WISCONSIN PUBLIC UTILITY INSTITUTE
October 31, 2014
Disclaimer
This report is provided for informational purposes only. Do not use this report as a primary basis for investment decisions or for decisions pertaining to plan funding,
accounting, or related regulatory requirements. In preparing this report, Pacific Global Advisors may have relied upon and assumed, without independent verification,
the accuracy and completeness of information provided by various third parties such as investment managers. Pacific Global Advisors is not able to independently verify
the accuracy and completeness of such information and makes no representation as to the information’s accuracy or completeness. This report may contain projections,
forecasts or estimates. Pacific Global Advisors makes various assumptions in connection with such forward looking information. Actual events or conditions may differ
from those assumed and not all relevant events or conditions may have been considered in developing the assumptions. Changes to the assumptions could have a
material impact on the information presented herein. Any “forward-looking” information contained in this presentation (such as illustrative cash flow, yields or returns) is
based upon certain assumptions about future events or conditions and is intended only to illustrate hypothetical results under those assumptions (not all of which are
specified herein). No representation is made that the performance presented herein will be achieved. Nothing contained herein should be construed as legal, actuarial
or accounting advice. You must retain an actuarial firm which is independent of Pacific Global Advisors to provide all actuarial services with respect to statutory and
regulatory requirements.
NOTHING IN THIS PRESENTATION CONSTITUTES AN OFFER OR SOLICITATION FOR THE PURCHASE OR SALE OF ANY FINANCIAL INSTRUMENT OR A
COMMITMENT BY PACIFIC GLOBAL ADVISORS AND ITS AFFILIATES TO ENTER INTO OR FACILITATE ANY TRANSACTION. Therefore, when considering
whether to purchase any financial instrument, or otherwise participate in any transaction, no reliance should be placed on the information in this presentation. Such
information is general, partial, preliminary and subject to change. The information contained in this presentation is not intended to be and is not warranted to be
complete in all respects and Pacific Global Advisors expressly disclaims the completeness and accuracy of such information. Nothing in this presentation should be
construed as a recommendation to purchase any financial instrument or participate in any transaction, or as legal, tax, regulatory or accounting advice.
Actual events or conditions are unlikely to be consistent with, and may differ materially from, those assumed. Accordingly, actual results will vary and the variation may
be material. Information about the past performance of issuers, financial instruments and markets should not be viewed as indicative of future results.
THESE MATERIALS CONTAIN HYPOTHETICAL PERFORMANCE RESULTS. HYPOTHETICAL PERFORMANCE RESULTS HAVE MANY INHERENT
LIMITATIONS, SOME OF WHICH ARE DESCRIBED BELOW. NO REPRESENTATION IS BEING MADE THAT ANY ACCOUNT WILL OR IS LIKELY TO ACHIEVE
PROFITS OR LOSSES SIMILAR TO THOSE SHOWN. IN FACT, THERE ARE FREQUENTLY SHARP DIFFERENCES BETWEEN HYPOTHETICAL PERFORMANCE
RESULTS AND THE ACTUAL RESULTS SUBSEQUENTLY ACHIEVED BY ANY PARTICULAR TRADING PROGRAM. ONE OF THE LIMITATIONS OF
HYPOTHETICAL PERFORMANCE RESULTS IS THAT THEY DO NOT REPRESENT ACTUAL TRADING AND ARE GENERALLY PREPARED WITH THE BENEFIT
OF HINDSIGHT. IN ADDITION, HYPOTHETICAL TRADING DOES NOT INVOLVE FINANCIAL RISK, AND NO HYPOTHETICAL TRADING RECORD CAN
COMPLETELY ACCOUNT FOR THE IMPACT OF FINANCIAL RISK IN ACTUAL TRADING. FOR EXAMPLE, THE ABILITY TO WITHSTAND LOSSES OR ADHERE
TO A PARTICULAR TRADING PROGRAM IN SPITE OF TRADING LOSSES ARE MATERIAL POINTS WHICH CAN ALSO ADVERSELY AFFECT ACTUAL TRADING
RESULTS. THERE ARE NUMEROUS OTHER FACTORS RELATED TO THE MARKETS IN GENERAL OR TO THE IMPLEMENTATION OF ANY SPECIFIC
TRADING PROGRAM WHICH CANNOT BE FULLY ACCOUNTED FOR IN THE PREPARATION OF HYPOTHETICAL PERFORMANCE RESULTS OR WHICH MAY
NOT REFLECT THE IMPACT THAT SUCH FACTORS MAY HAVE ON AN ADVISER’S DECISION MAKING IF THE ADVISER WERE ACTUALLY MANAGING
FUNDS, ALL OF WHICH CAN ADVERSELY AFFECT ACTUAL TRADING RESULTS.
Pacific Global Advisors and its affiliates do not provide tax advice. Accordingly, any discussion of U.S. tax matters included herein (including any attachments) is not
intended or written to be used, and cannot be used, (a) in connection with the promotion, marketing or recommendation of any of the matters addressed herein to
another person or (b) for the purpose of avoiding U.S. tax-related penalties.
This report may not be distributed to any person other than the recipient and may not be replicated in any form without the prior written consent of Pacific Global
Advisors.
1
1
Introduction
 Pacific Life has been offering insurance products since 1868
when its first policy was issued to Leland Stanford (founder of
Stanford University), the company’s first president
 Mutual insurance holding company structure
 $130 billion in company assets and 3,000 employees as of
December 31, 2013
 Counts more than half of the 100 largest U.S. companies as
clients1
 Primary business segments include
 Pacific Life Insurance Company
 Pacific Asset Management
 Aviation Capital Group
 Pacific Life Re
 Pacific Global Advisors (PGA)
 PGA, formerly “PAG,” was started at JPMorgan in 2005 to provide
risk advisory services to U.S. defined benefit pension plans,
defined contribution plans, nuclear decommissioning trusts,
voluntary employees’ beneficiary associations
 PAG was acquired by Pacific Life in July 2011
 PGA is located in New York City
“Pacific Life” refers to Pacific Life Insurance Company and its affiliates, including Pacific Life & Annuity Company and its ultimate parent Pacific Mutual Holding Company.
1Client count as of June 2014 is compiled by Pacific Life using the 2014 FORTUNE 500® list.
2
Pacific Global Advisors is a leader in pension innovation
U.S. Department of Labor advisory opinion1
LifeMetrics
2
The JPMorgan Longevity & Mortality Toolkit
5.5%
5.0%
4.5%
4.0%
3.5%
3.0%
2.5%
2.0%
1997
 While at JPMorgan, PGA’s team successfully
sought and obtained an Advisory Opinion from
the U.S. Department of Labor that managing
assets against liabilities is consistent with
ERISA pension law
2003
2005
2007
2009
2011
2013
2015
2017
 Changed the way the industry approaches the
investing (LDI) concepts in the U.S.
management of longevity risk by:
 Blending actuarial science and finance
 Providing simple practical tools
 Pension plans have historically viewed their
objective as maximizing asset returns
2
2001
longevity and mortality risk comprised of:
 Framework for longevity risk management
 Data on longevity and mortality
 Software models for longevity risk
 This opened the door for liability-driven
1
1999
 Innovative toolkit for measuring and managing
Obtained by PGA’s staff prior to its acquisition by Pacific Life.
Developed by PGA’s staff prior to its acquisition by Pacific Life.
3
2
PGA’s clients
Business snapshot
 PGA delivers a comprehensive risk management platform primarily targeted to US corporations
 To date, PGA has executed mandates with 7 clients representing approximately 29 plans and
trusts, including defined benefit pension plans, defined contribution plans, nuclear
decommissioning trusts (NDTs), and voluntary employees’ beneficiary associations (VEBAs)
 Assets under advisory are ~$21 BN as of 7/31/14
Pension Risk Advisory clients
PGA’s unique approach is well designed to address complex situations
Note: It is not known whether the listed clients approve or disapprove of PGA or its advisory services.
4
Agenda
Executive summary
5
PGA's Industry study
8
Key issues
11
Proposed solution
16
PGA's regulatory request
21
Appendix
23
 Case study
24
 Examples of pension reform
29
 State pension funding
31
 Additional thoughts on interest rate risk
33
 PGA contacts
36
5
3
Executive summary
 Defined Benefit (“DB”) plans within the utility industry represent a significant “contingent call on capital” in a capital
intensive industry, due to a heavy reliance on equity returns to pay benefits and unrewarded interest rate risk
 Historically, a high, industry-wide equity allocation was justified by the view that equities outperform in the long run
 However, this approach is no longer applicable due to a number of changing variables, including:
 Plan design changes:
– The closing and freezing of DB plans, along with a shift to Defined Contribution (“DC”) plans, has shortened the
investment horizon and reduced the growth of DB liabilities
 New legislation:
– The 2006 Pension Protection Act (“PPA”) closed many “funding holidays” by applying more stringent rules that
require plans to be fully funded over a seven-year time period. Hence, a long term investment horizon no longer
applies since losses must be funded over short periods and longer term performance then doesn’t help
– The 2012 Moving Ahead for Progress in the 21st Century Act (“MAP 21”) and The Bipartisan Budget Act of 2013
(“BBA”) have increased the penalties associated with running plan deficits by raising PBGC variable rate premiums
from the current level of 140 basis points to 3001 basis points by 2017
 Better financial theory:
– Equity risk premiums are not ‘free money’ but are fair compensation for the risk taken. Sponsors of DB plans
should budget where risk is best taken, and not ‘ignore’ market risks
 Additionally, U.S. generally accepted accounting principles (“U.S. GAAP”) can lead to higher investment risk by
recording expected return on assets (“EROA”) in current earnings and deferring actual gains and losses over a much
longer time horizon
1
Projected assuming a 2% per year annual increase in National Average Wages from 2013 forward.
6
Executive summary (cont’d)
 Not only do rate regulated utilities have a significant amount of asset risk within their DB plans, they also possess a
significant amount of unrewarded interest rate risk on the other side of the ledger with plan liabilities
 Advances in Asset Liability Management (“ALM”) techniques have increased the capability of controlling the
volatility of a pension plan regardless of market conditions without sacrificing investment returns
 In recognition of these key considerations, PGA recommends that rate-regulated utilities formally adopt a “Pension De-
Risking Plan,” resulting in:
 Lower funded status volatility
 Elimination of unrewarded interest rate risk
 Reduction of highly volatile equity investments
 Reduction of the likelihood of incurring penalties associated with plan surpluses or plan deficits
 Removal of incentives to optimize accounting results instead of economics
 More predictable and stable cash flows to meet future plan liabilities
 However, regulatory support is necessary to facilitate this change in order to avoid any unintended or adverse
consequences
7
4
Agenda
Executive summary
5
PGA's Industry study
8
Key issues
11
Proposed solution
16
PGA's regulatory request
21
Appendix
23
 Case study
24
 Examples of pension reform
29
 State pension funding
31
 Additional thoughts on interest rate risk
33
 PGA contacts
36
8
Industry review
 PGA has analyzed the financial statements of 54 publicly traded utilities 1 and estimate that as of September 30, 20142:
 DB exposure, as measured by the reported accounting liability (“PBO”), totaled approximately $162 BN, representing
26% of the industry’s aggregate market cap of $633 BN1 - Graph 1
 Even though the industry was fully funded on a PBO basis in 2007, the funded status dropped by over $36 BN in
20081 and remains underfunded despite contributions in excess of $41 BN - Graphs 2 and 3
 Despite the fact that the industry has been whipsawed out of $41 BN of capital and continues to have a deficit of $25
BN, rate-regulated utilities continue to maintain high equity allocations
Graph 1
Graph 2
PBO and assets
$BN
Assets
Graph 3
Funded status
Contributions
$BN
$BN
PBO
200
5 103%
180
162
-5
160
91%
-15
140
120
137
-25
-35
100
80
2007 2008 2009 2010 2011 2012 2013 Q3'14
79%
82%
84%
78%
72%
78%
-45
2007 2008 2009 2010 2011 2012 2013 Q3'14
DB exposures are material, contain a high degree of market risk, and represent a contingent call
on capital
1
Source: Bloomberg and 10-K reports (2007-2013). For a complete list of publicly traded, rate-regulated utility peer group members used in this analysis, see Appendix: Utility peer
group members. Two of the referenced companies were acquired. However, their financial data was nonetheless available.
2 Asset returns estimated by applying benchmark returns to 2013 asset allocation (Equities = MSCI World Index; Fixed Income = 50/50 split between Barclays Aggregate Bond Index
and Barclays Long Corporate Bond Index; Alternatives = HFRI FoF Index; Cash = Citigroup 3M Treasury Bills). Liabilities estimated based on change in Moody’s AA Index assuming a
duration of 12 years. Analysis excludes contributions, fees and expenses.
Note: Past performance is not necessarily indicative of future results.
9
5
2013 target allocations remain highly exposed to risk
FYE 2013 allocations maintain higher risk than necessary
 With an average EROA of 7.5%, the industry continues to attempt to cover interest expense, on-going service cost
and cure the plan deficits1 through large (and risky) equity “bets”
 Service cost is the cash equivalent of the benefit for working during the year; in a defined contribution plan, this
amount is paid in cash
 The large risk is taken by sponsors to try to earn the service cost instead of contributing it; if service cost were
contributed as it is done in defined contribution plans, sponsors would need to earn only 4.9%/year to keep pace
with liability growth
Average asset allocations:
Average projected costs:
Interest cost :
4.9%
Service cost:
2.4%
Liability growth rate:
7.3%
EROA: 7.5%
Cash & other
2%
Alternatives
13%
Fixed Income
40%
Equities
45%
The funded status of the DB plans across the industry have improved largely because of
ratepayer contributions
1
Source: Bloomberg and 10-K (2007-2013).
10
Agenda
Executive summary
5
PGA's Industry study
8
Key issues
11
Proposed solution
16
PGA's regulatory request
21
Appendix
23
 Case study
24
 Examples of pension reform
29
 State pension funding
31
 Additional thoughts on interest rate risk
33
 PGA contacts
36
11
6
Risky asset allocations in DB plans require the support of equity capital
Business
operations
Operational risks
Financing &
hedging
Financial risks
Corporate
risk budget
Corporation
Corporate-wide
risk budget
Pension assets
Financial risks
Pension
risk budget
Pension plan
Pension liabilities
Actuarial risks
 Corporations can take risk across their enterprise in the form of operational risk, financial risk and/or investment risk
with mismatches between pension assets and pension liabilities
 Collectively, the risks amalgamate to form corporate-wide risk, supported by equity capital
 A corporation’s specific risk profile essentially mirrors its credit ratings. Corporations with small risk budgets, relative to
their equity base, obtain high credit ratings and vice versa
 Corporations with large, risky DB plans must allocate a portion of their risk budget and equity base to support the
pension risk
 Unlike most industries, the utility industry is such a capital intensive business that service territories have to be
established, competition restricted, and heavy regulation is required
 It is arguable whether utilities are organized to run large, off-balance sheet capital market “bets”
Risky asset allocations in DB plans “divert” capital away from generating, transmitting, and
distributing electrical power
12
Pension investing with risky asset allocations is not a fair game
 In the capital markets, investing is a “fair” game in the sense that investors can either make money or lose money
 With U.S. DB plans, investing is NOT a fair game. Risk-takers are punished on both the upside and downside
 When a pension plan has a deficit, the sponsor is subject to:
–
Required contribution rules under ERISA (Pension Protection Act of 2006)
–
PBGC variable rate premiums (140 basis points in 2014, 240 basis points in 2015, 290 basis points in 2016, and
3001 basis points in 2017 on the then current deficit)
 When a pension plan has a surplus, any reverted proceeds are subject to:
–
Income tax, at the corporate rate, plus
–
Fifty percent (50%) excise tax (Internal Revenue Code Section 4980)
2,000
1,500
1,000
500
Usable surplus for ongoing service cost
0
(500)
(1,000)
(1,500)
(2,000)
1y
2y
3y
4y
5y
6y
With U.S. DB plans, risk-takers are punished on both the upside and on the downside
1
Projected assuming a 2% per year annual increase in National Average Wages from 2013 forward.
13
7
Corporate finance theory and the “Ibbotson fallacy of pension investing”
 Research by Ibbotson Associates1 has demonstrated that in the long-run, equities outperform bonds
 However, equity outperformance is fair compensation for the added risk as evidenced by the Great Recession of
2008
 Additionally, with the closure and freezes of DB plans coupled with required contribution rules, the investment horizons
are becoming shorter and the notion of long term investing no longer applies
Large losses realized in heavy equity oriented DB plans lead to significant contributions
1
Ibbotson, Roger G. and Goetzmann, William N., History and the Equity Risk Premium (April 6, 2005). Yale ICF.
Past performance is not necessarily indicative of future performance
14
Current pension accounting rules can lead to higher investment risk
 U.S. GAAP accounting rules have been a likely driver of high equity allocations
 Recording expected returns on assets in current earnings and allowing long term deferral of gains and losses into the
statement of income means that any actual underperformance goes largely unrecognized
 Consequently, current accounting rules focus on expected returns and do not reflect the true economics of DB plans
 As a result, higher levels of investment risk have been adopted than are optimal from an economic perspective
 By contrast, the elimination of expected returns in the income statement in International Reporting Standard IAS19 was
followed by a significant reduction in equity allocations for pension plan sponsors reporting under this standard 1
 By way of example, as of December 31, 2013, the utility industry had approximately $28 BN of cumulative unrecognized
pension losses2
1
2
Amir, Eli, Guan, Yanling, and Oswald, Dennis. “The Effect of Pension Accounting on Corporate Pension Asset Allocation.” Review of Account Studies 15.2 (June 2010): 345-366.
Source: Bloomberg and 10-K (2007-2013).
15
8
Agenda
Executive summary
5
PGA's Industry study
8
Key issues
11
Proposed solution
16
PGA's regulatory request
21
Appendix
23
 Case study
24
 Examples of pension reform
29
 State pension funding
31
 Additional thoughts on interest rate risk
33
 PGA contacts
36
16
PGA’s approach to risk managing DB plans
Asset Liability Management (ALM) principles can eliminate tail risk while maintaining a fully funded status
Pension risk management: changes in funded status are typically
attributable to adverse movements in interest rates and equity prices.
PGA uses a simple building block approach when designing an ALM
framework, consisting of the following:
Excess return to
meet objective
Demographic risk
Growth Portfolio
 Growth Portfolio (GP): return-seeking portfolio invested in a
Benefit accruals
Discount rate
Immunizing
Portfolio –
overlays
Immunizing
Portfolio – cash
instruments
or immunization, designed to meet short-term liquidity needs and
reduce the plan’s overall risk
 Immunizing Portfolio (IP) - cash: interest rate sensitive cash assets
Liquidity
Portfolio
Factors affecting
liabilities
diversified pool of assets to meet future liability growth
 Liquidity Portfolio (LP): cash portfolio of assets not utilized for growth
Pension asset portfolio designed to meet
future liabilities in the most efficient manner
designed to offset changes in the value of the liability due to changes
in interest rates including treasury strips, agencies, long duration
fixed income, etc.
 Immunizing Portfolio (IP) – overlay:: an overlay of interest rate
hedges designed to offset changes in the value of the liability due to
changes in interest rates including interest rate swaps, swaptions,
etc.
 Key drivers of risk management
 Balancing the asset allocation between the Growth, Immunizing, and Liquidity Portfolios
 Diversification of the Growth Portfolio across suitable asset classes
 Immunization of interest rate risk through the Immunizing Portfolio
17
9
Illustration of the benefits of a risk management framework (“ALM”) using a risk
decomposition example over 1 year horizon
ABC’s sample portfolio
PGA’s initial recommendation
$MM
$MM
Other
Demographic
risk
$657
$1,358
Longevity risk
Other
Demographic
risk
$657
Interest
rate
risk
$489
Longevity risk
Interest
rate
risk
Diversification
benefit
$1,188
Total
surplus risk
$977
Diversification
benefit
Alternative
asset risk
$490
$809
Interest
rate
risk
Alternative asset risk
Interest rate risk
US
equity
risk
Non-US equity
risk
Total
funded
status–
at-risk
Funded
status-atrisk
reduction
$487
Non-US equity
risk
US equity risk
Total
funded
statusat-risk
Pacific Global Advisors’ initial recommendation can significantly reduce the funded status-atrisk
Risks calculated at the 5th percentile.
This illustration contains hypothetical information which has inherent limitations
18
Implementation of an ALM approach
 Motivation for PPL to adopt an ALM approach
 Traditional pension management methodology (focused on assets only) was not working
– Interest rate movements and fluctuations in the equity markets were causing huge swings in funded status
– With large infrastructure rebuild costs looming, PPL did not want to use potentially limited financing access to
fund losses in the pension plan
 A belief that PPL could reduce risk without sacrificing returns and, in doing so, reduce ratepayer costs and funding
requirements
 Concerns that both investors and regulators would begin to penalize the traditional approach
 Concerns in moving forward
 Could not find any other industry “precedents” for what PPL wanted to do
 Incremental hard dollar costs and short-term “second guessing”
 The implementation process
 Made the Chief Investment Officer comfortable
 Drafted new Investment guidelines
 Made presentations to both the Fiduciary Committee and the Board of Directors
 Transitioned the Portfolio
19
10
Implementation of an ALM approach (cont’d)
 PPL’s results
 Administrative burdens were minimal during transition and reduced in the long-run
 Back testing was used to track actual funded status and total returns against a hypothetical portfolio
 Closing thoughts - Why so slow for utility companies to make the change to an ALM framework?
 Asset/Investment Management firms are protectors of the status quo
 There are also several unknowing enablers of the status quo:
– FASB – the accounting rules facilitate excessive risk taking with instant gratification for “wins” and deferred writeoffs for “losses.” Provides a tempting option for hitting earnings targets
– Regulators are unintentionally ignoring real risks within pension plans, which undermine the ability to achieve
and maintain a fully funded status with prudent investment policies
20
Agenda
Executive summary
5
PGA's Industry study
8
Key issues
11
Proposed solution
16
PGA's regulatory request
21
Appendix
23
 Case study
24
 Examples of pension reform
29
 State pension funding
31
 Additional thoughts on interest rate risk
33
 PGA contacts
36
21
11
Regulatory support for de-risking is required to avoid potential future funding crises
 Utility management teams are well aware of the benefits of de-risking DB plans but are hesitant to move forward without
regulatory support due to the risk of unanticipated consequences
 For example, funding a pension plan deficit can be executed with credit neutral debt issuance but, the resultant change in
the capital structure would reduce Net Income in the context of a rate case
 PGA believes that a logical approach would have regulators focus on DB plans meeting annual service costs (cost of paying
for people working) and funding current cumulative (but not future) deficits:
 Service cost should be recovered, since it is the same cost that would be incurred if equivalent benefits were paid in a DC
plan or in cash
 If losses have been accumulated to date, under the concept that recovery is available, then the recovery should still be
allowed. Nonetheless, trying to earn losses through high risk bets is equivalent to gamblers losing money and doubling
down their bets; recovery should be based on lower risk strategies that earn optimal risk-adjusted returns (and not focusing
on pure return)
 Future gains/losses on pension positions should be assumed by the sponsor; they do not need to bet on rates or equity
markets. If they do, both the wins and losses should go to investors
 As a first step, PGA recommends the Public Utility Commissions entice rate regulated utilities adopt a Pension De-Risking
Plan which would include:
– An extensive review of a utility’s current pension funding and investment guidelines
– The adoption of a de-risking plan which provides a glide path to a fully funded status, including an interest rate hedge
ratio equivalent to the plan’s funded status (on a G.A.A.P. basis), implemented over a transition period
– Retention of a reputable external “implementation” pension consultant with expertise in de-risking DB plans
 PGA understands that each company will have a unique set of circumstances and challenges. Details to be negotiated on an
individual basis
22
Agenda
Executive summary
5
PGA's Industry study
8
Key issues
11
Proposed solution
16
PGA's regulatory request
21
Appendix
23
 Case study
24
 Examples of pension reform
29
 State pension funding
31
 Additional thoughts on interest rate risk
33
 PGA contacts
36
23
12
Agenda
Executive summary
5
PGA's Industry study
8
Key issues
11
Proposed solution
16
PGA's regulatory request
21
Appendix
23
 Case study
24
 Examples of pension reform
29
 State pension funding
31
 Additional thoughts on interest rate risk
33
 PGA contacts
36
24
Overview of XYZ’s pension plan
Key pension stats
PBO and assets
PBO as a % of Market Cap:
75%
Service cost as % of PBO:
1.9%
Discount rate for PBO:
4.8%
Growth in liabilities:
6.7%
Projected ben. payments as % of assets:
5.4%
Expected return on assets:
8.0%
Average asset return (10-year):
Funded status
$MM
6.8%
Service Cost (2004-2013):
$1.6 BN
Contributions (2004-2013):
$3.4 BN
Source: XYZ10-K (2004-2013), Bloomberg.
Source: XYZ 10-K (2004-2013).
Contributions and service cost
Breakdown of liability & asset allocation
Source: XYZ 10-K (2004-2013).
$MM
Liability
Asset allocation
30% FI
67% Retired
10%
Alt
1% TV
Cost of running plan (p.a.)
Service provider expenses 1
Professional Fees
Administration Fees
Investment Fees 1
Other
Total
2
Avg annual contributions 2
32% Active
Source: XYZ 10-K (2004-2013).
60% Equities
Source: XYZ Form 5500 (2012 and 10-K (2013)
2.7 bps
0.0 bps
22.8 bps
11.7 bps
37.2 bps
$2.4 MM
$0.0 MM
$19.9 MM
$10.2 MM
$32.5 MM
428.0 bps
$339.9 MM
Annualized contributions
3
to become evenly funded3
181.6 bps
$144.2 MM
Total cost:
646.8 bps
$516.6 MM
Source: XYZ Form 5500 (2012) & 10-K (2004-2013).
1
Service provider fees, in basis points, were calculated as a percentage of assets listed in the 2012 Form 5500 of $8,753 MM.
Contributions made by the Sponsor from 2004-2013 of $3,399 MM averaged over a 10-year period and divided by average assets over a 10-year period of $7,941MM.
3 Current deficit of $1,442 MM amortized over a 10-year period divided by average assets over a 10-year period of $7,941 MM.
Note: Past performance is not necessarily indicative of future performance.
2
25
13
Absent recovery, XYZ’s DB plan can potentially be dominated by equity and
interest rate risks
Removing unrewarded interest rate risk can dramatically improve the risk profile of the plan’s funded status
Assets
 The Company’s U.S. DB plan has assets and liabilities,
Liabilities
14,000
12,000
$10,755MM
10,000
Other
8,000
Fixed
income
 Plan assets earn dividends, income streams, capital
appreciation, etc., in exchange for market risks
 Unlike plan assets, plan liabilities do not earn any returns
6,000
4,000
each of which comes with its own unique risks
$12,197MM
for taking on interest rate risk. Hence, interest rate risk is
considered an “unrewarded risk”
Liabilities
Equities
2,000
 Nonetheless, interest rate risk can represent over
50% of the total plan risk on an annual basis
0
 Consequently, removing interest rate risk can
dramatically improve the risk adjusted return of the plan
 PGA, as a Qualified Professional Asset Manager
Asset risk
+
(“QPAM”), can use interest rate swaps to nullify the
unrewarded interest rate risk without encumbering plan
assets
Liability risk
 As a result, PGA can:
 Improve the risk-adjusted return of total plan, and
 Capture term premium associated with interest rate
Asset & Liability covariance
swaps
=
XYZ risk management
objective
Funded status risk
The Company’s current situation
Current risk budget
($MM)
Net interest rate risk
Growth Portfolio risk
95th %ile risk
945
1,016
Risk as a % of
market cap
5.8%
6.3%
26
XYZ’s strategy
 XYZ’s pension plan potentially exposes the beneficiaries, as well as ratepayers, significant risk
 The PBO of $12.2 BN is approximately 75% of current market capitalization1
 The plan maintains a significant degree of financial risk due to the mismatch between assets and liabilities
 XYZ’s plan assets maintain a significant allocation to equity and alternative investments (i.e., 70% - totaling $7.5 BN –
representing roughly 45% of XYZ’s market cap) and lacks interest rate immunization 1
 Even though the plan was roughly fully funded in 2004 – 2007 and despite the contribution of $3.4 BN over the last 10
years, the plan has a current deficit of approximately $1.4 BN1
 Over the last 10 years, XYZ has experienced a combination of realized and unrealized net actuarial losses
that sum to $6.9 BN (equivalent to 32% of its capital expenditures and 6% of total revenues collected over the
10 year horizon)1
 The plan is 88% funded, on a G.A.A.P. basis, and no longer needs to attempt to earn an expected return of 8.0%
when liabilities are discounted back at 4.8% and on-going service cost is recoverable1
1
•
Source: Bloomberg.
27
14
Appendix: XYZ risk decomposition assumptions
Model inputs
Assumptions
Current XYZ Growth Portfolio allocation
70.0%
Current XYZ Immunizing Portfolio allocation
30.0%
Expected rate of return on Growth Portfolio
7.6%
Volatility of Growth Portfolio
13.5%
Corporate bond (XYZ Immunizing Portfolio) expected return
4.5%
Treasury rate
3.0%
Unhedged interest rate risk
10.0%
Hedged interest rate risk
2.5%
Correlation risk, corporate bonds
20.0%
Correlation, swaps and treasuries
0.0%
Assets ($MM)
10,755
Liabilities ($MM)
12,197
10 year swap term premium
0.6%
Assumed hedge ratio
30.0%
95th percentile factor
1.65
Treasury duration
20
Swap duration
10
Note: Effects of demographic risk have been ignored for simplicity.
28
Agenda
Executive summary
5
PGA's Industry study
8
Key issues
11
Proposed solution
16
PGA's regulatory request
21
Appendix
23
 Case study
24
 Examples of pension reform
29
 State pension funding
31
 Additional thoughts on interest rate risk
33
 PGA contacts
36
29
15
Placeholder for “Popular Pension Reformer” article
30
Agenda
Executive summary
5
PGA's Industry study
8
Key issues
11
Proposed solution
16
PGA's regulatory request
21
Appendix
23
 Case study
24
 Examples of pension reform
29
 State pension funding
31
 Additional thoughts on interest rate risk
33
 PGA contacts
36
31
16
Placeholder for “State pension funding” article
32
Agenda
Executive summary
5
PGA's Industry study
8
Key issues
11
Proposed solution
16
PGA's regulatory request
21
Appendix
23
 Case study
24
 Examples of pension reform
29
 State pension funding
31
 Additional thoughts on interest rate risk
33
 PGA contacts
36
33
17
Interest rate risk in a defined benefit plan is typically an ‘unrewarded risk’
Banks take advantage of the term premium
Pensions typically pay away the term premium
Lend for
mortgages
4.0%
3.5%
3.5%
3.0%
2.5%
Pay pension
interest cost
4.0%
3.0%
Borrow
from
depositors
2.5%
Earn
the term
premium
2.0%
Invest in
Barclays
Aggregate
Pay
the term
premium
2.0%
1.5%
1.5%
1.0%
1.0%
0.5%
0.5%
0.0%
0.0%
1yr
5yr
10yr
20yr
30yr
1yr
5yr
10yr
20yr
30yr
Source: Bloomberg, swap yield curve as of March 11, 2014
 Pension plans are subject to considerable interest rate risk. However, this risk can be hedged with advanced ALM
techniques at effectively no economic cost. Many pension plan sponsors traditionally ignore interest rate risk or feel
that they can ‘predict’ rates better than the market, amplifying funded status volatility. As a consequence, much of
the plan risk comes from these interest rate ‘bets’
Hedging plan liabilities with interest rate swaps allows a pension to reduce risk and earn back
the term premium
34
The markets are discounting interest rates close to 4% in five years
US swap curve (spot and forward rates)
Spot
1y Fwd
2y Fwd
3y Fwd
5y Fwd
5.0%
3.9%
4.0%
3.5%
3.0%
4.0%
3.8%
3.6%
3.8%
3.7%
3.7%
3.5%
3.3%
3.3%
3.4%
2.9%
2.7%
3.0%
3.9%
3.8%
3.7%
3.6%
3.4%
3.1%
2.7%
2.3%
2.0%
2.4%
2.0%
1.8%
1.4%
1.0%
0.9%
0.6%
0.3%
0.0%
1y
2y
5y
10y
20y
30y
As of 6/20/2014.
Source: Bloomberg, Pacific Global Advisors.
35
18
Agenda
Executive summary
5
PGA's Industry study
8
Key issues
11
Proposed solution
16
PGA's regulatory request
21
Appendix
23
 Case study
24
 Examples of pension reform
29
 State pension funding
31
 Additional thoughts on interest rate risk
33
 PGA contacts
36
36
Appendix: PGA contacts
Name & Title
Contact information
Timothy Jennings
Tel:
Fax:
E-mail:
(212) 405-6330
(212) 405-6450
[email protected]
Tel:
Fax:
E-mail:
(212) 405-6335
(212) 405-6450
[email protected]
Tel:
Fax:
E-mail:
(212) 405-6341
(212) 405-6450
[email protected]
Tel:
Fax:
E-mail:
(212) 405-6315
(212) 405-6450
[email protected]
Head of Client Origination
Jim Abel
Managing Director
Bruce Jurin
Managing Director
Calvin Yu
Vice President
37
19
Appendix: utility peer group members
Company
Ticker
Company
Ticker
AES Corporation
ALLETE, Inc.
Alliant Energy Corporation
Ameren Corporation
American Electric Power, Inc.
Avista Corporation
Black Hills Corporation
CenterPoint Energy, Inc.
CH Energy Group, Inc.
Cleco Corporation
CMS Energy Corporation
Consolidated Edison, Inc.
Dominion Resources, Inc.
DTE Energy Company
Duke Energy Corporation
Edison International
El Paso Electric Company
Empire District Electric Company, The
Entergy Corporation
Exelon Corporation
FirstEnergy Corp.
Great Plains Energy, Inc.
Hawaiian Electric Industries, Inc.
IDACORP, Inc.
Integrys Energy Group
ITC Holdings Corp.
MDU Resources Group, Inc.
AES
ALE
LNT
AEE
AEP
AVA
BKH
CNP
CHG
CNL
CMS
ED
D
DTE
DUK
EIX
EE
EDE
ETR
EXC
FE
GXP
HE
IDA
TEG
ITC
MDU
MGE Energy, Inc.
National Grid
NextEra Energy, Inc.
NiSource Inc.
Northeast Utilities
NV Energy
OGE Energy Corporation
Otter Tail Corporation
Pepco Holdings, Inc.
PG&E Corporation
Pinnacle West Capital Corporation
PNM Resources, Inc.
Portland General Electric
PPL Corporation
Public Service Electric and Gas Company
SCANA Corp.
SEMPRA Energy
Southern Company
TECO Energy, Inc.
UGI Corporation
UIL Holdings Corporation
Unitil Corporation
UNS Energy Corporation
Vectren Corporation
Westar Energy Inc.
Wisconsin Energy Corporation
Xcel Energy Inc.
MGEE
NGG
NEE
NI
NU
NVE
OGE
OTTR
POM
PCG
PNW
PNM
POR
PPL
PEG
SCG
SRE
SO
TE
UGI
UIL
UTL
UNS
VVC
WR
WEC
XEL
38
20