.2968, [email protected]

FOR INSTITITIONAL USE ONLY | NOT FOR PUBLIC DISTRIBUTION

This page intentionally left blank


Pension Risk FrameworkAsymmetric Risks

100

120

Short Call Option

60

80

nefit

to P

lan Unproductive/Trapped

Surplus

0

20

40Ben

PBGC Default

Long Put Option

0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100% 110% 120%Plan Funded Status

PBGC Default: A distressed plan will be taken over by the Pension Benefit Guaranty Corporation (PBGC), which will pay beneficiaries up a maximum guarantee amount

Risk Appetite Considerations

PBGC default is equivalent to a long put option on the plan, incentivizing the sponsor/participants to maximize risk taking in the plan

Unproductive Surplus: The surplus assets after all benefits have been paid are not owed to beneficiaries and sponsors must pay heavy tax penalties to revert the cash back to the corporate balance sheet

Unproductive surplus is equivalent to a short call option on the plan, as excess assets provide little benefit to participants or the sponsor

In between these two bookends, sponsors/participants should have a decreasing risk appetite as the plan moves from distressed to fully funded

3

The data/charts/graphs throughout this presentation are FOR ILLUSTRATIVE AND DISCUSSION PURPOSES ONLY. Source: J.P. Morgan Asset Management Inc.


Relationship between the pension fund and the sponsor

Sponsor’s balance sheet

Sponsor’s cash flow statement

Contributions reduce sponsor’s total assets but reduce the debt of the sponsor’s


















Contributions reduce sponsor’s total assets but

reduce the debt of the sponsor’s vs.

Pension liabilities are a commitment taken

vs. the pension fund

Contributions reduce Pension liabilities are a commitment taken










Contributions reduce Pension liabilities are a commitment taken by

the pension fund

Contributions reduce by the sponsor vs.

employees. Their net value (liabilities –

assets) or deficit is part of the sponsor’s

debt

Pension assets

Pension Liabilities

sponsor’s cash flows and increase pension

assets

Minimum contributions are set by law (Pension

P i A )

by the sponsor vs. employees. Their net

value (liabilities –assets) or deficit is

part of the sponsor’s debt

Pension assets

Pension Liabilities


assets


P i A )




Pension assets

Pension Liabilities


assets


P i A )




Pension assets

Pension Liabilities


assets


P i A )




Pension assets

Pension Liabilities


assets


P i A )




Pension assets

Pension Liabilities


assets


P i A )

commitment taken by the sponsor vs.

employees. Their net value (liabilities –

assets) or deficit is part of the sponsor’s debt

Pension assets

Pension Liabilities


assets


Protection Act)

The cost of running

Protection Act)

The impact of the The cost of running

Protection Act)


Protection Act)


Protection Act)


Protection Act)


Protection Act)

The impact of the The cost of running a The impact of the The cost of running

a pension fund is reflected in the

income statement Sponsor’s income

statement

pension fund on the accounts of

the sponsor is set by US Gaap(SFAS 156)

The cost of running a pension fund is reflected in the


statement





statement





statement





statement





statement





statement

ppension fund on the

accounts of the sponsor is set by US GAAP (SFAS 158)

STRICTLY PRIVATE/CONFIDENTIAL - FOR INTERNAL USE ONLY 14




Pension Example – XYZ Corporation

112%

92%81%

90%96%

76%72%

70%80% 100%

120%

1,400

1,600

1,800 Assets Liability Funded Status

70%80%90%

100%

Historical Asset AllocationHistorical Funded Status

75%

80% 81%

83% 72% 74%76%

40%

60%

80%

400

600

800

1,000

1,200

Mill

ions

10%20%30%40%50%60%70%

0%

20%

0

200

400

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

0%10%

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

Other % Fixed Income % Equities %

Corporate Financial Metrics – XYZ PlanMarket Levels

As of 12/31/2013 Value

Funded Status 80%

Liability/Market Cap % 54%1 000

1,2001,400

1,6001,800

2,000

400

500

600

700

800

00 L

evel

bps)

10yr UST (bps) A+ OAS (bps) S&P500

2013 Pension Expense/Net Income % 53.2%

2013 Contribution/EBIDTA % 16.7%

Correlation of Funded Status to Stock Price % 85%0

200400

600800

1,000

0

100

200

300

400

S&P5

0

Yiel

d/O

AS (

5

The data/charts/graphs throughout this presentation are FOR ILLUSTRATIVE AND DISCUSSION PURPOSES ONLY. Source: J.P. Morgan Asset Management Inc.Source: Milliman survey, Barclays Live. As of December 31, 2013



Pension Risk Metrics – Current Allocation at 80% Funded

Hedge Ratio =$ Duration of Assets

=1,931K

≈ 10%

Plan Metrics

1 6001,8002,000

usan

ds

Asset Liability

DV01 Asset-Liability Profile

Assets Value

Asset Value ($mm) $1,136

Asset Duration (yrs) 1.7

Liabilities Value

Liability Value ($mm) $1,420

Liability Duration (yrs) 13.4 Hedge Ratio = = ≈ 10%$ Duration of Liabilities 19,028K

400600800

1,0001,2001,4001,600

Thou

From a DV01 perspective, the plan is underhedged overall and

Hedge Ratio measures the sensitivity of the Plan to parallel changes in interest

rates

(y )

Value-at-Risk ($mm) $176

y (y )


30%15% 5% US Aggregate

S&P500

Total Plan Value

Funded Status % 80%

Rate Hedge Ratio % 10 1%

Funded Status at Risk ($mm) Asset-Liability Cashflow Profile

0200400

0.5yr 2yr 5yr 10yr 20yr 30yr Total

across the term structure

50%

EAFE

Hedge Funds

Rate Hedge Ratio % 10.1%

Spread Hedge Ratio % 8.7%

Funded Status VaR $mm $240

($ )

Rates

Divers-ification

Spreads

300

350

400

450

500

Mill

ions

AltsEquitySpreadsRates

60708090

100

Mill

ions

Assets Liabilities

Asset Liability Cashflow Profile

TotalVaREquity

Alts

0

50

100

150

200

250

01020304050 Significant

cashflow shortfall in belly and long end of the term structure

Diversification bucket captures the correlation

between assets and liabilities

6

0Assets Liabilities Diversification Net Risk

2014 2019 2024 2029 2034 2039 2044 2049 2054 2059 2064 2069 2074 2079




Pension Risk Metrics – End Game Allocation at 100% Funded

1400160018002000

hous

ands Asset Liability

Hedge Ratio =$ Duration of Assets

=19,000K

≈ 100%

Plan Metrics DV01 Asset-Liability Profile

Assets Value

Asset Value ($mm) $1,420

Asset Duration (yrs) 13.4

Liabilities Value

Liability Value ($mm) $1,420

Liability Duration (yrs) 13.4

400600800

100012001400Th

Hedge Ratio = = ≈ 100%$ Duration of Liabilities 19,028K(y )


y (y )


0% 5%

15%

0%0%

0%US Strips 25+ Yr

US Intermediate Credit A+

Total Plan Value

Funded Status % 80%

Rate Hedge Ratio % 100%

Improved hedge ratio overall and across the term

structure

0200

0.5yr 2yr 5yr 10yr 20yr 30yr Total

Funded Status at Risk ($mm) Asset-Liability Cashflow Profile

80%

Credit A+

US Long Credit A+

Rate Hedge Ratio % 100%

Spread Hedge Ratio % 90%

Funded Status VaR $mm $36

($ )

Rates

Spreads

400

500

600

Mill

ions

AltsEquitySpreadsRates

120 140 160 180 200

Mill

ions

Assets Liabilities

Asset Liability Cashflow Profile

The universe of 30+

Risk exposure of assets and liabilities are highly correlated

TotalVaR

Divers-ification

Spreads

Rates

0

100

200

300

0 20 40 60 80

100 The universe of 30+

maturing bonds is small and illiquid

7

0Assets Liabilities Diversification Net Risk

2014 2019 2024 2029 2034 2039 2044 2049 2054 2059 2064 2069 2074 2079




Illustrative Impact of Bonds on Funded Status

Max: 238%

200%

250%

STANDARD DEVIATION 200%

250%

STANDARD

Funded status volatility – 65% Equity and 35% Core Bond PortfolioFunded Status Volatility – 100% Equity Portfolio

Illustrative Impact of Bonds on Funded Status

93%100%

150%

00%

nded

Status

DEVIATION 42.0% Max: 162%

86%100%

150%

200%

unde

d Status DEVIATION

26.4 %

Min: 60%50%

Dec‐94

Dec‐95

Dec‐96

Dec‐97

Dec‐98

Dec‐99

Dec‐00

Dec‐01

Dec‐02

Dec‐03

Dec‐04

Dec‐05

Dec‐06

Dec‐07

Dec‐08

Dec‐09

Dec‐10

Dec‐11

Dec‐12

Dec‐13

Dec‐14

Fu Min: 71%50%

Dec‐94

Dec‐95

Dec‐96

Dec‐97

Dec‐98

Dec‐99

Dec‐00

Dec‐01

Dec‐02

Dec‐03

Dec‐04

Dec‐05

Dec‐06

Dec‐07

Dec‐08

Dec‐09

Dec‐10

Dec‐11

Dec‐12

Dec‐13

Dec‐14

F

Funded status volatility – 65% Long Bonds and 35% Equity Portfolio Funded status volatility – 100% Long Bond Portfolio

Max: 145%150%

200%

250%

tus

STANDARD DEVIATION 12.1 %

Max: 105%150%

200%

250%

Status

STANDARD DEVIATION

2.7 %

Min: 91%

109%

50%

100%

50%

ec‐94

ec‐95

ec‐96

ec‐97

ec‐98

ec‐99

ec‐00

ec‐01

ec‐02

ec‐03

ec‐04

ec‐05

ec‐06

ec‐07

ec‐08

ec‐09

ec‐10

ec‐11

ec‐12

ec‐13

ec‐14Fund

ed Sta

Min: 94%

Max: 105%98%

50%

100%ec‐94

ec‐95

ec‐96

ec‐97

ec‐98

ec‐99

ec‐00

ec‐01

ec‐02

ec‐03

ec‐04

ec‐05

ec‐06

ec‐07

ec‐08

ec‐09

ec‐10

ec‐11

ec‐12

ec‐13

ec‐14

Fund

ed

The data/charts/graphs throughout this presentation are FOR ILLUSTRATIVE AND DISCUSSION PURPOSES ONLY. Source: Barclays Capital and J.P. Morgan Asset Management Inc as of 12/31/14. Core bonds are represented by the US Aggregate bond index; Long bonds are represented by the Long G/C index; Equities are represented by the S&P 500 Index.

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8FOR INSTITITIONAL USE ONLY | NOT FOR PUBLIC DISTRIBUTION


Glidepath Conceptp pWe’ve examined risk metrics and strategic asset allocations for the Plan at two different points:

Current Allocation: 80% Funded, 30% Fixed Income, $240mm VaR

End Game Allocation: 100% Funded, 100% Fixed Income, $36mm VaR

The vast majority of plans utilize a structured plan of phase-in de-risking through a glidepath, which systematically decreases funded status risk as the Plan funded status improvesfunded status improves

Triggers for de-risking to the next phase can be based on:

Funded Status, Interest Rates, Passage of Time, Other

90%

100%

H d F d

Equity/Alts

40%

50%

60%

70%

80%Hedge Funds

EAFE

S&P500

US Long Credit A+

US Inter Credit A+

US Strips 25+ Yr

0%

10%

20%

30%

40%

Current Phase 1 Phase 2 Phase 3 End Game

US Long Gov/Credit

US Aggregate

Fixed Income

Funded Status Trigger 80% 85% 90% 95% 100%

Growth/Hedge Portfolio 70%/30% 70%/30% 52.5%/47.5% 30%/70% 0%/100%

Hedge Ratio 10% 28% 52% 70% 100%

Funded Status VaR $240 MM $184 MM $132 MM $89 MM $36 MM

ERoA 5 6% 5 8% 5 3% 5 1% 4 5%

9

ERoA 5.6% 5.8% 5.3% 5.1% 4.5%



*De-risking is a general term referring to strategies that aim at reducing the risk exposure of plan sponsors to their pension fund; however the term in no way implies the removal of risk.

Strong gross issuance still lags ultimate demandg g g2014 : Investment Grade Credit Fixed Supply by Sector

and Maturity

918 910 858

1,086 1,106 1,145

1,000

1,200

1,400 Annual: Investment Grade Credit Issuance

326

588

425 444 338 336

431

561 608

200

400

600

800

0

Private Defined Benefit Plans: De-risking?C t iti

Overall Supply: U.S. Long CreditDefined Benefit Pension Liabilities:

71.7 78.0 83.8 40

80

120

ns ($

)

Corporate equities

Credit market instruments

Defined Benefit Pension Liabilities:$3.1 Trillion ($0.8 Tr. in Credit)

Life Insurance Company Liabilities:$5.7 trillion ($3.5 Tr. in Credit)

Market value (‘000)

Market value (%) Count Yield to

worst

Total 1,579,317,737 100.00 1954 4.40

Corporate 1,248,546,777 79.06 1598 4.42

Aaa

(70.1)(41.8)

(4.1)

(65.4)

(11.0) (21.7) (17.3)(52.9)

4.1 35.2 27.1

-80

-40

0Bill

io Aaa 15,858,974 1.00 23 3.68

Aa 87,988,476 5.57 91 3.88

A 564,828,191 35.76 722 4.14

Baa 579,871,136 36.72 762 4.80

N C t

STRICTLY PRIVATE/CONFIDENTIAL - FOR INSTITUTIONAL USE ONLY 10

Source: Barclays Live. As of December 31, 2014. “U.S. Investment Grade Corporate Update“, Federal Reserve Flow of Funds data as of September 30, 2014.

10

-802008 2009 2010 2011 2012 2013 YTD 2014

Non-Corporate 330,770,960 20.94 356 4.32




Finding The (Im)Perfect Hedgeg ( ) g

100%

105%

Historical Funded Status Tracking – Hedge with Long Credit A or Better

90%

95%Defaults and downgrades are reflected in asset returns but are removed from the liability

discount curve

75%

80%

85%

Dec-96 Dec-97 Dec-98 Dec-99 Dec-00 Dec-01 Dec-02 Dec-03 Dec-04 Dec-05 Dec-06 Dec-07 Dec-08 Dec-09 Dec-10 Dec-11 Dec-12 Dec-13

A plan that invested in duration-matched Long Credit A+ would have experienced a funded status deterioration of almost 20% over the past 18 years

What may seem like a perfect hedge to the corporate based liability breaks down over time due to:

Downgrades and defaults: When a bond is downgraded or defaults the asset portfolio suffers a loss while the higher yielding bond will be removed from the discount curve, resulting in a higher liability and a lower funded status

Unhedged exposures: While a broad index may provide an overall duration match to the liability, there may still be resulting curve, credit and convexity exposures

Unhedgable exposures: The liability value is an imperfect measure of the pension plan obligation. Over time actual plan experience may/will differ from those baked into the underlying actuarial assumptions (e.g. mortality experience)

For these reasons, plans may structure a more bespoke fixed income benchmark to better match the liabilities and/or maintain a resilience buffer of surplus assets to offset unhedgable risks

11




Expected return over risk-free asset:Long Credit – given downgrades/defaults vs. “fallen angels”

Corporate Index by rating

Monthly Mean (bps)

Monthly St.Dev (bps)

Excess return of the Corporates (8/88-12/14)

DowngradeYear

Number of bonds 1-Year 2-Year

Post downgrade cum. performance of “fallen angels”

Aa 2.9 83.2A 2.6 116.7Baa 5.9 138.7Ba 21.9 215.8B 15 6 280 1

1990-1994 173 3.03% 7.88%

1995-1999 211 -0.52% 5.46%

2000-2005 771 4.16% 8.77%

Average monthly excess return on the Barclays Long

B 15.6 280.1Caa 13.0 432.9 2006-2011 372 7.06% 9.25%

Cum. returns of “fallen angels” debt vs. equitiesAdditional Salient Facts

Corporate Index for same time period is 2 basis points with a volatility of 181bps

“Fallen angels” bonds represent a significant proportion of the High Yield (15%-25%)

10 year correlation (monthly observations):

High Yield Ba/B: 0.84 (spread changes vs. A/AAA Corp.) Equities: 0.73 (total rtrns vs. HY Ba/B excess rtrns) Treasuries: 0.65 (total rtrns vs. A/AAA Corp. total rtrns)

– Over 80% of time Treasury returns have the same sign

12

– 2-12% tracking error

Source: JPMAM, Barclays data, “Investing in Fallen Angels”, Barclays Capital, February 2012The data/charts/graphs throughout this presentation are FOR ILLUSTRATIVE AND DISCUSSION PURPOSES ONLY. Source: J.P. Morgan Asset Management Inc.



Interest Rate Derivatives: Monetizing the Glidepathg p The glidepath framework presents an opportunity for plans to monetize the commitment to de-risk at higher funded status levels:

Strategy: Sell out-of-the money payer swaptions

In exchange for the swaption premium, the plan gives up some of the funded status gains as rates rise

If rates at maturity are below the strike price, the plan will simply pocket the premium

The plan is selling the right to the counterparty to force the Plan to extend duration once rates rise above a certain duration – which is part of the glidepath strategy anyway!

1,000,000

rity

Illustrative Payoff of Sold 1x10 Payer Swaption Illustrative Example

Current Funded Status 80%

0

500,000

onPa

yoff

at M

atur

Current Funded Status 80%

Asset DV01 1,931Liability DV01 19,028Net DV01 (17,097)

Next Trigger 85%

Strike Price of Payer

Premium collected from sale of Payer

-500,000

Sold

Pay

er S

wap

tio Next Trigger 85%Rate Move to Next Trigger 50bps

Rate VaR as % of Total VaR ~50%Expected Time Until Next Trigger 1yrPremium 2.2%

Current At-The-Money-Forward

Rate

Payer losses offset by decreasing liabilities as rates rise

-1,000,000

S Rate

Sell a 1x10 Payer struck +25bps out-of-the-money

Assume ~50% of the funded status increase will come from rates based on the VaRattribution

Expected time frame for trigger is 1year

13

p gg y



J.P. Morgan Asset ManagementThis document is intended solely to report on various investment views held by J.P. Morgan Asset Management. Opinions, estimates, forecasts, and statements of financial market trends that are based on current market conditions constitute our judgment and are subject to change without notice. We believe the information provided here is reliable but should not be assumed to be accurate or complete. The views and strategies described may not be suitable for all investors. References to specific securities, asset classes and financial markets are for illustrative purposes only and are not intended to be, and should not be interpreted as, recommendations. Indices do not include fees or operating expenses and are not available for actual investment. The information contained herein employs proprietary projections of expected returns as well as estimates of their future volatility. The relative relationships and forecasts contained herein are based upon proprietary research and are developed through analysis of historical data and capital markets theory. These estimates have certain inherent limitations, and unlike an actual performance record, they do not reflect actual trading, liquidity constraints, fees or other costs. References to future net returns are not promises or even estimates of actual returns a client portfolio may achieve. The forecasts contained herein are for illustrative purposes only and are not to be relied upon as advice or interpreted as a recommendationThe value of investments and the income from them may fluctuate and your investment is not guaranteed Past performance is no guarantee of future results Please note current performance may be higher or lower than the The value of investments and the income from them may fluctuate and your investment is not guaranteed. Past performance is no guarantee of future results. Please note current performance may be higher or lower than the performance data shown. Please note that investments in foreign markets are subject to special currency, political, and economic risks. Exchange rates may cause the value of underlying overseas investments to go down or up. Investments in emerging markets may be more volatile than other markets and the risk to your capital is therefore greater. Also, the economic and political situations may be more volatile than in established economies and these may adversely influence the value of investments made Selected risks Asset-backed securities may have additional risk because they may receive little or no collateral protection from the underlying assets, and are also subject to the risk of default. The risk of such defaults is generally higher in the case of mortgage-backed investments that include so-called “sub-prime” mortgages. International investing involves a greater degree of risk and increased volatility. Changes in currency exchange rates and differences in accounting and taxation policies outside the U.S. can raise or lower returns. Also, some overseas markets may not be as politically and economically stable as the United States and other nations. The Fund's investments in emerging markets could lead to more volatility in the value of the Fund. As mentioned y p y y g g yabove, the normal risks of investing in foreign countries are heightened when investing in emerging markets. In addition, the small size of securities markets and the low trading volume may lead to a lack of liquidity, which leads to increased volatility. Also, emerging markets may not provide adequate legal protection for private or foreign investment or private property.Interest Rate Risk. The Strategy mainly invests in bonds and other debt securities. These securities will increase or decrease in value based on changes in interest rates. If rates increase, the value of the Strategy’s investments generally declines. On the other hand, if rates fall, the value of the investments generally increases. Your investment will decline in value if the value of the investments decreases. Securities with greater interest rate sensitivity and longer maturities tend to produce higher yields, but are subject to greater fluctuations in value. Usually, the changes in the value of fixed income securities will not affect cash income generated, but may affect the value of your investment.Derivatives Risk. The Strategy may use derivatives in connection with its investment strategies. Derivatives may be riskier than other types of investments because they may be more sensitive to changes in economic or

k t diti th th t f i t t d ld lt i l th t i ifi tl d th St t ’ i i l i t t C t i d i ti i i t f f l A lt th St t b market conditions than other types of investments and could result in losses that significantly exceed the Strategy’s original investments. Certain derivatives may give rise to a form of leverage. As a result, the Strategy may be more volatile than if the Strategy had not been leveraged because the leverage tends to exaggerate the effect of any increase or decrease in the value of the Strategy’s portfolio securities. Derivatives are also subject to the risk that changes in the value of a derivative may not correlate perfectly with the underlying asset, rate or index. The use of derivatives for hedging or risk management purposes or to increase income or gain may not be successful, resulting in losses to the Strategy, and the cost of such strategies may reduce the Strategy’s returns. Derivatives also expose the Strategy to the credit risk of the derivative counterparty.The deduction of an advisory fee reduces an investor’s return. Actual account performance will vary depending on individual portfolio security selection and the applicable fee schedule. Fees are available upon request.The following is an example of the effect of compounded advisory fees over a period of time on the value of a client’s portfolio: A portfolio with a beginning value of $100 million, gaining an annual return of 10% per annum would grow to $259 million after 10 years, assuming no fees have been paid out. Conversely, a portfolio with a beginning value of $100 million, gaining an annual return of 10% per annum, but paying a fee of 1% per annum, would only grow to $235 million after 10 years The annualized returns over the 10 year time period are 10 00% (gross of fees) and 8 91% (net of fees) If the fee in the above example was 0 25% per annum the portfolio would would only grow to $235 million after 10 years. The annualized returns over the 10 year time period are 10.00% (gross of fees) and 8.91% (net of fees). If the fee in the above example was 0.25% per annum, the portfolio would grow to $253 million after 10 years and return 9.73% net of fees. The fees were calculated on a monthly basis, which shows the maximum effect of compounding.There can be no assurance that the professionals currently employed by JPMAM will continue to be employed by JPMAM or that the past performance or success of any such professional serves as an indicator of such professional’s future performance or success.All case studies are shown for illustrative purposes only and should not be relied upon as advice or interpreted as a recommendation. They are based on current market conditions that constitute our judgment and are subject to change. Results shown are not meant to be representative of actual investment results. Past performance is not necessarily indicative of the likely future performance of an investment.Any securities mentioned throughout the presentation are shown for illustrative purposes only and should not be interpreted as recommendations to buy or sell. A full list of firm recommendations for the past year is available upon request. upon request. J.P. Morgan Asset Management is the marketing name for the asset management business of JPMorgan Chase & Co. Those businesses include, but are not limited to, J.P. Morgan Investment Management Inc., Security Capital Research & Management Incorporated and J.P. Morgan Alternative Asset Management, Inc.Copyright © 2015 JPMorgan Chase & Co. All rights reserved.

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