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INSIGHTS

Corporate Finance MeetsPension Management:

A New Era for Pension Leaders

About JPMorgan Asset Management —Strategic Investment Advisory Group

The Strategic Investment Advisory Group (SIAG) partners with clients to developobjective, thoughtful solutions to the broad investment policy issues faced by corporate andpublic defined benefit pension plans, insurance companies, endowments and foundations.Our global team is one of JPMorgan’s primary centers for thought leadership and advisoryservices 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 asset-liability, risk budgeting and optimal asset allocation analysis, in line with client-specificinvestment guidelines, risk tolerance and return requirements.

SIAG brings a deep knowledge and understanding of capital markets behavior to all itsadvisory services, ensuring results and recommendations have real-world consistency and canbe tested under a variety of market scenarios. Strategic Investment Advisory Group servicesare offered as part of an overall asset management relationship to complement the manyways 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 Managementto skillfully manage their investment assets. This legacy of trusted partnership has been builton a promise to put client interests ahead of our own, to generate original insight, andtranslate that insight into results.

Today, our advice, insight and intellectual capital drive a growing array of innovativestrategies that span U.S., international and global opportunities in equity, fixed income, realestate, private equity, hedge funds and asset allocation.

Foreword The corporate pension playing field is about to experience the most significant series ofchanges — both in regulations and accounting rules — plan sponsors have seen in over threedecades. More stringent funding requirements under the Pension Protection Act of 2006 willincrease required contributions and their volatility while SFAS 158 has put pension assets andliabilities on the balance sheet, inextricably linking the health and performance of the planand its sponsoring corporation.

With these and anticipated FASB Phase Two reforms, the relationship between pensionmanagement and corporate finance will undergo a seismic shift. Pension plans will nowcompete head-on with sponsors’ core businesses for risk and resource allocations.

Can defined benefit plans succeed on this new playing field? We believe so — provided CIOs andcorporate executives adopt a new framework for managing the pension plan — whether theplan is active, closed or frozen. To be effective, this framework must enable the plan toachieve an attractive level of returns while being integrated into the corporation’s overall riskmanagement process. This will require both corporate finance-based metrics for measuringthe plan’s impact on corporate risk and the implementation of a broadly diversifiedinvestment portfolio that delivers adequate investment results while addressing the plan’s keymarket risk exposures, namely, the volatility of equity markets and interest rates.

We outline in this paper an approach to managing pension plans which incorporates thesefeatures and is designed to address the dual objectives of enhancing value for shareholders andensuring benefit security for participants.

We hope this framework and discussion will assist corporate and pension leaders within yourorganizations to successfully compete on the new pension playing field and welcome yourresponse to our latest thinking on effective pension plan management in this rapidlychanging environment.

Sincerely,

Bill McHugh Abdullah Sheikh212-648-1695 [email protected] [email protected]

Bill McHughManaging Director

Head of the StrategicInvestment Advisory

Group

and

Abdullah Sheikh, FIAStrategic Investment

Advisory Group

Table of Contents

Introduction: The need for a new approach . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .1

The imperative: Controlling pensions’ new risk profile . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .4

Tools for the new era: A corporate finance approach to pension management . . . . . . . . . . . . . . . . . . . . .8

Asset allocation in the context of corporate finance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .11

Illustrations of “at risk” measures: Green Corporation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .16

Risk reduction benefits of a Broadly Diversified Investment Portfolio (BDIP) . . . . . . . . . . . . . . . . . . .20

Concluding remarks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .24

JPMorgan Asset Management Long-Term Capital Market Return Assumptions (2006) . . . . . . .Appendix

1

Since the passage of ERISA over 30 years ago,defined benefit pension plans have grown to becomethe largest assets and liabilities of many U.S.corporations. (At end of third quarter 2006, totalcorporate pension assets reached $2.1 trillion.1) But,in spite of their size, under SFAS 87, pension planswere generally considered an off-balance sheet item.In addition, SFAS 87’s rules for calculating pensionexpense included the use of expected rather thanactual return on plan assets and extensive use ofsmoothing and amortization techniques that hid thetrue risks to the plan sponsor of offering a definedbenefit plan.

During 2006, however, pensions became a largerand more prominent source of risk to manycorporations. New funding and accountingregulations — The Pension Protection Act of 2006,(PPA) and SFAS 158 — call for new valuationmethods that will increase liabilities by as much as15%2, raise sponsors’ funding requirements for thoseliabilities from 90% to 100%, and requirecompanies to consolidate the net funded status oftheir plans on the balance sheets, withcorresponding changes in shareholder equity.

Purists may continue to think their pension planswill operate as a long-term investment, independentof corporate influence. However, by adding thepension plan to the corporate balance sheet,unfavorable changes in a plan’s funded status willaffect the risk profile of the corporation, andtherefore its credit standing, access to the capitalmarkets, and cost of capital. As a result of theincreased transparency of pension risk — inparticular, interest rate risk from mismatched assets

and liabilities, and the risk of large strategicinvestment allocations to equities — pension planswill surely receive greater attention from chiefexecutives, chief financial officers, corporate riskmanagers and boards of directors.

We fear a rude awakening, as corporatemanagements see the full implications of the newaccounting requirements on shareholder equity, andthe new funding regulations on cash flow. SFAS 158and the Pension Protection Act may be intended tobring stability to the pension system through moretransparent reporting and stronger funding, butwith these new dimensions of cost and risk, seniormanagement will place pension plans in competitionwith core businesses for risk and resource allocations.These new, more transparent regulations could meanthe end of many defined benefit plans, unless chieffinancial officers, treasurers and pension chiefinvestment officers can implement more effectivemeans of managing their plans’ risk exposures.

To measure the impact of pension plans on overallcorporate risk, and develop asset allocations that fit the new risk context, we have developed aholistic pension risk framework that links corporateCFOs’ notions of risk with pension allocationsadvocated by chief investment officers. The firstcomponent of the framework is a set of threemetrics, based on corporate finance concepts, thatestimate the effect of defined benefit plans oncorporate shareholder equity, cash flow, andearnings, represented by “shareholder equity at risk”(SHE@R), “corporate cash flow at risk” (CF@R),and “earnings at risk” (E@R).

Introduction: The need for a new approach

Recent reforms

place pension

plans in

competition with

sponsors’ core

businesses for

risk and resource

allocations.

1. Federal Reserve Bank, Flow of Fund Accounts of the U.S., December 20062. JPMorgan Asset Management, Strategic Investment Advisory Group

2

These metrics quantify (for a given pension portfolioallocation) the charges or credits to shareholderequity, cash flow and earnings attributable to theimpact on pension assets and liabilities of changes inthe financial markets. With these measures, CIOsand CFOs have a way to jointly determine howmuch risk the pension plan should present to thecorporation and to match the risk profile of theplan’s asset allocation to the company’s available risk capacity.

The second component of our framework is a“Broadly Diversified Investment Portfolio,” orBDIP — a novel method for setting assetallocation. BDIP takes into account interactionsbetween plan assets and liabilities, but also draws onour “at risk” measures to fine tune the plan’s assetsand liabilities to the risks of the consolidatedcorporation.

The ideas behind the framework are illustrated inExhibit 1. In essence, our new pension metricsmeasure the risk in the assets and liabilities of apension plan, while the BDIP solves for an assetallocation that both generates the return needed in

the plan, and matches the risk levels seniormanagement seeks. In the return dimension, toreduce the traditional reliance on public equities,BDIP encompasses a broad range of beta and alphasources for the plan’s investable universe, including:private equity, real estate, hedge funds, timber,commodities, infrastructure, oil and gas, andportable alpha programs, as well as traditional activemanagement in strategies where managers candemonstrate skill.

We believe that within the next five years —especially after Phase Two of the FASB’s accountingrule changes is issued — the typical final paypension plan will look radically different from thetraditional 70% stock, 30% bond model, and investbetween 25% and 35% of its assets in non-traditional asset classes. Cash balance plans will haveeven higher allocations, representing up to 50% ofplan assets.

The framework we propose is not a one-size-fits-allsolution. It will benefit companies differently,depending on plan assets, liabilities and surplusrelative to profits and shareholder equity, firms’ cost

Exhibit 1: A corporate finance approach to pension plan management

Source: JPMorgan Asset Management

Changing Environment Pension Risk Metrics Broadly Diversified Investment Portfolio

SHE@RShareholder Equity at Risk measures the balance sheet impact of a strategic investment policy.

CF@RCorporate Cash Flow at Risk measuresthe effect of funding requirements oncorporate liquidity.

E@REarnings at Risk measures the effect of changes in funded status on corporate earnings.

Hedge interest rate risk.

Reduce equity concentration and add new, consistent, uncorrelated sources of return: portable alpha, non-traditional assets.

Complement corporation’s operating risks and earnings cycles.

SFAS 158

Pension Protection Act

SFAS 87 andPhase Two Pension Accounting

New assessment of pension risks, in light of new regulation

New portfolio allocations, addressing new risks

Needed: A new,

holistic risk

framework

linking corporate

notions of risk

with CIOs’

strategies for

pension portfolio

allocations.

3

of capital and access to funds, and firms’ views oninterest rates and hedging risks. But with aconsistent framework that speaks to the goals ofboth the pension plan and the corporation, sponsorscan manage their plans to ensure benefit security forparticipants, and at the same time enhance value toshareholders. Chief executives, CFOs and chiefinvestment officers can measure and align thepension plan’s interest rate and equity risks to thecorporation’s risk tolerance with one corporatefinance-based model.

Senior managers have a responsibility to manage riskand enhance value for their shareholders, but alsohave a significant obligation under ERISA to protectthe security of participants’ benefits. Our frameworkaddresses these goals simultaneously. First,measurement and management of pension risks willstrengthen the corporation, better enabling thesponsor to honor its future funding obligations.Second, a Broadly Diversified Investment Portfolio(BDIP) should lead to a more efficient assetallocation for the plan, often earning the same orhigher return at lower risk. The end result is greatersecurity for participants and greater value forshareholders.

4

The pension playing field is about to experience themost significant series of changes — both inregulations and accounting rules — since theenactment of ERISA in 1974. In reaction to thepoor performance of corporate defined benefit plansin the weak markets of 2000 through 2002, theindustry is being forced to digest new rules for thefunding of benefit obligations (The PensionProtection Act of 2006), and for the reporting ofpension funded status on corporate balance sheets(SFAS 158, “Employers’ Accounting for DefinedBenefit Pension and Other Post-retirement Plans”).While the sources of risk inherent in pensionmanagement are fundamentally the same as theywere before the new rules’ arrival, the rule changeswill greatly magnify how these risks are realized bycorporate sponsors.

These new reporting and funding requirements aremeant to strengthen corporate DB plans in the longrun, by mandating greater transparency and strongerfunding positions. But as they are being adopted(between year end 2006 and 2010), the unfolding ofthe effects of the new regulations will make theviability of pension plans an agenda item at thesenior-most levels of corporate America. In the SFAS158 “on-balance sheet” environment and under newPPA mandates, pension contributions will increase,and short-term swings in the financial markets willhave direct and immediate effects on shareholderequity, cash flow and earnings. Pensions are beingtransformed from off-balance sheet operations withresults smoothed over many years, to largeconsolidated business units with high potentialshort-term volatility, bringing them to center stagefor executive managers — especially the CFO and Treasurer.

Pension plan chief investment officers are at theintersection of this change, and need to dramatically

rethink their approaches to risk and asset allocation.The first step in this process is to assess a plan’s“upstream” effects on shareholders, using themethodology and guidance of our corporate financeapproach to pension management. The second stepis to bring the plan’s risk profile in line with that ofthe corporation, through new techniques for riskmanagement and prudent asset selection.

The good ol’ days: Risk-taking in a favorable environmentThe sensitivity of liability valuations to interestrates is the single largest risk, and source ofvolatility, in most pension plans today. Even thoughmany plan managers have acknowledged theirliability risk exposure to interest rates in the past,most have been comfortable leaving this massiveinterest rate bet unhedged, because previousaccounting treatment offered little incentive tocontrol it. Moreover, many plan managers believethat duration extension has been “expensive” at thelow levels of interest rates prevailing for the pastfive years.

The typical duration of a final pay plan’s liabilities is13 years; holding all other factors equal, the value ofthe plan’s liabilities would increase by 13% for every1% decrease in the discount rate. (The oppositeeffect occurs when the discount rate rises.) On theother hand, the duration of most plans’ assets isgenerally less than three years, so assets wouldincrease by just 3% for every 1% decrease in thediscount rate.

Interest rate risk is not the only significant bet intoday’s pension plan. Given the muted effect of risk-taking on the plan and corporation under SFAS 87,traditional asset allocation led to significantconcentration of equity assets in portfolios.Experience of the last six years shows that largeequity holdings, even when diversified among

The imperative: Controlling pensions’ new risk profile

The corporation

must first, assess

a plan’s

“upstream”

effects on the

shareholders…

5

geographies, company size and growth and valuestyles, tend to move together when markets areunder stress.

The performance of U.S. corporate pension plans, asmeasured by funded ratios of the last six years, is thestar witness to the vulnerability of traditional assetallocation. As highlighted in Exhibit 2 and ourrecent Insights piece: Review and Outlook 2006:U.S. Corporate Pension Financial Performance, themedian funded ratio among the 200 largest U.S.corporate pension plans has declined sharply overthe last six years, from 122% in December 1999 to86% in 2005. Moreover, 81% of U.S. pension planswere underfunded at December 31, 2005.

The funded status decline is the result of pensionpolicies that sought to optimize asset returns, anddid not link asset performance to the growth andvaluation of benefit obligations. Given a favorableregulatory and accounting environment under SFAS 87, many CIOs chose to invest with a longtime horizon, in the asset class that offered thehighest long-term expected return — equities. Thestrong returns of equities through most of the 1990screated large surpluses for many plans, and positivereinforcement for high equity allocations. At thepopping of the tech bubble, many plans had

concentrated 60% or more of assets in equities, sothat the performance of pension assets has closelyparalleled the choppy behavior of the U.S. equity markets.

In contrast, organic growth and declining interestrates drove the liability growth of the past six years:the average discount rate used to value liabilitiesdeclined from 7.75% at the end of 1999 to 5.5% atthe end of 2005. Exhibit 3 shows the annualchanges in assets and liabilities for the 200 largestU.S. corporate plans from 1995 to 2005. In six ofthe eleven periods shown, liability growth outpacedasset growth, including five of the last six years,leading to the large deterioration in funded status.

The catalyst for changeRegulators acted deliberately, but firmly, to thepension funding crisis of 2000 through 2002. Tomake the reporting of pension risk more transparent,the Financial Accounting Standards Boardpromulgated SFAS 158. To improve the benefitsecurity of pension participants, the PensionProtection Act increases the level and immediacy ofpension fund contributions.

Exhibit 2: End-of-year funded ratios for top 200 corporatepension plans (PBO)

Source: JPMorgan Asset Management, Pensions & Investments,company annual reports

50%

70%

110%

150%

190%

90%

130%

170%

19

87

19

89

19

93

19

91

19

95

19

97

19

99

20

01

20

03

20

05

Median plan

Average of bottom 20%

Average of top 20%

End-of-year

Fund

ed ra

tio

Exhibit 3: Annual asset and liability growth


For illustrative purposes only. Assumes 10-duration liability, 2.5%service cost. Asset returns reflect a hypothetical portfolio of 65%equity, 35% Lehman Aggregate Bonds. Discount rate derived by theLehman AA Long Corporate Bond and Moody’s AA Long CorporateBond Yields. Assumes zero contributions. Benefits are not reflected inindividual years’ annual growth.

-15

-10

-5

0

5

10

15

20

25

30

35%

Liability growth

Asset growth

2005

2004

2003

2002

2001

2000

1999

1998

1997

1996

1995

% G

row

th

… and second,

bring the plan’s

risk profile in line

with the

corporation’s.

6

The impact of SFAS 158 SFAS 158 sets the stage for a new era of pensionmanagement by requiring corporations to reflect thesurplus or deficit of their plans on the corporation’sbalance sheet at fair market value. Overfunded planswill reflect an asset, and underfunded plans willreflect a liability, with offsetting entries as increasesor decreases in shareholder equity. Since mostcorporate plans are underfunded, many companieswill record an increase in “debt-like” liabilities, anda reduction in shareholder equity.

An overview of a corporation’s balance sheet riskprofile under the prior and new accountingregulations appears in Exhibit 4. Under SFAS 87,pension plans represented an off-balance sheetexposure, while under SFAS 158, the risk profile ofthe corporation increases, as pension risk moves onto the balance sheet.

Companies will not only recognize an initial deficitor surplus when SFAS 158 is adopted: they will alsoface charges or credits for the volatility in their

plans’ assets and liabilities for every year goingforward, so short-term volatility in a plan’s fundedstatus will increase the risk profile of thecorporation. Investors are watching closely, and incases where the net liability of the plan is largerelative to the corporation, this undesirable volatilitycould harm a company’s credit rating and raise itscost of capital.

SFAS 158 will force CFOs, treasurers and CIOs toeither embrace the volatility of plans’ significantinterest rate risk and equity concentration, or designa solution to manage or shed them — quickly.

The viability of pension plans in this new erarequires:

• New metrics for assessing, communicating andactively managing pension risk exposures

• A better asset selection framework — one whereinformed investment decisions and portfolioconstruction focus on both the short-term andlong-term effects of pension-related decisions onthe corporation’s well-being.


Operational

Financial

Other

• Commodities• FX• Interest rate

• Commodities• FX• Interest rate• Pensions

Pensions

Leases

Other

Operational

Financial

PensionsInterest rate

FX

Other OtherOther

Equity

Interest rate

Corporate balance sheet risk exposures

Corporate balance sheet risk exposures

Active management of risks

Active management of risks

SFAS 87 SFAS 158

Assets

Pension plan risk exposures

LiabilitiesOff balance sheet exposures

Exhibit 4: Balance sheet risk — before and after SFAS 158

7

Overview of PPABy requiring higher funding levels and morestringent valuation, the Pension Protection Act of2006 (“PPA”) magnifies the pension plan’s impacton corporate cash flow — the lifeblood of thecompany. The new legislation is comprehensive.

First, most corporations will be required to makehigher contributions — sooner than planned, unless they have been granted special fundingaccommodations such as the airline and autoindustries. PPA increases the target funding rate of aplan from 90% to 100%. Both targeted normal costand a shortfall contribution must be fundedannually. (Targeted normal cost is the present valueof benefits expected to be accrued during the year,while the shortfall contribution is the amountrequired to fund the plan’s deficit, amortized overseven years.)

Second, mature plans will see their requiredcontribution levels increase as they are required toreport a higher liability value in an upward slopingyield curve environment. PPA creates a segmentedyield curve for valuing current pension liabilitiesthat will cause near-term liabilities to be discountedat a lower rate on the curve, thus increasing theirvaluation. We estimate that for a typical plan, thechange in methodology will have the impact ofincreasing liabilities by 10% to 15%.

Third, the Act will create more volatility in boththe funded status of the plan and in contributionrequirements. It reduces the interest rate smoothingperiod for valuing liabilities from four years to twoyears, and the asset smoothing period from five yearsto two years. It also modifies interest rate smoothingfrom a weighted to an unweighted approach, andnarrows the prescribed corridor for valuing planassets, from 80% to 120% of actual market value to

90% to 110%. If the new rule had been in effect thelast five years, volatility in pension plan fundedstatus would have been twice as great, even thoughthat period was one of historically low volatility inmarket returns and interest rates. The stress tests ofthese rules on corporate cash flows in a period ofhistorically “normal” market and interest ratevolatility suggest significant cash flow impacts formany U.S. corporate plans.

Fourth, the Act defines a category of “at risk plans,”and establishes higher funding obligations for them.We estimate that 20 to 30 of the nation’s 200largest corporate pension funds might fall into this group.

Acting on the new imperativesMoving the plan to the balance sheet links pensioninvestment decisions directly to the financial well-being of the corporation. As a result, sponsors needto broaden their investment view, from a focus onlong-term asset returns, to considering the effects ofquarterly and annual changes in portfolio valuationson shareholder equity, cash flow and earnings. Atwo-horizon view contemplating both goals willresult in a better alignment of the plan’s risk profilewith the corporation’s ability to absorb risk in theshort term and long term, and improve the viabilityof defined benefit plans.

The implication for chief investment officers is thatasset allocation and portfolio construction mustembrace new risk parameters. Traditionally equity-heavy asset allocations, based on long-terminvestment horizons, will be replaced with morediversified portfolios that balance between the long-and short-term goals, and seek return through non-traditional assets, such as real estate, private equityand hedge funds, among others.

CIOs must

embrace new risk

parameters and

balance long-

and short-term

goals.

8

We believe that the viability of defined benefitpension plans in America depends on the adoptionof a corporate finance approach to pensionmanagement. This approach first measures andcontrols the risk plans add to the consolidatedcorporation’s balance sheet, earnings and cash flow,and second, integrates the plan’s liabilitymanagement and asset selection decisions into thecorporate risk profile. The corporate finance viewof plan management is designed to bring long-term stability and improved financial healthboth to the pension plan and the organizationsthat sponsor them. The approach enables seniormanagement to better understand and govern howthe risks of the pension plan affect the corporation.We of course advocate managing plans to followERISA’s exclusive benefit rules, and believe thebest route to compliance is to apply to pensionsthe same corporate finance based riskmanagement tools guiding a company’s corebusiness units.

The CIO’s skill set and leadership has never been ascritical to the future of DB plans as it is now — asmany plans need this expertise to successfully makethe transition to the new era. To improve theviability of pension plans in the new era, thecorporate finance approach empowers the CFO andCIO to:

• Gain greater control over the balance sheet riskexposures resulting from the plan

• Reduce the level and volatility of contributions

• Minimize undesired corporate “earnings at risk”

Managing the pension plan to enhanceshareholder valueCompanies offer benefit plans to attract and retain askilled workforce, but pension plans are not a

philanthropic exercise: like any other activity of thecorporation, they must be managed to enhanceshareholder value. In the case of pensions, this broadcorporate goal translates to providing benefitsecurity to plan participants, in addition tomanaging the risk the plan presents to thesponsoring company.

Essential to benefit security, and therefore toshareholder value, is strict compliance withERISA regulations. Like in other highlyregulated industries, regulatory compliance is a key factor in maximizing long-termshareholder value.

The logic for adopting a corporate financeperspective in the new era — treating the pensionplan as an integral part of the corporation’s balancesheet and income statement — is based upon therelationships between the plan and its sponsor:

• The risks associated with the plan’s investmentsare borne solely by shareholders.

• Plan assets and liabilities are “owned” by thesponsor, and are often significant in relation toshareholder equity and market capitalization.

• The volatility of a plan’s funded status can causevolatility in corporate earnings, cash flowrequirements and shareholder equity, and affect acorporation’s creditworthiness.

• Plan assets and liabilities are correlated (eitherpositively or negatively) with the firm’s otheroperational and balance sheet exposures, andtherefore need to be integrated and activelymanaged.

The greater prominence and transparency of pensionrisk under PPA and SFAS 158 is causing manyCFOs and CIOs to migrate risk management

Tools for the new era:A corporate finance approach to pension management

The CIO’s skill set

and leadership

has never been

as critical as it

is now.

9

techniques from the corporation to the pension plan,such as hedging interest rate risk. Although theconcepts of hedging unwanted risk exposures maybe new to some pension plans and their boards, it isnot new to most corporate treasury teams, whichhave been hedging interest rate, currency andcommodity exposures for over 20 years.

A new method for measuring, monitoring andmanaging pension riskWe have devised a rigorous framework based onthree new metrics of pension risk — entirelycustomizable to each plan and corporation’s currentsituation. The extent to which a corporation adoptsit will depend on important factors such as the sizeof the plan’s assets, liabilities and surplus relative tothe corporation’s balance sheet; the company’s cost ofcapital and access to funds; the firm’s views oninterest rates; and its philosophy toward hedging itsoperational and financial risks.

The traditional asset-only assessments of pensionplan performance are misguided, and with thearrival of SFAS 158 and the PPA, out of date.Consultants and plan sponsors have defined pensionplan risk in terms of either the volatility of returnson plan assets, as measured by the standarddeviation of returns, or the volatility of the plan’ssurplus. Unfortunately, these definitions do notprovide useful information on the effectiveness ofthe plan’s asset allocation, or its potential impact onthe corporation. For example, if we state that theplan has an expected return of 7% and a standarddeviation of return of 10%, it is difficult to assesswhether or not the allocation is appropriate foreither the plan or the sponsor’s risk profile. Thesame is true for measures of surplus volatility: theyprovide some insight as to the potential impact ofthe plan’s asset allocation on the plan, but do notexplain the upstream impact of asset allocation onthe corporation.

Shareholder equity at riskThe first measure defines risk in terms of SFAS 158and identifies both the expected change inshareholder value given the plan’s current assetallocation, and the amount of shareholder equity at risk, or SHE@R. SHE@R represents, for a givenportfolio allocation, the difference between theexpected impact on shareholder equity under SFAS 158 and the change from a “worse case”scenario. (We say “worse case,” rather than theconventional “worst case,” because our examplesdraw on the market experience from 2002 — a verytrying year for pension plans, but not the worst everseen.) If, for example, senior management expectedthat given the plan’s asset allocation, the corporationwould experience a $100 million increase inshareholder equity during the year, and in the worsecase scenario, the corporation would suffer a $600million decrease in shareholder equity, the SHE@Rwould be $700 million.

Cash flow at riskThe second measure defines risk in terms ofcontribution requirements under PPA. The focus ison expected contribution requirements, and the levelof corporate cash flow at risk, or CF@R. CF@Rrepresents the difference between the expected levelof contributions and a worse case scenario for a givenportfolio. If, for example, the corporation expectedthat the plan’s contribution requirement for theupcoming year would be $100 million, andestimates a worse case scenario of $200 million, theCF@R associated with the plan’s asset allocationwould be $100 million for the upcoming year.

Under PPA’s rule of amortizing funding shortfallsover seven years, the CF@R is not confined to oneyear. However, contributions would be $100 millionhigher in each of the next seven years than if theplan had achieved expected versus worse case results.This $100 million increase for seven yearsapproximates the level of shareholder equity at risk.

Pension plans

must be

managed to both

enhance

shareholder

value and

provide benefit

security to

participants.

10

Earnings at riskThe third measure defines risk in terms of thepotential impact of the pension plan on corporateearnings as calculated under the existing accountingrules of SFAS 87. (SFAS 158 does not addresspension expense, only balance sheet reporting.) Thefocus is on expected pension expense and the level ofcorporate earnings at risk, or E@R. E@R representsthe difference between the corporation’s expectedlevel of pension expense and a worse case, measuredfor the same portfolio allocation. If for example, thecorporation’s expected level of pension expense is$100 million, and the worse case scenario is $200million, E@R would be $100 million for theupcoming year.

As with CF@R, under SFAS 87’s rule of amortizinglosses, the initial E@R does not represent a one-timehit to corporate earnings. It would be reflected forthe upcoming year, and for each year of theamortization period. In addition, the worse casescenario will result in higher future pension expensebecause it has a lower asset base on which expectedreturn of plan assets will be based.

Given the extensive use of amortization andsmoothing techniques under SFAS 87, E@R issignificantly lower than it would otherwise be. Weexpect that under Phase Two of the accounting rulechanges, FASB will eliminate these techniques forthe calculation of pension expense. Unlesscorporations adjust their asset allocations, the newregulations will result in significant increases toearnings at risk (E@R).

11

Using these new measures of risk, the corporatefinance approach allows senior management to makemore informed pension decisions, and to assess thepotential impact of those decisions on shareholdervalue. Senior management is now in a position tomodify the risk exposure of the plan whenever thereis a misalignment between the level of risk in theplan, and the corporation’s ability to accept that risk exposure.

Our corporate finance approach provides chiefinvestment officers with a way to assess the impactof the new regulatory and accounting changes ontheir plans, and structure efficient portfolios thatboth ensure the benefit security of plan participantsand manage the risk the pension brings to bear onthe corporate sponsor. Rather than evaluateportfolios on the traditional measures of maximumreturn, or mean-variance efficiency of assets alone,possible portfolio allocations are ranked by theirexpected impact on shareholder equity, pensionexpense and contribution requirements, andpotential risk exposure as defined by SHE@R,CF@R and E@R.

In this context, efficient portfolios will be those thatalign to corporate objectives. They will:

• reduce uncompensated interest rate risk, byreducing the duration mismatch between planassets and liabilities, and

• reduce long-only equity concentration, in favorof broadening the universe of assets to achieveacceptable total return targets with lowerportfolio volatility.

The degree to which total return is impacted can bemanaged through the plan sponsor’s asset selectionand sub-asset class diversification decisions. Thesegoals can be achieved both by adjusting theinvestment mix of “physical” assets, and by hedging

the pension portfolio with synthetic assets such asderivatives — the same tools corporations apply totheir operating and financial risks.

In order to construct more efficient pensionportfolios, we believe that corporations shouldbroaden their plans’ universe of investments.

Reducing risk within the pension plan Every corporation has a risk budget that it setseither explicitly or implicitly. The share of totalcorporate risk devoted to the pension plan should bebased on several factors including the funded statusof the plan, the size of the plan’s surplus/deficitversus shareholder equity, and the financial strengthand overall financial goals of the corporation.

Because pension fund management is a non-corebusiness for the sponsor, the focus of riskmanagement should generally be to reduce, notredistribute, risk in the plan, so that risk can bedeployed in the corporation’s core operations. Theconcept is reflected in Exhibit 5.

Reallocating pension plan riskThis reallocation of risks enhances participants’benefit security in two ways. First, it results in amore efficient asset allocation for the plan, so theportfolio earns a similar return at lower volatility.Second, the reallocation of risks can strengthen thesponsor, making the corporation better able to meetbenefit obligations in the event of a shortfall in the fund.

Broadening the investable asset universeTo complement our corporate finance approach, wehave developed a new framework for portfolioconstruction, one that is radically different from thetwo-thirds equity, one-third bond asset allocationthat is in place at most corporate plans today. Weadvocate lowering interest rate risk throughduration management via long-term bonds and

Asset allocation in the context of corporate finance

To construct more

efficient

portfolios,

corporate plans

should broaden

their investment

universe.

12

derivative overlays, and recommend cutting the riskof equity concentration by implementing a BroadlyDiversified Investment Portfolio (BDIP).

As we discussed, the heavy concentration of equitieswithin most pension plans represents a second largerisk exposure to both the plan and shareholders.This risk exposure is magnified in the SFAS 158 era,in which pensions are a balance sheet exposure. Tomanage this asset concentration risk successfully,corporations need to broaden the plan’s investableuniverse. The experience of 2000 through 2002showed that even diversified portfolios of long-onlyequities move together in times of market stress.Reducing a plan’s long-only equity stake, andfunding a wide range of beta and alpha sources isthe winning approach — including private equity,

real estate, hedge funds, timber, commodities,infrastructure, and oil and gas. These are assetclasses and investment strategies that will generatereturns that are lowly or negatively correlated withequities, or with each other, and reduce thevolatility of the plan’s total return. Moving to thesestrategies calls for trade-offs in liquidity and feestructure, but offers plans the possibility of meetingor exceeding total return targets as long-only equityexposure decreases.

We believe that within the next five years, especiallyafter Phase Two of the accounting rule changes isissued, the typical final pay pension plan will havefrom 25% to 35% of its assets invested in non-traditional asset classes, versus about 10% today.

Exhibit 5: Reallocation of risks


Reallocation of risk exposures

Financial

Other

Pension

OperationalOperational

Financial

Other

Pension

Interest rate hedging

Reduced equity exposure

Corporate balance sheet risk

Pension risk management

Operational risk

Corporate balance sheet risk

— After —— Before —

The focus of

efficient portfolio

construction is to

reduce, not

redistribute, risk

in the plan and

redeploy it to

core businesses.

13

Cash balance plans will have even higher alternativeallocations, representing up to 50% of plan assets.We see the push for diversification not only at theasset class level, but deeper into local markets andinvestment techniques that deliver the lowcorrelations and return potential that investors need in the new era. For example, a typical realestate portfolio will not be restricted to the U.S.market, but will include real estate in Canada, the United Kingdom, continental Europe and Asia,where unique characteristics of the local populationand income density drive the market.

Increased allocations to non-traditional assets canresult in a new set of implementation issuesassociated with due diligence reviews and portfolio monitoring for some plan sponsors.However, prudently constructed BDIPs can enhancea plan’s risk-return profile.

Exhibit 6 illustrates the wide variety of non-traditional assets and strategies available to sponsorsfor constructing portfolios to meet their revised risk targets. For many strategies, managers are able to customize the risk level by adjustingportfolio structure, to specify a target tracking error against benchmarks.

Active management will play an increasinglyimportant role, as will portable alpha and absolutereturn strategies, because of the returns, flexibilityand diversification benefits they offer. In addition,corporations will broaden their use of derivativesboth to control risk and to enhance returns. Thebroader the number of alpha and beta sources, themore diversification the plan can achieve.

Infrastructure

Global, U.S.,International

Transportation

Power generation

Energy transmissionand distribution

Communicationsassets

Water distribution

Social infrastructure

Real estate


Core

Core plus

Value-added

Opportunistic

Public/Private

Debt/Equity

Hedge funds


Relative value• convertible arb• fixed income arb• equity market

neutral• statistical arb• merger arb• capital structure

Directional• distressed• opportunistic/

macro• dedicated short• long/short equity• emerging markets

Multi-strategy

Private equity


Venture capital• seed stage• mid and later

stages

Corporate finance • buyouts• expansion/growth

equity• consolidations• turn-arounds

Private debt• mezzanine• distressed

Industry-specialized

Enterprise value (size)

Other


Commodities

Currency

Timber

Oil and gas

Equity 130/30

We believe within

five years the

typical final pay

plan will have

25%–35% in

non-traditional

assets.Exhibit 6: Sample menu of non-traditional asset candidates for a Broadly Diversified Investment Portfolio (BDIP)


14

On the left hand side of Exhibit 7, we show thecurrent structure of a typical pension plan, wherethe plan has extensive exposure to equity risk and interest rate risk. The middle columnindicates the risk reduction strategies associatedwith the corporate finance approach, includingreducing the allocation to equities, hedging interestrate risk, and investing in a broad range of non-traditional asset classes. The implementation ofthese strategies reduces both pension plan risk andoverall corporate risk.

The selection of a BDIP for a pension plan isdependent on a series of factors that are bothcorporation and plan-based, detailed in Exhibit 8.

Some corporations may have implicitly considered anumber of the corporate factors listed in Exhibit 8when developing strategic investment policy, butfew have made hard estimates of the risks theypresent to corporate assets and earnings in the newera. By considering both corporate- and plan-related

factors, the BDIP assesses important trade-offsbetween risk control, investment results and thefinancial impact of the plan on the corporation.Including the corporate factors also gives eachcorporation a unique portfolio solution that fits itsown profile of business risks rather than a one-size-fits-all 70% / 30% asset allocation that is based onnormalized measures of the financial markets.

Because the BDIP approach focuses on corporate-based factors, it helps ensure that the total risk ofthe plan’s strategic investment policy is aligned withthe corporation’s capacity for absorbing risks. Theserisks are measured in terms of expected cash flow,expected change in shareholder equity and expectedearnings impact of the plan’s investment policy andan assessment of CF@R, SHE@R and E@R. Thisapproach enables BDIP to achieve its goal ofcontrolling and reducing the corporation’s riskexposure, while enabling the plan to achieve anappropriate level of return.

Exhibit 7: Risk reduction strategies under a corporate finance approach

Operational

Financial Equities Reduce exposure

Hedge exposure

Increase alternatives

Interest ratePension

Other

Operational

Corporate balance sheet

Current risk structure Proposed risk structure

Pension plan

Risk reduction strategies

Corporate balance sheet

Pension plan

Financial

Pension

OtherOther

Equities

Interest rate

Other


Exhibit 8: Factors shaping the development of Broadly Diversified Investment Portfolios


Corporate factors

• Status of the plan — open, closed, frozen

• The corporation’s industry, cyclicality, growthprospects and competitive position

• Financial strength — credit rating, capital access andcost of capital

• Significance of the plan’s funded status andcontributions to shareholder equity, earnings and cash flow

• Corporate tax strategy

• Correlations of pension returns and funded status withcorporate assets, liabilities and business operations

Plan factors

• Demographic profile of plan’s liabilities

• Growth rate of liabilities

• Funded status of the plan

• Plan design issues

• Actuarial issues

15

The dynamic nature of BDIPA firm’s BDIP should complement the risk profileof the corporation, and change as the risk appetiteand risk profile of the corporation change. Forexample, if the corporation is in a stage of thebusiness cycle in which it generates strong earnings,it might increase the risk profile of the pensionplan’s investments, taking on higher levels ofSHE@R, CF@R and E@R. Conversely, as thebusiness cycle fades, the corporation may wish toreduce pension risk exposures. Other reasons formodifying the BDIP might include:

• Changes in the corporation’s earnings and cashflow forecasts

• Corporate actions such as mergers, acquisitions,spin-offs, or reductions in force

• Changes in the plan’s funded status,demographics, or benefit levels

• Secular shifts in interest rates, risk premiums ormarket correlations

• The relative valuation of asset classes

A dynamically managed BDIP goes a step beyond aTactical Asset Allocation (TAA) strategy: TAAportfolios shift their exposures to assets based uponperceived mispricing of assets within the capitalmarkets, while changes in the BDIP are driven byboth changes in the risk profile and risk appetite ofthe corporation, and the relative attractiveness of oneasset class versus another.

A firm’s BDIP

should change as

its risk profile

and appetite

change.

16

Armed with these new measures of risk, thecorporate finance approach provides seniormanagement greater insight on the corporation’sability to accept pension risk exposure, and to adjustmisalignments between the level of risk in the planand its share of a corporate risk budget. Animportant end goal is to translate the pensionlexicon into a language that is most relevant for thechief financial officer. A better understanding of thesource and size of the pension risks leads to betterdecision making and support for the chiefinvestment officer in developing portfolio options.

Following are illustrations of our three newmeasures of pension risk, using as an example thefictional Green Corporation3, a large company with aslightly underfunded DB plan, and a traditional,equity-heavy asset allocation close to industryaverages. By comparing the outcomes of “expected”and “worse case” scenarios, our new measurescalculate the potential impact on shareholder equity,cash flow and earnings in a fully implemented SFAS 158 / PPA environment.

Our “worse” case assumption in this example isa recurrence of the market conditions of 2002— when the broad U.S. equity market dropped22%, while ten-year Treasury yields fell fromroughly 5.0% to 4.0%. For Green Corporation,the effects of such a scenario are enormous.Assuming a 50 bp decline in its discount rate,this scenario would reduce shareholder equityby 24%, cut cash flow by 22%, and decreaseearnings by 30%, with further repercussions inthe following years. The pension plan of thefictional Green Corporation is profiled in Exhibit 9.

The Green Corporation pension plan is very large,but in many ways is typical of most U.S. corporatepension plans: it is slightly underfunded; it has atraditional asset allocation that includes a highallocation (65%) to equities; and there is a largemismatch in the duration of the plan’s assets andliabilities. As a result, the plan has extensive equityand interest rate risk.

In our sensitivity analysis, we will assume twoscenarios, and measure the changes with ourcorporate finance-based risk measures. The firstscenario is an “expected” outcome that fits the long-term assumptions of the plan. In this case, there areno actuarial gains or losses; that is, the plan achieves

Illustrations of “at risk” measures: Green Corporation

Green Corporation

Assets $30BLiabilities and net worth:

Long term debt $16BOther $4BShareholder equity $10B

Forecasted sales $25BForecasted net income $1.4BForecasted cash flow from operations $2.4BTax rate 35%Green Corporation pension plan

Assets $14BLiabilities $15BAsset allocation:

Equities 65%Fixed income 30%Other 5%

Service cost 2.5% of liabilityDiscount rate 5.5%Expected return on assets (ERoA) 6.8%Duration of plan assets 1.3 yearsDuration of plan liabilities 13 years

A CIO’s goal:

translate the

pension lexicon

into a language

most relevant for

the CFO.

Source: JPMorgan Asset Management. Fictional company, forillustrative purposes only

Exhibit 9: Profile of Green Corporation

3. The following examples presented are shown for illustrative purposes only and should not be relied upon as advice or interpreted as arecommendation. They are based on current market conditions that constitute our judgment and are subject to change. Results are not meant to berepresentative of actual investment results. Past performance is not necessarily indicative of the likely future performance of an investment.

17

its expected return on assets, and there is no changein discount rates. (Please refer to the Appendix forour underlying capital market assumptions.)

The second scenario is a worse case scenario,modeled after the results in the markets during2002, in terms of asset performance, and changes inthe discount rate used to value plan liabilities.

The analysis will emphasize:

• The significant risk exposure to GreenCorporation associated with a conventional asset allocation

• The risk reduction available to the GreenCorporation from duration matching, and fromtotal hedging of the plan’s interest rate risk

• The benefits from reducing equity concentration,and investing in a Broadly DiversifiedInvestment Portfolio

Shareholder equity at risk (SHE@R)As described above, SHE@R is the differencebetween the expected change in shareholder equityfrom the plan’s current allocation, and the potentialimpact on shareholder equity under the corporation’sassumed worse case scenario. The Green Corporation’scurrent risk is reflected in Exhibit 10A.

For Green Corporation, the expected impact onshareholder equity for the current year is an increaseof $265 million. The worse case scenario for GreenCorporation is an approximately $3.2 billion declinein shareholder equity. SHE@R, the differencebetween the expected increase of $265 million andthe worse case scenario reduction of $3.2 billion, isalmost $3.5 billion (pre-tax). The after-tax level ofSHE@R ($2.3 billion) represents a potential 24%reduction in shareholder equity. This is a significantexposure, one that most corporations might verywell not like to have, and one that GreenCorporation can hedge away.

The Green Corporation is not alone in beingexposed to potentially very substantial reductions inshareholder equity: most corporations that sponsorfinal-pay plans with duration mismatches and heavyequity exposure face similar risk exposures.

Cash flow at risk (CF@R)The increased levels and volatility of pensioncontributions under PPA add a dimension ofcorporate cash flow at risk (CF@R). CF@R is thedifference between the plan’s expected contributionrequirement and an estimate of contributions basedon a worse case scenario.

SFAS 158: Balance sheet exposure ($ millions)

Expected change in shareholder equity $265Worse case scenario ($3,194)SHE@R (pre-tax) ($3,459)

Change in components ofshareholder equity Expected Worse caseService cost ($375) ($375)Interest expense ($825) ($825)ROA $947 ($1,567)Liability losses – ($945)Contributions* $518 $518Total $265 ($3,194)

PPA: Cash flow assessment ($ millions)

Expected contribution requirement* $510Worse case scenario $1,028CF@R $518

Change in cash flowcomponents Expected Worse case

Service cost $405 $429Initial amortization of$1 billion deficit $105 $105

Initial amortization ofworse-case deficit – $494

Total cash flow requirement $510 $1,028

Exhibit 10A: Green Corporation current portfolio — SHE@R

* The expected contributions are those that would be payable by theGreen Corporation over the current year, based on beginning-of-yearasset and liability values. For example, the total contribution of$518MM comprises a service cost of $375MM plus a deficitcontribution of $1 billion (amortized over seven years).

Exhibit 10B: Green Corporation current portfolio — CF@R

* The expected contributions are those that would be payable by theGreen Corporation over the next year (compared to the current year forSHE@R). These are derived based on forecasts of service cost andsurplus (or deficit). For example, under the worse case scenario, theservice cost is higher than under the expected scenario. This is a resultof a decline in discount rates, which results in a higher liability value(and hence a higher service cost).

18

As noted in Exhibit 10B, the worse case fundingrequirement is more than double the expectedcontribution requirement, and the incrementalfunding obligation of $518 million represents 22%of Green Corporation’s forecasted consolidatedcorporate cash flow.

Under PPA’s funding rules, the increased fundingrequirement is not a one-time event. In each of thenext seven years, contributions will be roughly $500 million higher than they would have beenotherwise, given the approximate $3.5 billionunexpected decline in shareholder equity. As aresult, in the worse case scenario, the plan willcontinue to be a drain on corporate cash flow for the foreseeable future.

Earnings at risk (E@R) Our third corporate finance measure is E@R. E@Rcan be expressed as the difference between the plan’sexpected pension expense and a downside estimateof pension expense. E@R reflects the potentialimpact to corporate earnings based on SFAS 87accounting rules. Under this standard, the volatilityof E@R is muted, due to the use of a “corridor” andto the amortization of net gains or losses only to theextent they exceed the corridor. Losses outside thecorridor are generally amortized into pensionexpense over a five to 15 year period. Given thelarge cumulative unrecognized losses accrued bymany plans, potential swings in pension expense canbe large: we anticipate that Phase Two of the FASB’saccounting rule changes will eliminate the practicesof smoothing and amortization, and lead toincreased levels of E@R.

In our assessment of Green Corporation, we assumethe amortization of losses over a seven year period.In Exhibit 10C, we show Green Corporation’spotential exposure to E@R through the pension plan.

Green Corporation’s worse case scenario is $904million, almost four times the expected level of$250 million. Green Corporation’s after tax E@R of$425 million, reflecting the after tax differencebetween the expected expense and the worse caseassessment, represents 30% of Green Corporation’sbudgeted net income of $1.4 billion. This higherlevel of E@R will reduce corporate earnings in theupcoming year, and in each of the following sixyears (assuming the plan remains outside thecorridor for recognizing gains). Depending on GreenCorporation’s tolerance for risk, it can modify E@Rby varying the risk profile of the plan.

E@R will likely be significantly higher under PhaseTwo of the FASB’s accounting rule changes. If weassume that smoothing is eliminated, GreenCorporation would have the same expected expenseof $250 million. E@R, however, could be as high as$3.7 billion — resulting in a significant operatingloss for Green — versus $654 million under therules of SFAS 87.

SFAS 87: Corporate earnings at risk ($ millions)

Expected expense* $250Worse case scenario $904E@R (pre-tax) $654

Change in componentsof corporate earnings Expected Worse case

Service cost $405 $429Interest expense $891 $857Expected ROA ($1,046) ($876)Amortization ofgains/losses – $494

Total $250 $904

Exhibit 10C: Green Corporation current portfolio — E@R

* As with our CF@R calculation, the expected expense is what theGreen Corporation would expect to incur next year. For example,under the worse case scenario, a drop in discount rates results in alower interest expense over the next year (although this is partiallyoffset by higher liability values). The expected RoA under the worsecase is also lower due to a fall in asset values as a result of poorlyperforming equity markets.

19

Stress testingStress testing is an important aspect of measuringrisk within the corporate finance framework. In theexamples of the Green Corporation, we used theextreme conditions of 2002 to model a worse casescenario. In practice, we would recommend thatcorporations develop several scenarios whenperforming stress tests on their portfolios, based onmany factors:

• Company-specific stress factors, developedinternally by the corporation as part of its overallbudgeting and risk management process, tomodel large, negative movements in thecurrency, interest rate, commodities or equitymarkets

• The expected volatility of the pension plan’sinvestment portfolio based upon either theportfolio’s volatility per the plan’s asset-liabilitystudy, or updated assumptions reflecting thecurrent market environment

• Value at risk assessments

• Historical return streams

20

Managing interest rate riskIn order to determine the potential benefitsassociated with duration matching, we compare therisk profile of Green Corporation’s current portfoliowith the risk profiles of two duration extensionstrategies designed to reduce corporate risk. In thefirst strategy, we assume that the duration of theplan’s fixed income portfolio is extended from thatof the Lehman Aggregate Bond Index(approximately four years) to the duration of theLehman Long Government/Credit Index(approximately ten years).

In the second, more comprehensive strategy, weassume that Green Corporation implements asynthetic dollar duration matching strategy on theentire portfolio. Swaps are used to extend theduration of plan assets to 13 years, so that the assetswill have a duration equal to the plan’s liabilities.(This strategy is similar to a corporate treasurygroup using derivatives to adjust the corporation’sexposure to fixed versus floating rate debt.) In thedollar duration strategy, the plan’s fixed rate asset exposure is transferred into floating rateinstruments, to match the floating rate nature of the liabilities.

In each example, we keep the plan’s actual fixedincome holdings at 30%. The first exampleillustrates managing interest rate risk by changingthe securities in the fixed income portion of thepension portfolio, while the second describesmanaging risk synthetically, through a derivativesoverlay. We don’t want to increase Green’s holdings to fixed income: pension obligations aregrowing organically at 8% per year, and increasingfixed income assets would lower the portfolio’s total expected return, and lock in highercontribution costs.

Duration extension: 30% of assetsFirst we assume the duration of the entire fixedincome portfolio is increased from four years(Lehman Aggregate) to ten years (Lehman Long Government/Credit). We also assume amodestly upward sloping yield curve, and thus nosignificant change in return from holding longer-duration bonds. Exhibit 11A reflects SHE@R forboth portfolios.

Although the expected change in shareholder equityis approximately the same for both portfolios, theproposed portfolio has both a more favorable worsecase scenario and a lower SHE@R: the longer bondportfolio moved more closely with liabilities inresponse to the 50 basis point reduction in theplan’s discount rate (as occurred in 2002, the worsecase year). The risk reduction achieved bylengthening asset duration on just 30% of thepension portfolio was in excess of $180 million.

Exhibit 11B provides the expected contributionrequirements and CF@R for both portfolios.

Risk reduction benefits of a Broadly Diversified Investment Portfolio

SFAS 158: Balance sheet exposure ($ millions)Long duration

Current bond portfolio —portfolio 30% of assets Benefit

Expected change in shareholder equity $265 $272 $7

Worse case scenario ($3,194) ($3,002) $192SHE@R (pre-tax) ($3,459) ($3,274) $185

PPA: Cash flow assessment ($ millions)Long duration


Expected contribution requirement $510 $509 $1

Worse case scenario $1,028 $1,000 $28CF@R $518 $491 $27

Exhibit 11A: Green Corporation — current vs. longduration portfolio — SHE@R

Exhibit 11B: Green Corporation — current vs. longduration portfolio — CF@R

21

Assuming a longer duration bond allocation, theCF@R is $27 million less severe for the proposedstrategy versus the current strategy. Moreimportant, this improvement is not a one-timeevent: for each of the seven years included in theamortization period, the corporation’s contributionrequirement would be reduced by $27 millionunder the proposed portfolio. (Note that in the newenvironment, the results of every year where thefunded status grows or shrinks will trigger sevenyears of adjustments.)

Last, Exhibit 11C shows pension expense associatedwith each portfolio.

The proposed portfolio has a slightly lower expectedpension expense, due to the slight return advantageassociated with longer duration. The E@R of theproposed portfolio is $37 million lower than thecurrent policy. Due to the amortization rules underSFAS 87, Green Corporation will continue to reflectthis benefit over the seven-year amortization period.In addition, going forward, the expected income on plan assets will be higher for the proposedportfolio, due to the portfolio’s higher level ofearning assets (due in turn to a smaller loss on the proposed portfolio).

Duration extension: 100% asset coverageInterest rate risk could be greatly reduced, althoughnot eliminated, through a derivative-based overlay

consisting of interest rate swaps or futures aligningthe duration of the plan’s assets with its liabilities.Exhibit 12A reflects the risk exposure of bothportfolios under SFAS 158.

A dollar-duration strategy fully matching assets andliabilities provides significant risk reduction toGreen Corporation. The change in shareholderequity is about the same under both strategies forthe expected case, although the dollar-durationmatched strategy results in a $2.3 billion reductionin SHE@R. Similar risk reduction is seen in CF@R($324 million for seven years), as shown in Exhibit 12B.

The worse case scenario of the proposed portfolio is$703 million. This represents a $325 millionreduction in contributions relative to the currentstrategy, and amounts to 14% of budgeted cash flowfrom operations. Once again, under PPA’samortization rules, the $325 million improvementunder the worst case scenario in corporate cash flowwill be repeated over the next six years.

Exhibit 11C: Green Corporation — current vs. long durationportfolio — E@R

SFAS 87: Corporate earnings at risk ($ millions)Long duration


Expected expense $250 $241 $9Worse case scenario $904 $858 $46E@R (pre-tax) $654 $617 $37

SFAS 158: Balance sheet exposure ($ millions)Current Swap overlayportfolio 100% of assets Benefit


Worse case scenario ($3,194) ($919) $2,275SHE@R (pre-tax) ($3,459) ($1,191) $2,268

Exhibit 12A: Green Corporation — current portfolio vs.portfolio with swap overlay — SHE@R

Exhibit 12B: Green Corporation — current portfolio vs.portfolio with swap overlay — CF@R

PPA: Cash flow assessment ($ millions)Current Swap overlayportfolio 100% of assets Benefit


Worse case scenario $1,028 $703 $325CF@R $518 $194 $324

22

Exhibit 12C shows the income statement impact ofthe two strategies.

With full dollar-duration matching, the proposedstrategy is significantly less risky than the currentstrategy. Note that the $477 million of reduction inE@R is not a one-time reduction; it will continue infuture years, as the full extent of the investmentlosses associated with the current portfolio areamortized into pension expense.

Of course, a company’s decision to lengthenduration will be based on its view on interest rates,and whether it wishes to hedge the plan’s interestrate risk. We assume that in most cases, sponsorsdon’t have the forecasting ability or appetite forleaving such a bet intact, and will wish to reduceduration mismatch, since it represents an“uncompensated” risk exposure.

Equity risk and the power of BDIPEquity risk, and overall pension plan risk, can bereduced by lowering the plan’s equity allocation andinvesting the proceeds in a Broadly DiversifiedInvestment Portfolio (BDIP) consisting of privateequity, hedge funds, real estate and other non-traditional asset classes.

We assume that after completing a corporatefinance-based asset-liability study, GreenCorporation management decides to invest planassets in the dollar-duration portfolio discussedabove, and to reduce equity exposure from 65% to35%, by allocating 10% each to private equity, realestate and hedge funds. Thanks to a higher expectedreturn for the new assets, the portfolio’s expectedannualized return increases to 7.2%, from 6.8%

under the current policy, based on JPMorgan AssetManagement Long-term Capital MarketAssumptions (as of 11/30/05).4

Exhibit 13A shows the potential impact onshareholder equity under each strategy.

The combination of duration hedging and reductionof equity concentration through BDIP has apowerful positive impact on the plan’s risk exposure:the expected increase in shareholder equity is $62million greater for the proposed portfolio due to itshigher expected return, and the worse case riskexposure and SHE@R of the proposed portfolio isapproximately $3 billion less than the currentportfolio. (The partial effect of adding non-traditional assets and reducing equity reducesSHE@R by $696 million.) After-tax SHE@R of thecurrent portfolio represents 24% of shareholderequity, while the after-tax SHE@R of the proposedportfolio represents only 3% of shareholder equity.

Reflected in Exhibit 13B is the potential impact oncorporate cash flow for each portfolio allocation.

SFAS 158: Balance sheet exposure ($ millions)Current 100% overlayportfolio plus BDIP Benefit


Worse case scenario ($3,194) ($168) $3,026SHE@R (pre-tax) ($3,459) ($495) $2,964

Debt/equity ratio (worse case) 2.67X 1.85X –

PPA: Cash flow assessment ($ millions)Current 100% overlayportfolio plus BDIP Benefit


Worse case scenario $1,028 $595 $433CF@R $518 $94 $424

CF@R as a percentage of expected cash flow (worse case) 22% 4% –

SFAS 87: Corporate earnings at risk ($ millions)Current Swap overlayportfolio 100% of assets Benefit

Expected expense $250 $241 $9Worse case scenario $904 $418 $486E@R (pre-tax) $654 $177 $477

Exhibit 13A: Green Corporation — current portfolio vs. swapoverlay plus BDIP — SHE@R

Exhibit 12C: Green Corporation — current portfolio vs.portfolio with swap overlay — E@R

Exhibit 13B: Green Corporation — current portfolio vs.swap overlay plus BDIP — CF@R

4. See Appendix for detailed assumptions.

23

The expected level of contributions for eachportfolio is approximately the same, given the newfunding rules under PPA. However, there is asignificant difference in the worse case between thetwo portfolios, with the proposed portfolio’sincremental funding obligation approximatey $430million less than that of the current portfolio. This$430 million improvement will be reflected in thecorporation’s cash flow from operations each year forseven years, as the higher funding deficit associatedwith the current portfolio is amortized into thefunding requirement of PPA. As reflected in Exhibit 13B, CF@R for the current portfoliorepresents 22% of forecasted cash flow fromoperations, versus 4% under the proposed strategy.

E@R for both portfolios is summarized in Exhibit 13C.

The expected pension expense associated with theproposed strategy is less than for the currentportfolio, due to the proposed portfolio’s higherexpected return (7.2% versus 6.8%). In terms of

expense, the proposed portfolio offers substantialrisk reduction: worse case pension expense is almost$700 million lower ($454 million after tax) for theproposed portfolio than the current strategy,representing 32% of budgeted net income.

Due to the amortization rules under SFAS 87, GreenCorporation will continue to reflect this almost$700 million reduction in pension expense for thenext seven years. In addition, going forward, theexpected return on plan assets will be higher for theproposed portfolio, due to its higher asset base.

Summary of findingsExhibit 13D summarizes the expected changes inshareholder equity, level of funding requirementsand pension expense for the current and proposedportfolios. In addition, the table shows the SHE@R,CF@R, and E@R of each portfolio. Importantly,although the risk profile of the proposed portfolio is26% higher than the current portfolio using thetraditional risk measure of asset volatility, it issignificantly lower according to our corporatefinance-based risk measures.

Change in Change in contribution Earningsshareholder equity requirement impact

Expected Asset Expected Worse Worse Expected WorseStrategy returns volatility (pre-tax) case SHE@R Expected case CF@R expense case E@R

Current 6.8% 10.2% $265 ($3,194) ($3,459) $510 $1,028 $518 $250 $904 $654Proposed 7.2% 12.9% $327 ($168) ($495) $501 $595 $94 $177 $205 $28Benefit $62 $3,026 $2,964 $9 $433 $424 $73 $699 $626

SFAS 87: Corporate earnings at risk ($ millions)Current 100% overlayportfolio plus BDIP Benefit

Expected expense $250 $177 $73Worse case scenario $904 $205 $699E@R (pre-tax) $654 $28 $626Operating profit margin(worse case) 8.4% 10.9% –

ROI (worse case) 3.2% 4.6% –

Exhibit 13C: Green Corporation — current portfolio vs. swapoverlay plus BDIP — E@R

Exhibit 13D: Green Corporation — current portfolio vs. swap overlay plus BDIP

24

Traditional defined benefit pension plans offer themost effective way to create retirement savings for aworkforce, through professional management,economies of scale in investing, and pooling of risks.But with the passage of the Pension Protection Actof 2006 and the implementation of SFAS 158 —with more accounting changes expected to follow— corporate sponsors will be fully exposed to theshort- and long-term economic risks of their plans’liabilities and investments.

The increased transparency resulting from thesechanges in rules focuses investors on the costs andvolatility associated with defined benefit plans.Accordingly, chief investment officers must assessthe risks their plans can present under manypotential portfolio allocations, develop new assetallocation and return scenarios, and then offer senior management actionable options forintegrating the “new era” pension risk into the corporate risk profile.

By defining risk in terms of CF@R, SHE@R andE@R, our corporate finance approach delivers aneffective framework for managing pension planswhile enhancing corporate shareholder value. It alsoidentifies an appropriate strategic investment policy— one that will ensure the long-term well-being ofthe plan — based on a holistic approach to riskmanagement. This Broadly Diversified InvestmentPortfolio (BDIP) will be quite different from typicaldefined benefit portfolios today, showing greaterdiversity of beta and alpha sources through lessreliance on equities, as well as hedging strategiesthat address the new risks presented by newregulations.

Defined benefit plans are clearly valuable tosponsors and their employees, but in this newregime, chief investment officers need creative newsolutions to controlling pension risk. We wish yousuccess during these exciting times, and lookforward to assisting in your efforts.

Concluding remarks

U.S. Cash 4.25% Higher real short-term rates than in recent years, as Fed needs to work hard to contain inflation.U.S. Treasuries (10-yr) TR 4.75% 10-yr yields to rise toward equilibrium level of 5.25%, but decline in bond prices to hurt returns as

yields rise.U.S. Aggregate TR 5.25% Spreads near equilibrium, but rise in Treasury yields to hurt returns until adjustment is complete.U.S. Long Duration Gov’t/Corp 5.25% Bond yields expected to rise, but search for yield expected to put cap on longer term rates.U.S. TIPS TR (nominal) 4.75% Real yields expected to rise, hurting returns in early years. U.S. High Yield TR 7.25% Spreads assumed to widen from current historically low levels. Some haircut to returns from expected

defaults.Non-U.S. World Govt. Bond Index TR (local currency) 3.00% Bond yields expected to rise, hurting returns in early years. Non-U.S. World Govt. Bond 4.75% Decline in the dollar (particularly against Japan, whose weight in WGBI is large) to provide an average Index TR (USD) 175bp per annum boost to returns. Emerging Market Debt TR 7.50% Spreads assumed to widen, but by less than High Yield; assumes secularly improving credit quality of

EM universe.U.S. Municipal TR 4.00% Bond yields expected to rise, hurting returns in early years.

U.S. Large Cap TR 7.25% Sum of below building blocks (EPS Growth + Dividend Yield + Impact of Changes in P/E Multiples).U.S. Large Cap EPS Growth 5.50% Boost from productivity acceleration is waning. EPS growth expected to be slightly below nominal GDP

growth.U.S. Large Cap Dividend Yield 2.25% Dividend payout ratios expected to rise.U.S. Large Cap P/E Impact on Return -0.50% Expect minor amount of multiple contraction, taking multiples back toward averages of past low inflation

periods.U.S. Mid Cap TR 7.50% 25 bps premium over Large-Cap. Small-Caps have become comparatively expensive and no longer appear toU.S. Small Cap TR 7.50% warrant a return premium relative to Mid-Caps. U.S. Large Cap Growth TR 7.00% Value expected to outperform growth over long time periods.U.S. Large Cap Value TR 7.50%EAFE TR (local currency) 7.75% Non-U.S. economic and (especially) profit performance expected to improve, fueling a small rise in P/E

multiples. EAFE TR (USD) 8.75% Decline in the dollar (particularly against Japan) to provide an average 100bp per annum boost to USD

EAFE returns.Emerging Market Equity TR (USD) 8.75% Improved economic and profit performance by EM economies. Currencies likely to rise over time vs. USD.

Expected 10-15 year annualized

compound USD returns Rationale

U.S. Inflation 2.50% Inflation to remain generally well-contained, but risks are to the upside given tight supply-demand balance in energy.

U.S. Real GDP 3.25% Productivity growth expected to remain strong, but below the exceptional gains of recent years.

Private Equity TR (Industry median) 8.50% Forecast is modestly above those on higher-risk categories of public equity. Only top quartile managers can be expected to substantially beat public market returns. (See note below.)

U.S. Direct Real Estate (unlevered) 6.75% Less than equity return, more than fixed income. Reflects strong operating income yields.REITs 7.00% A bit higher than return on direct real estate due to leverage. Premium constrained due to comparatively

expensive REIT valuations. Hedge Fund (non-directional) TR 5.75% Hedge Funds to deliver only moderate returns but with comparatively low risk. Top managers expected to Hedge Fund (directional) TR 7.00% beat these returns. (See note below.)

Note: Private Equity and Hedge Funds are unlike other asset classes shown above, in that there is no underlying investible index. The return estimates shown above for theseassets are our estimates of industry medians; the dispersion of returns among different managers in these asset classes is typically far wider than in traditional assets. Given thecomplex risk-reward tradeoff in these assets, we counsel clients to rely on judgment rather than quantitative optimization approaches in setting strategic allocations to these assetclasses. Please note all information shown is based on assumptions; therefore, exclusive reliance on these assumptions is incomplete and not advised. The assumptions should notbe relied upon as a recommendation to invest in any particular asset class. The individual asset class assumptions are not a promise of future performance. Note that these assetclass assumptions are passive-only; they do not consider the impact of active management. Return estimates are on a compound or internal rate of return (IRR) basis. Equivalentarithmetic averages, as well as additional notes, are shown on the next page.

U.S. Economic Indicators

Alternatives

Equity

Fixed Income

Appendix

JPMorgan Asset Management long-term capital market return assumptions

As of November 30, 2005

(continued from prior page)Expected returns employ proprietary projections of the “equilibrium” returns of each asset class (as well as equilibrium estimates of their future volatility). We estimate the“equilibrium” performance of an asset class or strategy by analyzing current economic and market conditions and historical market trends. Equilibrium estimates represent ourprojection of the central tendency (going out over a very long time period) around which market returns may fluctuate, because they reflect what we believe is the value inherent in eachmarket. It is possible that actual returns will vary considerably from this equilibrium, even for a number of years. References to future returns for either asset allocation strategies orasset classes are not promises or even estimates of actual returns a client portfolio may achieve. 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 marketconditions. 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 thepurchase or sale of any financial instrument. The views and strategies described may not be suitable for all investors. This material has been prepared for information purposes only,and is not intended to provide, and should not be relied on for, accounting, legal or tax advice.

Correlation Matrix

FixedIncome

Equities

Other

U.S

. Inf

lati

on

U.S

. Cas

h

U.S

. Tre

asur

yIn

dex

U.S

. TIP

S

U.S

. Agg

rega

te

U.S

. Mun

icip

al

U.S

. Lon

g D

urat

ion

Gov

t/Co

rp

U.S

. Hig

h Yi

eld

Non

-U.S

. Wor

ld G

ovt.

(hed

ged)

Non

-U.S

. Wor

ld G

ovt.

(unh

edge

d)

Emer

ging

Mar

kets

Deb

t

U.S

. Lar

ge C

ap

U.S

. Lar

ge C

ap V

alue

U.S

. Lar

ge C

ap G

row

th

U.S

. Mid

Cap

U.S

. Sm

allC

ap

EAFE

(unh

edge

d)

EAFE

(hed

ged)

Emer

ging

Mar

ketE

quit

y

REI

Ts

U.S

. Dir

ectR

ealE

stat

e

Hed

ge F

und

Hed

ge F

und

(non

-dir

ecti

onal

)

Hed

ge F

und

(dir

ecti

onal

)

Priv

ate

Equi

ty

U.S. Inflation 1.0% 2.50% 2.50% 1.00

U.S. Cash 0.5% 4.25% 4.25% 0.00 1.00

U.S. Treasury Index 4.7% 4.50% 4.60% -0.08 0.11 1.00

U.S. TIPS 4.9% 4.75% 4.87% 0.07 -0.06 0.77 1.00

U.S. Aggregate 3.7% 5.25% 5.32% -0.09 0.12 0.97 0.75 1.00

U.S. Municipal 3.3% 4.00% 4.05% -0.09 0.08 0.87 0.72 0.88 1.00

U.S. Long Duration

Govt/Corp. 8.0% 5.25% 5.55% -0.14 0.02 0.95 0.77 0.96 0.86 1.00

U.S. High Yield 10.0% 7.25% 7.71% -0.13 -0.11 0.00 0.04 0.14 0.14 0.22 1.00

Non-U.S. World Govt.

(hedged) 2.6% 4.75% 4.78% -0.03 0.30 0.73 0.52 0.72 0.65 0.70 0.05 1.00

Non-U.S. World Govt.

(unhedged) 8.1% 4.75% 5.06% -0.07 -0.18 0.43 0.41 0.42 0.39 0.38 0.00 0.32 1.00

Emerging Market Debt 14.4% 7.50% 8.44% 0.03 0.00 0.08 0.17 0.18 0.16 0.19 0.49 0.13 0.04 1.00

U.S. Large Cap 15.6% 7.25% 8.36% -0.10 0.05 -0.19 -0.16 -0.07 -0.11 -0.04 0.49 -0.06 -0.04 0.55 1.00

U.S. Large Cap Value 14.5% 7.50% 8.46% -0.10 0.04 -0.18 -0.11 -0.07 -0.11 -0.04 0.45 -0.02 0.00 0.55 0.90 1.00

U.S. Large Cap Growth 19.6% 7.00% 8.73% -0.08 0.04 -0.18 -0.18 -0.08 -0.12 -0.05 0.47 -0.11 -0.06 0.49 0.94 0.71 1.00

U.S. Mid Cap 17.6% 7.50% 8.89% -0.11 0.02 -0.20 -0.13 -0.11 -0.12 -0.07 0.49 -0.15 0.01 0.57 0.86 0.82 0.82 1.00

U.S. Small Cap 20.2% 7.50% 9.32% -0.11 -0.04 -0.24 -0.16 -0.14 -0.15 -0.09 0.53 -0.16 0.00 0.53 0.71 0.61 0.74 0.88 1.00

EAFE (unhedged) 14.9% 8.75% 9.74% -0.08 -0.11 -0.22 -0.13 -0.13 -0.12 -0.09 0.46 -0.15 0.20 0.53 0.79 0.71 0.74 0.75 0.71 1.00

EAFE (hedged) 14.8% 8.75% 9.74% -0.04 0.05 -0.33 -0.26 -0.23 -0.23 -0.17 0.48 -0.17 -0.26 0.54 0.81 0.72 0.77 0.73 0.69 0.85 1.00

Emerging Market

Equity 23.6% 8.75%11.18% -0.03 -0.19 -0.29 -0.12 -0.19 -0.16 -0.15 0.52 -0.20 -0.04 0.68 0.70 0.64 0.67 0.73 0.72 0.75 0.74 1.00

REITs 13.6% 7.00% 7.85% -0.03 -0.08 -0.02 0.11 0.04 0.09 0.07 0.31 0.08 0.16 0.38 0.29 0.42 0.18 0.40 0.45 0.29 0.22 0.37 1.00

U.S. Direct Real Estate 7.1% 6.75% 6.99% -0.05 0.15 0.25 0.22 0.29 0.26 0.28 0.19 0.26 0.14 0.26 0.25 0.28 0.20 0.26 0.23 0.18 0.15 0.16 0.40 1.00

Hedge Fund 6.0% 6.50% 6.67% 0.01 0.06 -0.08 -0.03 -0.01 0.02 0.03 0.45 -0.01 -0.13 0.59 0.54 0.43 0.57 0.61 0.69 0.57 0.63 0.65 0.26 0.18 1.00

Hedge Fund

(non-directional) 4.0% 5.75% 5.83% -0.03 0.35 -0.04 0.03 0.04 0.04 0.05 0.48 0.04 -0.08 0.55 0.45 0.44 0.41 0.52 0.54 0.37 0.43 0.41 0.29 0.23 0.67 1.00

Hedge Fund (directional) 7.0% 7.00% 7.23% -0.02 0.01 -0.13 -0.04 -0.04 -0.01 0.00 0.53 -0.05 -0.04 0.64 0.67 0.56 0.68 0.75 0.82 0.69 0.71 0.73 0.35 0.22 0.85 0.65 1.00

Private Equity 30.0% 8.50%12.30% -0.05 -0.08 -0.21 -0.12 -0.12 -0.10 -0.06 0.53 -0.18 -0.02 0.46 0.56 0.40 0.64 0.70 0.91 0.60 0.59 0.67 0.33 0.16 0.60 0.52 0.82 1.00

Expe

cted

Vol

atili

ty

Annu

aliz

ed C

ompo

und

US

D R

etur

n

Mea

n Ex

pect

ed U

SD

Ret

urn

JPMorgan Asset Management long-term capital market return assumptions

As of November 30, 2005

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 orcompleteness. This material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. References to specificsecurities, 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 investingin any securities referred to herein. Past performance is not indicative of future results. Indices do not include fees or operating expenses and arenot available for actual investment. Indices presented, if any, are representative of various broad base asset classes. They are unmanaged andshown 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 isnot intended to provide, and should not be relied on for, accounting, legal or tax advice. You should consult your tax or legal advisor regardingsuch matters.

JPMorgan Asset Management is the marketing name for the asset management businesses of JPMorgan Chase & Co. and its affiliates worldwidewhich includes but is not limited to J.P. Morgan Investment Management Inc., JPMorgan Investment Advisors, Inc., JPMorgan High Yield PartnersLLC, Security Capital Research & Management Incorporated, J.P. Morgan Alternative Asset Management, Inc. and JPMorgan Asset Management(Canada) Inc.

www.jpmorgan.com/assetmanagement © JPMorgan Chase & Co., December 2006.

JPMorgan Asset Management • 245 Park Avenue, New York, NY 10167 • www.jpmorgan.com/assetmanagement

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