Capital Market Assumptions

Transcription

1 Aon Hewitt Consulting Investment Consulting Practice Capital Market Assumptions As of September 30, 2014 Risk. Reinsurance. Human Resources.

2 Table of contents Buyback bonanza short term gain for longer term pain?...3 Inflation...6 Government bonds...7 Inflation-linked government bonds...8 Investment grade corporate bonds...9 US high yield debt and emerging market debt...9 Equities...10 Private equity...11 Real estate...11 Hedge funds...12 Volatility...12 Correlations...13 Capital market assumptions methodology...14 Contacts Capital Market Assumptions

3 Buyback bonanza short term gain for longer term pain? Economic growth has been weak, corporate revenue growth nowhere to be found and earnings per share growth has ticked along gradually yet US equities have shot the lights out in terms of returns. How to make sense of it all? Well, one explanation lies in corporate buybacks the act of companies repurchasing their own shares in the market. These have become a really important feature of the equity market environment with wide ranging implications for both the near term and long term prospects for equity markets. This article is an abbreviated version of a recent research note written by Aon Hewitt s Global Asset Allocation team which has been adapted for the purposes of this quarter s Capital Market Assumptions publication. Attention here is focused on the US equity market where buybacks have always been more common than elsewhere. If you would like a copy of the original longer research note then please contact your Aon Hewitt consultant. A historic perspective Dividends have traditionally represented the method used by companies to return cash to shareholders and, on the face of it, companies appear to have become less generous over time. So far this millennium, dividend payout ratios (the proportion of earnings that are paid out in dividends) have averaged only around 35%, well below the 50% average of the previous three decades. However, this is because dividends are no longer the only game in town when it comes to cash distributions. Companies have increasingly turned to share buybacks as an alternative means of returning cash to shareholders. According to Standard & Poors ( S&P ), over 80% of S&P 500 companies bought back shares during the second quarter of 2014 and buybacks have been significantly outstripping dividends for most of the past 10 years. Consequently, though dividend payout ratios have been low, when buybacks are included, payout ratios have, in fact, been much higher. Companies have been using around 85% of their earnings to pay dividends and buy back stock. Dollar value of dividends and buybacks: S&P 500 ($bn) Dividends Buybacks Source: S&P Aon Hewitt 3

4 Buybacks have clearly become an important feature of the equity market environment. This has both positive and negative implications. Our research comes to a number of major conclusions: 1. Demand from companies to buy back their shares is one reason why US equity prices have risen so strongly despite mediocre economic growth. 2. Fortunately for equity investors, US companies have the finance and motivation for buyback activity to continue at an elevated level, supporting equity markets in the near term. 3. More worryingly, the only source of demand for equities has been from companies themselves so markets have become dependent on corporate buying to support prices. The rest of the market has been a net seller in aggregate so had it not been for companies buying shares, selling pressure would surely have pushed prices lower. High cash levels, relatively cheap debt financing and management incentives which are linked to share prices and/or earnings per share (EPS) growth all encourage buybacks. Cumulative Inflows into US Equities: ($bn) Nonfinancial companies Overseas buyers Insurance companies Pension plans Households, mutual funds and ETFs Source: Federal Reserve, Aon 4 Capital Market Assumptions

5 4. Further buybacks may support share prices or even push them higher but buying back shares when valuations are expensive is value-destructive in the long run. Buybacks are value-accretive for a company when they are bought back for below their fair value. They are effectively buying them back on the cheap. However, the opposite is also true and buybacks can have a negative long term impact if they take place when shares are overvalued. Current equity markets remain fully valued on most measures and expensive on others so although high levels of buybacks should continue to support prices in the near term, the longer term impact of buying back shares at current levels will be at best neutral, and at worst, value-destructive. 6. If sustained, current levels of buybacks could do long term damage to the earnings capacity of listed companies, and with it, long term prospects for economic growth and equity market returns. By choosing to pay out the vast majority of their profits through a combination of buybacks and dividends, companies are retaining only a small proportion of their profits within the business to generate future growth. If current profitability and payout ratios were to be maintained then our calculations suggest that companies would struggle to generate much more than 2% nominal earnings growth on a sustainable basis. This would have a disastrous impact on economic growth and longer term equity market prospects. Current buyback policies may lead to near term gains but at the expense of longer term pain. 5. Headline EPS growth figures overstate underlying earnings growth due to the impact of buybacks. Earnings EPS= Number of shares oustanding Buybacks which reduce the number of shares outstanding will lead to EPS growth outpacing overall earnings growth. Across the S&P 500 overall, Barclays estimate that, on average, companies have benefitted from a 1-2% EPS growth boost as a result of buyback activity but in some cases the impact has been much larger. For example, Apple s Q2 earnings increased by around 12% but EPS grew by almost 20%. This is not genuine growth but instead has been manufactured by Apple s buyback program! Higher EPS figures can lead to higher share prices as analysts often value companies based on their EPS. By buying back shares, a company could potentially inflate both its EPS and, as a consequence, its share price. There is an argument that one reason for the popularity of buybacks is that management remuneration packages are often linked to EPS growth and this could help explain the upsurge in buyback activity in the 2000s. Unless there is a dramatic change to remuneration practices, which there is no reason to expect without regulatory change, management will continue to be incentivized to utilize buybacks as a means of boosting their take-home pay. Implications for our Capital Market Assumptions Our expectation is that as the economic recovery progresses and companies grow more confident regarding the outlook, they will divert cash away from buybacks and towards profitable investment opportunities. Indeed, when looking through the long term lens of our Capital Market Assumptions, we look past the current high payout ratio and instead assume that in the long run, companies pay out the proportion of their earnings (through dividends and/or buybacks) that allows them to maintain their growth at sustainable levels. This payout ratio is significantly below current levels. Current high payout ratios are unsustainable in the long run. When setting our Capital Market Assumptions, we make the simplifying assumption that long term sustainable payout ratios are broadly comparable across the developed world. However, we assume that emerging market companies pay out a smaller proportion of their earnings as a greater proportion must be retained in order to finance their faster growth rates. Aon Hewitt 5

6 Inflation USD GBP EUR CHF CAD JPY CPI Inflation (10yr assumption) 2.2% 2.1% 1.7% 1.1% 1.9% 1.6% RPI Inflation (10yr assumption) 3.1% Realized inflation has been falling on a global basis but despite the concern that has been raised over the potential for very low inflation or deflation across many countries, consensus expectations for longer term inflation remain relatively well grounded. CPI inflation expectations have been downgraded slightly but inflation is expected to be relatively close to central banks 2% target level over the next 10 years in the US, UK and Canada. Nearer term expectations for European inflation have fallen further but inflation is expected to pick up in later years, raising the 10 year assumption to 1.7%. The Japanese authorities have undertaken huge amounts of monetary stimulus with an objective to generate growth and break the hold deflation has had over the economy, attaining a new higher inflation target of 2%. The consensus has consequently been revising up inflation expectations for Japan but remains unconvinced that the 2% inflation target will be achieved on a sustainable basis. Japanese inflation is expected to be around 1.6% per annum over the next 10 years in Japan. Though below the 2% target, this is significantly higher than the experience of the past decade. 6 Capital Market Assumptions

7 Government bonds 10yr Annualized Nominal Return Assumptions USD GBP EUR CHF CAD JPY US 5yr 2.5% 2.4% 2.0% 1.4% 2.2% 1.9% 15yr 3.4% 3.3% 2.9% 2.3% 3.1% 2.8% UK 5yr 2.4% 2.3% 1.9% 1.3% 2.1% 1.9% 15yr 3.4% 3.3% 2.9% 2.3% 3.1% 2.9% Eurozone 5yr 1.6% 1.5% 1.1% 0.6% 1.3% 1.1% 15yr 2.8% 2.8% 2.3% 1.8% 2.6% 2.3% Switzerland 5yr 1.5% 1.4% 1.0% 0.5% 1.2% 1.0% 15yr 2.3% 2.2% 1.8% 1.3% 2.0% 1.8% Canada 5yr 2.3% 2.2% 1.8% 1.3% 2.0% 1.8% 15yr 3.1% 3.1% 2.6% 2.1% 2.9% 2.6% Japan 5yr 1.0% 0.9% 0.5% -0.1% 0.7% 0.4% 15yr 1.7% 1.6% 1.2% 0.6% 1.4% 1.2% We take French bonds to represent Eurozone bonds, as there is a reasonably liquid market in French inflation-linked bonds and we want to ensure consistency between the nominal and inflationlinked government bond returns. Our calculation of a weighted average Eurozone government bond yield leads to a figure which is slightly higher than the yield on French government bonds. Our analysis therefore supports the use of French bonds as a proxy for Eurozone bond portfolios, where these portfolios do not have a large exposure to the higher yielding periphery. Bond markets had a taper tantrum in May/June 2013 when the US Federal Reserve suggested that it was ready to consider tapering its quantitative easing program. Yields moved sharply upwards and ended the year much higher than before the Federal Reserve had spoken. However, experience in 2014 so far has been counter to what was very much a consensus view at the start of the year. Rather than continuing to move higher, yields have fallen back quite markedly and yield curves have flattened long duration yields have fallen by more than short duration yields. Key reasons for this lie in the deterioration in the European situation and also falling inflation rates. The European recovery has gone into reverse during Economic weakness and deflationary concerns mean that the European Central Bank ( ECB ) has eased monetary policy further, cutting interest rates and making cheap funds available to the banking sector. This has pushed European yields down sharply and further than elsewhere, particularly at short durations. Europe is a large part of the global economy and the deterioration in the European situation has raised concerns over the impact on growth prospects for other economies. Inflation has also been on a declining trend on a global basis and could fall further in the near term given falling commodity prices. Both a weaker growth environment and declining inflationary pressures mean that central banks are under less pressure to raise interest rates and a slower more gradual approach is likely thereafter. For example, at one stage markets were pricing in a strong likelihood that the Bank of England would raise interest rates before 2014 was over. Things have changed however and expectations for the first rate rise have since been pushed back towards the end of These factors have been major contributors to lower fixed income yields and flatter yield curves. As a result of this, our return assumptions for government bonds are now lower than at the start of the year in local currency terms, with assumptions for short duration bonds falling by more than long duration bonds. The short duration assumptions have fallen by more because the flattening in yield curves means that the average yield on these bonds over the projection period is a lot lower than at the start of the year. The larger downward moves in European bond yields lead to relatively large reductions in European fixed income bond assumptions during Significantly lower yields lead to much lower return assumptions for Swiss and Japanese government bonds in local currency terms. Aon Hewitt 7

8 Inflation-linked government bonds 10yr Annualized Nominal Return Assumptions USD GBP EUR CHF CAD JPY US 5yr 2.9% 2.8% 2.4% 1.8% 2.6% 2.4% 10yr 2.9% 2.8% 2.4% 1.8% 2.6% 2.4% UK 5yr 2.6% 2.6% 2.1% 1.6% 2.4% 2.1% 15yr 2.3% 2.2% 1.8% 1.2% 2.0% 1.7% Eurozone 5yr 2.1% 2.0% 1.6% 1.0% 1.8% 1.5% 10 yr 2.0% 2.0% 1.5% 1.0% 1.8% 1.5% Canada 5yr yr 2.4% 2.4% 1.9% 1.4% 2.2% 1.9% We have taken French bonds to represent Eurozone bonds, partly because there is a reasonably liquid market in French inflation-linked bonds. Our analysis of nominal government bonds also suggests that French bonds are a reasonable proxy for Eurozone government bonds so we make the same assumption here for consistency. The bonds represented are linked to Eurozone inflation. We formulate return assumptions for 10 year US and Eurozone inflation-linked government bonds rather than 15 year bonds. This is because we think that the absence of inflation-linked bonds at the longest durations in these markets can lead to misleading 15 year bond return assumptions. We also no longer publish a 5 year duration Canadian inflation-linked government bond assumption due to the lack of short duration bonds in this market. A second factor influencing inflation-linked bond return assumptions is inflation expectations. In this respect, returns from UK index-linked gilts benefit in relative terms compared with the other markets by virtue of the fact that returns on these bonds are linked to UK RPI inflation. This has an impact because other regional inflation-linked bond returns are linked to CPI inflation and this is assumed to be much lower than UK RPI inflation. UK real yields remain well below the level of the other markets so if it were not for the difference between RPI and CPI inflation, the return assumption for UK index-linked gilts would be much lower compared with the other regions than shown in the table above. A similar story holds for inflation-linked as for nominal government bonds when, after the large rises seen in 2013, real yields have fallen back in Short duration real yields are in negative territory for all of the markets covered in our Capital Market Assumptions and are even negative at long durations in the UK and Europe. Low real yields lead to low return assumptions for these bonds. 8 Capital Market Assumptions

9 Investment grade corporate bonds 10yr Annualized Nominal Return Assumptions USD GBP EUR CHF CAD JPY US 5yr 3.2% 3.1% 2.7% 2.1% 2.9% 2.6% 10yr 4.4% 4.4% 3.9% 3.4% 4.2% 3.9% UK 5yr 3.2% 3.2% 2.7% 2.2% 3.0% 2.7% 10yr 3.8% 3.8% 3.3% 2.8% 3.6% 3.3% Eurozone 5yr 1.9% 1.8% 1.4% 0.8% 1.6% 1.3% 10yr 2.6% 2.6% 2.1% 1.6% 2.4% 2.1% Switzerland 5yr 1.8% 1.7% 1.3% 0.7% 1.5% 1.2% 10yr 2.2% 2.1% 1.7% 1.1% 1.9% 1.6% Canada 5yr 3.3% 3.3% 2.8% 2.3% 3.1% 2.8% 10yr 4.2% 4.1% 3.7% 3.1% 3.9% 3.6% Japan 5yr 1.1% 1.1% 0.6% 0.1% 0.9% 0.6% 10yr 1.3% 1.2% 0.8% 0.3% 1.0% 0.8% Corporate bond returns depend on both a government yield component and a credit spread component but also take account of losses arising from defaults and bonds being downgraded. As with all fixed income assets, the decline in government yields during 2014 has put downward pressure on our corporate bond assumptions. However, in addition, credit spreads in many regions have declined and this means that corporate bond return assumptions have generally fallen by a larger amount than the government bond assumptions. US high yield debt and emerging market debt After having fallen to very low level, the high yield debt credit spread increased by a large 0.9% during the third quarter. This benefits future return expectations for high yield debt although low government yields continue to be a drag on long term prospects. Taking these points together as well as allowing for average default experience, US high yield debt is now assumed to return 4.2% a year over the next 10 years. When the US first mentioned that it may be ready to consider tapering, emerging market assets were among the worst affected, suffering very poor performance. This raised the credit spread that could be earned on US dollar denominated debt. This credit spread subsequently declined but remains elevated relative to US high yield debt. The differing movements in these credit spreads mean that a credit return premium has opened up for emerging market debt relative to high yield debt. As with high yield debt, lower Treasury yields have put downward pressure on the US dollar denominated emerging market debt assumption, which stands at 4.7% a year as at 30 September. Aon Hewitt 9

10 Equities 10yr Annualized Nominal Return Assumptions USD GBP EUR CHF CAD JPY US 6.7% 6.6% 6.1% 5.6% 6.4% 6.1% UK 7.4% 7.4% 6.9% 6.3% 7.2% 6.9% Europe ex UK 6.9% 6.8% 6.4% 5.8% 6.6% 6.3% Switzerland 6.6% 6.6% 6.1% 5.5% 6.4% 6.1% Canada 7.0% 6.9% 6.4% 5.9% 6.7% 6.4% Japan 6.5% 6.4% 5.9% 5.4% 6.2% 5.9% Emerging Markets 8.4% 8.3% 7.9% 7.3% 8.1% 7.8% Our equity return assumptions are driven by market valuations, earnings growth expectations and assumed payouts to investors. The price you pay is one of the single biggest drivers of returns, even over the long term. Looking back over recent experience, strong equity market performance has been driven more by increasing valuations than increasing profits. Therefore, as markets have become more expensive, our equity return assumptions have consequently fallen. UK equities have a higher return assumption than the other developed markets. The main reason for this is that this equity market is currently the cheapest of the developed markets in valuation terms. As at 30 September, UK equities were trading on a multiple of around 14 times our 2014 earnings assumption. In contrast, US equities were valued at over 17 times our 2014 earnings assumption. Investors in UK equities are therefore paying less for expected future earnings, which raises the return assumption for the UK market relative to elsewhere. Emerging market equities have significantly underperformed developed markets over the past few years for a variety of reasons including a reduction in emerging market growth prospects and more recently, concerns over the impact of less accommodative US monetary policy. This cheapened the relative valuation of emerging market equities and, even after allowing for a reduction in emerging market growth prospects, has led to an increased return premium opening up for emerging market equities over developed markets. The earnings growth component of our equity return assumptions comprises both near term and longer term elements. While our Capital Market Assumptions process typically involves using consensus inputs, for some time we have believed that the consensus of analysts forecasts has been unrealistically optimistic regarding near term earnings growth prospects. Unlike analysts, against a backdrop of weak global growth we do not expect company profit margins to increase from their already elevated levels. For this reason, we have developed our own in-house corporate earnings paths which have led to lower growth assumptions than forecast by the consensus. For the major developed markets, we assume low single digit earnings growth over the next few years. Not being influenced by short-term market sentiment, our near term earnings growth assumptions have been relatively stable overall, in contrast to consensus expectations which have varied far more. In the long term, we assume that companies earnings growth is related to GDP growth. Crucially, we do not assume a oneto-one relationship between a country s growth rate and the long term earnings growth potential of companies listed on the stock market within that country. We do this because many companies are international in nature and derive earnings from regions outside of where they have a stock market listing. An implication is that European company earnings have only about a 50% direct exposure to developments in the Eurozone and similarly, investors in non-european equity markets should not consider themselves insulated from events there either. It is also notable that emerging markets are an important driver of profits earned in the developed world. 10 Capital Market Assumptions

11 Private equity We assume that global private equity will return 9.0% per annum over the next 10 years in US dollar terms. The assumption represents a diversified private equity portfolio with allocations to leveraged buyouts (LBOs), venture capital, mezzanine and distressed investments. Return expectations for these different strategies depend on different market factors. For example, distressed investments are influenced by the outlook for high yield debt. Similarly, LBO returns are influenced by the outlook for equity markets as well as the cost of the debt used to finance these LBOs. The current low interest rate environment is therefore beneficial for LBO investors. Notwithstanding this, whereas in the past leverage has been a big driver of private equity returns, particularly for LBOs, in future the ability of managers to add value through operational improvements will become more important. On our analysis, the median private equity fund manager has historically performed in line with the median public equity manager, but high performing private equity managers have performed significantly better. Our assumption incorporates the level of manager skill ( alpha ) associated with such a high performing manager. This contrasts with our other equity return assumptions where no manager alpha is assumed. Real estate 10yr Annualized Nominal Return Assumptions USD GBP EUR CHF CAD JPY US 7.0% 6.9% 6.5% 5.9% 6.7% 6.4% UK 6.7% 6.6% 6.1% 5.6% 6.4% 6.1% Europe ex UK 6.4% 6.4% 5.9% 5.3% 6.2% 5.9% Canadian 5.8% 5.7% 5.3% 4.7% 5.5% 5.2% The US currently offers the highest real estate return assumption of all of the markets covered in our Capital Market Assumptions. Although capital values have been rising, this market continues to benefit from a healthy rental yield and a relatively robust outlook for rental growth. In Europe, signs of stabilization have provided some support to real estate capital values and they have been rising in parts of the region. This has put some downward pressure on rental yields although they have been more stable than in the other major markets. This region continues to offer a weak rental growth outlook because, unlike equity markets which benefit from their international exposure, real estate is much more closely tied to the fortunes of the region in question. A weak rental outlook acts as a drag on the return prospects for European real estate. Our assumptions here are in respect of a large fund which is capable of investing directly in real estate. The assumptions relate to the broad real estate market in each region rather than any particular market segment. Our analysis allows for the fact that real estate is an illiquid asset class and revaluations can be infrequent, leading to lags in valuations compared with trends in underlying market values. While our real estate assumptions do not include any allowance for active management alpha or active management fees, there is an allowance for the unavoidable costs associated with investing in a real estate portfolio. These include real estate management costs, trading costs and investment management expenses. Aon Hewitt 11

12 Hedge funds Volatility Our fund of hedge funds return assumption is 5.0% a year in US dollar terms. We formulate this by combining the return assumptions for a number of representative hedge fund strategies. As with private equity, this assumption includes allowances for manager skill and related fees (including the extra layer of fees at the fund of funds level), but unlike private equity, this is for the average fund of funds in the hedge fund universe rather than for a high performing manager. Our analysis allows for the fact that hedge fund managers have been unable to deliver the high levels of alpha that they did in the more distant past and that alpha generation is likely to remain challenging moving forwards. The individual hedge fund strategies we model as components of our fund of hedge funds assumption are equity long/short, equity market neutral, fixed income arbitrage, event driven, distressed debt, global macro and managed futures. Our modelling of these strategies includes an analysis of the underlying building blocks of these strategies. For example, we take into account the fact that equity long/ short funds are sensitive to equity market movements. In practice the sensitivity of equity long/short funds to equity markets can vary substantially by fund with some behaving almost like substitutes for long only equity managers, while others retain a much lower exposure. Our assumptions are based on our assessment of the average sensitivity across the entire universe of equity long/short managers. Given the nature of the asset class, our hedge fund return assumptions are more stable than, for example, our US equity return assumption. Nonetheless, the strategies are impacted by changes to the other asset class assumptions. For example, most hedge funds are cash+ type investments to a greater or lesser extent so the rise in cash return expectations during 2013 raised the hedge fund assumptions and the decline during 2014 has lowered the hedge fund assumptions. Similarly, changes to our equity and high yield return assumptions influence assumptions for those strategies which are related to these markets, such as equity long-short and distressed debt. 15yr Inflation-Linked Government Bonds 9.0% 15yr Government bonds 11.0% 10yr Investment Grade Corporate Bonds 9.0% Real Estate 14.5% US High Yield 14.0% Emerging Market Debt (USD denominated) 12.0% UK Equities 20.0% US Equities 19.0% Europe ex UK Equities 20.0% Japan Equities 20.0% Canada Equities 20.0% Switzerland Equities 20.0% Emerging Market Equities 28.5% Global Private Equity 26.0% Global Fund of Hedge Funds 8.0% As set out in the lead article to our 30 June 2013 Capital Market Assumptions publication, history, forward looking indicators and our view on the economic cycle all enter our volatility assumption setting process and the volatilities in the table above are representative for each asset class over the next 10 years overall. For illiquid asset classes, such as real estate, de-smoothing techniques are employed. All volatilities shown above are in local currency terms. For emerging market equities, global private equity and global fund of hedge funds the local currency is taken to be USD. Volatility in asset markets has fallen to unusually low levels given the uncertainties facing financial markets and the global economy. To a large extent this has been driven by the backstop that central banks have been providing to markets. One example concerns the statement by the President of the European Central Bank, Mario Draghi, that the central bank would do whatever it takes to save the euro. This reassured markets and brought about a period of relative calm when before there had been stress. When the US Federal Reserve stated in May 2013 that it may soon start to reduce some of the support that it has been providing to markets, volatility was reignited before falling back once again. Volatility again spiked more recently but only for a short period. Throughout, our assumptions have looked through this recent period of low volatility and instead have been and continue to be at a somewhat elevated level relative to history. Please note that due to the level of yields and shape of the yield curve in Japan and Switzerland, lower volatility assumptions apply to bond investments in these markets. 12 Capital Market Assumptions

13 Correlations IL FI CB RE UK Eq US Eq Eur Eq Jap Eq Can Eq CHF Eq EM Eq Gbl PE Gbl FoHF IL FI CB RE UK Eq US Eq Eur Eq Jap Eq Can Eq CHF Eq EM Eq Gbl PE Gbl FoHF 1 Domestic Inflation-Linked Government Bonds Domestic Government bonds Domestic Investment Grade Corporate Bonds Domestic Real Estate UK Equities US Equities Eurozone Equities Japan Equities Canada Equities Switzerland Equities Emerging Market Equities Global Private Equity Global Fund of Hedge Funds The matrix above sets out representative correlations assumed in our modelling work, shown on a rounded basis. All correlations shown above are in local currency terms and can be used by UK, US, European, Canadian and Swiss investors for the asset classes where return and volatility assumptions exist (e.g. Swiss real estate is not modelled). A different set of correlations apply for Japanese investors. Correlations are highly unstable, varying greatly over time, and this feature is captured in our modelling where we employ a more complex set of correlations involving different scenarios. Our correlations are forward looking and not just historical averages. In particular, we think that in many ways the experience of this millennium has been quite different from the previous 20 years, being more cyclical in nature with less strong secular trends. This has many implications. For example, the equity/government bond correlation in the table above is negative which also incorporates the feature that this correlation is negative in stressed environments. The lead article to the 30 June 2014 Capital Market Assumptions publication included further detail on the drivers of the equity/government bond correlation. Aon Hewitt 13

14 Capital market assumptions methodology Overview Aon Hewitt s Capital Market Assumptions are our asset class return, volatility and correlation assumptions. The return assumptions are best estimates of annualized returns. By this we mean median annualized returns that is, there is a 50/50 chance that actual returns will be above or below the assumptions. The assumptions are long term assumptions, based on a 10 year projection period and are updated on a quarterly basis. Material uncertainty Given that the future is uncertain, there is material uncertainty in all aspects of the Capital Market Assumptions and the use of judgment is required at all stages in both their formulation and application. Allowance for active management The asset class assumptions are assumptions for market returns, that is we make no allowance for managers outperforming the market. The exceptions to this are the private equity and hedge fund assumptions where, due to the nature of the asset classes, manager performance needs to be incorporated in our Capital Market Assumptions. In the case of hedge funds we assume average manager performance and for private equity we assume a high performing manager. Inflation When formulating assumptions for inflation, we consider consensus forecasts as well as the inflation risk premium implied by market break-even inflation rates. Government bonds The government bond assumptions are for portfolios of bonds which are annually rebalanced (to maintain constant duration). This is formulated by stochastic modelling of future yield curves. Inflation-linked government bonds We follow a similar process to that for nominal government bonds, but with projected real (after inflation) yields. We incorporate our inflation profiles to construct nominal returns for inflation-linked government bonds. Corporate bonds Corporate bonds are modelled in a similar manner to government bonds but with additional modelling of credit spreads and projected losses from defaults and downgrades. Other fixed income Equities Equity return assumptions are built using a discounted cashflow analysis. Forecast real (after inflation) cashflows payable to investors are discounted and their aggregated value is equated to the current level of each equity market to give forecast real (after inflation) returns. These returns are then converted to nominal returns using our 10 year inflation assumptions. Private equity We model a diversified private equity portfolio with allocations to leveraged buyouts, venture capital, and mezzanine and distressed investments. Return assumptions are formulated for each strategy based on an analysis of the exposure of each strategy to various market factors with associated risk premia. Real estate Real estate returns are constructed using a discounted cashflow analysis similar to that used for equities, but allowing for the specific features of these investments such as rental growth. Hedge funds We construct assumptions for a range of hedge fund strategies (e.g. equity long/short, equity market neutral, fixed income arbitrage, event driven, distressed debt, global macro, managed futures) based on an analysis of the underlying building blocks of these strategies. We use these individual strategies to formulate a fund of hedge funds assumption which is quoted in the Capital Market Assumptions. Currency movements Assumptions regarding currency movements are related to inflation differentials. Volatility Assumed volatilities are formulated with reference to implied volatilities priced into option contracts of various terms, historical volatility levels and expected volatility trends in future. Correlations Our correlation assumptions are forward looking and result from inhouse research which looks at historical correlations over different time periods and during differing economic/investment conditions, including periods of market stress. Correlations are highly unstable, varying greatly over time. This feature is captured in our modelling. Emerging market debt and high yield debt are modelled in a similar fashion to corporate bonds by considering expected returns after allowing for losses from defaults and downgrades. 14 Capital Market Assumptions

15 Contacts Duncan Lamont T: +44 (0) Disclaimer This document has been produced by Global Investment Consulting of Aon Corporation. Nothing in this document should be treated as an authoritative statement of the law on any particular aspect or in any specific case. It should not be taken as financial advice and action should not be taken as a result of this document alone. Consultants will be pleased to answer questions on its contents but cannot give individual financial advice. Individuals are recommended to seek independent financial advice in respect of their own personal circumstances. Aon Corporation 200 E. Randolph Street Chicago Illinois 60601, USA Copyright 2014 Aon Corporation

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