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December 5, 2006 9:15-9:55am

Pension Fund Risk Management Conference A Holistic View of Pension Fund Risk. December 5, 2006 9:15-9:55am. For Investment Professional Use Only – Not for Distribution. Presenting to: Pension Fund Risk Management Conference Attendees Representing Schroders: Alan Brown – Head of Investment.

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December 5, 2006 9:15-9:55am

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  1. Pension Fund Risk Management Conference A Holistic View of Pension Fund Risk December 5, 2006 9:15-9:55am For Investment Professional Use Only – Not for Distribution Presenting to: Pension Fund Risk Management Conference Attendees Representing Schroders: Alan Brown – Head of Investment

  2. Agenda • I. Introduction • A Panoply of Risks • Best Practice & Dynamic Policymaking • II. Fixed Income • Liability based portfolios • Absolute return strategies • III. Equities • “130/30” strategies • Benchmark unaware strategies • Alpha transport • Leverage • IV. AlternativesV. Case Study: Schroder Benefit Retirement System

  3. A Panoply of Risks • Providing Pensions can not be Riskless • Investment Risk ….. AND • Longevity • Regulatory • Tax • Sponsor • Accounting • Agency

  4. Best Practice & Dynamic Policymaking • Current Best Practice • Asset-liability study result: strategic benchmark = numeraire • Risk management focus is portfolio vs. benchmark, not benchmark vs. liability • Unrealistic assumptions about risk appetite vs. wealth condition • Single-period optimization instead of path dependant

  5. Best Practice & Dynamic Policymaking • Dynamic Policymaking • Risk premia vs. wealth condition: an inverse relationship • Shifts focus from benchmark risk to risk budgeting and surplus management • Recognizes skewness in managing upside/downside risk • New outcome: Strategic Investment Policy with risk budget conditioned on funding ratioand risk premia

  6. Fixed Income Management Current Standard Practice Has Significant Weaknesses • Significant tracking error vs. liabilities • No increase in expected return for that tracking error • No financial theory underpinning cap weighted bond benchmarks • Opportunity set much larger than just the benchmark • Yields close to generational lows

  7. Fixed Income Management Yields Near Generational Lows US Investment Grade Credit Spreads US Ten Year Nominal Yield US Ten Year Real Yield (deflated by headline inflation) Source: Merrill Lynch/Bloomberg

  8. Fixed Income Management A Fork In The Road • Risk Averse Investors • LDI solutions • Return Seeking Investors • Absolute Return Strategies • Benchmark, LIBOR + X% • Duration, short and long positions allowed within limits • Credit, short and long positions allowed within limits • Leverage, permitted within limits

  9. Equity Management “The Triumph of Hope Over Experience” • Alpha managers and “best ideas” portfolios: • Alpha is a negative sum game • Concentration may raise risk, not reward • “130/30” Portfolios • Benchmark unaware strategies • Portable alpha • Leverage

  10. Equity Management Leveraging Beta Normal Portfolio Geared Portfolio % Equities Bonds Borrowings Total 60 (9.0) 40 (4.5) 0 (4.5) 100 (7.2) 82 (9.0) 40(4.5) 22(4.5) 100(8.2) Numbers in brackets = returns/costs Source: Schroders Past performance is not a guide to future performance and may not be repeated. The value of investments and the income from them may go down as well as up and investors may not get back the amounts originally invested.

  11. Alternative Investments “The New New Thing” • Move toward multi-strategy funds – away from single strategy and fund of funds • Allows aggregation of fees based on total portfolio performance • Potential for better risk control – integrated controls at the aggregate level • Challenge is to find individual single firms with credible multi-strategy capability

  12. Case Study: Schroder Benefit Retirement System Articulating The Challenge • Schroders Benefit Retirement System • Closed to new members (except for limited transfers) • Approximately $900 million in assets • The Impetus For Rethinking Our Strategy • Bear market impact on funding ratio • New IFRS accounting rules • UK’s new Pension Protection Fund – akin to PBGC • Recognition that current industry “best practice” is flawed Issue mentioned is for illustrative purposes only and is not a recommendation to buy or sell.

  13. Case Study: Schroder Benefit Retirement System The Firm’s Approach • Key Stakeholders In The Process • Plan Sponsor (Schroders’ CFO) & Plan Trustees Plan Sponsor’s Goal: • Minimize long-term funding cost, subject to: • Minimizing the risk at the 95% confidence limit of the funding ratio dropping by more than 10% in any one year Plan Trustees’ Goal: • Maximize the long-term funding ratio, subject to: • Minimizing the risk at the 95% confidence level of the funding ratio dropping by more than 10% in any one year THESE ARE SIMILAR, BUT MATERIALLY DIFFERENT OBJECTIVES Issue mentioned is for illustrative purposes only and is not a recommendation to buy or sell.

  14. Case Study: Schroder Benefit Retirement System The Proposed Solution • First Move: • Top-up plan with cash contribution • Restore funding ratio to 100% • Next, A Redesigned Asset-Liability Study: • Covariance matrix was built relative to liabilities • Expected Alpha included in return estimates • Alpha Transport strategies permitted • Both conventional and LDI fixed income alternatives were permitted assets • No artificial constraints driving domestic bias Issue mentioned is for illustrative purposes only and is not a recommendation to buy or sell.

  15. Case Study: Schroder Benefit Retirement System The Risk Budget • First Define: • Set at 20% of the prevailing level of pre-tax profits • Next, Apply : • LDI Portfolio – A “slice” or a “chunk at the front”? • Term structure of interest rates • Cash collateral • Growth portfolio Issue mentioned is for illustrative purposes only and is not a recommendation to buy or sell.

  16. Excess return 5.0 Schroder Growth Portfolio 4.5 4.0 Schroder’s Recommended Portfolio (35% Liability Matched, 65% Growth) 3.5 3.0 2.5 x Current Schroder Portfolio 2.0 Liability Matching Portfolio 1.5 1.0 0.5 0.0 0 2 4 6 8 10 Case Study: Schroder Benefit Retirement System The Proposed Solution - Excess Return vs. Tracking Error Tracking Error % vs. Liabilities Source: SMART, Hewitt Past performance is not a guide to future performance and may not be repeated. The value of investments and the income from them may go down as well as up and investors may not get back the amounts originally invested. Issue mentioned is for illustrative purposes only and is not a recommendation to buy or sell.

  17. Case Study: Schroder Benefit Retirement System The Proposed Solution Underlying (Alpha) % Net (Asset) % Allocation Swap % • Growth Portfolio • Expected Return* 4.6% • Expected Risk 9.1% • Equities • Specialist UK equities • North America equities • US Smaller Cos • Specialist Eur ex UK equities • Tokyo Fund • Japan Smaller Cos • Asian Equity Yield • High Return Bonds • EMD • Global High Yield • Alternatives • SIRE • Diversified FOHF • Concentrated FOHF • Credit Renaissance • Japan Long / Short • Private Equity • Cash • Total 53.0% 20.0% 0.0% 1.0% 11.0% 11.0% 5.0% 5.0% 15.0% 10.0% 5.0% 32.0% 15.0% 3.0% 3.0% 2.0% 2.0% 5.0% 2.0% 100.0% 10.0% -8.0% -2.0% 0.0% 55.0% 20.0% 10.0% 1.0% 11.0% 3.0% 5.0% 5.0% 15.0% 10.0% 5.0% 30.0% 15.0% 3.0% 3.0% 2.0% 2.0% 5.0% 0.0% 100.0% *Return over Liabilities Source: Schroders Issue mentioned is for illustrative purposes only and is not a recommendation to buy or sell.

  18. A New Approach to “Best Practice” • Benchmarks • Market cap benchmarks challenged on many fronts • Liability or absolute return alternatives • Benchmark unaware strategies • Improving Risk–Return Ratios • “130/30” portfolios • Benchmark unaware strategies for Sharpe ratios • Leverage – a powerful new tool Realistic treatment of upside/downside risk

  19. Biography Alan Brown – Head of Investments Executive Director Joined Schroders in 2005 as Head of Investments, and Director of Schroders plc In 1995 Alan joined State Street Global Advisors, initially as Managing Director of the London office, and later as Group Chief Investment Officer and Vice Chairman of SSgA, and Executive Vice President of State Street Corporation He joined Posthorn Global Asset Management in 1984 as Head of Fixed Income, moving to PanAgora Asset Management as Chief Investment Officer in 1989. Investment career commenced in 1974 upon joining Morgan Grenfell as an equity analyst before moving to New York to go through the JP Morgan Commercial Bank Management Program. He returned to London becoming an International Fixed Income Fund Manager, eventually moving up to Director of Investments responsible for all Fixed Income Member of the Group Management Committee. Externally he is Chairman and Treasurer of the CERGE-EI US Foundation (Centre for Economic Research and Graduate Education – Economics Institute), CFA Advisory Council for Market Integrity, MSCI Barra Editorial Advisory Board and Carbon disclosure Project Advisory Board BA, MA in Natural Science (Physics), Cambridge Telephone: +44 (0) 207 658 6575 Fax: +44 (0) 207 658 6400 Email: alan.brown@schroders.com

  20. Disclaimer • For professional advisers only. This material is not suitable for private customers. • The data contained in this document has been sourced by Schroders and should be verified before further publication or use. Schroders has expressed their own views and opinions in this document and these may change • Issued in February 2006 by Schroder Investments Limited, 31 Gresham Street, London EC2V 7QA. Registered no. 2015527 England. Authorized and regulated by the Financial Services Authority

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