Capital Market Assumptions

Transcription

1 Capital Market Assumptions How volatile will markets be? In order to be useful, volatility assumptions need to reflect not just the past but also the outlook for the future. Asset markets do not move in a straight line and nor is the future ever known with any certainty. This publication sets out our annualized best estimate return assumptions for a range of asset classes over a 10 year projection period. We should note, however, that these are only central estimates, as our analysis assumes that there is a 50/50 chance that what actually transpires will be higher or lower than these figures. Such return assumptions therefore only tell part of the story. When carrying out any analysis of long term investment strategy or assetliability modeling, the variability and uncertainty around these returns are key components which need to be taken into account. One measure of this variability is volatility (the dispersion in returns over time). We quote representative volatility assumptions for a number of asset classes towards the end of this publication. It is worth pointing out that volatility is a simple, but crude, measure of the variability of returns as it does not properly capture all the characteristics of asset returns. For example, asset returns exhibit fat tails (extreme outcomes are more likely than simple models would suggest) and negative skew (extremely bad outcomes are more likely than extremely good outcomes). Our detailed asset modeling incorporates a fuller picture to take account of these features, though this is outside the scope of this article. Does the past equate to the future? There are a number of approaches to setting volatility assumptions. Traditionally, the focus has been on long term average historic experience. We believe that taking this approach unselectively can be very misleading. The first problem behind just relying on history is choosing the appropriate history. How far back should we be looking at the data? For example, data on US equities is available as far back as the 1790s. This is clearly very long term but it is highly questionable whether the behavior of the five sole securities which traded on the New York Stock Exchange in 1790 has any relevance for what is likely to occur over the 10 years from today. A bigger problem is that quite a few asset classes have evolved recently. Is it appropriate to use shorter historic periods for asset classes such as emerging market debt but use a much longer history for US equities? This makes comparability difficult. Furthermore, the world changes over time. Going back to emerging market debt, the fact that this asset class has seen a noticeable improvement in credit quality over the past decade means older data is now less relevant. An even bigger and more general question is whether long term average behavior (however you care to define long term) is appropriate as a guide for the future environment? Relying on history may well be appropriate if current and expected market conditions were at close to an average state of the world but how would we allow for an environment that appears different or abnormal? As of June 30, 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 Equities 6 Private Equity 7 Real Estate 7 Hedge Funds 8 Volatility 9 Correlations 10 Capital Market Assumptions Methodology 11

2 Taking a forward looking approach While the past definitely does not equate to the future, and the past itself can be interpreted differently depending on choice of historic periods, it is still where we have to start. The history of how volatile markets have been through both good and bad times, is central to our understanding of what the future may hold. However, we believe that we can improve on historic averages of volatility in order to take a forward looking view. This is consistent with our approach to setting return assumptions themselves, where, for example, we do not assume that equities will always outperform bonds by the same amount but instead assess the valuations and outlook for each asset class at each quarter end. Our approach to setting volatility assumptions comprises three main elements. Historic analysis, taking both the longest time period available and shorter rolling periods into account. This enables a more detailed and richer analysis of how assets have behaved during different economic conditions. For example, the chart below shows the volatility of US and European equities based on data since Such an approach clearly shows how significantly volatility has changed over time. This approach allows us to partly overcome the problem of asset classes with more limited performance history, since it allows us to compare relative volatilities over shorter time periods. Annualized rolling 20 quarter volatility 35% 30% 25% 20% 15% 10% 5% 0% US Source: Datastream Europe ex UK Dec-74 Dec-79 Dec-84 Dec-89 Dec-94 Dec-99 Dec-04 Dec-09 For illiquid asset classes, infrequent valuations will smooth returns, understating volatility. As a result, we use desmoothing techniques (statistical techniques which correct for stale valuations) to better reflect the volatility an investor is exposed to. Utilization of forward looking market indicators of future volatility. We believe this is an essential analytical component to setting a forward looking volatility assumption. A key input here is implied volatility calculated from option prices. This provides an indication of what is priced into markets for future equity market volatility over the life of the option. Of course, implied option volatilities can be influenced by many factors unrelated to volatility, for example illiquidity. This can lead to implied volatility overstating future volatility levels. We value implied option volatility mainly for what it tells us about upcoming trends in volatility. As an example of the value of the information contained in implied option volatility pricing, it is instructive to take the example of conditions in Then, realized volatility was declining, continuing a multi-year trend. An equity volatility assumption based solely on historic averages would at the time have shown expected future volatility to be at low levels. Around this time, however, implied volatility was increasing dramatically, a canary in the coalmine for the very high levels of volatility that were subsequently experienced over 2007/08 (see chart based on data from multiple major investment banks). Change in historic and forward looking measures of volatility of US equities (2005-7) 10% 8% 6% 4% 2% 0% -2% -4% -6% -8% -10% Source: Datastream, Aon Hewitt, multiple major investment banks Historic (annualized trailing 3yr volatility) Forward looking (indicative 3yr implied volatility) Today, analysis of longer dated implied volatility suggests that the risks have declined from their very elevated levels of a few years ago. Importantly, however, they remain higher than pre-crisis levels. Our view regarding where we are in the economic cycle and the outlook for volatility. Though we believe implied volatility to be useful, we do not regard it as an unbiased predictor of future volatility. We must therefore use professional oversight to compare the signals from option markets with our own views. We can then use this forward looking information to set volatility assumptions with reference to historic experience. For example, while we believe that the risks of some of the more extreme tail risk events, such as an imminent and disorderly breakup of the Eurozone, have declined we believe that the uncertainties facing financial markets as monetary stimulus starts to be withdrawn against a backdrop of very uneven global growth will lead to somewhat elevated volatility levels. This is consistent with the message from implied volatility that risks have fallen from their highs, but still remain a significant feature of the investment landscape. History, forward looking indicators and our view on the economic cycle all enter our volatility assumption setting process as outlined here. Reflecting the messages from our analysis on all three, our current volatility assumptions have been set at a somewhat above average level compared with historic average experience. They are, however, below the levels seen in implied volatility in options markets. 2 Aon Hewitt Proprietary and Confidential

3 Inflation USD GBP EUR CHF CAD JPY CPI Inflation (10yr assumption) 2.1% 2.3% 1.9% 1.3% 2.0% 1.0% RPI Inflation (10yr assumption) - 3.2% 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 show 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 haigher 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 1.3% 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 2.6% 2.8% 2.4% 1.8% 2.5% 1.8% 15yr 3.0% 3.3% 2.8% 2.3% 2.9% 2.2% UK 5yr 2.4% 2.6% 2.2% 1.6% 2.3% 1.6% 15yr 2.8% 3.0% 2.6% 2.0% 2.7% 2.0% Eurozone 5yr 2.7% 2.9% 2.5% 1.9% 2.5% 1.8% 15yr 3.1% 3.3% 2.9% 2.3% 2.9% 2.2% Switzerland 5yr 1.8% 2.0% 1.6% 1.0% 1.7% 1.0% 15yr 2.5% 2.7% 2.3% 1.7% 2.4% 1.7% Canada 5yr 2.6% 2.8% 2.4% 1.8% 2.5% 1.8% 15yr 3.2% 3.5% 3.1% 2.5% 3.1% 2.4% Japan 5yr 1.7% 1.9% 1.5% 0.9% 1.6% 0.9% 15yr 2.1% 2.4% 2.0% 1.4% 2.0% 1.3% 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 will 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. Capital Market Assumptions 3

4 However, since last autumn there have been ever more convincing signs that the low in yields may now have passed and that the uneven path to higher yields may have finally commenced. 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. More recently, resilient US growth and a falling unemployment rate have forced the Federal Reserve to announce that it could start to taper its quantitative easing program as early as this September and end it completely by next summer. This is sooner than markets had anticipated and US yields consequently moved much higher over May and June. Given the globally integrated nature of government bond markets this has 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 Return assumptions for 15 year duration government bonds are broadly similar in local currency terms across the US, Canada, Eurozone and UK at around 3%. Conversely, significantly lower low yields lead to much lower return assumptions for Swiss and Japanese government bonds in local currency terms (1.7% and 1.3%, respectively). Inflation-Linked Government Bonds 10yr Annualized Nominal Return Assumptions Duration USD GBP EUR CHF CAD JPY US 5yr 2.7% 2.9% 2.5% 1.9% 2.6% 1.9% 10yr 2.7% 2.9% 2.5% 1.9% 2.5% 1.8% UK 5yr 2.6% 2.8% 2.4% 1.8% 2.4% 1.7% 15yr 2.2% 2.4% 2.0% 1.4% 2.1% 1.4% Eurozone 5yr 2.9% 3.1% 2.7% 2.1% 2.7% 2.0% 10yr 2.8% 3.0% 2.6% 2.0% 2.6% 1.9% Canada 5yr yr 2.7% 2.9% 2.5% 1.9% 2.5% 1.8% 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 in recent months, raising return assumptions for these bonds. In the case of the US, the rise in real yields on Treasury Inflation Protected Securities has in fact been far greater than the rise in Treasury yields. This has led to a reduction in breakeven inflation (the difference in yield between fixed and inflation-linked bonds of equivalent duration) which in part reflects a reduction in inflation expectations and this has been reflected in our reduced US inflation assumption. However, in part it also reflects a reduction in the premium that investors are prepared to pay for protection against uncertain future inflation. i.e. investors have become less concerned about US inflation risks. 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. 4 Aon Hewitt Proprietary and Confidential

5 Investment Grade Corporate Bonds 10yr Annualized Nominal Return Assumptions (AA-rated bonds) Duration USD GBP EUR CHF CAD JPY US 5yr 3.6% 3.8% 3.4% 2.8% 3.4% 2.7% 10yr 4.3% 4.5% 4.1% 3.5% 4.2% 3.5% UK 5yr 3.4% 3.6% 3.2% 2.6% 3.2% 2.5% 10yr 3.8% 4.1% 3.7% 3.1% 3.7% 3.0% Eurozone 5yr 2.8% 3.0% 2.6% 2.0% 2.7% 2.0% 10yr 3.2% 3.4% 3.0% 2.4% 3.1% 2.4% Switzerland 5yr 2.3% 2.5% 2.1% 1.5% 2.1% 1.4% 10yr 2.9% 3.1% 2.7% 2.1% 2.7% 2.0% Canada 5yr 3.6% 3.8% 3.4% 2.8% 3.5% 2.8% 10yr 4.4% 4.6% 4.2% 3.6% 4.2% 3.5% Japan 5yr 1.8% 2.0% 1.6% 1.1% 1.7% 1.0% 10yr 2.2% 2.4% 2.0% 1.4% 2.0% 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 increase in government bond yields during the second quarter has meant that return assumptions for corporate bonds have increased noticeably this quarter, especially as this has been accompanied by relatively flat to slightly higher credit spreads. Returns in excess of 4% 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 US High Yield Debt and Emerging Market Debt Very poor recent performance from high yield debt has cheapened valuations and raised our long term return assumption. US high yield debt is now assumed to return 4.8% per annum over the next 10 years, much higher than has been the case over recent quarters. This increase has been driven by both higher return expectations for the underlying government bond component and also an increase in the credit spread. However, it is worth noting that even after this increase, the high yield credit spread remains below its start of year levels and below the historic average. As with high yield debt and other fixed income asset classes, US dollar denominated emerging market debt has suffered poor performance recently, driven both by rising US Treasury yields and an increasing credit spread. In turn, this has cheapened valuations and has raised the return assumption for emerging market debt to 5.2% per annum over the 10 years from 30 June. However, while the high yield debt credit spread remains below levels from earlier this year, the emerging market debt credit spread has been on a more sustained upward move and ended the quarter at levels not seen since last August. This has led to a return premium opening up for emerging market debt relative to high yield debt. Capital Market Assumptions 5

6 Equities 10yr Annualized Nominal Return Assumptions USD GBP EUR CHF CAD JPY US 7.2% 7.4% 7.0% 6.4% 7.0% 6.3% UK 7.8% 8.0% 7.6% 7.0% 7.7% 6.9% Europe ex UK 7.5% 7.7% 7.3% 6.7% 7.3% 6.6% Switzerland 7.1% 7.3% 6.9% 6.2% 6.9% 6.2% Canada 7.8% 8.0% 7.6% 7.0% 7.6% 6.9% Japan 6.4% 6.6% 6.2% 5.6% 6.3% 5.5% Emerging Markets 9.0% 9.3% 8.8% 8.2% 8.9% 8.1% The earnings growth component of our equity return assumptions comprises both near term and longer term elements. While our Capital Market Assumptions process typically involves using consensus inputs, for some time we have believed that the consensus of analysts forecasts has been unrealistically optimistic regarding near term earnings growth prospects. Unlike analysts, against a backdrop of weak global growth we do not expect company profit margins to increase from their already elevated levels. For this reason, we have developed our own in-house corporate earnings paths which have led to lower growth assumptions than forecast by the consensus. For the major developed markets, we assume low single digit earnings growth over the next few years. Not being influenced by short-term market sentiment, our near term earnings growth assumptions have been relatively stable overall, in contrast to consensus expectations which have varied far more. In the long term, we assume that companies earnings growth is related to GDP growth. Crucially, we do not assume a 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. UK equities have a noticeably 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 and the price you pay is one of the single biggest drivers of returns, even over the long term. As at 30 June, UK equities were trading on a multiple of around 12 times our 2013 earnings assumption. In contrast, US equities were valued at around 15 times our 2013 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 a higher return assumption than the developed markets, reflecting the greater long term growth potential of this sector of the market. This return premium has increased over recent quarters as emerging market equities have significantly underperformed developed markets, cheapening the relative valuation of emerging market equities. 6 Aon Hewitt Proprietary and Confidential

7 Private Equity We assume that global private equity will return 9.4% 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 7.3% 7.5% 7.1% 6.5% 7.1% 6.4% UK 7.2% 7.4% 7.0% 6.3% 7.0% 6.3% Europe ex UK 6.7% 6.9% 6.5% 5.9% 6.5% 5.8% Canada 6.3% 6.5% 6.1% 5.5% 6.1% 5.4% In a common currency, 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 earlier in the financial crisis. This results in a lower return assumption. In Europe, the economic difficulties facing the region continue to put downward pressure on capital values. This raises rental yields, putting upward pressure on long term return prospects. 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. Capital Market Assumptions 7

8 Hedge Funds Our fund of hedge funds return assumption is 5.1% per annum 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 that can be assumed for cash continues to be at very low levels has had a negative impact on hedge fund return assumptions. 8 Aon Hewitt Proprietary and Confidential

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 Equities 20.0% US Equities 19.0% Europe ex UK Equities 20.0% Japan Equities 20.0% Canada Equities 20.0% Switzerland Equities 20.0% Emerging Market Equities 28.5% Global Private Equity 26.0% Global Fund of Hedge Funds 8.0% As set out in the lead article to this quarter s publication, our volatility assumptions are forward looking (while also having regard to history) and the volatilities in the table above are representative for each asset class over the projection period. 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 has been driven by the backstop that central banks have been providing to markets. One example corresponds to last autumn when, in response to renewed tensions in the Eurozone, the President of the European Central Bank, Mario Draghi, stated 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, recent statements from the US Federal Reserve that it may soon start to reduce some of the support that it has been providing to markets have reignited volatility. Throughout, our assumptions have looked through this recent period of low volatility and instead have been and continue to be at an elevated level relative to history. This is consistent with implied volatilities and also our views regarding the outlook, as explained in the lead article to this publication. 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. Capital Market Assumptions 9

10 Correlations IL FI CB RE UK Eq US Eq Eur Eq Jap Eq Can Eq CHF Eq EM Eq Gbl PE Gbl FoHF IL FI CB RE UK Eq US Eq Eur Eq Jap Eq Can Eq CHF Eq EM Eq Gbl PE Gbl FoHF 1 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 Eq UK Equities n Jap Eq Japan Equities n Can Eq Canada Equities n CHF Eq Switzerland Equities n EM Eq Emerging Market Equities n Gbl PE Global Private Equity n US Eq US Equities n Eur Eq Eurozone Equities n Gbl FoHF Global Fund of Hedge Funds The matrix above sets out representative correlations assumed in our modeling work. 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. 10 Aon Hewitt Proprietary and Confidential

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. Equities Equity return assumptions are built using a discounted cashflow analysis. Forecast real (after inflation) cashflows payable to investors are discounted and their aggregated value is equated to the current level of each equity market to give forecast real (after inflation) returns. These returns are then converted to nominal returns using our 10 year inflation assumptions. Private Equity We model a diversified private equity portfolio with allocations to leveraged buyouts, venture capital, and mezzanine and distressed investments. Return assumptions are formulated for each strategy based on an analysis of the exposure of each strategy to various market factors with associated risk premia. Real Estate Real estate returns are constructed using a discounted cashflow analysis similar to that used for equities, but allowing for the specific features of these investments such as rental growth. Hedge Funds We construct assumptions for a range of hedge fund strategies (e.g. equity long/short, equity market neutral, fixed income arbitrage, event driven, distressed debt, global macro, managed futures) based on an analysis of the underlying building blocks of these strategies. We use these individual strategies to formulate a fund of hedge funds assumption which is quoted in the Capital Market Assumptions. Currency Movements Assumptions regarding currency movements are related to inflation differentials. Volatility Assumed volatilities are formulated with reference to implied volatilities priced into option contracts of various terms, historical volatility levels and expected volatility trends in future. Correlations Our correlation assumptions are forward looking and result from 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. Capital Market Assumptions 11

12 Disclaimer This document has been produced by Global Investment Consulting of Aon Corporation. Nothing in this document should be treated as an authoritative statement of the law on any particular aspect or in any specific case. It sahould not be taken as financial advice and action should not be taken as a result of this document alone. Consultants will be pleased to answer questions on its contents but cannot give individual financial advice. Individuals are recommended to seek independent financial advice in respect of their own personal circumstances. Aon Corporation 200 E. Randolph Street Chicago Illinois USA Copyright 2012 Aon Corporation 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 SB3747