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Capital Market AssumptionsAs of 31 March 2017

Aon HewittConsulting | Investment Consulting Practice

Risk. Reinsurance. Human Resources.

2 Capital Market Assumptions

Aon Hewitt 3

Low volatility: is it here to stay? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4

Inflation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7

Fixed income government bonds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8

Inflation-linked government bonds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9

Investment grade corporate bonds . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10

U.S. high yield debt and emerging market debt . . . . . . . . . . . . . . . . . 10

Equities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11

Private equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12

Real estate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13

Hedge funds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14

Volatility . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15

Risk–return . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15

Correlations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16

Capital Market Assumptions methodology . . . . . . . . . . . . . . . . . . . . . . 17

Contacts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18

Table of contents

Aon Hewitt 3


Low volatility: is it here to stay?

Volatility running at low levels for some time

Volatility in global markets has been strikingly low in recent

years. Over the last three years, volatility in U.S. equities has

been running at only a little over 10% on an annualised basis,

substantially lower than the long-term average in the

mid-teens. The downturn in volatility is less marked in

fixed income markets, but the three year rolling numbers for

long duration U.S. treasuries (15 year duration) also show

a similarly low path. As both charts show, this measure of

‘running’ volatility measured across rolling three year periods,

is approximately at the levels seen about a decade ago near

the time of the outbreak of the great financial crisis.

A key question we need to ask when framing our forward

looking volatility assumptions now is whether the low

volatility over the past few years is indicative of a sustained

period of much lower volatility having arrived? This is a

reasonable challenge to our assumptions process. As we can

see from the chart below, even on a ten year rolling view,

realised volatility is appearing below our current long term

forward looking assumption for U.S. equities. If the recent

pattern of low volatility were to persist, our assumption would

look far too conservative. In fixed income, the picture is more

nuanced, though here too, a continuation of recent trends

would also indicate excessive volatility pessimism on our part.

Volatility path dependent on markets

There is an important contextual point to make here on our

volatility assumption. First, our assumption is associated with

a range of possible outcomes, and as a median in this range,

it has a 50/50 probability of outcomes being either above or

below. This matters because the level of volatility depends on

market states; market falls tend to be associated with higher

volatility and buoyant market conditions tend to be associated

with low volatility. In our models, we allow volatility to have

‘extreme tails’, allowing for sensitivity to broad market risk

factors or shocks. Our median U.S. volatility assumption is 17%,

but the tails show figures as low as 10% and as high as 25%.

With market conditions having been on the strong side for

both fixed income and equities for a number of years, we

already have a ready explanation for the downward trend in

volatility over this period. The question as we look ahead is

whether volatility remains this low and for how long. Our

volatility assumption needs to take into account the prospect

of a full market cycle being completed, and given that this is

already the second longest bull market in history, it would not

be unreasonable to assume that a period of market falls now

fall within our horizon, with a consequent impact on volatility.

We also have an additional and potentially more important

0%

5%

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15%

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25%

2003

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2008

2009

2010

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0%

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18%

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12%

2003

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2016

Equity market volatility

(MSCI U.S., monthly returns) 3Y rolling standard deviation 5Y rolling standard deviation

10Y rolling standard deviation CMA — 10Y Volatility

Fixed income volatility

(Barclays Long Treasury — 10 Year Duration, monthly returns) 3Y rolling standard deviation 5Y rolling standard deviation

10Y rolling standard deviation CMA — 10Y Volatility

Source: Datastream, MSCI, Aon Research

Source: Datastream, MSCI, Aon Research

Aon Hewitt 5

factor here which adds another dimension to the volatility

assumption. Though too complex to statistically test to any

degree of satisfaction, it is our firmly-held view, and a widely

held view too, we believe, that low volatility and strong asset

prices over an extended period of time (fixed income and

equities) have been encouraged by the activities of central

banks around the world. The regime of ultra-low interest rates,

quantitative easing and massive central bank balance sheet

expansion seen since 2009 was intended by central banks as

a stimulus to combat weak economic growth and inflation.

A key mechanism for this type of monetary policy to work its intended effect was the so-called ‘portfolio balance channel’1, which seeks to encourage investors to move to riskier assets and away from low or near zero yielding ‘risk-free’ assets. This

has worked well. Risky asset prices have been stronger than

they would have been otherwise in such a mixed economic

environment. Investors have driven up risky asset prices given

low returns on cash and bonds, the latter also bid up strongly.

Equally important, volatility has been suppressed by these

measures. Of course, there have been times when market

conditions have become unsettled, but active central banks

have restored calm quickly and volatility spikes have been

very short-lived.

We expect volatility to rise

What happens looking ahead? We are now moving to the

final stages of global monetary policy support to markets.

We should expect volatility to rise. Even without central

banks’ balance sheet expansion of quantitative easing in the

picture, rising interest rates are normally associated with some

move up in volatility. This time, we have the additional factor

of a reversal of quantitative easing as the U.S. Federal Reserve

attempts to unwind its balance sheet expansion. The effects

are very uncertain, as this has not been attempted before.

The U.S. Federal Reserve may well manage it well with no

impact on volatility, or it could introduce some level of

disruption to markets. The grounds for believing that

volatility will rise are therefore at least as strong as in

previous monetary policy cycles.

Finally, and this is difficult to evaluate quantitatively, higher

political uncertainty than in the past, given the loss of

support of the political centre in many countries, is another

factor that markets are likely to have to contend with. So far,

U.S. political risk has only sporadically brought volatility to

markets, but there could be a tipping point.

Bringing all this together, we expect market volatility to

more closely match the perceived risks of the economic and

market environment than seen in the recent past. How will

this happen in practice? It may be that the period of very low

volatility seen ends suddenly in a large market drawdown as

in 2008 if economic or other market conditions deteriorate

quickly. Alternatively, volatility could edge up gradually

as markets become less confident in the ability of both

governments and central banks to alleviate weak or uncertain

economic conditions. We do not have a high-conviction

view on how this plays out. What is clear, though, is that

in either case, much like the end of previous periods

of low volatility, the seeming calm seen in markets will

retrospectively be seen to have been quite transitory.

The bottom line is that high as our volatility projections

might seem against recent experience, and this is

particularly so in equities, they are consistent with our

expectation of a reversion to somewhat higher levels over

time. It should be said that though the low volatility anomaly

is more marked in equities, our view is that some edging

up of fixed income volatility is also likely.

1 www.federalreserve.gov/newsevents/speech/bernanke


What markets are saying about the volatility outlook

Our capital market assumptions’ methodology on volatility

makes some forward-looking judgements but an important

element is also to look at broader market views and

expectations on volatility. For stocks, one clue on how

markets are thinking about volatility looking ahead is to look

at implied option volatility, an indication of the market’s view

of expected volatility in the future. The most widely observed

measure by commentators is the so called VIX index. This is

a forward looking measure, but this is only useful as a short

term gauge. We are more interested in how volatility is likely

to fare over the next few years rather than the next month.

There are some longer option volatility measures available

which provide some clues. The level of volatility in these

options is not a predictor of levels of realised volatility given

the long established tendency of realised volatility to be lower

than signalled by option volatility. However, moves in option

volatility over different points in time do carry important

information on how markets see likely trends developing.

We show a compilation of a volatility term structure curves at

different points in time over the past few years below to look

at shifting expectations.

As the chart shows, an upward slope to volatility pricing

remains an abiding feature of volatility markets. However,

there are movements in the steepness or shape of the upward

sloping term structure over time. In the middle of 2016

when market conditions were unsettled, the starting point of

expected volatility was on the higher side of recent history,

and this was also accompanied by a fairly steep upward slope

of the volatility curve for the next few years. That slope has

since flattened. The market is back to signalling low expected

volatility over the next few years in the way seen in the 2014/15

period, albeit moving higher over time. Further out, however,

i.e. between 5 and 10 years, there is an indication of a steeper

climb in volatility than that seen in the 2014/15 period.

S&P Index impled volatility term structure

19/05/17 30/06/16 30/06/15 30/06/14

Source: Bloomberg, Aon ResearchS&P 500 index — The market-cap weighted index includes 500 leading companies and captures approximately 80% of available market capitalization

10%

15%

20%

25%

30%

5 10 15Year ahead

20 25 30

Aon Hewitt 7

Inflation

Longer term inflation assumptions are unchanged for the UK,

U.S., Europe, Canada, Switzerland and Japan relative to last

quarter. Energy prices have been one of the main drivers of

late pushing inflation higher but we see this impact being

completely absorbed over the last few months and we expect

its impact to moderate over the short term. As a result we

reduced our near term inflation expectations for U.S., UK,

Canada and Europe.

Of the countries considered, inflation in only the UK, U.S. and

Canada are expected to be at or above their respective central

bank 2% targets. Meanwhile, systemic deflationary pressures

in Japan and Switzerland persist meaning the respective

central bank inflation targets will continue to undershoot over

the 10 year horizon, based on our expectations.

USD GBP EUR CHF CAD JPY

CPI Inflation (10yr assumption) 2.2% 2.1% 1.6% 1.1% 2.0% 1.1%

RPI Inflation (10yr assumption) — 3.2% — — — —

Source: Aon Hewitt Capital Market Assumptions. Please see appendix for more information.


Fixed income government bonds

In the first quarter of 2017, nominal government bond yields

partially retraced the upward movement seen toward the

end of 2016. This has led to lower nominal government bond

returns that are considered in the Capital Market Assumptions,

with the exception of Eurozone government bond returns

which have moved materially higher.

UK fixed income return assumptions have fallen the most

which reflects the larger fall in yields relative to other regions.

Alongside slowing reflationary momentum, a more pessimistic

outlook of the UK economy over Brexit pushed nominal yields

lower. UK interest rates reached their lowest point since the

immediate aftermath of the EU referendum vote. The U.S.

administration faces hurdles in passing bills on tax reform

and confidence in a positive boost to economic growth and

inflation has somewhat reduced. This had the result to push

U.S. nominal yields, and therefore government bond returns,

lower. In contrast, Eurozone nominal government bond yields

moved higher on the back of greater political uncertainty

before the French presidential elections. The upward

movement in yields had also been supported by improving

economic conditions, firming commodity prices and a mild

uptick in expected interest rates over the next half-decade. As

such, Eurozone nominal government bond returns are 0.4%

higher since last quarter. Japanese yields firmed slightly since

31 December 2016, especially for long-dated bonds which has

driven the government bond assumptions slightly higher.

In our assumptions we take French bonds to represent Eurozone

bonds, as we want to ensure consistency between the nominal

and inflation-linked government bond returns and there is a

reasonably liquid market in French inflation-linked bonds. Our

calculation of a weighted average Eurozone government bond

yield leads to a figure which is slightly higher than the yield on

French government bonds. Our analysis therefore supports the

use of French bonds as a proxy for Eurozone bond portfolios,

where these portfolios do not have a large exposure to the

higher yielding periphery.


U.S. 5yr 2.4% 2.3% 1.8% 1.3% 2.2% 1.3%

15yr 3.1% 2.9% 2.5% 1.9% 2.9% 2.0%

UK 5yr 1.1% 1.0% 0.6% 0.0% 0.9% 0.1%

15yr 1.5% 1.4% 0.9% 0.4% 1.3% 0.4%

Eurozone 5yr 1.5% 1.4% 0.9% 0.4% 1.3% 0.4%

15yr 2.3% 2.1% 1.7% 1.1% 2.1% 1.2%

Switzerland 5yr 0.9% 0.8% 0.3% -0.2% 0.7% -0.2%

15yr 1.6% 1.5% 1.1% 0.5% 1.4% 0.6%

Canada 5yr 1.8% 1.7% 1.2% 0.7% 1.6% 0.7%

15yr 2.7% 2.6% 2.2% 1.6% 2.5% 1.7%

Japan 5yr 1.0% 0.9% 0.5% -0.1% 0.8% 0.0%

15yr 1.5% 1.4% 0.9% 0.4% 1.3% 0.4%

10yr Annualised Nominal Return Assumptions

Source: Aon Hewitt Capital Market Assumptions. Please see appendix for more information. In our assumptions we take French bonds to represent Eurozone bonds.

Aon Hewitt 9

Inflation-linked government bonds

Similar to their nominal counterparts, the return assumptions

for index-linked government bonds decreased across the

board with the exception of Eurozone and long-dated

Japanese bonds. Relative to other regions, U.S. index-linked

government bond returns decreased the most due to a

combination of lower near-term inflation expectations and

falling real yields. Whilst changes in the UK real yield curve

were limited over the quarter, the return assumption for UK

index-linked government bonds was lowered on the back of

a decrease in long-duration real yields and a slight downward

adjustment to inflation expectations. Elevated political risk in

the Eurozone drove real yields upwards and as a result moved

index-linked government bond returns significantly higher.

We have taken French bonds to represent Eurozone

bonds, partly because there is a reasonably liquid market

in French inflation-linked bonds. Our analysis of nominal

government bonds also suggests that French bonds are

a reasonable proxy for Eurozone government bonds so

we make the same assumption here for consistency. The

bonds represented are linked to Eurozone inflation.

We formulate return assumptions for 10 year U.S. and

Eurozone inflation-linked government bonds rather than

15 year bonds. This is because we think that the absence

of inflation-linked bonds at the longest durations in these

markets can lead to misleading 15 year bond return

assumptions. We no longer publish a 5 year duration

Canadian inflation-linked government bond assumption

due to the lack of short duration bonds in this market.


U.S. 5yr 2.8% 2.7% 2.2% 1.6% 2.6% 1.7%

10yr 2.8% 2.7% 2.2% 1.7% 2.6% 1.7%

UK 5yr 1.3% 1.2% 0.7% 0.2% 1.1% 0.2%

15yr 0.8% 0.7% 0.2% -0.3% 0.6% -0.2%

Eurozone 5yr 1.9% 1.8% 1.4% 0.8% 1.7% 0.9%

10 yr 1.9% 1.8% 1.3% 0.8% 1.7% 0.9%

Canada 5yr — — — — — —

15yr 2.4% 2.2% 1.8% 1.2% 2.2% 1.3%


Source: Aon Hewitt Capital Market Assumptions. Please see appendix for more information. In our assumptions we take French bonds to represent Eurozone bonds.


Investment grade corporate bonds

Corporate bond returns depend on both a government

yield component and a credit spread component but also

take account of losses arising from defaults and bonds being

downgraded. The lead article to the Aon 30 June 2015

Capital Market Assumptions publication discusses these

two potential drivers of credit losses in more detail.

The corporate bond return assumptions have generally

moved slightly lower over the quarter, primarily due to the

fall in underlying government bond returns. Lower initial

credit spreads compound lower return expectations.

The only exception to this is our corporate bond returns in

Europe where significant increases in French government

bond yields (used as proxy for Eurozone bonds in our

modelling) has given the appearance of very low credit

spreads. An additional risk adjustment to the longer-dated

Eurozone corporate bond assumption has led to a 0.2%

lower return over the quarter. UK corporate bond return

expectations fell the most, which reflected the stronger

fall in UK government bond yields over the quarter. A similar,

albeit weaker, trend relative to the UK, was followed by

U.S. investment grade corporate bonds.


U.S. 5yr 3.2% 3.1% 2.6% 2.1% 3.0% 2.1%

10yr 3.9% 3.8% 3.3% 2.8% 3.7% 2.8%

UK 5yr 2.0% 1.9% 1.4% 0.9% 1.8% 0.9%

10yr 2.2% 2.1% 1.6% 1.1% 2.0% 1.1%

Eurozone 5yr 1.7% 1.5% 1.1% 0.5% 1.5% 0.6%

10yr 1.6% 1.5% 1.0% 0.5% 1.4% 0.5%

Switzerland 5yr 1.3% 1.2% 0.7% 0.2% 1.1% 0.2%

10yr 1.6% 1.4% 1.0% 0.4% 1.4% 0.5%

Canada 5yr 2.9% 2.7% 2.3% 1.7% 2.7% 1.8%

10yr 3.7% 3.5% 3.1% 2.5% 3.5% 2.6%

Japan 5yr 1.3% 1.2% 0.7% 0.2% 1.1% 0.2%

10yr 1.4% 1.3% 0.8% 0.3% 1.2% 0.4%



U.S. high yield debt and emerging market debt

U.S. high yield debt spreads continued on a narrowing trend

over the first quarter of 2017, buoyed by improving risk

appetite. Similar to investment grade corporate bonds, lower

spread levels detract from our return expectations. This is

compounded by the reduction in the lower assumptions for

government bond returns. Overall, the assumption has been

adjusted lower by 0.4% to 3.9% per annum over the next 10

years. It is worth noting that our high yield debt assumption

already incorporates an expectation that defaults will be

consistently higher in future than the very low levels seen

over recent years. The lead article to the Aon 31 December

2015 Capital Market Assumptions publication discusses the

High Yield assumption in more detail.

Our return assumption for USD-denominated emerging

market debt (“EMD”) is 4.1% a year for the next 10 years.

Similar to high yield, the assumption moved lower due to the

fall in yields on the underlying government bond component

and a narrowing of credit spreads over the quarter, reversing

the effect that followed the U.S. election.

Aon Hewitt 1111 Capital Market Assumptions

Equities

Our equity return assumptions are driven by current market

valuations, earnings growth expectations and assumed

payouts to investors. The price you pay is one of the biggest

drivers of returns, even over the long term. Looking back over

recent experience, strong equity market performance has

been driven more by increasing valuations than increasing

profits. With the exception of Japanese equities, higher

valuations continue to act as headwinds to all regional

equities. However, corporate earnings growth in the UK, U.S.

and Europe have more than offset these expensive valuations.

A volatile energy outlook has led to downward revisions for

our earnings growth estimates for Canadian equities. Swiss

and Japanese equities have similarly had their respective

earnings growth expectations lowered over the quarter. UK

assumptions increased the most by 0.3% this quarter ending

31 March 2017, as sterling weakness and a relative rebound

in commodity prices have boosted expected profit margins.

Our European equity assumptions have increased on the back

of an upward adjustment in earnings forecasts with greater

expectations of a revival in cyclically depressed earnings.

Return assumptions remain fairly close between the U.S., UK

and Europe. UK equities were trading on a multiple of around

17.5 times our 2016 earnings assumption, while U.S. equities

were valued at around 17.8 times our 2016 earnings assumption.

Our emerging market equities return assumption has fallen

from last quarter, primarily due to higher valuations on the

back of greater investor inflows; a reversal of the trend that

followed the U.S. election late in 2016. A modest increase in

our earnings growth assumptions for the region offset some

of the decrease in our assumptions from higher valuations.

The earnings growth component of our equity return

assumptions comprises both near term and longer term

elements. While our Capital Market Assumptions process

typically involves using consensus inputs, for some time we

have believed that the consensus of analysts’ forecasts has

been unrealistically optimistic regarding near term earnings

growth prospects. Unlike analysts, against a backdrop of

weak global growth, we do not expect company profit

margins to increase from their already elevated levels. For

this reason, we have developed our own in-house corporate

earnings paths which have led to lower growth assumptions

than forecast by the consensus. Not being influenced by

short-term market sentiment, our near term earnings growth

assumptions have been relatively stable overall, in contrast

to consensus expectations, which have varied far more.

In the long term, we assume that companies’ earnings

growth is related to GDP growth. Crucially, we do not

assume a one-to-one relationship between a country’s

growth rate and the long term earnings growth potential of

companies listed on the stock market within that country.

We do this because many companies are international in

nature and derive earnings from regions outside of where

they have a stock market listing. An implication is that

European company earnings have only about a 50% direct

exposure to developments in the Eurozone and similarly,

investors in non-European equity markets should not

consider themselves insulated from events there either.

It is also notable that emerging markets are an important

driver of profits earned in the developed world.


U.S. 6.5% 6.4% 5.9% 5.3% 6.3% 5.4%

UK 6.8% 6.6% 6.2% 5.6% 6.6% 5.7%

Europe ex UK 7.0% 6.9% 6.4% 5.8% 6.8% 5.9%

Switzerland 6.2% 6.1% 5.6% 5.1% 6.0% 5.1%

Canada 6.5% 6.3% 5.9% 5.3% 6.3% 5.4%

Japan 6.2% 6.0% 5.6% 5.0% 5.9% 5.1%

Emerging Markets 7.5% 7.4% 6.9% 6.3% 7.3% 6.4%




Private equity

We assume that global private equity will return 8.6% per

annum over the next 10 years in U.S. dollar terms; an increase

of 0.1% from the previous quarter, following similar increases

in our listed equity assumptions. The slightly lower high

yield assumption has had a minimal impact on expected

returns. The assumption represents a diversified private

equity portfolio with allocations to leveraged buyouts (LBOs),

venture capital, mezzanine and distressed investments.

Return expectations for these different strategies depend on

different market factors. For example, distressed investments

are influenced by the outlook for high yield debt so receive a

boost from higher return expectations in this area. Similarly,

LBO returns are influenced by the outlook for equity markets

as well as the cost of the debt used to finance these LBOs.

Notwithstanding this, whereas in the past leverage has

been a big driver of private equity returns, particularly for

LBOs, in future the ability of managers to add value through

operational improvements will become more important.

On our analysis, the median private equity fund manager has

historically performed in line with the median public equity

manager, but high performing private equity managers have

performed significantly better. Our assumption incorporates

the level of manager skill (‘alpha’) associated with such a high

performing manager. This contrasts with our other equity

return assumptions where no manager alpha is assumed.

Aon Hewitt 13

Real estate


U.S. 5.5% 5.4% 4.9% 4.3% 5.3% 4.4%

UK 5.6% 5.5% 5.0% 4.5% 5.4% 4.5%

Europe ex UK 6.0% 5.9% 5.4% 4.8% 5.8% 4.9%

Canada 5.1% 4.9% 4.5% 3.9% 4.9% 4.0%


Expensive valuations continue to exert downward pressure on

most of our real estate assumptions. However, lower capital

values in the U.S. and UK support higher rental yields.

The UK assumption has increased by 0.1% thanks to a

combination of higher rental yields (driven by lower capital

values) as well as higher expected rental growth. Our

assumptions, however, still remain below pre-Brexit levels,

where concerns over the impact of Brexit on capital values

and rental growth weighed on return expectations. The

U.S. assumption is also 0.1% higher from the previous

quarter, supported by higher rental yields. Lower rental

yields, meanwhile, has led our European assumptions 0.1%

lower. Our Canadian assumptions are, meanwhile, unchanged

from last quarter, despite downward pressure applied from

higher capital values. The fall in the European assumptions

has driven our expectations for the region lower than both

the UK and U.S. markets, for the first time in over a year.

Our assumptions here are in respect of a large fund which is

capable of investing directly in real estate. The assumptions

relate to the broad real estate market in each region rather

than any particular market segment. Our analysis allows

for the fact that real estate is an illiquid asset class and

revaluations can be infrequent, leading to lags in valuations

compared with trends in underlying market value. These

assumptions do not include any allowance for active

management alpha but do include an allowance for the

unavoidable costs associated with investing in a real estate

portfolio. These include real estate management costs,

trading costs and investment management expenses.



Hedge funds

Our fund of hedge funds return assumption is unchanged at

3.8% a year in U.S. dollar terms. We formulate this by combining

the return assumptions for a number of representative hedge

fund strategies. As with private equity, this assumption includes

allowances for manager skill and related fees (including the

extra layer of fees at the fund of funds level), but unlike private

equity, this is for the average fund of funds in the hedge

fund universe rather than for a high performing manager.

Dispersion in returns is high and we expect top quartile

managers to deliver considerably better performance.

As set out in the lead article to the Aon 30 September

2015 Capital Market Assumptions publication, our analysis

allows for the fact that hedge fund managers have been

unable to deliver the high levels of ‘alpha’ that they

did in the more distant past and that alpha generation

is likely to remain challenging moving forwards.

The individual hedge fund strategies we model as components

of our fund of hedge funds’ assumption are equity long/

short, equity market neutral, fixed income arbitrage, event

driven, distressed debt, global macro and managed futures.

Our modelling of these strategies includes an analysis of

the underlying building blocks of these strategies. For

example, we take into account the fact that equity long/

short funds are sensitive to equity market movements. In

practice the sensitivity of equity long/short funds to equity

markets can vary substantially by fund with some behaving

almost like substitutes for long only equity managers, while

others retain a much lower exposure. Our assumptions are

based on our assessment of the average sensitivity across

the entire universe of equity long/short managers.

Given the nature of the asset class, our hedge fund return

assumptions are more stable than, for example, our U.S. equity

return assumption. Nonetheless, the strategies are impacted

by changes to the other asset class assumptions. For example,

most hedge funds are ‘cash+’ type investments to a greater

or lesser extent, so changes in return expectations for cash

will contribute to hedge fund assumptions. Similarly, changes

to our equity and high yield return assumptions influence

expected returns for those strategies which are related to

these markets, such as equity long-short and distressed debt.

Aon Hewitt 15

Volatility

Risk–return

History, forward looking indicators and our view on

the economic cycle all enter our volatility assumption

setting process and the volatilities in the table above

are representative for each asset class over the next ten

years overall. For illiquid asset classes, such as real estate,

de-smoothing techniques are employed. All volatilities

shown above are in local currency terms. For emerging

market equities, global private equity and global fund

of hedge funds the local currency is taken to be USD.

Please note that due to the level of yields and shapes

of the yield curves in Japan and Switzerland, lower

volatility assumptions apply to bond investments in these

markets. This is because as yields fall towards 0% (or

even below), the potential for further significant declines

becomes more limited and this limits volatility — although

clearly the risk of upward moves remains high.

15yr Inflation-Linked Government Bonds 9.0%

15yr Fixed Income Government Bonds 11.0%

10yr Investment Grade Corporate Bonds 9.0%

Property / Real Estate 12.5%

U.S. High Yield 12.0%

Emerging Market Debt (USD denominated) 13.0%

UK Equities 19.0%

U.S. Equities 17.0%

Europe ex UK Equities 19.0%

Japan Equities 20.0%

Canada Equities 19.0%

Switzerland Equities 19.0%

Emerging Market Equities 30.0%

Global Private Equity 25.0%

Global Fund of Hedge Funds 9.0%



The chart below plots our risk and return assumptions for a selection of asset classes that

are covered as part of our Capital Market Assumptions. These asset classes are shown

from a U.S. perspective and as such, all returns are quoted in U.S. dollar terms.

Japan Equities Canada Equities

SwitzerlandEquities

EmergingMarketEquities

Global Private Equity

Global Fund of Hedge Funds U.S. High Yield

Emerging Market Debt (USD denominated)

UK Equities

U.S. Equities

Europe exUK Equities

10yr Investment GradeCorporate Bonds

Property / Real Estate

15yr Fixed IncomeGovernment Bonds

15yr Inflation-LinkedGovernment Bonds

0%

1%

2%

3%

4%

5%

6%

7%

8%

9%

10%

0% 5% 10% 15% 20% 25% 30% 35% 10-Year Volatility

10-Y

ear

Nom

inal

Ret

urn

Risk–return based on Q1 2017 Capital Market Assumptions


Correlations

IL FI CB RE UK Eq U.S. Eq Eur Eq Jap Eq Can Eq CHF Eq EM Eq Gbl PE Gbl FoHF

IL 1.0 0.5 0.4 0.1 -0.1 -0.1 -0.1 0.0 -0.1 -0.1 0.0 0.0 -0.1

FI 1.0 0.8 0.1 -0.2 -0.2 -0.2 -0.1 -0.2 -0.2 -0.1 0.0 -0.2

CB 1.0 0.1 0.1 0.1 0.1 0.0 0.1 0.1 0.0 0.1 0.1

RE 1.0 0.4 0.4 0.4 0.3 0.4 0.4 0.3 0.3 0.3

UK Eq 1.0 0.9 0.9 0.7 0.9 0.9 0.8 0.6 0.7

U.S. Eq 1.0 0.9 0.7 0.9 0.9 0.8 0.7 0.8

Eur Eq 1.0 0.7 0.9 0.9 0.8 0.6 0.7

Jap Eq 1.0 0.7 0.7 0.6 0.4 0.5

Can Eq 1.0 0.8 0.8 0.6 0.7

CHF Eq 1.0 0.8 0.6 0.7

EM Eq 1.0 0.6 0.7

Gbl PE 1.0 0.5

Gbl FoHF 1.0

Domestic Inflation-Linked Government Bonds

Europe ex UK Equities

Domestic Fixed Income Government Bonds

Japan Equities

Domestic Investment Grade Corporate Bonds

Canada Equities Global Fund of Hedge Funds

U.S. Equities

Global Private EquityDomestic Real Estate / Property

Switzerland Equities

UK Equities

Emerging Market Equities

The matrix above sets out representative correlations

assumed in our modelling work, shown on a rounded basis.

All correlations shown above are in local currency terms

and can be used by UK, U.S., European, Canadian and Swiss

investors for the asset classes where return and volatility

assumptions exist (e.g. Swiss real estate is not modelled).

A different set of correlations apply for Japanese investors.

Correlations are highly unstable, varying greatly over time, and

this feature is captured in our modelling, where we employ a

more complex set of correlations involving different scenarios.

Our correlations are forward looking and not just historical

averages. In particular, we think that in many ways the

experience of this millennium has been quite different from

the previous 20 years, being more cyclical in nature with

less strong secular trends. This has many implications. For

example, the equity/government bond correlation in the

table above is negative, which also incorporates the feature

that this correlation is negative in stressed environments.

The lead article to the Aon 30 June 2014 Capital Market

Assumptions publication included further detail on the

drivers of the equity/government bond correlation.



Capital Market Assumptions methodology

Overview

Aon Hewitt’s Capital Market Assumptions are our asset class return, volatility and correlation assumptions. The return assumptions are ‘best estimates’ of annualised returns. By this we mean median annualised returns – that is, there is a 50/50 chance that actual returns will be above or below the assumptions. The assumptions are long term assumptions, based on a 10 year projection period and are updated on a quarterly basis.

Material uncertainty

Given that the future is uncertain, there is material uncertainty in all aspects of the Capital Market Assumptions and the use of judgement is required at all stages in both their formulation and application.

Allowance for active management

The asset class assumptions are assumptions for market returns, that is we make no allowance for managers outperforming the market. The exceptions to this are the private equity and hedge fund assumptions where, due to the nature of the asset classes, manager performance needs to be incorporated in our Capital Market Assumptions. In the case of hedge funds we assume average manager performance and for private equity we assume a high performing manager.

Inflation

When formulating assumptions for inflation, we consider consensus forecasts as well as the inflation risk premium implied by market break-even inflation rates.

Fixed income government bonds

The government bond assumptions are for portfolios of bonds which are annually rebalanced (to maintain constant duration). This is formulated by stochastic modelling of future yield curves.

Inflation-linked government bonds

We follow a similar process to that for nominal government bonds, but with projected real (after inflation) yields. We incorporate our inflation profiles to construct nominal returns for inflation-linked government bonds.

Corporate bonds

Corporate bonds are modelled in a similar manner to government bonds but with additional modelling of credit spreads and projected losses from defaults and downgrades.

Other fixed income

Emerging market debt and high yield debt are modelled in a similar fashion to corporate bonds by considering expected returns after allowing for losses from defaults and downgrades.

Equities

Equity return assumptions are built using a discounted cashflow analysis. Forecast real (after inflation) cashflows payable to investors are discounted and their aggregated value is equated to the current level of each equity market to give forecast real (after inflation) returns. These returns are then converted to nominal returns using our 10 year inflation assumptions.

Private equity

We model a diversified private equity portfolio with allocations to leveraged buyouts, venture capital, and mezzanine and distressed investments. Return assumptions are formulated for each strategy based on an analysis of the exposure of each strategy to various market factors with associated risk premia.

Real estate / property

Real estate returns are constructed using a discounted cashflow analysis similar to that used for equities, but allowing for the specific features of these investments such as rental growth.

Hedge funds

We construct assumptions for a range of hedge fund strategies (e.g. equity long/short, equity market neutral, fixed income arbitrage, event driven, distressed debt, global macro, managed futures) based on an analysis of the underlying building blocks of these strategies.

We use these individual strategies to formulate a fund of hedge funds’ assumption which is quoted in the Capital Market Assumptions.

Currency movements

Assumptions regarding currency movements are related to inflation differentials.

VolatilityAssumed volatilities are formulated with reference to implied volatilities priced into option contracts of various terms, historical volatility levels and expected volatility trends in future.

Correlations

Our correlation assumptions are forward looking and result from in-house research which looks at historical correlations over different time periods and during differing economic/investment conditions, including periods of market stress. Correlations are highly unstable, varying greatly over time. This feature is captured in our modelling.

18 Capital Market Assumptions Aon Hewitt 18

ContactsTapan Datta T: +44 (0)20 7086 [email protected]

Matthieu Tournaire T: +44 (0)20 7086 [email protected]

Disclaimer

This document has been produced by Aon Hewitt’s Global Asset Allocation Team, a division of Aon plc and is appropriate solely for institutional investors. Nothing in this document should be treated as an authoritative statement of the law on any particular aspect or in any specific case. It should not be taken as financial advice and action should not be taken as a result of this document alone. Consultants will be pleased to answer questions on its contents but cannot give individual financial advice. Individuals are recommended to seek independent financial advice in respect of their own personal circumstances. The information contained herein is given as of the date hereof and does not purport to give information as of any other date. The delivery at any time shall not, under any circumstances, create any implication that there has been a change in the information set forth herein since the date hereof or any obligation to update or provide amendments hereto. The information contained herein is derived from proprietary and non-proprietary sources deemed by Aon Hewitt to be reliable and are not necessarily all inclusive. Aon Hewitt does not guarantee the accuracy or completeness of this information and cannot be held accountable for inaccurate data provided by third parties. Reliance upon information in this material is at the sole discretion of the reader.

Past results are not indicative of future results. The tables and graphs included herein present expected returns, which are forward-looking expectations by AHIC based on informed historical results and internal analysis. These do not represent actual historical results. There can be no guarantee that any of these expected results will be achieved. The Capital Market Assumptions (CMAs) represents AHIC’s outlooks on capital markets and economies over the next 10 years. These views are constructed based on our framework of analyzing fundamental, valuation and long-term drivers of capital markets.

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 or completeness. The views and strategies described may not be suitable for all investors. Opinions referenced are as of December 2016, and are subject to change due to changes in the market, economic conditions or changes in the legal and/or regulatory environment and may not necessarily come to pass. This information is provided for informational purposes only and should not be considered tax, legal, or investment advice.

References to specific securities, asset classes and financial markets are for illustrative purposes only and are not intended to be, and should not be interpreted as, recommendations. This material is distributed for informational purposes only. The information contained herein is based on internal research derived from various sources and does not purport to be statements of all material facts relating to the information mentioned, and while not guaranteed as to the accuracy or completeness, has been obtained from sources we believe to be reliable.

This document does not constitute an offer of securities or solicitation of any kind and may not be treated as such, i) in any jurisdiction where such an offer or solicitation is against the law; ii) to anyone to whom it is unlawful to make such an offer or solicitation; or iii) if the person making the offer or solicitation is not qualified to do so. If you are unsure as to whether the investment products and services described within this document are suitable for you, we strongly recommend that you seek professional advice from a financial adviser registered in the jurisdiction in which you reside. We have not considered the suitability and/or appropriateness of any investment you may wish to make with us. It is your responsibility to be aware of and to observe all applicable laws and regulations of any relevant jurisdiction, including the one in which you reside.

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