Investment Strategy Quarterly

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1 Investment Strategy Quarterly Third Quarter 213 Defined Benefit Pensions: Addressing Underfunding The financial crisis and subsequent persistent low-interest-rate environment has magnified key issues regarding defined-benefit pensions. Although these issues are reasonably easy to identify, solutions are often challenging, and may be painful to implement. Here we look at pension data of firms in the S&P 5 over the past 1 years to examine the state of the corporate pension system. We will conclude with investment implications and our views on potential solutions. Chart 1 Pension Assets and Obligations, Millions of Dollars Chart 2 Pension Funding Status, Thousands of Dollars Pension Fair Value Assets Pension Projected Benefit Obligations S&P 5 Pension Data The fair value of pension assets for companies comprising the S&P 5 has grown each year between 22 and 211 except 28. Pension benefit obligations (PBO), or liabilities, have grown at roughly the same rate over that time period (Chart 1). Unfortunately, on the whole assets are not large enough to cover the expected future obligations of the plans, and the discount rates and expected returns on assets (ROA) may in fact be overly optimistic. The gap between pension assets and PBO is the funding status, the key metric used to gauge the overall health of pensions of S&P 5 firms. In 211, S&P 5 pensions were underfunded by $352 billion, and there did not appear to be an impetus for much improvement in 212 (Chart 2). We believe the seemingly chronic underfunding of the pension system is worrisome; only 6.5% of S&P 5 firms had fully funded pensions in 211. In our view, solving the underfunding problem of many pensions has a few potential solutions, each with acute downside risks and challenges. The Road Traveled There are several apparent reasons we point to for the large and widening funding gap of many pension funds: pnc.com/institutionalinvestments For institutional investors only. Not to be provided to retail investors.

2 below-average equity market performance; persistently low interest rates; declining allocation to equities; and changes in reporting requirements. Weak Equity Market Performance Over the past 1 years, the S&P 5 has had a few very good years and a few atrocious years. Although the returns so far this decade have been good, the previous decade s return was well below average (Table 1). Table 1 S&P 5 Total Return by Decade S&P 5 Capital Income Total Decade Appreciation Return Return 193s -5.3% 5.4% -.1% 194s s s s s s s Source: Ibbotson Associates, PNC These returns have affected ROA growth and the overall underfunding of pensions. Combined with a declining allocation to equities, it has resulted in asset returns inadequate to close the underfunding gap. Also noteworthy is the volatility associated with these returns. Since 22 the S&P 5 has produced negative returns for only two years; however, the largest intrayear decline for the index averaged 18% between 22 and 212, compared with an average intrayear drop of 13% over the previous 2 years (Chart 3). Chart 3 Intrayear Declines versus Calendar-Year Returns Percent Calendar Year Returns Intrayear Declines Source: Standard and Poor s, J.P. Morgan, PNC Shift in Asset Allocation: Plugging One Hole, but Exposing Another S&P 5 firms pension funds have shifted assets away from equities into fixed income, which has reduced the expected risk and return within the funds (Chart 4). In 23, pension asset allocation was 65.1% equity versus 28.5% fixed income. Chart 4 Pension Fund Asset Allocation Percent Equity Bonds Property This allocation has shifted considerably since then, and in 211 the allocation was 47.7% equity and 38.2% fixed income. This abrupt shift in asset allocation could make sense the demographics of a pension s constituents could be aging, thus making the plan more risk averse. However, we believe such a large shift may be further exposing the underfunding problem. Without returns in excess of the discount rate, the funding ratio is not likely to improve without additional funds being added to the plan. We are not necessarily recommending pensions increase their allocation to equities, but we believe there must be a conscious decision on the level of risk being taken both market risk and underfunding risk should be considered. Discount Rate to Return on Assets Relationship Interest rates in the United States have been low for several years; the Federal Reserve has kept the federal funds target rate near zero and has expanded its balance sheet with longer-duration securities to contribute to keeping longerterm interest rates low. These policies have helped many consumers repair their balance sheets, have supported the housing recovery that began last year, and have contributed to the recovery in business investment spending. However, these policies are not without costs, many of which come at the expense of savers in the economy; in this case pension funds, but the same could be said for others funding their own retirement. While borrowers are benefiting from the low-interest-rate environment, savers are stuck in a quagmire of staying with safer assets but earning a return that could fall short of inflation or of taking on more risk. For institutional investors only. Not to be provided to retail investors. Defined Benefit Pensions: Addressing Underfunding 2

3 Discount Rate In pension fund accounting, projected obligations are sensitive to the discount rate used. The discount rate in general should be reflective of the rate needed to fulfill liabilities. Typically, the yields on high-quality fixed-income instruments Moody s AA Corporate Index, the investmentgrade bond index have been fairly good indicators of discount rates used. Thus, over the past five years, pension funds have significantly lowered the discount rate used in projections. A pension plan s funding status is sensitive to the discount rate, and the lower the discount rate, the larger the PBO and the more pressure on the funding status of the plan given a plan s actual rate of return. In 211, the average discount rate used for S&P 5 pensions was 4.8% (Chart 5), which was down from 5.4% in 21 (Chart 6), but was still above the AA and investmentgrade corporate credit yields. This suggests to us that the discount rate might be too high, which means the magnitude of S&P 5 pension underfunding is likely understated. Changes in Reporting Requirements Corporate pension plans are subject to both ERISA and FASB rules. ERISA determines the cash contribution funding requirements and FASB determines the financial reporting requirements of the pension plans. Recent changes in the regulations governing pension plans put emphasis on marking to market pension liabilities which, coupled with the unprecedented recent volatility of the securities markets, created significant volatility of pensions impact on balance sheet, expense, and cash contribution requirements. FASB issued new standards; companies are required to recognize the funded status of their defined benefit plans, and the funding surplus or deficit is now reported on the balance sheet rather than in a footnote. Therefore, changes in the market value of a plan s assets relative to liabilities will immediately affect the balance sheet. The second phase of the accounting reform is in progress, and the proposed changes may significantly increase volatility of the pension expense reported in the income statement. Solutions for Getting Pensions Off Life Support Increase Contribution Perhaps the most unappealing solution for correcting the underfunding is for a pension plan sponsor to use current assets to fund pension liabilities. This is not typically appealing because this would mean additional contributions that may limit the opportunity to use the funds for other corporate purposes. In some cases, there may not be a viable alternative to this because the underfunding of some plans may be too large to close the gap quickly and safely enough. LDI Approach to Asset Allocation However, we believe there is a more palatable solution for many. We believe that using a liability driven investment Chart 5 Discount Rate and Expected Rate of Return Percent Chart 6 Fixed-Income Index Yields Pension Discount Rate Pension Expected Long-Term Return on Assets Rate Moody's AA Corporate Index U.S. 1-Year Treasury Index 1/85 1/88 1/91 1/94 1/97 1/ 1/3 1/6 1/9 1/12 (LDI) approach may help address how pension plans frame their current situation. LDI can help plan fiduciaries understand how assets are matched to liabilities and which assets have market risk exposure, which permits plan fiduciaries to better manage fund assets to match future liabilities. This keeps one piece of the investment puzzle more knowable the plan assets can be matched to specific plan liabilities allowing plan fiduciaries attention to be turned to how much market risk the plan sponsors wish to tolerate in light of the assets needed to match liabilities. Asset Allocation Using an LDI Approach We believe that by framing the pension investment process using an LDI approach, we are better able to help pension plans reach their needed funding status or maintain their status while being mindful of the risks. The LDI framework is fully customizable, allowing for a complete assessment of pension plan assets and liabilities to better allow for pension 3 Defined Benefit Pensions: Addressing Underfunding For institutional investors only. Not to be provided to retail investors.

4 Table 2 S&P 5 Component Companies Funding Status Sensitivity (billions) Actual Rate Discount Rate of Return 3.7% 4.2% 4.7% 5.2% 5.7%.% -$ $ $39.4 -$ $ % % % % % Source: FactSet Reserach Systems Inc., PNC obligation management. In general there are six steps to PNC Institutional Investment s LDI process: initial analysis: determining the current status and likely obligation path; asset and liability modeling; dynamic asset allocation: begins with current asset allocation then provides alternative allocations; liability-based benchmarks; LDI portfolio strategies; and monitoring. There are a number of strategies that can be used when constructing the LDI portfolio, including the following. Full replication involves replication of the discount rate benchmark by investing in each security based on the security s weight in the benchmark. This should result in the lowest tracking error. Stratified sampling involves investing in only a subset of securities represented in the benchmark according to the specified criteria. Duration matching invests in assets in order to match the duration of the pension plan liability. Key rate duration matching is investing in assets in order to match several key rate durations of the pension plan liability. Horizon matching matches cash flow of the near-term maturities and then duration matches maturities of cash flows thereafter. Operationally, the details of implementing such an approach are arduous, but they could be a vital step to getting or keeping a pension plan on track. We believe the best way to understand LDI is by thinking about having the option to put pension assets into two portfolios. Portfolio 1 is the knowable bucket. In this portfolio, assets are duration matched with specific liabilities typically using a series of fixed-income products. Although the portfolio construction underlying this portfolio is detailed, describing it is reasonably straightforward. There is limited to no market risk within this bucket as the asset value of the investment portfolio should fluctuate in unison with pension liabilities. This bucket is used to lock in gains in order to fund liabilities. Ideally, a pension plan would have all of its assets in this bucket, if it had adequate resources to fulfill future obligations. And the ultimate goal of LDI is to put pension funds on a path to be able to lock in gains to fund all liabilities with matching assets. Portfolio 2 is the market-risk bucket. When beginning to implement LDI, it is extremely unlikely that a pension plan has adequate resources to fully fund liabilities without taking market risk or significantly increasing contributions. Thus, this second bucket becomes a key part of implementing LDI in that pension plans will use this bucket to attempt to grow current assets by adding market exposure. The amount of market exposure will vary depending on funding status and the ability and willingness of the pension plan fiduciaries to take on market risk. The key is that with LDI, pension plan fiduciaries will have a much clearer view of the risks they are taking. We have published an in-depth white paper describing the theory and operational details of an LDI approach to investing, and more details can be obtained from a PNC Institutional Investments Relationship Manager. Although the end goal for a pension plan looking to fully implement LDI is to be 1% liability matching fixed income, we believe that most plans at the beginning of deploying LDI will move back toward a more balanced asset allocation, which currently means a higher allocation to equities relative to bonds. If this is the case, we urge plan fiduciaries to be mindful of the risk inherent in this decision. 1 See April 212 PNC Investment Outlook, You Can t Always Get What You Want. For institutional investors only. Not to be provided to retail investors. Defined Benefit Pensions: Addressing Underfunding 4

5 Conclusion For underfunded pension funds we see three key risks that should be considered before an investment strategy is implemented. Importantly, these risks are dynamic and need to be weighed against each other: underfunding risks the risk of falling short of obligations, requiring the sponsor to contribute fresh capital to keep the pension plan solvent; market risk the risk of assets losing value due to fluctuations in capital markets; and regulatory risk. As a result of these numerous challenges over the past few years, pension plan sponsors now have much stronger incentives to manage pension risks more aggressively and therefore utilize LDI strategies as an effective tool for pension risk management. All told, there are more than a few pension funds that are in need of an augmented plan to improve the funding status, or they risk continuing to fall short when these defined benefits come due. We view it as key to understand the risks associated with falling short of required payments as well as the risks associated with taking additional market risk. PNC Institutional Investments believes that one of the most important approaches to investing is to diversify across all major asset classes to more effectively manage risk and return. We use our proprietary tools, analytical techniques, and experience to allocate assets among the major asset classes and monitor risk to achieve uniquely focused client requirements. We ultimately believe working with a PNC Institutional Investments Relationship Manager to implement an investment strategy using the PNC Institutional Investments LDI framework could be the best way to balance these risks. 5 Defined Benefit Pensions: Addressing Underfunding For institutional investors only. Not to be provided to retail investors.

6 E. William Stone, CFA, CMT Marsella Martino Rebekah M. McCahan Paul J. White, PhD, CAIA The PNC Financial Services Group, Inc. ( PNC ) uses the names PNC Wealth Management, Hawthorn, PNC Family Wealth and PNC Institutional Investments to provide investment and wealth management, fiduciary services, FDIC-insured banking products and services and lending of funds through its subsidiary, PNC Bank, National Association, which is a Member FDIC, and uses the names PNC Wealth Management and Hawthorn, PNC Family Wealth to provide certain fiduciary and agency services through its subsidiary, PNC Delaware Trust Company. This report is 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 this report is dependent upon the judgment and analysis applied by duly authorized investment personnel who consider a client s individual account circumstances. Persons reading this report 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 this report was obtained from sources deemed reliable. Such information is not guaranteed as to its accuracy, timeliness or completeness by PNC. The information contained in this report and the opinions expressed herein are subject to change without notice. Past performance is no guarantee of future results. Neither the information in this report 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. Hawthorn and PNC do not provide legal or accounting advice and neither provides tax advice in the absence of a specific written engagement for Hawthorn to do so. 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 Wealth Management, Hawthorn, PNC Family Wealth and PNC Institutional Investments are registered trademarks of The PNC Financial Services Group, Inc. Investments: Not FDIC Insured. No Bank Guarantee. May lose value. 213 The PNC Financial Services Group, Inc. All rights reserved. pnc.com/institutionalinvestments For institutional investors only. Not to be provided to retail investors.