A Guide to the Strategic Corporate Pension Portfolios

Transcription

1 May 2018 A Guide to the Strategic Corporate Pension Portfolios WHITE PAPER The PNC Institutional Advisory Solutions (IAS) Investment Strategy team has developed the Strategic Corporate Pension Portfolios based on specific investment goals and objectives. This report discusses the portfolios and key elements of their development. While every institutional portfolio is customized to meet the needs of the particular client, we have built a series of so-called strategic portfolios to serve as a baseline for client portfolios with similar objectives and provide a starting point for helping similar clients achieve their long-term objectives. This report outlines the recommended Strategic Corporate Pension Portfolios and discusses the key elements of their development. The portfolios have been developed to address the specific challenges faced by pension plans with respect to balancing a potentially underfunded plan status with the need to control various plan-related risks to the plan sponsor, the longer duration nature of liabilities, and any ongoing liquidity needs. Additionally, we decided to develop this baseline portfolio set based on specific investment objectives deemed representative of typical corporate pension plans with similar objectives, regulatory, and/or accounting standards. The portfolios can serve as a baseline recommendation for corporate pension plans, regardless of size, access to a full asset-liability study, or desire for a glide path. 1 A high-level review of the plan s assets and liabilities is a good starting point to select an appropriate asset allocation for a pension plan. More robust asset-liability solutions, such as glide paths, that incorporate these portfolio construction principles can be prepared and implemented. Corporate Pension Client Profile The profile outlined in this report is unlikely to precisely describe any one pension client. Each client has unique and often rather complex needs. However, we have outlined several portfolios to guide the development of an asset allocation that fits a particular plan s needs. We believe it is important to establish baseline portfolios reflecting well-defined, albeit somewhat simplified, investment objectives as a starting point for addressing more complex situations. We start by defining, at a high level, a corporate defined-benefit (DB) pension plan. Chartered Financial Analyst (CFA) Institute provides the following description of a corporate DB pension plan: 2 a type of pension plan in which an employer promises a specified monthly benefit when an employee retires that is predetermined by a formula based on the employee s earnings history, tenure of service, and age, rather than depending on investment returns. In this particular case, the employer (that is, the plan sponsor) is typically a corporation that is, a legal entity that is separate and distinct from its owners. The Strategic Corporate Pension Portfolios are being developed for a hypothetical DB plan with the following key characteristics: Plan funded status: Underfunded to adequately funded A rule of thumb is the higher the deficit, the lower the funded status and, therefore, the lower the risk tolerance. If a funding shortfall already exists, the plan has relatively less ability (but perhaps not less willingness) to take on risk, particularly in 1 A glide path refers to the automatic adjustment of a targeted asset allocation based on a prescribed formula or quantitatively driven process over the time horizon of a pension plan and typically results in an allocation that becomes more conservative as the plan approaches the end of the horizon. 2 J. L. Maginn, D. L. Tuttle, D. W. McLeavey, and J. E. Pinto (Eds.), Managing Institutional Investor Portfolios, 3 rd ed., CFA Institute (New York: Wiley, 2007),

2 extreme situations where the viability of the plan might be called into question. For the sake of capturing the broadest group of plans with this analysis, we will assume that despite being underfunded, the plans still have the ability and willingness to take on more risk to increase the likelihood of maintaining and/or closing their funding gap. Additionally, due to taxation rules, pension plans have limited use for large surpluses because they cannot be easily returned to plan sponsors. Therefore, plans are disincentivized to maintain overly aggressive allocations at high funded status levels given the asymmetric reward-risk profile (that is, they may have limited upside and potentially unlimited downside). As a result, a closed or frozen pension plan s risk tolerance should decrease as funding levels improve. Sponsor financial status: Constrained In general, higher debt levels and leverage ratios coupled with required contributions from the plan sponsor imply relatively less risk tolerance. Common risk exposures: None The operating results of the corporation are presumed to have low or no correlation with investment returns for the purposes of this analysis, which implies a greater risk tolerance. However, special consideration may be given to plan sponsors that face correlated economic risks to the asset classes outlined in this report. Plan special features: None For the purposes of modeling and simulation, we assume there are no special features that might artificially lower the duration of plan liabilities, such as early retirement provisions or lump-sum distributions. The absence of any such provisions would imply a greater risk tolerance. Ultimate goal: Minimize risk Pension plans are a source of risk to a corporation s balance sheet, income statement, and cash position. Many plan sponsors desire to minimize marketrelated risks to the portfolio so that it does not affect the operations of the company. This is best achieved when the plan is fully funded by immunizing the liability stream with long-duration fixed income or by transferring the obligation to an insurance company. As mentioned earlier, fully funded plans with the desire to immunize interest rate risk are not the target audience for this particular analysis. We have also chosen to follow the recommended guidelines from CFA Institute with regard to the creation of an investment policy statement (IPS) 3 for this exercise. The Strategic Corporate Pension Portfolios are being developed for a hypothetical DB plan which meets the following criteria: Domicile: The DB plan is a U.S.-domiciled tax-exempt entity whose asset value and spending needs are dollar denominated. Risk profile: Despite the long time horizon, the DB plan has a moderate-to-high risk profile. An underfunded status and constrained balance sheet are partially offset by the lack of durationreducing special features and correlation with the market. Return objective: The primary return objective for the DB plan is to achieve a total return sufficient to fund its liabilities (that is, we define success in the modeling and simulations of our analysis by achieving modest, positive excess returns above the forecast liability stream in at least 50% of the scenarios modeled). This is unique relative to other strategic asset allocations we have developed, which typically target a specified rate of returns at the outset and defines a liability-centric approach. Time horizon: For the purposes of this analysis, we have assumed the plans using these portfolio recommendations are operating with a 10-year time horizon. Liquidity needs: We understand that pension plans make periodic distributions to participants, and these portfolios are designed to accommodate that need. Tax concerns: As a tax-exempt investor, the portfolio shall be invested in assets with a focus on total return without distinction made between returns generated from income or capital gains. 3 Ibid. 2

3 Legal/regulatory: the Employee Retirement Income Security Act of 1974, as amended (ERISA) and the Pension Benefit Guaranty Corporation (PBGC). Unique circumstances: The organization has sufficient size, scope, experience, and resources to qualify for and maintain an allocation to private equity, private real estate, and hedge funds. There are no self-imposed constraints against investing in certain asset classes or industries viewed as having negative ethical or welfare-related connotations that need to be considered in managing this portfolio. Composition and Development of the Portfolios Several key considerations are worth mentioning at the outset. Market Sensitivity of Pension Plan Liabilities The economic sensitivity of corporate DB plan liabilities is an important consideration. At the highest level, DB plan liabilities act like a highquality, investment-grade corporate bond, with a few important exceptions (that is, they are not affected by defaults and downgrades and do not typically have embedded options). This is mostly a result of prescribed assumptions from the Internal Revenue Service (IRS) and U.S. GAAP 4 on how to measure the obligations. The cash flows of a pension plan can be projected out several decades based on sophisticated actuarial techniques that incorporate a plan s provisions and thoroughly researched assumptions regarding life expectancy and participant behaviors. These payment streams can be discounted, much like cash flows from a corporate bond, to determine the liabilities present value. U.S. GAAP prescribes the use of a AA or higher corporate bond yield curve to measure liabilities for financial reporting purposes. The IRS requires the use of a A-AAA corporate bond yield curve (on a smoothed basis) to determine the liability measurement for plan funding purposes. The result of these prescribed discounting functions is a present value measurement that is highly sensitive to corporate bond interest rates at all points of the yield curve, and particularly at the longer end (maturities 10-plus years). This interest rate sensitivity is measured as duration. Most plans that are closed or frozen have an average duration of years. Because liabilities are reported on a net-basis for financial reporting and contribution requirements are determined based on shortfalls, a pension plan liability can be thought of as a large negative position in a corporate bond portfolio. We have examined and optimized the recommended portfolios in that context throughout this report. The size of the negative allocation will depend on the assumed funded ratio of the plan with higher negative allocations representing lower funded ratios. For this analysis, we have chosen to represent and model the typical liability stream for each portfolio based on the Merrill Lynch Average US Pension Plan AAA-A Corporate Discounted Index (PUAC), which was designed to track the performance of U.S. pension liabilities. 5 We relied on the index s historical volatility and correlations with the broader asset class universe, but we made some assumptions and minor adjustments using options-adjusted spreads, default rates, and the mix of government/credit exposures to better project the return over the 10 year forecast horizon. 6 Sources of Full Funding Pension plans have three primary sources to achieve full funding. First is the excess performance of returnseeking assets (RSA), such as public equities or alternatives. These asset classes generally have higher long-term return expectations 4 US GAAP stands for Generally Accepted Accounting Principles and is the accounting standard adopted by the U.S. Securities and Exchange Commission. 5 The index is compiled based on sample projected pension plan liabilities, provided by Mercer, for a typical average U.S. pension plan and measures the percentage change in the net present value of the pension liabilities themselves. This particular series, as its name suggests, tracks the AAA-A corporate discount curve. 6 Available upon request. 3

4 and volatilities than liabilities. To the extent the RSA returns exceed liability returns, the plan s funded status improves. However, the magnitude of this excess performance must increase as the funded status decreases due to the smaller asset pool necessary to support a growing liability. Second, as discussed previously, interest rates affect the measurement of plan liabilities. Increasing interest rates can shrink the market value of plan liabilities in comparison to plan assets for an underhedged plan. Finally, contributions play an important part in today s pension plan landscape. The Pension Protection Act of 2006 dramatically changed pension plan funding requirements. In short, pension plans must measure plan assets and liabilities under a prescribed set of assumptions to calculate a funded status. If that funded status is negative, the plan must make payments to amortize that deficit over seven years. In constructing our portfolios, we acknowledge that plans with an economic deficit will generally receive contributions that improve the plan s funded ratio. In our view, any single source will not likely drive a plan to full funding, but all must be considered when constructing an optimal asset allocation. A Spectrum of Corporate Pension Plan Scenarios Corporate pension plans today cover a broad range of time horizons and risk postures. One aspect of developing an appropriate asset allocation is considering both the expected time horizon and risk preferences of the fiduciaries managing the plan. To address this, we attempt to group pension plans based on these two measures and have developed a matrix of likely situations in which plan sponsors may find themselves (Figure 1, page 5). First, we look at a pension plan s time horizon, ranging from indefinite/long (10-plus years), to medium (5 10 years), and to short (fewer than 5 years). Next, we look at overall portfolio risk, which is a preference of the fiduciaries managing the plan. This preference is typically evident from a plan s allocation to return-seeking assets and can be explored with high-level asset-liability analysis or a more robust asset-liability study. We classify this as heavy, balanced, and light to denote the weight of RSA relative to liability-hedged assets (LHA). RSA are held with the expectation that returns will exceed the returns on plan liabilities over long time horizons. LHA primarily comprise investment-grade bonds selected to match a plan s liability profile and are held to reduce the volatility of a plan s funded status. This is accomplished by building a portfolio of bonds that moves in tandem with plan liabilities as market conditions change. Time horizon and portfolio risk are not the only two classifications to categorize pension plan positions. However, when combined, they create a broad representation of plan circumstances that require the development of unique asset allocations. Although in Figure 1 (page 5) we outline nine formal corporate pension allocations, we have also developed a tenth recommendation that does not fit neatly into the matrix. This allocation is designed for plans with very long time horizons (that is, well beyond 10 years) and that do not have the intention to terminate, and may thus require a heavy allocation to RSA. In this particular portfolio, we include an additional allocation to private equity. In general, we believe most plans fall into the three categories highlighted with green boxes in Figure 1. The risk preferences and time horizons of a plan will change over time, and therefore a plan will likely shift through these three most common categories. A typical glide path will use these three distinct portfolios to manage the plan s unique needs as its funded status evolves. Given the wide range of corporate DB plan circumstances, it isn t uncommon for a plan to fall into the other six categories. In this section, we will focus on the three portfolios along the diagonal that represent the three most common positions in which a plan may find itself. To illustrate the progression, we start by defining Portfolio 1. Consider a pension plan today with a large funding deficit of 70% on a projected benefit obligation (PBO) basis. The plan sponsor contributes the minimum, leaving the pension plan with a long expected time horizon to full funding. The plan maintains a significant allocation 4

5 Figure 1 Corporate Pension Allocation Matrix Dimension 2 - Portfolio Risk (RSA vs LHA) Heavy Balanced Light 75% RSA 50% RSA 25% RSA Dimension 1 - time horizon; investment opportunity Broad Liquid/Semi-liquid Narrow indefinite time horizon (10+ years) Portfolio 1 Portfolio 2 Portfolio 3 definite or medium horizon 5+ years Portfolio 4 Portfolio 5 Portfolio 6 Shorter time horizons Portfolio 7 Portfolio 8 Portfolio 9 Source: PNC to RSA in an attempt to outperform the plan s liabilities. Portfolio 1 is designed for a plan that can accommodate a broad opportunity set: The time horizon is long enough to allow strategies to play out over market cycles. There are sufficient RSA to provide liquidity for benefit payments. Allocations to alternative strategies can be large enough to be effective contributors to plan results. Public equity beta needs to be diversified to reduce portfolio volatility. Over time, the plan s funded status may improve with contributions and strong RSA performance. The plan sponsor s risk tolerance decreases with an improving funded ratio, and the allocation to RSA is decreased in favor of LHA into roughly equal proportions (Portfolio 5). The constraints on Portfolio 5 become narrower for a few reasons: The shorter time horizon leaves less time for long-natured strategies. The lower level of RSA leaves less room for meaningful allocations to alternative strategies. The plan is closer to its end state, and the need for liquid investments is greater to allow for opportunistic settlement of plan liabilities. The need for public equity diversification is lower due to the reduced equity exposure. Finally, as the plan s status shifts to the lower right (Portfolio 9), equity and interest rate risk have been substantially reduced as the plan approaches a full funding position and the sponsor has a much lower appetite for risk for fear of losing the funded ratio improvements. This new style of portfolio is distinctly different from the previous two styles. Portfolio 9 s investment set is limited because: The time horizon is short. 5

6 There aren t enough RSA to maintain meaningful allocations to alternative strategies. The return-seeking portfolio must be mostly liquid, else the portfolio may become overly concentrated to less liquid strategies. Public equity beta diversification is no longer a necessity since the overall portfolio exposure is low. Based on these core assumptions and special considerations, the primary focus/objective was to construct portfolios utilizing various combinations of traditional and alternative asset classes that would be capable of achieving modest excess returns above a plan s projected liability stream. High Level Allocations 7 We begin by laying out the asset allocations of the Strategic Corporate Pension Portfolios at a high level. As seen in Table 1 (page 7), public equities comprise the majority of the return-seeking portion of the portfolios (that is, excluding the liability hedge component). The sizable equity position reflects the need for significant long-term growth potential in the portfolios. It is also supported by the notion that because they tend to mean-revert, equities help stabilize long-run portfolio returns. Beyond the traditional asset classes commonly categorized within public equities, we were selective about incorporating additional asset classes, since the liability-hedging components of each recommended allocation take up a fairly significant portion of the overall portfolio. Instead of having small allocations to a broader list of asset classes, we chose quality over quantity and narrowed the list to six: private equity, private real estate, real estate investment trusts (REITs), global infrastructure, high yield, and emerging market debt. However, as the plan progresses toward fully funded status (that is, de-risks), some of these more unique asset classes drop off and are replaced by an increasing allocation to the liability hedge. Allocations to real estate offer the potential to derive consistent/recurring income generation for the portfolio, add diversification benefits via lower correlation to traditional asset classes, the potential to outpace inflation at various points in the economic cycle, and ultimately positive real returns. Also, historically, real estate has experienced lower volatility than other asset classes because it is typically less affected by short-term economic conditions. 8 Global infrastructure investments tend to have monopolistic features and contracts embedded with inflation adjusters, key characteristics that provide relatively lower risk expectations than both private equity and traditional large-cap core public equities. Relative to fixed income securities, infrastructure is unique in that the asset provides stable cash flows like traditional fixedcoupon bonds but with the potential for capital appreciation. The fixed income portions of the portfolios primarily consist of a long-duration government/ credit allocation (intended to match or at least partially hedge the liability stream), supplemented with smaller allocations to high yield and emerging market debt. These smaller allocations are considered RSA since high yield and emerging market debt tend to offer substantially higher return profiles over time than core taxable fixed income for tax-exempt investors, this is enough to justify their higher-risk profiles, in our view. Our analysis also shows the correlations/ characteristics of these asset classes tend to be additive from a portfolio diversification standpoint. Worth noting, we have deliberately excluded an allocation to commodities for a few reasons. There is no solid basis for believing that a long position in commodities earns a persistently positive and significant risk premium. Depending on the specific asset and environment, the risk premium may actually accrue to the short position. An exception to this is timber, which does typically generate a positive economic return over time and may be viewed as a component of a REIT allocation. Active trading strategies involving both long and short positions, that is, 7 The allocations shown in Table 1 are not intended to be a recommendation for a plan based solely on its funded ratio. The appropriate allocation between RSA and LHA can be determined with analysis of each plan s assets and liabilities. 8 Maginn et al., Managing Institutional Investor Portfolios,

7 Table 1 Asset Allocations of Corporate Pension Portfolios As of 4/30/18 Narrow Liquid/Semi-Liquid Broad Heavy (7) Balanced (8) Light (9) Heavy (4) Balanced (5) Light (6) Heavy (1) Balanced (2) Light (3) w/pe (10) Public Equities 75.00% 50.00% 25.00% 57.00% 40.00% 23.00% 53.00% 36.00% 18.00% 48.00% U.S % 26.00% 15.00% 34.00% 24.00% 12.00% 31.00% 22.00% 11.00% 28.00% International 23.00% 15.00% 10.00% 18.00% 12.00% 9.00% 17.00% 11.00% 7.00% 15.00% REITs 7.00% 4.00% 0.00% 0.00% 0.00% 2.00% 0.00% 0.00% 0.00% 0.00% Global 7.00% 5.00% 0.00% 5.00% 4.00% 0.00% 5.00% 3.00% 0.00% 5.00% Infrastructure Public Fixed Income 0.00% 0.00% 0.00% 10.00% 5.00% 2.00% 8.00% 5.00% 0.00% 8.00% High Yield 0.00% 0.00% 0.00% 4.00% 0.00% 0.00% 3.00% 0.00% 0.00% 3.00% Emerging 0.00% 0.00% 0.00% 6.00% 5.00% 2.00% 5.00% 5.00% 0.00% 5.00% Market Alternatives 0.00% 0.00% 0.00% 8.00% 5.00% 0.00% 14.00% 9.00% 7.00% 19.00% Hedge Funds 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 6.00% 4.00% 4.00% 6.00% Private 0.00% 0.00% 0.00% 8.00% 5.00% 0.00% 8.00% 5.00% 3.00% 6.00% Real Estate Private Equity 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 7.00% Liability Hedge 25.00% 50.00% 75.00% 25.00% 50.00% 75.00% 25.00% 50.00% 75.00% 25.00% U.S. Gov/Corp Long 25.00% 50.00% 75.00% 25.00% 50.00% 75.00% 25.00% 50.00% 75.00% 25.00% Illustrative Funded Ratio 75.00% 90.00% % 75.00% 90.00% % 75.00% 90.00% % 75.00% Cash 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% Shading connotes portfolios that lie along the diagonal in Figure 1. Source: PNC Commodity Trading Advisors, may be viewed as falling within our hedge fund allocation. Although natural resources tend to be positively correlated with short-term inflation, there is scant evidence they provide reliable protection of purchasing power over long horizons. The funded positions of Table 1 are approximations intended to represent the economic characteristics of plans that are poorly funded, underfunded, or adequately funded, respectively. The positive Liability Hedge positions in Table 1 (25%, 50%, 75%) are, in our view, meaningfully different and intended to represent allocations for the three funded levels these are not formal recommended allocations. The split between RSA and LHA can be best determined by either an asset-liability study or custom analysis from the IAS Pension Solutions Group. The key is to identify where a plan falls in the matrix and then prorate the allocations accordingly based on that RSA/LHA split. Other Related Considerations While the focus of the portfolios examined has been on the return-seeking components of the portfolio, we would like to make a few points regarding the Liability Hedge portfolio. We believe the plan s long bond portfolio should be constructed to limit the plan s funded status risk if interest rates move unfavorably. Our default recommendation for the Liability Hedge portfolio is a long duration bond portfolio tailored to the profile of the plan s liabilities. This is a departure from the conventional core bond portfolio that dominates asset-only frameworks. The primary reason for this allocation is to partially offset the significant interest rate risk inherent in pension plan liabilities. As discussed previously, pension obligations are highly sensitive to interest rate movements. A plan s funded status 7

8 can increase dramatically if interest rates rise faster than expected, even with a 50% allocation to long duration bonds. 9 A long duration bond portfolio, while giving up some upside in a rising rate environment, provides additional benefits to the portfolio. It provides protection to plan surpluses if interest rates fall. Additionally, the long duration portfolio typically provides higher yields than aggregate bond portfolios. This is important because pension plan liabilities also have an associated yield and increase with the passage of time. Liability yield is most similar to long-duration corporate bond yields, and a pension plan s funded status could deteriorate as time passes because the plan s liabilities yield more than a core bond portfolio. A long-duration bond portfolio reduces this drag on a pension plan s funded status. Many plan sponsors prefer to wait for interest rates to rise before extending the duration of the fixed income portfolio. This can be accommodated in a dynamic strategy if the sponsor has high conviction that rates will rise faster than what s currently priced into the market. However, our position is that waiting to extend duration is an opportunity cost to the plan and forgoes critical downside protection in falling rate environments. Negative portfolio returns may result from holding long-duration fixed income if interest rates rise dramatically. However, as discussed previously, this is a positive outcome overall for an underhedged pension plan. Therefore, we feel it is worth the risk of potential capital losses given the additional yield provided and the level of protection the long-duration bond portfolio provides relative to a core fixed income portfolio. We also give specific consideration to the government versus credit allocation of the Liability Hedge portfolio and the presence of return-seeking assets. Public equity and credit spreads tend to be correlated over long periods of time. The level of correlation can vary greatly from period to period; however, we generally consider that public equity and credit spreads have meaningful correlation. This correlation can lead to over-hedging a portfolio to changes in credit spreads. Our default recommendation is holding the market weight of the long-duration bond universe and adjusting the credit exposure in the Liability Hedge portfolio downward as the allocation to RSA increases and upward as the allocation to RSA decreases. Detail of Public Equity Allocations Table 2 (page 9) highlights the public equity allocations at a more granular level. As indicated in Table 2, we maintain a strategic home country bias relative to market capitalization weights, which would be closer to 50%/50% of total public equities. Aside from slavish adherence to market capitalization weights, we see no compelling reason for a bigger international allocation. Correlation among markets is quite high. With more than 20% already allocated to international stocks (and many U.S. managers holding some foreign stocks), the marginal diversification benefit beyond this level is likely to be small. The U.S. market is as diversified with respect to sectors and industries as the whole global market. International equities generally entail currency exposure, which adds volatility but is not necessarily adequately and reliably compensated and has not been shown to offer reliable purchasing power protection. Also worth noting, we do not have explicit allocations to Core equities in any of the corporate pension allocations. Including core allocations in the portfolios with small liability hedges and little to none in allocations with large liability hedges would have been inconsistent from a strategic perspective and overly complicated and impractical from an implementation standpoint. Excluding Core freed up some portfolio space to allocate to the alternative asset classes noted in the earlier section, maintain sizable allocations to each asset class, and, ultimately, preserve the ability to express a strategic Value style tilt. 9 Why is this the case? The plan is still underhedged. In this scenario, the plan is both underfunded and still partially invested in equities, which inherently leaves interest rate risk in the portfolio. At higher interest rates, the deferred payments become much less valuable relative to the hedging portfolio and the overall/total portfolio. The hedging portfolio moves proportionally to the liability, but the dollar magnitude of the changes are not one-for-one. 8

9 Table 2 Public Equity Allocations As of 4/30/18 Total Public Equity Narrow Liquid/Semi-Liquid Broad Heavy (7) Balanced (8) Light (9) Heavy (4) Balanced (5) Light (6) Heavy (1) Balanced (2) Light (3) w/pe (10) 75.00% 50.00% 25.00% 57.00% 40.00% 23.00% 53.00% 36.00% 18.00% 48.00% U.S % 30.00% 15.00% 34.00% 24.00% 14.00% 31.00% 22.00% 11.00% 28.00% Large Cap 19.00% 13.00% 8.00% 16.00% 12.00% 6.00% 13.00% 10.00% 5.00% 12.00% S&P 500 Growth 9.00% 6.00% 3.50% 7.50% 5.50% 2.50% 6.00% 4.50% 2.00% 5.50% S&P % 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% S&P 500 Value 10.00% 7.00% 4.50% 8.50% 6.50% 3.50% 7.00% 5.50% 3.00% 6.50% Mid Cap 12.00% 8.00% 4.00% 11.00% 7.00% 3.00% 11.00% 7.00% 3.00% 11.00% S&P 400 Growth 5.50% 3.50% 1.50% 5.00% 3.00% 1.00% 5.00% 3.00% 1.00% 5.00% S&P % 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% S&P 400 Value 6.50% 4.50% 2.50% 6.00% 4.00% 2.00% 6.00% 4.00% 2.00% 6.00% Small Cap 7.00% 5.00% 3.00% 7.00% 5.00% 3.00% 7.00% 5.00% 3.00% 5.00% S&P 600 Growth 3.00% 2.00% 1.00% 3.00% 2.00% 1.00% 3.00% 2.00% 1.00% 2.00% S&P % 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% S&P 600 Value 4.00% 3.00% 2.00% 4.00% 3.00% 2.00% 4.00% 3.00% 2.00% 3.00% REITs 7.00% 4.00% 0.00% 0.00% 0.00% 2.00% 0.00% 0.00% 0.00% 0.00% International 30.00% 20.00% 10.00% 23.00% 16.00% 9.00% 22.00% 14.00% 7.00% 20.00% Developed Large Cap MSCI MSCI World ex-us Growth 17.00% 11.00% 8.00% 13.00% 9.00% 7.00% 12.00% 8.00% 5.00% 11.00% 8.00% 5.00% 3.50% 6.00% 4.00% 3.00% 5.50% 3.50% 2.00% 5.00% MSCI MSCI World ex-us 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% MSCI MSCI World ex-us Value 9.00% 6.00% 4.50% 7.00% 5.00% 4.00% 6.50% 4.50% 3.00% 6.00% Emerging/Frontier Markets 6.00% 4.00% 2.00% 5.00% 3.00% 2.00% 5.00% 3.00% 2.00% 4.00% Global Infrastructure 7.00% 5.00% 0.00% 5.00% 4.00% 0.00% 5.00% 3.00% 0.00% 5.00% Shading connotes portfolios that lie along the diagonal in Figure 1. Source: PNC Public Equity Breakdown (Percent of Total) Table 3 (page 10) depicts the breakdown of public equities by both market capitalization (small, mid, and large) and style (growth and value) categories. As shown in Table 3, the portfolios are overweight in small cap and mid cap compared to their fairly low market capitalization weights. These allocations allow us to more fully capture the wellknown size factor, take advantage of the fact that mid-cap stocks often exhibit stronger performance as large-cap managers look for acquisition opportunities in relatively smaller firms, and, more generally, reduce reliance on mega-cap names that dominate the large-cap universe. We have also introduced explicit allocations to Growth and Value styles with a moderate tilt toward Value. The tilt toward Value reflects the well-known empirical regularity that over time Value stocks tend to outperform Growth stocks on a risk-adjusted basis. 9

10 Table 3 Public Equities by Market Capitalization and Style* As of 4/30/18 Narrow Liquid/Semi-Liquid Broad Approximate Heavy (7) Balanced (8) Light (9) Heavy (4) Balanced (5) Light (6) Heavy (1) Balanced (2) Light (3) w/pe (10) Market Cap Size U.S. Only** Large Cap 42.2% 43.3% 53.3% 47.1% 50.0% 42.9% 41.9% 45.5% 45.5% 42.9% 89.5% Mid Cap 26.7% 26.7% 26.7% 32.4% 29.2% 21.4% 35.5% 31.8% 27.3% 39.3% 7.3% Small Cap 15.6% 16.7% 20.0% 20.6% 20.8% 21.4% 22.6% 22.7% 27.3% 17.9% 3.2% Total*** Large Cap 48.0% 48.0% 64.0% 50.9% 52.5% 56.5% 47.2% 50.0% 55.6% 47.9% 70.5% Mid Cap 16.0% 16.0% 16.0% 19.3% 17.5% 13.0% 20.8% 19.4% 16.7% 22.9% 15.1% Small Cap 9.3% 10.0% 12.0% 12.3% 12.5% 13.0% 13.2% 13.9% 16.7% 10.4% 14.4% Style Growth 34.0% 33.0% 38.0% 37.7% 36.3% 32.6% 36.8% 36.1% 33.3% 36.5% Value 39.3% 41.0% 54.0% 44.7% 46.3% 50.0% 44.3% 47.2% 55.6% 44.8% * The size and style categories do not sum to 100% because we have excluded REITs, Global Infrastructure and Emerging Markets from the calculations. ** Relative to the S&P 500, S&P 400, and S&P 600 as a % share of maket capitalization in the S&P 1500, as reported via Factset. *** Relative to the Large, Mid, and Small Cap indexes comprising the MSCI AC World Index, as reported via Factset. Shading connotes portfolios that lie along the diagonal in Figure 1. Source: PNC Performance and Return/Risk Characteristics of the Portfolios The next sections examine the performance and estimated return/risk characteristics of the Strategic Corporate Pension Portfolios. Return Expectations Falling 10 Over the last 10 years, our capital market assumptions have been in a declining trend (that is, for both equities and fixed income), with much of this decline concentrated in the past 5 years. Our expected returns for equities and fixed income are approximately 150 and 100 basis points lower, respectively. Are equity returns in the 12-13% range considered reasonable, or are 7-8% returns more appropriate? At one time, 12-13% was considered a reasonable assumption, at least by historical standards. However, not so today, in our view. We think there has been a cyclical shift lower in returns largely a function of the following key items: where we presently stand at this stage of the business cycle (later innings); sluggish overall economic growth; peaking corporate profits and margins; a lack of capital investment activity; stretched valuations (at least by historical standards), which do not leave room for material multiple expansion; and being on the verge of a slow, but extended, interest rate tightening cycle. The implications from these views, of course, have had a material impact on how we think about designing portfolios for our clients and in conversations regarding long-term strategic asset allocation positioning, as well as tactical guidance, risk-taking/mitigating exposures, and shortfall risks. 10 The capital market assumptions used in this analysis are the rolling 10-year assumptions we publish at the end of each calendar year, which we believe for the purposes of this analysis are most representative of the time horizon associated with corporate DB plans. 10

11 The key consideration is, of course, how long do investment returns remain under pressure? Is it a cyclical change (that is, specific to the current business cycle) or more of a secular phenomenon (that is, with lasting, long-term effects)? We used 10-year capital market assumptions for modeling purposes in this analysis to more closely resemble what we believe a corporate DB plan is likely to experience over the course of several market cycles. Despite this, we do not see a materially improved returns backdrop over the next 10-plus years either. This translates into a heightened concern, in our view, regarding potential shortfall risks (that is, the risks a corporate DB plan s benefit obligations or liabilities exceed the amount of available assets/cash) and the associated implications of having to play catch up over the remainder of the horizon a highly undesirable outcome. Key Nominal Portfolio Characteristics The return expectations highlighted in Table 4 offer a useful means to compare the portfolios. Most importantly, portfolios should be selected based on a plan s position determined by the decision matrix outlined in the section A Spectrum of Corporate Pension Plan Scenarios (page 4) and not based on a targeted or pre-specified rate of return. Table 4 summarizes the key characteristics of our Strategic Corporate Pension Portfolios, both from an asset-only perspective and including the projected liability stream. The expected (that is, arithmetic) returns shown are not compounded returns. Hence, they should not be interpreted as the growth rate of the portfolio over multiperiod horizons. Using a well-known volatility adjustment, 11 we have approximated the expected nominal growth rates for each of the Corporate Pension Portfolios as shown in the line labeled Median Compound Growth Rate in Table 4. The Projected Excess Returns represent the expected portfolio returns in excess of the expected liability returns. These returns reflect the higher return requirement for plans with lower funded ratios given the smaller pool of assets that support the liabilities. Conclusion Finding the optimal balance between return and risk is always a key issue in choosing the appropriate asset allocation and overarching investment strategy to meet a client s goals and objectives. What makes this exercise even more important for underfunded corporate DB plans, but all the more challenging in today s environment, is the trend of declining forward investment returns. We remain mindful of the more difficult return environment, but have chosen to take a liability-centric approach to developing corporate pension plan strategic asset allocations. This means we strived in our research and analysis to achieve modest, positive excess returns above the forecast liability stream, instead of explicitly targeting predefined rate(s) of return. We believe the liability-centric approach is better suited to meet the individual needs of corporate DB Table 4 Key Portfolio Characteristics As of 4/30/18 Narrow Liquid/Semi-Liquid Broad Heavy (7) Balanced (8) Light (9) Heavy (4) Balanced (5) Light (6) Heavy (1) Balanced (2) Light (3) w/pe (10) Asset-Only Expected Arithmetic Return 6.73% 5.77% 4.84% 6.64% 5.73% 4.82% 6.56% 5.66% 4.79% 6.74% Volatility 12.81% 9.12% 7.41% 11.33% 8.35% 7.57% 10.92% 8.07% 7.19% 11.35% Median Compound Growth Rate 5.94% 5.35% 4.48% 5.97% 5.32% 4.46% 5.95% 5.29% 4.48% 6.03% Asset-Liability Projected Excess Return 0.45% 0.42% 0.09% 0.36% 0.38% 0.07% 0.28% 0.31% 0.04% 0.47% Shading connotes portfolios that lie along the diagonal in Figure 1. Source: PNC 11 The growth rate is approximately equal to the annual expected return minus one-half the annual variance. 11

12 plans, particularly given their numerous and unique regulatory constraints. With this as the backdrop, the IAS Investment Strategy team has conducted extensive analysis to design/develop customized solutions specifically for corporate DB plans, and this paper is the culmination of that research effort. Indeed, we think these Strategic Corporate Pension Portfolios are excellent solutions capable of meeting the unique needs, long-run return objectives, and benefit obligations of typical corporate DB plans over a 10 year investment horizon. Amanda E. Agati, CFA Managing Director, Institutional Chief Investment Strategist Adam Hickman, ASA Asset Liability Research Director The PNC Financial Services Group, Inc. ( PNC ) uses the marketing name PNC Institutional Advisory Solutions for discretionary investment management, trustee, and other related activities conducted by PNC Bank, National Association ( PNC Bank ), which is a Member FDIC. Standalone custody, escrow, and directed trustee services; FDIC-insured banking products and services; and lending of funds are also provided through PNC Bank. These materials are furnished for the use of PNC and its clients and does not constitute the provision of investment advice to any person. It is not prepared with respect to the specific investment objectives, financial situation, or particular needs of any specific person. Use of these materials is dependent upon the judgment and analysis applied by duly authorized investment personnel who consider a client s individual account circumstances. Persons reading these materials should consult with their PNC account representative regarding the appropriateness of investing in any securities or adopting any investment strategies discussed or recommended in this report and should understand that statements regarding future prospects may not be realized. The information contained in these materials was obtained from sources deemed reliable. Such information is not guaranteed as to its accuracy, timeliness or completeness by PNC. The information contained in these materials and the opinions expressed herein are subject to change without notice. Past performance is no guarantee of future results. Neither the information in these materials nor any opinion expressed herein constitutes an offer to buy or sell, nor a recommendation to buy or sell, any security or financial instrument. Accounts managed by PNC and its affiliates may take positions from time to time in securities recommended and followed by PNC affiliates. PNC does not provide legal, tax, or accounting advice unless, with respect to tax advice, PNC Bank has entered into a written tax services agreement. PNC does not provide services in any jurisdiction in which it is not authorized to conduct business. PNC Bank is not registered as a municipal advisor under the Dodd-Frank Wall Street Reform and Consumer Protection Act ( Act ). Investment management and related products and services provided to a municipal entity or obligated person regarding proceeds of municipal securities (as such terms are defined in the Act) will be provided by PNC Capital Advisors, LLC. Securities are not bank deposits, nor are they backed or guaranteed by PNC or any of its affiliates, and are not issued by, insured by, guaranteed by, or obligations of the FDIC, the Federal Reserve Board, or any government agency. Securities involve investment risks, including possible loss of principal. PNC Institutional Advisory Solutions is a registered service mark of The PNC Financial Services Group, Inc The PNC Financial Services Group, Inc. All rights reserved. 12