Capital Market Assumptions

Transcription

1 Capital Market Assumptions Deciphering the yield curve Much is written about the level of yields in the market and expectations regarding where yields are headed in future. However, less is written about the shape of the yield curve and this is the focus of this article. We first give an overview of three of the main explanations for the shape of the yield curve and then explain how these relate to current market pricing. Though described as hypotheses, these are not mutually exclusive and do not exist independently of each other. Normally, at any point in time they can often be used in combination with one other to explain different sections of the yield curve. Expectations hypothesis This hypothesis states that the shape of the yield curve is determined by market participants expectations for future interest rates. It is most useful for understanding the yield curve at short maturities but is less useful at longer maturities where other effects can dominate as described later. For example, this hypothesis suggests that the return on a 2 year bond is the same as the return you would earn by buying a 1 year bond today and then buying another 1 year bond immediately when the first one matures. This concept can then be extended to longer term bonds. For example the return on a 10 year bond is the same as the expected return earned by rolling over 1 year bonds on an annual basis. Put slightly differently, the 10 year yield is explained as the expectation for the 1 year yield over each of the next 10 years. This theory can be used to explain any shape of yield curve so long as the implied path for short rates can be justified. By extension, the current steep upward slope of the yield curve means that the market is expecting short dated interest rates to rise over time. Conversely, if the slope was downward sloping then this would be consistent with the market expecting short dated interest rates to fall over time, often indicative that a more challenging economic environment lay ahead. This theory can be useful in understanding the shape of the yield curve at short maturities, where the market has visibility on the future path of short interest rates forward guidance issued by central banks is the clearest example of this. However, it As of December 31, 2013 Contents Inflation 3 Government Bonds 3 Inflation-Linked Government Bonds 4 Investment Grade Corporate Bonds 5 US High Yield Debt and Emerging Market Debt 5 uities 6 Private uity 7 Real Estate 7 Hedge Funds 8 Volatility 9 Correlations 10 Capital Market Assumptions Methodology 11

2 2 Aon Hewitt Proprietary and Confidential struggles to explain the shape at longer maturities. Does an upward sloping yield curve between years 20 and 30 as is the case in many regions (see Chart) mean that the market is expecting interest rates to rise over that period? Given the lack of information that market participants have on central bank policy so many years into the future, this seems unlikely and further explanation is required. Liquidity Preference hypothesis. This hypothesis states that investors prefer their money to be readily available in liquid low-risk assets e.g. cash. Investors who lock their money up in longer dated bonds are taking on additional risks as longer dated bonds are less liquid and their prices are more sensitive to movements in interest rates (due to a concept known as duration). As a result, to compensate long bond investors for bearing these risks, they demand an additional premium over the return they would expect to earn by rolling over a series of short dated bonds. This can be contrasted with the Expectations hypothesis which would suggests these expected returns are equivalent. This hypothesis suggests that the longer the maturity, the larger the required rate pick-up/risk premium. As the risk premium increases with maturity, in isolation this suggests that yield curves should be upward sloping. It can also be combined with the Expectations hypothesis to describe the yield curve as reflecting expected short rates plus an additional liquidity premium which increases with maturity. This provides a reasonable explanation for the upward shape of the yield curve at all but the longest maturities in most markets. However, this explanation struggles to explain a curve which is flat or downward sloping at long maturities such as the current UK yield curve shown below. As the yield pick up suggested by the Liquidity Preference hypothesis increases with maturity, the only way a downward sloping yield curve could be rationalized would be if short rates were expected to continue falling over time. As already indicated, it seems unlikely that market participants are making major calls on central bank policy so far into the future. Segmentation hypothesis This hypothesis states that the slope of the yield curve is driven by supply and demand from investors and it can be used to explain just about every type of yield curve, providing a reasonable supply/demand argument can be made. It can even explain a yield curve that is downward sloping at long maturities. While more uncommon in the dominant US market, prior to the financial crisis, observers of the UK gilt market had grown used to a yield curve that sloped downwards at long maturities, even considering this normal. A well-recognized explanation for this attributes the inverted yield curve to excess demand from UK pension schemes to hedge their long dated liabilities with limited supply of matching long dated fixed income gilts. The yield curve deciphered Rather than relying on a single simple explanation, current yield curve shapes can be more usefully explained using a combination of the hypotheses outlined in this article, with different sections of curves driven by different factors: The current low level of short dated bond yields across the developed world is clearly driven by expectations that central banks will keep short rates at very low levels in the near term. The increase in yields over the subsequent few years is related to expectations of short rates rising over time. Japan is slightly different as Japanese short term interest rates have been very low for over 15 years and the Japanese central bank is in the midst of a major monetary easing program. Consequently, the market is not expecting Japanese short rates to increase any time soon and the Japanese yield curve is much flatter at short maturities than the other regions. Thereafter, the rising yield curve over intermediate to long maturities can be explained by the Liquidity Preference hypothesis. The Segmentation hypothesis can then be overlaid atop of these other two hypotheses to explain any divergences from them, such as the downward slope of the UK yield curve at long maturities. Government yield curves 4 3 Yield % 2 1 UK Japan US France Maturity Source: Bloomberg

3 Capital Market Assumptions 3 Inflation USD GBP EUR CHF CAD JPY CPI Inflation (10yr assumption) 2.2% 2.3% 1.8% 1.3% 2.0% 1.4% RPI Inflation (10yr assumption) 3.3% Given the sluggish pace of the global economic recovery and the spare capacity that exists in developed economies around the world, there are few immediate risks of inflation moving sustainably higher. This is reflected in consensus expectations, which indicate that only moderate inflation is expected in the US, Canada, Europe and the UK over the next few years. Over the next 10 years overall, CPI inflation is expected to be relatively close to central banks 2% target level in all of these regions. The Japanese authorities have undertaken huge amounts of monetary stimulus, committing to doubling the size of the monetary base within two years with an objective to generate growth and break the hold deflation has had over the economy, attaining a new higher inflation target of 2%. While these actions are impressive in scale, the consensus remains unconvinced that the 2% inflation target will be achieved and inflation is expected to be around 1.4% 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. Government Bonds 10yr Annualized Nominal Return Assumptions USD GBP EUR CHF CAD JPY US 5yr 3.2% 3.3% 2.8% 2.3% 3.0% 2.4% 15yr 3.6% 3.7% 3.2% 2.6% 3.3% 2.7% UK 5yr 3.1% 3.2% 2.7% 2.2% 2.8% 2.2% 15yr 3.5% 3.6% 3.1% 2.6% 3.3% 2.7% Eurozone 5yr 3.0% 3.1% 2.6% 2.1% 2.7% 2.1% 15yr 3.4% 3.5% 3.0% 2.5% 3.2% 2.6% Switzerland 5yr 2.1% 2.2% 1.7% 1.2% 1.9% 1.3% 15yr 2.9% 3.0% 2.5% 2.0% 2.7% 2.1% Canada 5yr 3.1% 3.2% 2.7% 2.2% 2.8% 2.3% 15yr 3.7% 3.8% 3.3% 2.8% 3.4% 2.8% Japan 5yr 1.6% 1.7% 1.2% 0.6% 1.3% 0.7% 15yr 2.2% 2.3% 1.8% 1.3% 2.0% 1.4% 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 inflation-linked 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. Government bond yields fell to exceptionally low levels during 2012 as a result of a combination of: (1) central bank actions, both through quantitative easing in its various forms and an expectation that interest rates would be kept low for an extended period of time and (2) safe haven flows resulting from the challenging economic environment and ongoing problems in the Eurozone. Yields also found support at low levels by an absence of any serious inflationary concerns.

4 4 Aon Hewitt Proprietary and Confidential However, since then there have been ever more convincing signs that the low in yields may now have passed and that the uneven path to higher yields is underway. Initially, improved sentiment regarding the state of the US economy and renewed central bank action, most notably the European Central Bank s declaration that it would underwrite peripheral European bonds and the Federal Reserve s launch of apparently open-ended quantitative easing, lifted the specter of gloom from markets. This relieved some of the demand for safe haven assets. Then, in response to continued economic improvement, the US Federal Reserve spooked markets last May by suggesting that it was ready to taper its quantitative easing program. This led to sharp upward moves in yields. Tapering was formally announced in December and yields ended the year markedly higher than they started it. Given the globally integrated nature of government bond markets, these developments have affected not just US yields but yields in other markets too. The consequence is that, though still very low by historic standards and relative to expected inflation, return assumptions for government bonds in the majority of regions are now at their highest level since June Higher yields mean that return assumptions for 15 year duration government bonds are somewhat higher in the UK and US markets than elsewhere in local currency terms, at 3.6% a year. Conversely, significantly lower yields lead to much lower return assumptions for Swiss and Japanese government bonds in local currency terms (2.0% and 1.4%, respectively). Inflation-Linked Government Bonds 10yr Annualized Nominal Return Assumptions USD GBP EUR CHF CAD JPY US 5yr 3.2% 3.3% 2.7% 2.2% 2.9% 2.3% 10yr 3.2% 3.3% 2.8% 2.2% 2.9% 2.3% UK 5yr 3.0% 3.1% 2.6% 2.1% 2.7% 2.1% 15yr 2.5% 2.6% 2.1% 1.6% 2.3% 1.7% Eurozone 5yr 3.0% 3.1% 2.6% 2.1% 2.8% 2.2% 10yr 2.9% 3.0% 2.5% 2.0% 2.7% 2.1% Canada 5yr 15yr 3.0% 3.1% 2.6% 2.0% 2.7% 2.1% 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 similar story overall holds for inflation-linked as for nominal government bonds, with real yields having risen significantly since earlier in 2013, raising return assumptions for these bonds. 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.

5 Capital Market Assumptions 5 Investment Grade Corporate Bonds 10yr Annualized Nominal Return Assumptions (AA-rated bonds) USD GBP EUR CHF CAD JPY US 5yr 3.9% 4.0% 3.5% 3.0% 3.6% 3.0% 10yr 4.5% 4.6% 4.1% 3.6% 4.3% 3.7% UK 5yr 3.8% 3.9% 3.4% 2.9% 3.6% 3.0% 10yr 4.2% 4.3% 3.8% 3.2% 3.9% 3.3% Eurozone 5yr 3.2% 3.3% 2.8% 2.3% 2.9% 2.3% 10yr 3.6% 3.7% 3.2% 2.7% 3.3% 2.7% Switzerland 5yr 2.5% 2.6% 2.1% 1.5% 2.2% 1.6% 10yr 3.1% 3.2% 2.7% 2.2% 2.9% 2.3% Canada 5yr 4.1% 4.2% 3.7% 3.2% 3.9% 3.3% 10yr 4.9% 5.0% 4.5% 3.9% 4.6% 4.0% Japan 5yr 1.7% 1.8% 1.3% 0.8% 1.4% 0.9% 10yr 2.1% 2.2% 1.7% 1.2% 1.9% 1.3% 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 large increases in government bond yields during 2013 have led to noticeable increases in return assumptions for corporate bonds although this has been offset to an extent by falling corporate bond credit spreads. Returns of around 4.5% are now assumed for long duration corporate bonds in all of the US, UK and Canada, the first time this has been the case since late However, in late 2011 return assumptions of this magnitude were driven principally by higher credit spreads whereas today they have been driven by higher return assumptions for the underlying government bond components. US High Yield Debt and Emerging Market Debt Rising Treasury yields have put upward pressure on our US high yield debt return assumption, although this has been partially offset by declining credit spreads. This was particularly the case during the fourth quarter when the high yield credit spread fell to a post-financial crisis low, well below its long term average level. Taking these points together as well as allowing for average default experience, US high yield debt is now assumed to return 4.5% 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. Although it reduced slightly in the fourth quarter it remains elevated relative to history, unlike the high yield credit spread. 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, higher Treasury yields have put upward pressure on the US dollar denominated emerging market debt assumption, which stands at 5.4% a year as at 31 December.

6 6 Aon Hewitt Proprietary and Confidential uities 10yr Annualized Nominal Return Assumptions USD GBP EUR CHF CAD JPY US 6.8% 6.9% 6.4% 5.9% 6.6% 6.0% UK 7.6% 7.7% 7.2% 6.6% 7.3% 6.7% Europe ex UK 7.0% 7.1% 6.6% 6.1% 6.8% 6.2% Switzerland 6.9% 7.0% 6.5% 5.9% 6.6% 6.0% Canada 7.5% 7.6% 7.1% 6.5% 7.2% 6.6% Japan 6.3% 6.4% 5.9% 5.3% 6.0% 5.4% Emerging Markets 8.8% 9.0% 8.4% 7.9% 8.6% 7.9% 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 2013, strong equity market performance was 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 31 December, UK equities were trading on a multiple of around 13 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 the US tapering its quantitative easing program. This has 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. 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 one-to-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. 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.

7 Capital Market Assumptions 7 Private uity We assume that global private equity will return 9.1% 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 7.2% 7.3% 6.8% 6.3% 7.0% 6.3% UK 7.0% 7.1% 6.6% 6.0% 6.7% 6.1% Europe ex UK 6.8% 6.9% 6.4% 5.8% 6.5% 5.9% Canada 6.2% 6.3% 5.8% 5.2% 5.9% 5.3% 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 recovered from their lows, this market continues to benefit from a healthy rental yield and a relatively robust outlook for rental growth. This can be contrasted with the Canadian market where, although there is a reasonable outlook for rental growth, this market offers a lower rental yield as capital values did not fall to the same extent as the US during the financial crisis. This results in a lower return assumption. In Europe, although there have recently been signs of stabilization, over recent years the economic difficulties facing the region have put downward pressure on capital values, raising rental yields and putting upward pressure on long term return prospects relative to elsewhere. However, this region offers the weakest 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.

8 8 Aon Hewitt Proprietary and Confidential Hedge Funds Our fund of hedge funds return assumption is 5.3% 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 modeling 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. Therefore, the fact that the return expectation for cash has picked up during 2013 has had a positive impact on hedge fund return assumptions. Counteracting this, the returns on many strategies are related to equity markets and the fact that our equity return assumptions have fallen puts downward pressure on our hedge fund assumptions.

9 Capital Market Assumptions 9 Volatility 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 uities 20.0% US uities 19.0% Europe ex UK uities 20.0% Japan uities 20.0% Canada uities 20.0% Switzerland uities 20.0% Emerging Market uities 28.5% Global Private uity 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. Until very recently, volatility in asset markets had fallen to unusually low levels given the uncertainties facing financial markets and the global economy. To a large extent this was 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. However, when the US Federal Reserve stated last May that it may soon start to reduce some of the support that it has been providing to markets, volatility was reignited. 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. This is consistent with implied volatilities and also our views regarding the outlook. 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.

10 10 Aon Hewitt Proprietary and Confidential Correlations IL FI CB RE UK US Eur Jap Can CHF EM Gbl PE Gbl FoHF IL FI CB RE UK US Eur Jap Can CHF EM Gbl PE Gbl FoHF 1 n IL Domestic Inflation-Linked Government Bonds n FI Domestic Government Bonds n CB Domestic Investment Grade Corporate Bonds n RE Domestic Real Estate n UK UK uities n Jap Japan uities n Can Canada uities n CHF Switzerland uities n EM Emerging Market uities n Gbl PE Global Private uity n US US uities n Eur Eurozone uities n Gbl FoHF Global Fund of Hedge Funds The matrix above sets out representative correlations assumed in our modeling 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 modeled). A different set of correlations apply for Japanese investors. Correlations are highly unstable, varying greatly over time, and this feature is captured in our modeling 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 last decade 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.

11 Capital Market Assumptions 11 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 modeling 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 modeled in a similar manner to government bonds but with additional modeling of credit spreads and projected losses from defaults and downgrades. Other Fixed Income Emerging market debt and high yield debt are modeled in a similar fashion to corporate bonds by considering expected returns after allowing for losses from defaults and downgrades. uities uity 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 uity 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 in-house 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 modeling.

12 SB4193 Disclaimer This document has been produced by the Global Investment Consulting of Aon plc. 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 plc Registered No: Registered Office: 8 Devonshire Square, London EC2M 4PL, United Kingdom Copyright 2014 Aon plc. All rights reserved. About Aon Hewitt Aon Hewitt is the global leader in human resource consulting and outsourcing solutions. The company partners with organizations to solve their most complex benefits, talent and related financial challenges, and improve business performance. Aon Hewitt designs, implements, communicates and administers a wide range of human capital, retirement, investment management, health care, compensation and talent management strategies. With more than 29,000 professionals in 90 countries, Aon Hewitt makes the world a better place to work for clients and their employees. For more information on Aon Hewitt, please visit