Funded Status Watch Report
As of November 30, 2009

Funded Status Watch tracks the evolving funding status of a typical U.S. corporate defined benefit (DB) plan over time based on two different investment strategies. The first investment strategy represents a “traditional” asset allocation based on median market survey statistics of U.S. corporate DB plans with more than $1 billion in assets. The second investment strategy incorporates two of Watson Wyatt’s building blocks — liability-driven investment (LDI) and beta diversity.

The primary goal of Funded Status Watch is to track the changing relationship between asset and liability returns through time. Accordingly, we emphasize the fundamental importance of focusing on net returns in managing the financial results of a DB plan regardless of whether the focus is on funded status, cash contribution requirements, balance sheet or accounting expense. A second goal of Funded Status Watch is to provide a living case study. We encourage readers to compare and contrast the results of the two investment strategies with the performance of their own pension plans. We hope that these comparisons and contrasts will be fruitful.

Investment Strategies

The two investment strategies are profiled in Exhibit I and described below. The second strategy incorporates two of Watson Wyatt’s building blocks – LDI and beta diversity – into the strategic asset allocation.¹ For purposes of simplicity, we have not incorporated improved alpha, our third building block, into Funded Status Watch, although it is an important risk-budgeting factor that each plan sponsor should consider based on its financial and governance circumstances.

• Traditional – This allocation is based on the approximate median asset allocation for corporate DB plans with more than $1 billion in assets. Public market equities represent the major growth and risk exposure in the structure with an allocation of 60 percent. The fixed-income segment is a broad multi-sector portfolio with an allocation of 30 percent. Finally, there is a 10 percent allocation to a combination of alternative investments—real estate, private equity and hedge funds.
• LDI – By incorporating two of our building blocks, LDI and beta diversity, this portfolio contains a larger allocation to fixed income and uses swaps to achieve a 75 percent hedge of the liability's interest rate sensitivity. The portfolio also increases the allocations to alternative asset classes to improve diversification of the sources of return. Consequently, this portfolio has reduced exposure to and reliance on the risk premium of the public equity markets but a greater governance requirement associated with the higher allocation to alternatives.

Exhibit I. Asset allocation of the two investment strategies

Plan Liability Profile

The selected liability profile is that of a relatively mature pension plan that has recently been frozen. Consequently, no employees will earn additional benefit accruals. The projected expected benefit payments over the next 60 years are displayed in Exhibit II. Although many corporate plan sponsors have frozen their DB plans as a first step to manage the growth and volatility of liabilities, a frozen plan will continue to exist and require management until all benefit payment obligations have been met.

Exhibit II. Expected benefit payments over next 60 years

The duration of the liability is 11 years, which can be thought of as the present-value-weighted average of when the benefit payments will be paid. More importantly, the duration can be thought of as the approximate percentage increase in the value of the liability due to a one percent decrease in the general level of interest rates. From our experience working with our DB clients, the duration of a plan depends heavily on the plan’s provisions and participant demographics. It is possible for the duration of a DB plan to be as low as 8 years or as high as 20 years.

It is common practice to distill the defining properties of the liability into this single number, the duration. However, in the real world there is much more to understanding the liability than duration that must be addressed in order to create an effective liability hedge.

One key issue to be managed during implementation of the liability-hedging strategy is the sensitivity of the cash flow projection due to changing economic conditions. For example, if the plan pays lump sums based on market rates, the size of the projected cash flows will also change significantly as interest rates change. Cash balance plans, final average pay plans, and other common plan designs almost always have features that add to the complexity of analysis. These details are critical to properly understand how much the value of the liability changes due to changes in general levels in interest rates, which forms the cornerstone of an effective liability-hedging strategy.

Another issue to be managed during implementation of the liability-hedging strategy is curve risk. Exhibit III displays the liability’s duration exposure across the different maturity segments of the yield curve. When interest rates move in a non-parallel fashion, making sure that asset cash flows are similar to those of the liabilities across the yield curve is critical to avoiding unpleasant surprises.

Exhibit III. Yield Curve Duration Exposure

Liability Return Calculation Methodology

The value of the liability is simply the present value of expected future benefit payments. This value is determined by discounting the benefit payments based on the current swap curve. We chose the swap curve because it is the segment of the fixed-income market that has the most depth and liquidity in longer-dated securities. As a result, it is the best representation of an investment strategy that can be implemented to immunize the liability’s expected cash flows.² It is also a benchmark that an investment manager will accept and is consequently appropriate in evaluating the implementation of a liability hedging strategy.

This “market” value of the liability based on using the swap curve is a larger amount than is reported for regulatory purposes (either funding or accounting) because interest rates on swaps are lower than on high-quality corporate bonds. Regulations in the U.S., both funding and accounting, are based on using a high-quality corporate bond curve in the present value calculation. One consequence is that a plan sponsor needs to be more than 100 percent funded on a regulatory basis in order to be able to immunize the plan in market terms.³

Also, interest rates on swaps can move differently than interest rates on other fixed-income securities. Accordingly, there are often multiple perspectives that are important when answering the question, “What was the liability’s return for the period?” We work with clients on a case-by-case basis to determine what level of detail is required in monitoring investment performance.

Finally, the cash flows are adjusted for benefit payments from the beginning of the period to the end of the period. The present values are calculated at the beginning and end of period based on the swap curves at each moment in time. The liability return is then determined to account for the change in value during the period. Our Funded Status Watch methodology does not try to reflect the economic sensitivity of the size of the projected benefit payments. It also does not try to reflect actual experience relative to the actuarial assumptions used in the projection.

Results for "Market" Funded Status

During the month of November, the funded status for pension funds managed under both a traditional and LDI strategy improved on a market liability basis. Asset and liability performance were positive for the month; however, assets outperformed liabilities on a relative basis. Asset levels increased primarily due to positive equity performance, and liabilities increased due to decreasing swap rates.

For the month, global equity returns ranged from positive 3 percent to positive 6 percent. Fixed income performance was positive for both market-based and long duration mandates. The LDI portfolio outperformed the traditional strategy by 15 basis points for the month, primarily driven by an allocation to swaps, as those rates fell over the period.

As mentioned in prior issues of Funded Status Watch, an important point to remember when using an LDI strategy compared to a more traditional investment approach is that the goal of an LDI strategy is not always to outperform the traditional investment strategy in asset-only terms. Rather, the goal is to improve the financial efficiency of a plan by managing the volatility of the funded status over time.

It is also important to note that liability performance is sensitive to the methodology selected to calculate the value of the liabilities. For Funded Status Watch purposes, we have selected “market liability” as the primary benchmark (based on the swap curve) because it is the segment of the fixed-income market that has the most depth and liquidity in longer-dated securities. The proxy for “market liability” performance in November experienced a 2.4 percent increase as swap yields decreased from 3.97 percent to 3.80 percent.

From a regulatory point of view, liability performance for November was similar to that experienced via the market liability; however, corporate rates fell to a lesser degree. The regulatory liability used for funding and accounting purposes increased by 1.5 percent as yields fell from 5.46 percent to 5.36 percent. Consequently, the traditional investment approach had a positive net return of 1.8 percent for the month and the LDI asset approach had a positive 2.0 percent net return. The net return is defined as the asset return (in percentage terms) less the liability return (in percentage terms), and is the fundamental measure to evaluate risk and reward as it relates to a pension plan’s financial results.

While the liability performance was similar for both the “market” and “regulatory” approaches this month, this will not always be the case. For example, earlier this year there was a single month where these two returns diverged by more than 8 percentage points. This difference is an example of the basis risk we have historically advised plan sponsors to be mindful of when they implement an LDI approach.⁴

As noted in Exhibit IV, at the end of November 2009, the funded status for a corporate plan managed under the traditional investment approach was 31.0 percent⁵ below its January 1, 2008 level. Over the same period, the funded status for the LDI strategy was 20.3 percent⁶ below its January level – a 10.8 percentage point preservation of funded status over the past 23 months, using our “market liability” proxy.

Over the past 11 months, the funded status for the plan managed under the traditional strategy has improved by 14.7 percentage points (increasing from 54.2 percent to 68.9 percent). In the same time period, a plan managed under the LDI approach has improved by 7.5 percentage points (increasing from 72.2 percent to 79.7 percent). The increase in swap rates (lower liability estimate) coupled with strong year-to-date equity performance (higher asset value) led to the dramatic improvement in funded status for the traditional approach. The funded status of the LDI approach did not benefit to the same extent due to the lower allocation to return-seeking assets, most notably public equities. However, the LDI approach has remained true to its intent and provided more stability and less volatility in managing plan funded status over time.

Exhibit V shows the developments of year-to-date net returns for 2009, as well as developments since Funded Status Watch’s January 1, 2008 inception. For the month of November, the net return was positive 1.0 percent for the traditional strategy and positive 1.1 percent for the LDI approach. Looking back over the last 23 months, monthly net returns for the LDI approach have ranged over 17.2 percentage points from top to bottom, while returns for the traditional approach have had a range of 33.8 percentage points – over two times the level of volatility on a monthly basis.

Exhibit VI shows the two strategies’ year-to-date results as of November 30, 2009.

In past issues, we have stated that the recent volatility in the funded status may highlight the inherent financial volatility of a pension plan. At Watson Wyatt, we strongly advocate the belief that plan sponsors must address and determine the appropriate amount of risk in their asset allocation.

Exhibit IV. Historical "Market" Funded Status

Exhibit V. "Market" Funded Status Historical Returns

Exhibit VI. “Market” Funded Status Returns (January 1, 2009- September 30, 2009)

Exhibit VII displays a plot of the two strategies monthly asset vs. liability returns. Over time, this picture will capture the level of “tracking error.” If the assets were perfectly matched with the movements of the liability, all of the points would fall on the black diagonal line. The amount of risk the investment strategy has can be seen by how far up or down the points are relative to the diagonal line. Over time, a plan sponsor would hope that more of the points fall above and to the left of the diagonal line to compensate for the investment risk.

For those that prefer numbers over pictures, we have also calculated the average absolute value of the difference between the asset and liability monthly returns. When we convert these values into annualized numbers, this measure of tracking error amounts to 24.8 percent for the traditional strategy compared with 15.1 percent for the LDI approach.

Exhibit VII. Asset vs. Liability Monthly Returns

For more information, please contact Chris Wittemann, chris.wittemann@watsonywatt.com.

Methodology - Detailed Assumptions

The assets were assumed to be equal to the liability on this market basis as of January 1, 2008. No contributions are expected to be made into the plan.

Both investment strategies assume monthly rebalancing back to the target asset allocations outlined in Exhibit I above. The following indices are used to develop return assumptions on a prospective basis:
 

Monthly Index Returns	Asset Class
S&P 500	US Large Cap
Russell 2500	US Smid Cap
MSCI ACWI x US	International
LB Universal	Fixed Income - Universal
LB Long G/C	Fixed Income - Long
NCREIF	Real Estate
Cambridge Private Equity Index	Private Equity
HFRI FoF Composite	Hedge Fund of Funds

NCREIF Index returns are only calculated on a quarterly basis and become available approximately 25 days after quarter-end. The Cambridge Private Equity index is only calculated on a quarterly basis and the data is lagged a full quarter (i.e. fourth quarter information becomes available at the beginning of April). HFRI FoF Composite monthly returns are also not available in the first few days after the end of the month.

Due to these circumstances, we have decided on the following methodology for determining a timely return series for these asset classes. For real estate, we are using the total return on the three month T-Bill rate for the last two months of the quarter. For the first month of the quarter, the return is calculated to be the rate that allows the quarterly return for the preceding three months to equal the newly published quarterly return for NCREIF. For example, the January 2009 monthly return is the fourth quarter 2008 return of the index less the three month T-Bill returns for November 2008 and December 2008.

For private equity, we are using the total return on the three month T-Bill for the last two months of the quarter. For the first month of the quarter, the return is calculated to be the rate that allows the quarterly return for the preceding three months to equal the newly published quarterly return for the CA Private Equity Index. For example, the January 2009 monthly return is the third quarter 2008 return of the index less the three month T-Bill returns for November 2008 and December 2008.

For hedge fund-of-funds, we are lagging the HFRI FoF Composite returns one month. For example, the January 2009 monthly return is the December 2008 return of the Index.

About Watson Wyatt Investment Consulting
Watson Wyatt Investment Consulting, a division of Watson Wyatt, is focused on creating financial value for institutional investors through independent, best-in-class investment advice. We are specialist investment professionals who provide coordinated investment strategy advice based on expertise in risk assessment, strategic asset allocation and investment manager selection.

Watson Wyatt Investment Consulting provides investment advice to some of the world’s largest pension funds and institutional investors, and has more than 500 associates in Europe, the Americas and Asia.

In the United States, investment advisory and investment consulting services are provided by Watson Wyatt Investment Consulting, Inc., a subsidiary of Watson Wyatt & Company. Watson Wyatt Investment Consulting, Inc., is a registered investment adviser with the Securities and Exchange Commission.

About Watson Wyatt
Watson Wyatt (NASDAQ and NYSE: WW) is the trusted business partner to the world’s leading organizations on people and financial issues.

Our client relationships, many spanning decades, define who we are. They are shaped by a deep understanding of our clients’ needs, a collaborative working style and a firm-wide commitment to service excellence.

Our consultants bring fresh thinking to client issues, along with the experience and research to know what really works. They deliver practical, evidence-based solutions that are tailored to your organization’s culture and goals.

With 7,700 associates in 33 countries, our global services include:

• Managing the cost and effectiveness of employee benefit programs
• Developing attraction, retention and reward strategies that help create competitive advantage
• Advising pension plan sponsors and other institutions on optimal investment strategies
• Providing strategic and financial advice to insurance and financial services companies
• Delivering related technology, outsourcing and data services