NEW YORK SAN FRANCISCO LONDON TOKYO

An ERM Perspective on Company Pensions

Presentation by Zvi Bodie at the

Enterprise Risk Management Symposium

April 26, 2004

April 14, 2004

Principle #1: Pooling and spreading of mortality risk lowers costs and improves welfare.

Principle #2: Trading of market risk exposures through financial markets and intermediaries lowers costs and improves welfare.

Principle #3: As transaction costs fall, more efficient markets, contracts, and institutions for reallocating risks and capital resources will evolve.

Principle #4: Law of One Price: The fair-market risk-adjusted rate of return on all assets equals the risk-free rate.

ERM of pensions calls for a synthesis of principles and practices from actuarial science and financial economics

2

Defined benefit pension plans make employees long-term lenders to their companies.

The resulting credit risk is largely undiversifiable by employees and is a source of potential economic inefficiency.

Funding reduces employee exposure to this credit risk and forces plan sponsors to openly compete for the savings of their employees as a source of financing.

The part of the pension obligation that is guaranteed by the company is the vested accumulated benefit obligation (ABO) not the projected benefit obligation (PBO).

The economic cost of guaranteed pensions to the plan sponsor is the cost of a replicating portfolio of traded assets that hedges the ABO.

Economics of corporate pensions

3

Facts and fallacies about investing in the stock market

Even after accounting for mean reversion, equities are not a good match for pension liabilities. Investing pension assets in equities to offset pension liabilities is a risky business. If done at all, it is probably best undertaken by a transparent financial intermediary that is adequately capitalized. When an undercapitalized corporate plan sponsor undertakes this activity, it exposes its shareholders and beneficiaries to risk. If the pension plan is guaranteed by an outside entity such as the PBGC in the U.S., this risk may ultimately be transferred to taxpayers.

Pension plan economic balance sheet

5

ASSETS LIABILITIES & NW

Investments ABO

Guarantees From plan sponsor From private insurers From government

Fund surplus

Firm-wide integrated risk balance sheet

A risk balance sheet expresses the risk profile (i.e., volatility of expected returns) of a firm’s components and the correlations between them. It is used to assess the marginal contribution of individual components to a firm’s total risk

Whether in terms of value or risk, total firm assets must equal total firm equity plus liabilities, DB pension plan included.

Measures of firm-wide risk:

Beta – cost of capital

Sigma – debt capacity

VaR – capital adequacy

6

A company’s pension expenses are currently computed using actuarial methods that anticipate a positive equity risk premium and dampen the volatility of actual equity returns. Thus, companies whose plans invest in equities overstate their earnings and understate the volatility of earnings and net worth. Companies that invest in fixed income instruments are punished by higher reported costs without visible benefits from risk reduction. The illusory arbitrage opportunity created by generally accepted accounting practices constitutes a major barrier to the adoption of sound pension funding and asset allocation strategies.

The problem of accounting bias

7

If a firm issues bonds to fund its pension liability and invests the proceeds in bonds issued by other firms, it pays the after-tax interest rate and earns the before-tax rate.

It therefore should fund to the fullest extent possible and invest 100% in bonds.

But any reduction in aggregate tax revenue collected by government will surely be offset.

The tax arbitrage argument

8

Traditional DB plans are in decline and are being replaced by DC plans and self-directed retirement accounts. As a result, risk is transferred to individuals who are ill-equipped to manage it.

As market interest rates, equity prices, and pension regulations change, many plan sponsors have lost the advantages coming from rules that permit opaque pension accounting, lax funding, and generous tax benefits. Under fair value accounting, their DB plans appear to be much too costly.

The current funding deficits are being treated as resulting from an unpredictable “perfect storm.” Plan sponsors are portrayed as needing “temporary” relief from an unavoidable crisis.

Current pension policy issues

9

If all firms adopted an immunization policy, the result would be a shift from the current system of equity cross-holdings to a system of bond cross-holdings.

The new system would be more transparent and offer fewer perverse incentives to plan sponsors facing bankruptcy.

False alarm about economic consequences of immunization

10

Good fortune will reign, equity prices will rise, and the problems will become less pressing.

Equity prices will not go up enough to eliminate the pressure entirely, but will go up enough to prevent an immediate crisis. The problems will be chronic and linger.

Eventually new intermediaries offering new contract designs will replace traditional DB plans to supply the guaranteed component of the private pension system.

Future possibilities for the pension system

11

This presentation was prepared by Integrated Finance Limited (“IFL”) solely for the benefit and internal use of the client to whom it is addressed (together with such client’s subsidiaries, the “Company”) in order to assist the Company in evaluating, on a preliminary basis, the matters addressed herein. Neither this presentation nor any of its contents may be disclosed to any other party or used for any other purpose without the prior written consent of IFL.

Notwithstanding the foregoing, IFL and the Company (and each of their employees, representatives, or other agents) may disclose to any and all persons, without limitation of any kind, the tax treatment and tax structure of any transaction described herein and all materials of any kind (including opinions or other tax analyses) that have been provided to them relating to such tax treatment and structure.

This presentation is for discussion purposes only and should be viewed solely in conjunction with the related oral presentation made by IFL. The information in this presentation is based upon management forecasts and reflects prevailing conditions and IFL’s views as of this date, all of which are subject to change. In preparing this presentation, IFL has relied upon and assumed, without independent verification, the accuracy and completeness of all information available from public sources or which was provided to IFL by or on behalf of the Company or which was otherwise reviewed by IFL. In addition, IFL’s analyses are not and do not purport to be appraisals of the assets, stock or business of the Company or any other entity. IFL makes no representation as to the actual value which may be received in connection with a transaction nor the legal, tax or accounting effects of consummating a transaction.

Legal Disclaimer

12