INSIGHTS FOR PENSION DECISION-MAKERS INSIGHTS. U.S. Corporate Pension Financial Performance 2007: How does your plan compare?

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1 INSIGHTS FOR PENSION DECISION-MAKERS INSIGHTS U.S. Corporate Pension Financial Performance 2007: How does your plan compare?

2 About JPMorgan Asset Management Strategic Investment Advisory Group The Strategic Investment Advisory Group (SIAG) partners with clients to develop objective, thoughtful solutions to the broad investment policy issues faced by corporate and public defined benefit pension plans, insurance companies, endowments and foundations. Our global team is one of JPMorgan s primary centers for thought leadership and advisory services for institutional clients in the areas of asset allocation, pension finance and risk management. The team s expertise is supported by powerful analytical capabilities for conducting assetliability, risk budgeting and optimal asset allocation analysis, in line with client-specific investment guidelines, risk tolerance and return requirements. In response to the changing needs of CFOs, treasurers and CIOs, our suite of tools has been expanded to include corporate finance-based risk management analytics for assessing and proactively managing the impact of the pension plan on the corporation as a whole. SIAG brings a deep knowledge and understanding of capital markets behavior to all its advisory services, ensuring results and recommendations have real-world consistency and can be tested under a variety of market scenarios. Strategic Investment Advisory Group services are offered as part of an overall asset management relationship to complement the many ways in which JPMorgan Asset Management provides clients with value-added insights. About JPMorgan Asset Management For more than a century, institutional investors have turned to JPMorgan Asset Management to skillfully manage their investment assets. This legacy of trusted partnership has been built on a promise to put client interests ahead of our own, to generate original insight, and to translate that insight into results. Today, our advice, insight and intellectual capital drive a growing array of innovative strategies that span U.S., international and global opportunities in equity, fixed income, real estate, infrastructure, private equity, hedge funds and asset allocation.

3 John H. Hunt Chief Executive Officer, Institutional Americas, JPMorgan Asset Management Foreword Suddenly, corporate pension plans are demanding an increasing share of attention from nearly every CFO, treasurer and CIO. While many plans have experienced continued improvement in funded status, they have also witnessed the initiation of a new and challenging era for pension leaders. For the largest 150 U.S. corporate defined benefit plans, strong market returns in 2006 spurred asset growth while rising interest rates curtailed liabilities, resulting in an increase in funded status for the median plan, from 86% in 2005 to 93% in These positive market forces continued through the first half of However, pension reform headwinds tempered plan sponsors exuberance and heightened the focus of corporate executives on the potential risks of the pension plan to the corporation as a whole. For the seven years that we have published our annual report on the financial performance of the largest U.S. corporate DB plans, our goal has been to provide an actionable corporate perspective on pension plan results. With the enactment of the Pension Protection Act (PPA) and SFAS 158 in 2006, and possible Phase II FASB reforms on the horizon, the link between the pension plan and the financial well-being of the corporation has become increasingly transparent. In response, we have endeavored to assist our clients as they seek new strategies and tools for managing the delicate balance between optimal returns and minimal risk, not only for the plan but for the sponsoring corporation as well. This year s review focuses more than ever on pension plan performance through the corporate finance lens, applying new risk management tools to the holistic assessment of pension risks. Many of our readers may already be familiar with our corporate at risk measurements for earnings, cash flow and stockholders equity. In this report, we introduce you to new applications of these risk management tools which allow our corporate clients to assess how effectively they are managing their pension plans relative to their peers. I hope you will find the enclosed analysis insightful and, most importantly, of value in making more informed pension investment decisions. As I embark on my new role as CEO of JPMorgan s Institutional Americas Asset Management team, I want to assure you of our continued commitment to assist corporate CFOs, treasurers and CIOs in their efforts to respond to the needs of pension plan participants and shareholders alike and to provide you with innovative investment management strategies, frameworks, tools and expertise for managing the total risk of your pension plans. Best regards, John H. Hunt john.h.hunt@jpmorgan.com

4 Authors: Bill McHugh Managing Director, Head of the Strategic Investment Advisory Group Gabriella Barschdorff, CFA Vice President, Strategic Investment Advisory Group Abdullah Sheikh, FIA, FSA Strategic Investment Advisory Group U.S. corporate pension financial performance 2007: How does your plan compare? Table of Contents Executive summary Introduction Status of U.S. corporate pension plans Putting funded status in perspective: Assessing the upstream impact of the plan on the corporate sponsor Managing pension risk How does your plan compare? JPMorgan U.S. corporate pension plan peer group analysis tool Conclusion Appendix Editor: Barbara Heubel Vice President Institutional Investment Marketing

5 Our risk metrics suggest 40% of the top 150 plans may have cause for concern Executive summary U.S. corporate defined benefit plan status In 2006, the largest 150 U.S. corporate defined benefit pension plans experienced another strong year. For the median plan: Liabilities grew by just 5.3%, the slowest rate in seven years, held down by an increase in longterm discount rates. Assets grew by 16.3%, given solid investment returns of 12.9% and contributions of 3.4%. Funded status improved from 86% to 93% versus year-end The percentage of plans fully funded at year-end 2006 nearly doubled versus the prior year, increasing from 16% to 31% update So far in 2007, markets have continued to boost pension plan s funded status. We estimate that the median plan ended the first half of this year 96% funded versus 93% at year-end Putting funded status in perspective Recent regulatory and accounting changes have led to heightened awareness of the upstream impact of the pension plan on the sponsoring corporation. To help assess the financial risks of the pension plan to the corporation, we applied our set of at risk metrics to the 150 largest plan universe. The amount at risk is defined as the difference between the expected and worse case * impact of pension plan performance on selected corporate financial measures (shareholders equity, cash flow and earnings). Assuming 10% at risk is cause for concern, we estimate that for our 150 plan universe as a whole, risk levels attributable to the pension plan appear generally manageable, given the following median plan results: 9% of after-tax shareholders equity is at risk as a result of the pension plan 8% of operating cash flow is at risk 6% of after-tax earnings is at risk These median values, however, mask vast differences across corporations. For our 150 plan universe, approximately 40% have at risk ratios exceeding the 10% level. Furthermore, if Phase II of FASB s accounting reforms eliminate smoothing and amortization techniques in calculating pension expense, the risk to earnings could be considerably greater. Managing pension risk Considerable downside risk reduction can be achieved by hedging away interest rate risks through duration extension strategies and by diversifying the sources of portfolio alpha and beta. As a result, we see a shift in portfolio allocations to longer duration strategies, a decrease in traditional equity allocations and an increase in international, alternative and other nontraditional asset classes. Competitive analysis Using the above at risk metrics and other analytical tools, together with a rich source of financial information for the top 150 corporate plans, we are able to provide CFOs, treasurers and CIOs with insights to support their efforts in making effective pension plan related decisions. * Since on a forward-looking basis the worst case is unknown, we use the market experience of 2002 and refer to this as a worse case scenario. 1

6 2006 another strong year for pension plans, but better tools for risk management are needed Introduction In this, our annual report on the state of the largest 150 U.S. corporate defined benefit pension plans 1, we review prior year pension plan financial performance, identify industry trends and evaluate pension results from the perspective of the plan as well as the corporation. Our objective is not simply to report results, but to provide CFOs, treasurers and CIOs with insights critical to making informed pension investment decisions. In the first section of this report we focus on the status of U.S. corporate pension plans and the drivers of the improvement in funded status for In the second section, we put the improvement in funded status in perspective. Despite strong performance, plan sponsors find themselves at a crossroads. Recent regulatory and accounting changes have increased the transparency of the costs and risks associated with sponsoring defined benefit pension plans. We discuss the potential impact of these recent rule changes on the largest 150 plans and provide a framework for measuring the potential upstream effects of pension plan performance on the sponsoring corporation. In section three, we explore ways to effectively and proactively manage the risk of the pension plan to the corporation. The discussion focuses on hedging uncompensated risk exposures such as interest rate risk, as well as on diversifying alpha and beta sources within the pension portfolio. Finally, as pension reforms strengthen the link between plan performance and shareholder value, we continue to build on our corporate finance framework for managing pension assets. In the final section of this report, we illustrate the type of pension decision-making insights that we develop for clients in order to help them make more informed investment decisions. This involves using our analytical framework and tools to combine planspecific information with our analysis of the 150 largest U.S. corporate pension plans and their industry subgroups. We use a hypothetical example to illustrate the value of this peer group analysis. Status of U.S. corporate pension plans 2006 Another strong year The funded status of the nation s 150 largest corporate pension plans improved during 2006 as reflected in Exhibit 1. As of year end 2006, the median plan was 93% funded compared to 86% at the end of The percentage of plans that were fully funded almost doubled, from 16% in 2005 to 31% in The improvement in funded status noted in Exhibit 1 was attributable to: asset returns (12.9% for the median plan) and large contribution levels (totaling $37 billion for the 150 plans) resulting in strong asset growth, and an average increase in discount rates of 18 basis points, which had the effect of curtailing liability growth. Given these factors, assets grew by 16.3%, outpacing liabilities which grew by only 5.3%. 1 We obtained the data for this report from the December 31, 2006 annual financial statements of the U.S. corporations who sponsor the largest 150 corporate defined benefit pension plans. The plans range in size from $1.2 billion to $113 billion in 2006 year-end total plan assets. 2

7 Exhibit 1: End-of-year funded ratios for top 150 corporate plans Funded ratio 190% 170% 150% 130% 110% 90% 70% 50% Average of top 20% Median plan Average of bottom 20% End-of-Year Sources: JPMorgan Asset Management, P&I, company annual reports Factors driving assets and liabilities Exhibit 2 is a simplified schematic of the components of liability and asset growth during Exhibit 2: Components of 2006 asset and liability growth 0% 5.3% 5.5% 2.5% (2.7%) Liability growth Interest cost Decomposing liability growth The first two components of liability growth are service cost (the present value of incremental pension benefits earned by active workers each year) and interest cost (the increase in the present value of pension benefits due to the passage of time), which represent the normal growth of a pension liability each year. The third component (duration-related Service cost Duration-related change Sources: JPMorgan Asset Management, P&I, company annual reports % 3.4% 12.9% 2001 Asset growth Contributions Investment return 2006 change) reflects the impact of changes in interest rates on the valuation of plan liabilities. The duration-related change can result in increases in liability values (in a declining interest rate environment) or decreases in liability values (in a rising interest rate environment). To the great relief of many plan sponsors, long-term discount rates finally rose in 2006 after six years of decline (Exhibit 3). The average discount rate used by plans in our universe of the top 150 corporate plans rose from 5.55% in 2005 to 5.73% in The increase in discount rates had the effect of driving down liability values by approximately 2.7%. The rise in discount rates, coupled with a continued decline in service cost (from 3.2% in 1999 to 2.5% in 2006) resulted in an average liability growth rate of 5.3%, the slowest since Exhibit 3: End-of-year long-term high quality market discount rates and average reported pension discount rates Discount rate 8.0% 7.5% 7.0% 6.5% 6.0% 5.5% Average rate used by companies Market rate 5.0% End-of-year Sources: JPMorgan Asset Management, Lehman Brothers, P&I, company annual reports. The chart shows the average discount rate used to value the pension liabilities as reported in financial statements, as well as the Lehman Brothers Long AA yield (the market rate). Decomposing asset growth Asset growth is a combination of investment returns and contributions. As seen in Exhibit 2, asset growth as a whole was very strong in Median investment returns of 12.9%, together with contributions of 3.4%, provided total asset growth of 16.3%. 3

8 Median funded status saw further improvement in the first half of 2007 Investment return Pension portfolios experienced double-digit growth in 2006, for the third year out of the past four. As in most previous years, large plans tended to do better than small plans with about 1.4% outperformance in Possible explanations include differences in asset allocation by size of plan, with the very largest plans typically having a greater proportion of assets in higher-performing alternative strategies, as well as better access to top-performing managers. Exhibit 4: Return on plan assets in the top 150 corporate plan universe Actual return on assets (%) Median -8.9% 21.1% 11.6% 9.6% 12.9% By plan size Largest decile Smallest decile Sources: JPMorgan Asset Management, P&I, company annual reports Contributions Among our universe of the top 150 corporate plans we found: 96% of plan sponsors made contributions in Contributions as a percent of plan assets were 3.4%, the lowest level since The average contribution was $245 million (the median was lower at $110 million). The largest contribution in dollar terms was $3.1 billion. Exhibit 5: Employer contributions as a percentage of plan assets Median 1.8% 4.8% 5.0% 4.9% 3.4% Largest contribution % Plans who made contributions Sources: JPMorgan Asset Management, P&I, company annual reports As in previous years, realized contributions were higher than planned (3.4% versus 1.9% of plan assets). For 2007, companies have stated that they are expecting to contribute a bit less still, equivalent to only about 1.6% of plan assets update So far in 2007, markets have provided a further boost to pension plan funded status. As of June 30, 2007, we estimate that the median plan s funded status was 96%, an improvement compared to 93% at the end of The main drivers have been a slight uptick in discount rates during this period, as well as strong equity market performance 2. 2 Lehman Brothers Long AA yield was 5.86% on June 30, 2007, compared to 5.5% year-end S&P 500 and EAFE have risen by 7.9% and 10.4% respectively. In this estimate we have assumed half a year's worth of service cost and benefit payments. 4

9 Putting funded status in perspective: Assessing the upstream impact of the plan on the corporate sponsor Despite the fact that funded ratios have improved and pension deficits are generally modest in size, in many cases the pension plan may still pose a significant financial risk to the corporate sponsor. This is especially true given that risks and costs associated with sponsoring defined benefit plans have become more transparent with the enactment of the Pension Protection Act (PPA) and SFAS 158 in 2006 (see Appendix for details). If another period of falling rates and/or declining equity markets were to occur, pension plans could be seriously affected and with them, corporate balance sheets and cash flows. Assessing these risks requires a dynamic and forward-looking analysis that can capture the relationships between financial market performance, the funded status of pension plans, and the financial well-being of corporate sponsors. Analyzing surplus volatility 3, which brings assets and liabilities together, is a step in the right direction. However, in our work with corporate clients, we go one step further. We measure the upstream impact of the pension plan on the corporation using three risk metrics: Shareholders Equity@Risk (SHE@R), Cash Flow@Risk (CF@R) and Earnings@Risk (E@R). These metrics define risk as the difference between the expected and a worse case impact of the plan on the corporation. For example, as seen in Exhibit 6, in assessing the potential impact of a hypothetical plan on shareholders equity, we calculate that the expected change in shareholders equity, given the pension plan s asset allocation, will be an increase of $265 million. In a worse case scenario we estimate that instead of increasing by $265 million, shareholders equity would decrease by $3,194 million. The difference between the expected impact and worse case scenario is the Shareholders Equity@Risk amount of $3,459 million. Similar calculations can be done to assess the plan s potential impact on corporate cash flow and earnings A corporate finance view We applied metrics to the 150 largest U.S. corporate pension plans. Since we did not have access to projected cash flows and projected net income for all companies, we used actual 2006 cash flow from operations and 2006 net income in our analysis. In addition, for the sake of simplicity, we ignored the phase-in rules for PPA and assumed it was fully implemented. While the worse case scenario can be defined in several ways, in our analysis of the top 150 corporate plans, we defined it Exhibit 6: Corporate finance-based metrics for assessing the pension risk of Company A Shareholders' Equity@Risk SHE@R SFAS 158 expected change in shareholders' equity $265 MM worse case scenario -$3,194 MM Shareholders' Equity@Risk (SHE@R) $3,459 MM Cash Flow@Risk CF@R Pension Protection Act (PPA) expected contribution requirement $510 MM worse case scenario $1,028 MM Corporate Cash Flow@Risk (CF@R) $518 MM (for 7 years) Earnings@Risk E@R FASB 87 and Phase II expected pension expense $250 MM worse case scenario $904 MM Corporate Earnings@Risk (E@R) $654 MM (for 15 years) numbers are defined as the difference between the expected outcome and the worse case outcome. Source: JPMorgan Asset Management. Hypothetical example. 3 Surplus volatility is defined as the standard deviation of the difference between asset and liability returns. 5

10 Median pension measures mask significant risks to many sponsoring corporations as a repeat of the actual capital market events of We chose this definition because it is a quite recent, real event that for pension plans truly did represent a worse case scenario 4. Our analysis for the top 150 plans indicates that for the universe as a whole, risk levels seem relatively manageable, with the median numbers as follows 5 : After-tax Shareholders Equity@Risk versus Shareholders Equity 9% Cash Flow@Risk versus total Operating Cash Flow 8% After-tax Earnings@Risk versus Net Income 6% However, these median values mask vast differences across corporations, with quite a few cases in which a corporation s results are much higher than the median, indicating that the pension plan can pose a significant risk to the company. In Exhibits 7 through 9, we show the number of plans within the top 150 that fall into each category of riskiness relative to underlying corporate financials. In conducting this analysis, we assumed levels in excess of 10% of shareholders equity, operating cash flow and net income would be deemed significant by most plan sponsors. If, for example, given a plan s current asset allocation, a Exhibit 7: Number of top 150 plans by Shareholders Equity@Risk ratio Number of complanies companies (48%) 13 Up to 10% 11-20% 21-30% 31-40% Greater than 40% Shareholders' Risk vs. Shareholders' Equity Sources: JPMorgan Asset Management, P&I, company annual reports 6 23 company s Shareholders Equity@Risk (on an aftertax basis) is $20 million and total year-end shareholders equity was $200 million then 10% of the company s shareholders equity is at risk due to the pension plan. As Exhibit 7 shows, 72 companies, or 48% of the companies in our sample, have estimated Shareholders Equity@Risk above 10% of shareholders equity. Similarly, if the Cash Flow@Risk is $20 million, and the company s projected operating cash flow was $200 million, 10% of that cash flow is at risk because of potential volatility in the plan s funded status. As Exhibit 8 illustrates, 68 companies, or 45% of the sample, have estimated Cash Flow@Risk levels in excess of 10% of 2006 cash flow from operations. It is important to note that the Cash Flow@Risk number is not a one-time event. The definitions used here are broadly in line with PPA s funding regulations which stipulate a seven-year amortization period for funding. In this example, therefore, the $20 million would be the incremental contribution or hit to corporate cash flow in each year for seven years. The same interpretation applies to the risk to corporate earnings. If a corporation s Earnings@Risk is $20 million (on an after-tax basis) and total yearend after-tax earnings were $200 million, then 10% Exhibit 8: Number of top 150 plans by Cash Flow@Risk ratio Number of complanies companies (45%) 16 Up to 10% 11-20% 21-30% 31-40% Greater than 40% Cash Risk vs. Operating Cash Flow Sources: JPMorgan Asset Management, P&I, company annual reports From a pension plan perspective, 2002 represented the single worst year in recent history for many plans, with sharply negative equity markets, coupled with a drop in the discount rate. (See Appendix for additional details.) Since on a forward-looking basis the worst case is unknown, we refer to 2002 as a worse case. 5 numbers capture total defined benefit pension plan liabilities for each company, both the U.S. and non-u.s. portions. The non-u.s. portion of the liability is subject to other funding rules which are not detailed here. These calculations are on an after-tax basis for shareholders equity and earnings, assuming 15-year amortization for Earnings@Risk. Shareholders equity, operating cash flow and net income were end-of-year

11 of the company s earnings are at risk due to the pension plan. In other words, the riskiness of the pension plan (primarily interest rate and equity risk) could potentially cause a 10% reduction in earnings in a worse case versus a normal market environment. Exhibit 9 suggests that 55 companies, or 37% of our sample, have estimated Earnings@Risk in excess of 10% of after-tax earnings under SFAS 87 accounting rules. Exhibit 9: Number of top 150 plans by Earnings@Risk ratio Number of complanies companies (37%) 7 Up to 10% 11-20% 21-30% 31-40% Greater than 40% Risk vs. Net Income Sources: JPMorgan Asset Management, P&I, company annual reports 0 15 As with Cash Flow@Risk, Earnings@Risk numbers do not represent a one-time event. The definitions used here are broadly in line with current accounting regulations under SFAS 87 which allow amortization of gains and losses over the average remaining service period of active employees. (We used 15 years as an approximation). In this example, therefore, the $20 million would be the incremental hit to earnings in each year for 15 years. Potential implications of FASB Phase II reforms The Financial Accounting Standards Board (FASB) is conducting a second phase of its analysis of pension accounting. It is likely that phase two will result in the elimination of the smoothing and amortization techniques used to calculate pension expense. If that is the case, and assuming phase two were applicable in 2006, approximately 93% of our universe of plan sponsors would have Earnings@Risk of at least 10% of company earnings versus 37% under SFAS 87. 7

12 Broadly diversified, duration-matched portfolios can reduce pension risk to the corporation Managing pension risk Given an increased awareness of the risks and costs associated with sponsoring a defined benefit plan, corporations are exploring ways to more effectively manage a plan s risk exposures while still achieving their desired return on plan assets. Their focus is increasingly on controlling the two largest sources of risk for most plans: interest rate risk (due to the duration mismatch between plan assets and liabilities) and equity risk (due to the heavy allocation to and inherent volatility of equities). In attempting to manage their plans more effectively, plan sponsors are becoming more concerned with minimizing short-term downside risks, while still achieving long-term expected outcomes. Implementing the following strategies can help to meet these twin objectives: Hedging away interest rate risk through the lengthening of the duration of the plan s assets. Long duration strategies can be implemented by investing in longer duration fixed income securities, entering into interest rate swaps, or a combination of these strategies. Diversifying the range of alpha sources the plan invests in. Plans are increasingly investing in market neutral strategies, long-biased long/ short strategies, portable alpha and other absolute return strategies. The more sources of consistent alpha and the lower the correlation among them, the more successful the strategy. Diversifying the range of beta sources that the plan invests in. These beta sources can include private equity, hedge funds, real estate, infrastructure, commodities, oil and gas, timber and other investment strategies. As with alpha, the more beta sources and the lower the correlation of returns among beta sources, the more successful the strategy. In a recent white paper 6, we demonstrated the potential risk reduction available through the implementation of long duration strategies and broadly diversified investment portfolios, using the hypothetical Green Company as an example. Exhibit 10 is a synopsis of that analysis, updated with our most recent capital market assumptions, as of November This table compares surplus volatility as well as measures for the plan under two different portfolio allocations: the current, more traditional allocation (65% equity, 30% fixed income, 5% alternatives), versus the new, broadly diversified allocation (40% equity, 30% fixed income and 30% alternatives) plus a swap overlay to match the duration of plan assets and liabilities. The analysis clearly demonstrates the significant potential risk management benefits of using a more corporate finance-based perspective in establishing the plan s investment policy. For example, as seen under the Risk reduction column in Exhibit 10, standard volatility measures, which focus only on plan assets, suggest that the new portfolio allocation heightens Green Company s pension risk profile, increasing the volatility of asset returns from 10.0% to 13.2%. From a more holistic view, however, the new longer duration, diversified asset portfolio substantially reduces the risk of the pension plan to the corporation: Shareholders Equity@Risk is reduced from 23% to 5% of shareholders equity. Cash Flow@Risk is reduced from 22% to 5% of operating cash flow. Earnings@Risk is reduced from 31% to 3% of net income. Surplus volatility is reduced from 13.3% to 9.1%. We believe these risk metrics capture the true measure of pension plan risk. 6 Corporate Finance Meets Pension Management: A New Era for Pension Leaders, JPMorgan Asset Management, January

13 Exhibit 10: Potential risk reduction with a broadly diversified portfolio plus long duration swap overlay for the hypothetical Green Company New allocation: Current Diversified plus Risk reduction ($ millions) allocation swap overlay given new allocation Expected change in shareholders equity $289 $328 Worse case scenario (3,194) (367) Shareholders Equity@Risk (pre-tax) 3, ,788 as a % of shareholder s equity (after-tax) 23% 5% 18% Expected contribution requirement $486 $480 Worse case scenario 1, Cash Flow@Risk as a % of operating cash flow 22% 5% 17% Expected pension expense $213 $169 Worse case scenario Earnings@Risk (pre-tax) as a % of net income (after-tax) 31% 3% 28% Surplus volatility 13.3% 9.1% 4.2% Portfolio characteristics Equity 65% 40% Fixed Income Alternatives,other 5 30 Duration assets Duration liabilities 1.3 years 13 years 13 years 13 years Expected return Asset volatility 6.9% 10.0% 7.2% 13.2% 3.2% Green company financial ($ billions) Shareholders equity $10 $10 Operating cash flow Net income Source: JPMorgan Asset Management. Hypothetical Green Company. For illustrative purposes only. How does your plan compare? To translate insights from our analysis of the top 150 U.S. corporate pension plans to a more actionable plan-specific level, we have developed a tool for analyzing pension plans relative to their peers. This competitive analysis capability brings together: Corporate financial statement, pension plan and portfolio allocation information for the top 150 U.S. defined benefit plans JPMorgan metrics JPMorgan long-term capital market return assumptions (or your own assumptions) Software for competitive analysis of your plan versus the top 150 corporate plan universe and/or the relevant industry or sector subset. These capabilities are an extension of our existing suite of corporate finance-based risk management tools which we use to enhance our strategic investment advisory work with plan sponsor clients. Some of the competitive dimensions along which this tool can help assess your plan include: Accounting assumptions (discount rate, expected return on assets) Liability growth measures (service cost, interest cost, benefit payments) Corporate risk factors Shareholders Equity@Risk Cash Flow@Risk Earnings@Risk The following case study re-visits the hypothetical Green Company to illustrate how this peer analysis can enable CFOs, treasurers and CIOs to more 9

14 Exhibit 11: How does your plan compare? Green Company 2006 Top 150 corporate plans Industrial Goods All industry groups Select metric Select metric Key statistics Materiality of plan Deficit as % of market capitalization Deficit as % of shareholders' equity Financial statement Pension expense (income) as % of net income Actual contributions as % of operational cash flow Maturity of plan Benefit payout rate as % of discount rate Asset allocation effectiveness Liability growth rate versus expected return on assets Duration effectiveness Impact of interest sensitivity of plan on cash flow and earnings Selected metrics Pension plan PBO funding ratio Service cost as % of PBO Interest cost as % of PBO Benefit payouts as % of PBO Actual return on assets Expected return on assets Actual contributions as % of assets Actual contributions as % of liabilities Expected contributions as % of assets Expected contributions as % of liabilities Benefit payments/service cost Discount rate Liability growth rate Asset allocation % Equity % Bonds % Real estate % Other Corporation Pre-tax Shareholders' Equity@Risk as % of shareholders' equity Pre-tax Cash Flow@Risk as % of cash flow Pre-tax Earnings@Risk as % of net income (FAS 87) Pre-tax Earnings@Risk as % of net income (Phase II) The U.S. Corporate Pension Plan Peer Group Analysis Tool is part of a suite of JPMorgan proprietary analytics supporting advisory services provided to JPMorgan Asset Management plan sponsor clients. 10

15 Is the plan s expected asset return assumption too aggressive (conservative)? proactively manage the efficiency of their plans from a competitive perspective and help ensure that the risk exposure of their plan is consistent with the corporation s desire and ability to bear risk. Case study The hypothetical Green Company In this example, we assume that the Green Company belongs to the Industrial Goods sector. To illustrate the insight a peer group analysis can provide, we consider the following three questions as they relate to the Green Company: Is the company overly aggressive in setting its expected return on assets defined as the long term return assumption based on a plan s asset allocation policy? Have the company s investment and funding decisions consistently enhanced its competitive position over time, based on its funded ratio defined as the market value of assets divided by the Projected Benefit Obligation of liabilities? Is Green Company s pension plan exposing the corporation to an acceptable level of Cash Flow@Risk defined as the difference between the expected contributions into the pension plan under PPA and the contributions under a worse case scenario (assumed once again to be 2002 for the purposes of this case study)? A more comprehensive analysis could involve additional accounting, liability and corporate risk measures, as seen in Exhibit 11. Green Company Expected return on assets Peer Group: Top 150 US corporate pension plans To assess the aggressiveness of the Green Company s accounting assumption, Exhibit 12 shows 2006 expected return on assets plotted against the percentage of plan assets invested in equity for all the companies in our universe. We would intuitively expect to see a positive correlation between these two numbers, i.e. higher equity allocations paired with higher expected return assumptions, given that the former is usually one factor used in determining the latter. However, for our universe, the correlation between the two variables is remarkably low (at 0.06) with the majority of plans having equity allocations between 60% and 70% of plan assets and expected return assumptions between 8% and 8.5%. Exhibit 12: Expected return on assets versus portfolio equity allocation (%) Green Company versus the top 150 U.S. corporate pension plans Expected return on assets 10.0% 9.5% 9.0% 8.5% 8.0% 7.5% 7.0% 6.5% Green Company 6.0% 25% 35% 45% 55% 65% 75% 85% % Equity Sources: JPMorgan Asset Management, P&I, company annual reports. For illustrative purposes only Based on this analysis, the Green Company s accounting assumption appears aggressive (with an expected return on assets of 9.0%). While a significant number of its peers have a higher allocation to equities than the Green Company s 65%, most of these companies have expected return assumptions below that of the Green Company. 11

16 Are the company s investment and funding policies still appropriate, from a fiduciary and competitive viewpoint? Green Company Funding ratio over last 6 years Peer Group: Industrial Goods sector One way to assess how a company s pension plan has fared under different market environments is to consider the funded ratio over time, relative to its peer group. If the funded ratio is consistently above median, there is good reason to believe that past investment and funding decisions have improved the company s competitive position (and not detracted from beneficiary or shareholder value). As seen in Exhibit 13, although the Green Company pension plan s funding ratio fell to a low of 87% at the end of 2002 (due to falling discount rates and equity markets), it has remained above median in each of the last six years. Exhibit 13: Year-end pension funding ratio Green Company versus the Industrial Goods sector PBO funding ratio 130% 120% 110% 101% 100% 100% 90% 80% 70% 60% 50% 87% 80% 94% 83% 96% 87% 91% 88% Green Company 97% 75th Median 93% 25th Of course, interpretation of the above funding ratio analysis requires consideration of how the Green Exhibit 14: Contributions as % of liabilities Green Company versus the Industrial Goods sector Percentile 95th Sources: JPMorgan Asset Management, P&I, company annual reports. For illustrative purposes only Green Company 8% 6% 1% 1% 1% Sector median 1% 3% 3% 3% 3% Sources: JPMorgan Asset Management, P&I, company annual reports. For illustrative purposes only 5th Company s contributions compare to its peer group. As seen in Exhibit 14, Green Company s contributions as a percentage of liabilities were above the sector median for 2002 and 2003, and below the sector median for 2004, 2005 and This pattern of contributions had a positive overall impact on the company s funding ratio relative to the Industrial Goods sector. As equity markets fell significantly over 2002 (with the S&P500 down 22%), an above median contribution improved the Green Company s yearend standing relative to its peers. The timing of its next large contribution, in 2003, was also fortunate. As markets rallied over 2003 (with the S&P500 up 29%) the plan s dollar (or money weighted ) investment return improved. We believe such analysis can provide insight into whether past investment and funding policies remain appropriate from a fiduciary and competitive viewpoint. Green Company Cash flow at risk Peer Group: Industrial Goods sector Previously in this report, we defined three metrics for evaluating the upstream risk of pension plans to their sponsoring corporations: Shareholders Equity@Risk, Cash Flow@Risk, and Earnings@Risk (See Exhibit 6, page 5). In this section, we illustrate how peer group analysis can provide insights into the relative efficiency with which a pension plan is being managed, from a corporate finance perspective, and how this peer positioning can potentially be improved by a change in the pension plan s strategic asset allocation. Returning to the Green Company case study, we look at one of these risk metrics for companies in the Industrial Goods sector 2006 Cash Flow@Risk (CF@R) as a percent of operating cash flow 12

17 Is the risk to corporate cash flow from the pension plan at an acceptable level? Exhibit 15: Industrial Goods peer group ranking based on 2006 Cash as a % of operating cash flow 2006 CF@R as % of CF 105% 100% 45% 40% 35% 30% 25% 20% 15% 10% 5% 0% Green Company Diversified + swap overlay Green Company Current allocation Company ranking Upper quartile Median quartile Lower quartile Sources: JPMorgan Asset Management, P&I, company annual reports. For illustrative purposes only. We cap values at 101% for companies with negative cash flow or CF@R greater than 100% of operational cash flow. and compare Green Company s relative performance under the two different asset allocation scenarios identified earlier (See Exhibit 10, page 9): Current pension portfolio 65% equity, 30% fixed income, 5% alternatives New broadly diversified, duration matched portfolio 40% equity, 30% fixed income, 30% alternatives, plus a swap overlay to match the duration of pension assets and liabilities As seen in Exhibit 15, with CF@R as a percent of operating cash flow at 22% (close to the median), the Green Company is in relatively good standing versus its peers. However, the risk to the business from the pension plan is still significant (and at a level that, we believe, many corporations would consider unacceptably high for their plans). Exhibit 15 shows that should the Green Company shift to a portfolio strategy with less equity concentration and less exposure to interest rate volatility, it could significantly improve its competitive risk profile. Under the new allocation, CF@R as a percent of cash flow drops dramatically, from 22% to 5%. This moves Green Company s ranking from median to first quartile versus its Industrial Goods competitors. Conclusion Despite recent improvements in the funded status of the largest U.S. corporate defined benefit pension plans, significant risks still exist for many plan sponsors, especially in light of recent and potential future pension accounting and funding reforms. Asset allocation Change on the horizon We see significant interest among our clients in addressing both interest rate risk and equity concentration risk in their pension portfolios, to prevent negative market outcomes from threatening the health of their plans and their corporations. As a result, we are witnessing a shift in portfolio allocations to longer duration strategies (including the use of swaps or derivative overlays), a decrease in traditional equity allocations and an increase in international, alternative and other non-traditional asset class allocations. We anticipate that this trend will continue as CFOs, treasurers and CIOs adjust to this new and challenging era for pension plans. New challenges require new methods and metrics and new tools for simulating and testing innovative solutions. We are committed to being on the forefront of this innovation curve and to working closely with our plan sponsor clients in helping them to assess and address the performance and risk management of their pension plans. If you are a client of JPMorgan Asset Management and are interested in a peer group analysis of your plan or further information on the Strategic Investment Advisory Group s corporate finance-based risk management tools, please call your JPMorgan Asset Management contact or one of the authors of this report. 13

18 APPENDIX 2006 was an eventful year for pension plans with the passage of the Pension Protection Act (PPA) and new accounting rules governing pensions under SFAS 158. Below is a high level summary of these changes and their implications. Key aspects of the Pension Protection Act and implications for DB plans New rule: Stricter funding rules (100% funded ratio target replaced 90%) Liability valuation based on a yield curve (three maturities instead of one) Shorter smoothing periods in valuing assets and liabilities Implication: More contributions / investment returns will be needed Reported liability values may increase More volatility on both the asset and liability side Source: JPMorgan Asset Management SFAS 158, the new standard for pension accounting, requires companies to include the pension deficit or surplus on the corporate balance sheet at market value. The impact of this rule change varied greatly from company to company but the majority experienced an increase in liabilities (because most plans are underfunded), and a subsequent decrease in shareholders equity. Going forward, we expect this new rule to add significantly to balance sheet volatility. Details of assumptions used in scenario analysis measures Actual Asset Class Indices Expected RoA 2002 RoA Cash U.S. cash (T-bills) 4.50% 1.7% Bonds Lehman Aggregate Long duration bonds Lehman Long gov /credit EMD JPM EMBI U.S. Equity S&P U.S. Small cap Russell International equity MSCI EAFE (hedged) Emerging equity MSCI EME REIT NAREIT Equity Global real estate NCREIF Hedge FoF HFRI HFoF Private equity Wilshire Microcap Change in rates Lehman Long AA corp -50 bps Source: JPMorgan Asset Management long-term capital market return assumptions. As of November 30, 2006 (for Expected RoA). The JPMorgan Asset Management assumptions are presented for illustrative purposes only. They must not be used, or relied upon, to make investment decisions. 14

19 Opinions and estimates offered constitute our judgment and are subject to change without notice, as are statements of financial market trends, which are based on current market conditions. We believe the information provided here is reliable, but do not warrant its accuracy or completeness. This material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. References to specific securities, asset classes, and financial markets are for illustrative purposes only and are not intended to be, and should not be interpreted as, recommendations. These materials have been provided to you for information purposes only and may not be relied upon by you in evaluating the merits of investing in any securities referred to herein. Past performance is not indicative of future results. Indices do not include fees or operating expenses and are not available for actual investment. Indices presented, if any, are representative of various broad base asset classes. They are unmanaged and shown for illustrative purposes only. The views and strategies described may not be suitable for all investors. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, accounting, legal or tax advice. You should consult your tax or legal advisor regarding such matters. JPMorgan Asset Management is the marketing name for the asset management businesses of JPMorgan Chase & Co. and its affiliates worldwide which includes but is not limited to J.P. Morgan Investment Management Inc., JPMorgan Investment Advisors, Inc., Security Capital Research & Management Incorporated and J.P. Morgan Alternative Asset Management, Inc. JPMorgan Chase & Co., July 2007 IMWP_US2007

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