Watson Wyatt’s investment outlook for 2009

Singapore, 18 December 2008 - Carl Hess, global head of investment consulting at Watson Wyatt, said: “2009 will likely herald a deepening of this recession and in turn will bring a new investment regime which will be much more conservative on average than what we've seen over the past 20 years. Starting in 2009, one of the challenges will be finding a better balance of risk-sharing between sponsor and participants than traditional defined benefit and defined contribution plans have offered to date. If the great global shift to defined contribution continues, then the search for better designs - that deliver value while properly addressing participants’ investing behaviour - will be critical.”

Paul Trickett, European head of investment consulting at Watson Wyatt, said: “As we enter a potentially deep and protracted global recession next year, we are hopeful that pension funds, despite the crisis, will move away from excessive short-termism and increasingly embrace a longer-term time horizon. This could be the catalyst for fresh thinking on the governance and management of institutional assets and test the ability of funds to be adaptable.”

“While funds and managers will be challenged in 2009, so will most investment consultants who will need to continue to evolve their businesses further broadening the spectrum of offerings that range from 'traditional consulting' through to fund of fund operators. This greater breadth of offering follows increased demand for consultants to add value in explicit ways and be fully accountable for their performance and is a positive development.”

“2009 will see more pension funds matching their investment strategies with their governance capabilities, by either simplifying their strategy or raising their game. This will result in an acceleration of certain funds moving towards lower cost, passive solutions as well as more delegation to specialists and greater resources being added to internal investment teams.”

Roger Urwin, global head of investment content at Watson Wyatt, said: “Pension funds will continue to face a number of problems in 2009, notably an increasingly crisis-prone financial system, high investment costs and too much short-termism. While we take the view that these problems are deep-rooted, our positive thought is that this is a world of opportunity for those fit enough to adapt and that this crisis is likely to result in greater innovation and more cost-effective solutions from the asset management and consulting industries around the world.”

“In 2009, we will continue to promote the idea of adding to internal fund governance through a reduction in external spend. A practical suggestion is that funds could consider shaving 10% off their external spend on asset managers to re-allocate it to their internal governance resources; in effect doubling it.”

Robert Brown, chairman of the global investment committee at Watson Wyatt said: “We expect little prospect for significant near-term recovery of the global economy, despite there being a collapse in inflationary pressures and very significant fiscal and monetary policy actions by the authorities in the US and the UK. In addition to the financial risks, asset market trends have also reflected the economic risks with rising bond prices and real yields, falling equity prices, the underperformance of cyclical stocks and a fall in commodity prices. The dislocation in financial markets has been and continues to be acute and uncertainty over how well the world economy will cope remains elevated. This should keep investors cautious and mainly seeking to identify value and take risk in those investments with more supportive fundamentals and valuations. However, it should be borne in mind that the best buying opportunities are typically before economic stabilisation and recovery are clear."

Nick Horsfall, senior investment consultant at Watson Wyatt said: “In 2009, greater attention will be paid to the quantitative and qualitative features of risk and as a result investment boards will be better primed to take adjusting actions as necessary.”

“Increased risk aversion by counterparty banks as well as higher costs in 2008 hindered UK pension funds in their use of derivatives to hedge risk. Regardless, demand continued to remain high and this is likely to remain the case in 2009. However, the crisis has resulted in a shrinking of UK inflation-linked market which is expected to be in the range of £20 billion - £25 billion this year, having reached £35 billion in 2007. This marks a pause in a rapid growth trend which started in 2004 when the estimated size of the UK market was £3 billion.”

Tim Hodgson, senior investment consultant at Watson Wyatt, said: “Most investors will have to ‘run as fast they can’ in 2009 just to keep up with a radically changing economic and investment landscape. The warehouse of options from which investors can build portfolios will not change that much, however the pricing, liquidity and counterparty issues will exercise everyone’s attention to the full.”

“Managing risk will need to involve better qualitative skills (and not just quantitative representation) if it is to better protect pension fund balance sheets, however unfortunately innovation in risk sophistication will most likely not keep up with the speed of changing investment conditions in 2009.”

“In 2009 we will see 'beta creep' and the coming of age of smart betas, which will eventually increase the options available to investors to secure cheap market and ‘market plus’ returns.”

Craig Baker, global head of manager research at Watson Wyatt, said: “A better deal on fees remains to be struck - too much beta is being sold at an alpha price. While we strongly believe skilled managers should be fairly compensated, fees are generally still too high for the value they deliver, particularly as we enter a lower-return environment. Also, performance fees introduced to align interests have been less than effective because they are generally poorly designed and tipped in managers’ favour. For a number of years we have been trying to rectify this situation and negotiate a fairer deal on fees, but only now we are seeing real progress.”

“In 2009 more hedge funds will disappear, either from necessity or from their desire to re-set their high water mark. In addition, mass redemptions over coming weeks will affect short-term performance to perpetuate the cycle. While these are very substantial changes, we still believe in the ability of highly talented investors to adapt to a changing environment and consequently still generate good performance. In our opinion, the hedge fund industry still boasts a high proportion of the most talented investors in the world and as such we believe that the best hedge funds and funds of hedge funds will adapt and benefit from recent events. We also believe that there will be a number of good things, such as an improvement in fee structures and greater alignment of interests, to come out of the turmoil - particularly for long-term institutional investors.”

Jane Welsh, global head of private markets research at Watson Wyatt, said: “In the recent past, cheap and readily available debt combined with rising prices and an accommodating exit environment created an ideal environment for private equity managers to generate strong returns for investors without needing to exercise particularly high levels of skill and investment judgment. That era is over and the new world will reward those long-term and selective managers with strong track records of creating value through accelerating the earnings growth of their portfolio companies.”

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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 co-ordinated 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 US investment advisory and investment consulting services are provided by Watson Wyatt Investment Consulting, Inc., which is a subsidiary of Watson Wyatt Worldwide Inc. Watson Wyatt Investment Consulting, Inc., is a registered investment adviser with the Securities and Exchange Commission.

Watson Wyatt (NYSE, NASDAQ: WW) is the trusted business partner to the world’s leading organisations on people and financial issues. The firm’s global services include: managing the cost and effectiveness of employee benefit programs; developing attraction, retention and reward strategies; advising pension plan sponsors and other institutions on optimal investment strategies; providing strategic and financial advice to insurance and financial services companies; and delivering related technology, outsourcing and data services. Watson Wyatt has 7,600 associates in 32 countries and is located on the Web at www.watsonwyatt.com.