epo RiceRt - T. Rowe Price · Horizons Fund—a small-cap growth portfolio—observes, “The bottom-ing process can be brutal for inves-tors. But I am relatively optimistic. Investors

»A Pe r s p e c t i ve O n F i n a n c i a l To p i c s Fo r O u r I nve s t o r s

RepoRtt. Rowe pRice

Issue No. 102 Winter 2009

Economy, Credit Keys to Market RevivalEnduring the worst bear market in at least a generation, global investors entered 2009 facing a deep recession, unprecedented deleveraging due to the collapse of the U.S. credit bubble, and volatile world equity and fixed-income markets fraught with risks.

Market forecasts are always haz-ardous, but T. Rowe Price portfolio managers stress that this year brings greater uncertainty than in memory. In particular, it will be one in which investors should keep a sharp eye out for signs of the recession abating and a return to normal functioning of credit markets.

At the same time, the firm’s invest-ment managers note that equity markets typically have rebounded months in advance of an end to the recession. So while this more-than-year-old recession could linger beyond this summer—and stocks could suffer more downturns—a market recovery could begin later this year.

“My belief is that, sometime in 2009, equity markets could improve on expectations for an economic recovery and a possible rebound in corporate earnings in 2010,” says Brian Rogers, T. Rowe Price chair-man and chief investment officer. “For fixed-income investors, this year likely will see a return to some sem-blance of normal yield relationships.”

Continued on page 2

Generally, T. Rowe Price managers say that global stock and bond markets offer attractive opportuni-ties at recent valuation levels, but investors should take a long-term view of potential returns—at least three to five years.

As Bill Stromberg, director of global equities, puts it, “The massive policy responses of governments and central banks around the world should ultimately jump-start growth, restore confidence, and allow for credit and equity markets to normalize. From a variety of perspectives, stocks look cheap. But that alone isn’t enough. We need a return of confidence in the economy for normal levels of risk taking to return.”

Economic Indicators

Early signals of the United States beginning to climb out of this purga-tive recession could include a slowing of the pace of the precipitous declines in employment, housing starts, and business inventories.

Alan Levenson, T. Rowe Price’s chief economist, describes such improvements as “addition by lack of subtraction—things that have

InsIde ThIs Issue

3 Perspectives: Economy Faces Stiff Challenges But Recovery on the Horizon

5 Gradual Return to Normalcy for Bond Markets Expected

8 Stocks: Opportunities, Risks Abound in Wake of Market Crash

12 Positioning Portfolios Following a Market Meltdown

13 International Markets Offer Attractive Valuations But Their Near-Term Outlook For Gains Subdued

15 Emerging Markets Poised to Benefit From Potential Rebound

16 Personal Finance: Retirement Income: Recovering From Market Devastation

18 Explaining Monte Carlo Analysis Used in Retirement Study

19 Performance Update • Equity Market Review • Fixed-Income Market Review • Fund Performance Tables

2 www.troweprice.com

Market RevivalContinued from page 1

been hurting the economy beginning to not hurt quite so much.”

His overall economic forecast: job losses accelerating into the first quar-ter of 2009 with job growth resuming later this year and an unemployment rate of 8.5% by year-end; slowing household income growth even as consumers are rebuilding their bal-ance sheets; lower energy costs aiding a gradual recovery restrained by continued financial restructuring; and a real annual gross domestic product (GDP) rate of just 0.5% for the year.

Mr. Levenson says that inflation is falling so fast that the United States could see short-term deflation (a short-term negative rate for the consumer price index).

But he says that “deflation with a capital D”—dreaded widespread price declines as in the 1930s or as in Japan in the 1990s—“is not likely because of the stimulative actions by the Federal Reserve and other central banks.”

Bonds: “New Normal”

Investors should also keep an eye on global credit markets. Despite some positive signs, these markets are still struggling to restore normal liquidity after freezing last fall.

“A key sign that the economy is stabilizing will be the normalization of credit spreads [yield differences],” Mr. Stromberg says. “Corporate bonds are important to watch. When their interest rates begin to fall, it will signal a return to stability.”

As 2009 opened, damaged credit markets and a bleak economic outlook had sparked such a flight to safety that U.S. Treasuries were offering rock bottom yields. Meanwhile, corporate bond yields, especially those on high-yield bonds, were soaring and trading at a record spread over Treasuries.

Mary Miller, director of the firm’s Fixed Income Division, sees that

changing this year, with bonds inching back to a “new normal and investors’ attention shifting from credit risk to interest rate risk.” She cautions, however, that there remains a “pretty heavy overhang of credit-rating downgrades to come.”

In 2009, she says, investors in low-yielding cash will “find it painful to sit on the sidelines as interest rates reach almost nothing in money market funds. We think other sectors that have seen significant yield increases—sectors that may be liquidity impaired but not credit impaired—may outper-form cash and Treasury bonds.”

These sectors include investment-grade corporates, municipal bonds, and certain agency-backed mort-gages and asset-backed bonds.

Stocks: Guarded Optimism

T. Rowe Price equity managers generally are guarded about the 2009 outlook.

However, they do see compelling opportunities for long-term inves-tors in the stocks of companies with attractive valuations (and room for their multiples to expand), solid balance sheets with little debt, and

the abilities to gain market share.“The market is pricing in contin-

ued fundamental weakness for the foreseeable future today, despite unprecedented monetary and gov-ernment intervention,” says David Giroux, manager of the Capital Appreciation Fund. “When the fundamentals turn, the rally across all asset classes could be significant.”

Nevertheless, the near term may still be painful. As Jack Laporte, the veteran manager of the New Horizons Fund—a small-cap growth portfolio—observes, “The bottom-ing process can be brutal for inves-tors. But I am relatively optimistic. Investors tend not to have a good appreciation for how far up or down markets can go. When it does turn around, the market could surprise people on how far and how fast it may go.”

Adds Mr. Rogers: “Despite all the fear, now is the time to begin positioning for a market rebound—without taking undue risk for your circumstances. After a period of steep market decline, fleeing stocks has generally not been a smart thing to do.”

40

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100

10/09/2007

03/24/2000

08/25/1987

01/11/1973

11/29/1968

03/06/1937

DTP operators please note:• After updating graph, manually adjust value labels by moving up 2pts to align with center of grid lines.• Be sure to add commas (or remove duplicate %) in labels as needed each time graph is revised. • Check that apostrophes are curved in the correct direction for dated labels. • Size of graph can be altered slightly if needed. • Height of graphic box can be adjusted to fit surrounding copy (titles and footnotes/notes). • Bottom grid line is a .5pts rule placed on top of graph's bottom grid line.

Comparing Depth and Duration of Equity Bear Markets

Source: T. Rowe Price Associates. Data provided by Ned Davis Research, Inc.

Current Bear Market Has Been Both Fast and Furious (Based on S&P 500 Stock Index)

1937(-54.50%)

Current Bear Market 2007

(-51.63%)

1968(-36.06%)

1973(-48.20%)

2000(-49.15%)

— 3/6/1937

— 11/29/1968

— 1/11/1973

— 8/25/1987

— 3/24/2000

— 10/9/2007

Duration in Months From Start of Bear Market to Trough

1987(-33.51%)

302826242220181614121086420

www.troweprice.com 3

Continued on page 4

Perspectives

Economy Faces Stiff Challenges But Recovery on the HorizonBy Alan Levenson, T. Rowe Price Chief Economist

The National Bureau of Economic Research, the accepted arbiter of U.S. business cycle dating, declared in early December 2008 that a six-year period of economic expansion had ended a year earlier.

The news came as no surprise. Weakness in the housing sector had been undermining growth for 18 months even before the business cycle peaked and employment had been declining throughout 2008. Housing continued to play a domi-nant role in the early stages of the recession.

The steady drumbeat of weak data in the fourth quarter of 2008 further revealed an economy mired in a broadening and deepening slump. Financial market pressures intensi-fied along with sharp cutbacks in the business sector and heightened caution by consumers. Retail sales, durable goods orders, and industrial output plunged under the weight of deleveraging forces by consumers, businesses, and homeowners.

Indeed, the economy is likely to get worse before it gets better as the factors underlying weak demand per-sist well into this year. On the heels of a sharp contraction at the end of last year, real gross domestic product (GDP) will probably decline about 1.5% in the first quarter before stabi-lizing and resuming a modest growth pace in the second half. Overall, it likely will be essentially flat for the four quarters of 2009.

The recession should be evolving toward a cyclical recovery by the end of the year or early 2010, as some of the current drags on growth—such as cutbacks in consumer spending and

business investment—lose some of their force. The pace of retrenchment is close to maximum intensity, and monetary policy is fully engaged in efforts to stimulate demand.

A greater fiscal policy effort involving tax and spending measures should further reduce downside risks and solidify the path to recovery. A $350 billion (2.5% of GDP) annual infusion of public sector demand would be appropriate and help offset the anticipated shortfall in demand from the private sector. So a two- to three-year, $700 billion to $1 trillion proposal may be in the works.

Here’s a look at some of the forces the economy is grappling with and some potential remedies as we embark on 2009.

Stagnant Personal Income

In this weak economic environ-ment, employment declined by 1.9 million over the final four months of last year, with headcounts rising

in barely a quarter of private indus-try sectors—the lowest diffusion of job gains in at least 26 years.

Expect to see significant job losses continue through most of 2009 as the unemployment rate rises above 8.5%. All in all, about 3.5 million jobs may be lost since the start of the recession, representing an overall 2.5% decline in employment.

Consumers have responded by using less debt and saving more. Rising unemployment, declining financial and housing wealth, and tight credit conditions are discour-aging consumer borrowing and heightening the imperative to rebuild balance sheets after an extended period of increasing indebtedness.

As a result, the personal saving rate has risen sharply in recent months, reducing spending relative to income growth. An expected two-percentage-point increase in the personal saving rate over the

-600

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400

600

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More Job Losses Expected

— Nonfarm Payroll Employment

Cha

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Sources: Bureau of Labor Statistics, Haver Analytics, and T. Rowe Price.

2009 reflects T. Rowe Price estimates

'00 249 121 472 286 225 -46 163 3 122 -11 231 138 '01 -16 61 -30 -281 -44 -128 -125 -160 -244 -325 -292 -178 '02 -132 -147 -24 -85 -7 45 -97 -16 -55 126 8 -156 '03 83 -158 -212 -49 -6 -2 25 -42 103 203 18 124 '04 142 27 334 270 282 89 112 83 176 359 63 144 '05 125 209 119 332 177 261 368 213 110 105 361 152 '06 232 273 259 147 22 94 262 191 165 73 182 199 '07 126 25 177 46 162 107 57 74 81 140 60 41 '08 -76 -83 -88 -67 -47 -100 -67 -127 -403 -320 -584 -524 -524'09 -240 -220 -150 -80 0 10 35 60 85 100 115 130


Recovery on the HorizonContinued from page 3

course of 2009 translates to about a 1.5-percentage-point decline in GDP due to reduced consumer spending.

Sharply lower energy prices are providing a powerful boost to purchasing power, but it is unlikely to persist, and inflation-adjusted consumer spending is likely to remain virtually stagnant through most of 2009. At the same time, the trajectory of the rise in the savings rate will slow, which will reduce the pressure on spending relative to income.

Falling Capital Spending

Meanwhile, the business sector, though less leveraged than house-holds, appears to have embarked this summer on its own cycle of balance sheet repair.

For example, the financing gap of nonfinancial corporations—the excess of capital spending relative to internally generated cash flow—fell by 50% in the third quarter of 2008 from the spring quarter’s cycle high.

Business capital spending softened over the summer and accelerated to the downside into year-end as weaker product demand and tight credit discouraged capacity additions and encouraged inventory liquidations.

The capital spending pullback will continue through the first half of this year. So the corporate financing gap should narrow by the end of 2010.

Foreign Trade

Even as the domestic economy weakened, strong foreign trade performance contributed almost 1.6 percentage points to GDP growth through the first nine months of 2008, helping to moder-ate the overall economic slide.

The steepening employment and production downturn since last September reflects in part the impact of slower overseas

economies on demand for U.S. exports, which plunged 9% in the September and October period. That drop unwound almost 90% of the previous year’s growth.

Even as imports decline in response to a weaker domestic economy, net exports are unlikely to contribute significantly to growth in 2009.

Policy Responses

Aggressive policy responses by government authorities are under-way or in development to support private sector demand. This should help cap the potential growth in unemployment and reduce the risks that the economy falls into deflation (a period of broadly falling prices).

The Federal Reserve cut its policy rate to zero in December, bringing to an end the long-reigning interest rate-targeting regime in which it set a target for the federal funds rate and then committed to supplying reserves to the banking system.

Now, the Fed has formally entered the realm of “quantitative easing”—attempting to influence financial con-ditions and economic activity through the growth of its balance sheet.

Don’t expect the Fed to target a specific level of assets but rather to purchase securities on the open

market in whatever quantities prove necessary to improve credit flows and reduce borrowing costs.

The Fed already has programs in place to purchase commercial paper and the debt securities of Fannie Mae, Freddie Mac, and the Federal Home Loan Banks.

It will soon initiate a program to purchase the mortgage-backed secu-rities of Fannie, Freddie, and Ginnie Mae, as well as open a lending facility to encourage the purchase of high-quality asset-backed securities.

Policymakers are also evaluating the potential benefits of purchasing longer-term Treasury securities.

The scale of credit market stress over the past 18 months has been unprecedented and the restrain-ing force of deleveraging on the economy may be so as well.

The threats posed by a signifi-cant and sustained withdrawal of private sector demand for goods and services and supply of credit is daunting. However, they are being met by aggressive public sector action to bolster demand through fiscal policy and to expand the supply of credit through monetary policy. Those efforts should put the economy on a better track before the end of this year.

Households & Nonprofit Org: Net Worth as a % of Disposable Personal Income (%)

Personal Saving Rate (SA, %)


outperform Treasuries this year, including investment-grade corporate bonds, high-quality mortgage-backed securities, certain asset-backed securities, and municipal bonds.

“There is compelling valuation in the bond market, and investors are being much better compensated in yields now for the risk they are taking than they were just a few months ago,” Ms. Miller says. “I’m optimistic that investors will start gravitating to higher-yielding assets in 2009.”

Brian Brennan, manager of the firm’s U.S. Treasury bond funds, says that investors flocking to government bonds for safety could actually suffer principal declines as interest rates move higher over the next couple of years.

“U.S. Treasuries are the gold stan-dard for risk aversion, pushing rates to historically low levels,” he says.

But Mr. Brennan says Treasury investors should be cautious “unless you feel we are going to have a Japanese-type scenario like the 1990s, when the Bank of Japan kept rates at very low levels for more than a decade, and you believe that the fiscal stimulus measures, not just in the U.S. but globally, will not gain any traction. You have to be pessimistic about growth over the next decade to be buying longer-term Treasuries now.”

Investment-Grade Bonds

The U.S. Treasury is expected to issue more than $1.5 trillion in debt this year, but other bond markets have been starved for capital though demand suddenly improved at year-end, sparking a rally. The deleverag-ing by investors, companies, and consumers has meant the supply of financial assets like stocks and bonds exceeds the demand. This illiquidity

While the global credit crisis and depressed economy brought more devastation to stocks than bonds in 2008, they also wreaked havoc in the fixed-income markets, causing some unprecedented declines.

Investment-grade corporate bonds averaged a total return of -4.94% last year—the worst since 1974—while high-yield “junk” bonds suffered a historic decline of 26.2%. That dwarfed the prior high-yield record drop of 6% in 1990. Meanwhile, U.S. Treasury bonds on average provided a total return of 13.7%.

Concerns about creditworthi-ness and a severe lack of liquidity crippled credit markets in recent months, sparking a massive flight to quality and pushing yield spreads for corporate, municipals, and other bonds to record levels relative to Treasury securities.

As a result, opportunities to earn unusually attractive yields—even in higher-quality bonds—are preva-lent, but T. Rowe Price managers remain concerned about the near-term outlook and urge caution when investing in such higher-risk sectors as noninvestment-grade and emerging market bonds.

Gradual Return to Normalcy for Bond Markets ExpectedMary Miller, director of the firm’s

Fixed Income Division, expects the problems plaguing the credit markets to continue into this year. But she sees gradual improvement “as we move troubled assets into stronger hands and get troubled loans off the books of financial institutions. Atten-tion will shift from credit risk, which has been all-consuming for the last year and a half, to interest rate risk” as the economy recovers.

However, the outlook for fixed-income investing remains very uncertain. No one knows how long or severe the U.S. recession, and downturn in economies overseas, will be, despite massive investments by government authorities and central banks.

In addition, financial institutions globally took more than $1 billion in write-downs of toxic assets in 2008 and the International Monetary Fund projects the total to reach $1.4 trillion. More capital injections from central banks and other sources will be needed.

Ms. Miller says that the flight to quality has driven Treasury bonds to overvalued levels. She expects other higher-yielding sectors to

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20YTD

Three months

U.S. CorporateHigh Yield

EmergingMarkets

U.S. CorporateInvestment Grade

Global Aggregateex-U.S. Dollar

U.S. Municipal Bond

U.S. Mortgage-Backed Securities

U.S. Treasury*

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U.S. Corporate High YieldEmerging MarketsU.S. Corporate Investment GradeGlobal Aggregate ex-U.S. DollarU.S. Municipal BondU.S. Mortgage-Backed SecuritiesU.S. Treasury


2008 Bond Market PerformanceTotal Return by Sector as of December 31, 2008

� Three Months� YTD

*U.S. government bonds are guaranteed as to the timely payment of principal and interest.Source: Credit Suisse, Barclays Capital, J. P. Morgan.

Retu

rn (%

)

Three months YTDU.S. Treasury 8750 13740U.S. Mortgage-Backed Securities 4340 8340U.S. Municipal Bond 740 -2470Global Aggregate ex-U.S. Dollar 5660 4390U.S. Corporate Investment Grade 3980 -4940Emerging Markets -6010 -10910U.S. Corporate High Yield -18790 -26170

8.8

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Continued on page 6


and credit fears drove yields on investment-grade corporate bonds to 9%, a record six percentage points (600 basis points) over comparable term Treasuries, compared with a historically low 80 basis points in the first quarter of 2007 before the subprime mortgage crisis erupted.

“There are just too many cheap assets and not enough capital to take advantage of them,” says David Tiberii, manager of the Corporate Income Fund. While the yield spread has narrowed recently, he says investment-grade corporate securi-ties are “fundamentally cheap” and expects this sector to outperform Treasury bonds over the next two to three years. “These low Treasury yields will get eaten up by inflation when we return to a more normal economic environment.”

Still, Mr. Tiberii advises caution because “the economic cloud on the horizon looks very bad and could potentially push defaults or down-grades to record highs. If you are willing to take some risk but not a lot of risk, dip your toe into high-quality bonds.”

Dan Shackelford, manager of the New Income Fund, which also invests in investment-grade debt securities, says that with yields in the 8% to 9% range, this sector offers “the best opportunities I have seen in a long time. We’re not banking on capital appreciation, but these yield spreads could enable you to absorb a period of weakness and still come out ahead.”

While Mr. Tiberii is concerned about inflation down the road, stemming from the massive cost of the government’s rescue measures and bulging deficit, Mr. Shackelford says that in the near term the bond market has been “bracing itself for deflation [a sustained period of falling prices], which is rare. That is creating

problems in the market for Treasury inflation-protected bonds (TIPS) and causes stress for corporates. Delever-aging is a very powerful force so its downward effect on price levels can’t be ignored, and we have not really had a fire drill on what deflation does.”

Mr. Shackelford advises investors to stay diversified and focus on intermediate-term, higher-quality bonds “which can offer good yields in an environment where returns are going to be tough.”

High-Yield Bonds

As investors fled to Treasuries, junk bond yield spreads widened to record-shattering levels, pushing toward a whopping 19 percentage points (1900 basis points) over the 10-year Treasury yield near year-end, though that spread narrowed to 1600 basis points in January.

In addition, more than 80% of high-yield securities—spanning every industry sector in that market—are trading at distressed levels, mean-ing they have a high probability of default or restructuring. This implies that the default rate for the high-yield market, relatively low in recent years,

could reach as high as 20% over the next couple of years—compared with a record 16% in 1989 to 1990.

“When sentiment is as overwhelm-ingly negative as it is now, the market has a tendency to overshoot on losses,” Mark Vaselkiv, manager of the T. Rowe Price High Yield Fund, says. “The value of all securities has been indiscriminately crushed, as the market hasn’t appropriately distin-guished between varying degrees of credit quality. Many of these compa-nies will survive.”

Mr. Vaselkiv says the economic climate and expected default rates, looking to 2010, are keys to performance this year. If investors anticipate a better economic climate in 2010 or before, high-yield bonds could rebound in 2009. However, with deteriorating economic condi-tions and increasingly prohibitive borrowing costs, many companies could face strong headwinds.

But with current market yields recently hovering around 17.5%, and with a large majority of high-yield issuers expected to remain viable, investors are being well compensated for the risks. Moreover, the market has generated its best performance

Emerging Debt

IG Corporate

Municipal Bond Index

U.S. High Yield Index

10-year Treasury Index

12/089/086/083/0812/079/076/073/0712/06

10-Year Treasury Rates and Credit Yields From December 31, 2006, Through December 31, 2008

Bond MarketsContinued from page 5


after periods of distress, returning 44% in 1991 after the 6.4% drop the prior year, for example.

“There is very good potential for this market to generate significant absolute returns once the economy stabilizes and begins recovering,” Mr. Vaselkiv says. “Long-term investors may be rewarded for their patience and courage.”

Municipal Bonds

Like investment-grade corporates, the municipal bond market has suf-fered from a significant supply and demand imbalance as hedge funds, brokerage firms, and other institu-tional investors have pulled back from the market. As a result, some states and local municipalities have had difficulty issuing bonds just as tax revenues are declining. This has raised credit concerns and pushed yields to historically high levels.

Yields on longer-term munis (10- to 30-year maturities), for example, have recently been well above those of comparable maturity Treasury bonds. Historically, long-term muni yields have averaged about 80% to 90% of Treasury yields because muni interest income is exempt from federal income tax and possibly state tax as well, but, in December, munis yielded twice as much as Treasuries.

For those in a 35% tax bracket, a 30-year AAA rated municipal bond with a recent yield of 5.8% provides a taxable-equivalent yield of 8.9%. Moreover, investors face significantly less credit risk with muni bonds than with corporate bonds.

“Munis are not immune to the downturn,” says Hugh McGuirk, a T. Rowe Price municipal bond manager. “We will experience some credit problems, but historically the default rate has been very low. The market’s problems recently have been more related to technical issues than long-term fundamentals.”

Mr. McGuirk says munis offer good long-term value, especially if income tax rates rise in the next few years. He advises investors to make gradual investments and focus on intermediate-term bonds (5- to 10-year maturities) to reduce volatility. “Once we find a proper equilibrium between supply and demand, I think those buying munis now will be rewarded, but it could be a rocky road until we get there.”

International Bonds

Foreign bond performance was undermined by the rapid rise of the U.S. dollar against foreign currencies in the second half of 2008. T. Rowe Price managers expect that trend

to moderate, and note that foreign bonds not only provide diversifica-tion for U.S. investors but also higher-yielding opportunities for government-issued debt.

“Foreign markets also have less exposure to the mortgage and housing market than in the U.S.,” says Ian Kelson, manager of the International Bond Fund.

Mr. Kelson says European corpo-rate bonds are attractive, benefiting from the European Central Bank’s decision to cut its key lending rate, and further cuts are expected as economies weaken. He also sees less currency risk in Europe with the euro having already fallen steeply against the dollar from its peak. And he is finding attractive opportunities in countries where bond prices have declined due to selling pressure and lack of liquidity, citing Mexico and Hungary, two investment-grade countries offering yields above 9%.

“By investing in several countries, currencies, and sectors,” he says, “U.S. investors can moderate the risk in their portfolios and possibly enhance their overall return.”

Bonds issued by emerging markets offer attractive yields—10% to 12% for sovereign issues and higher for corporate debt—but also more risk. This market also suffered a precipi-tous decline following the collapse of Lehman Brothers last September, the fall in commodity prices, and the flight of capital to safer harbors.

Mike Conelius, manager of the Emerging Markets Bond Fund, says some markets are fundamentally cheap and expects to see an improve-ment in 2009 as volatility subsides and investors become less risk averse. “We see this as a deep value opportu-nity, but one that might take two or three years to play out, so investors have to be patient.”

As of December 31, 2008

CSFB HY Annual Returns (%)

-30-20-1001020304050 JPM 12 Month Default Rates

2008 200620042002200019981996199419921990


Stocks: Opportunities, Risks Abound in Wake of Market CrashLarge, well-established companies are generally financially stronger than smaller companies; more diversified in terms of products, services, and markets; and less dependent on the U.S. economy for earnings growth.

While these advantages provided little help last year in weathering a historic financial crisis and unfolding global recession, they could prove more favorable for large-cap stocks in 2009.

In the financial maelstrom that has engulfed global equity markets, large-cap stocks in the U.S., as reflected by the S&P 500 Index, declined 37%—the worst year since 1937—compared with the 33.8% decline in the Russell 2000 Index of smaller companies.

As a result, large-cap stocks may have relinquished the leadership position that they had finally attained in 2007, after significantly trailing small-caps most of this decade.

Larry Puglia, veteran manager of the Blue Chip Growth Fund, says that large multinational companies, though less sensitive to the U.S. economy, have been hurt by the weakening economies overseas, par-ticularly in Europe. In addition, the strengthening dollar over the second half of 2008 made U.S. exports more expensive and undermined earnings from abroad, which typically account for about 40% of S&P 500 earnings.

In addition, Mr. Puglia says that larger companies may have been more adversely affected by the breakdown in the credit markets because they are somewhat more dependent on the smooth functioning of those markets for their funding.

The havoc in the financial sector—with such firms as Lehman Brothers, Bear Stearns, Merrill Lynch, Ameri-can Insurance Group, and Wachovia

failing or merging—exacerbated the large-cap decline, though it also hurt small-cap performance.

Compelling ValuationsLooking ahead, T. Rowe Price managers agree that many leading blue chip companies, as well as many small-cap stocks, offer compelling valuations that should make them rewarding investments for patient investors.

As reflected in the table on page 9, the median price/earnings ratio for large-, mid-, and small-cap stocks is substantially below their historical averages since 1969, according to The Leuthold Group.

Managers caution, however, that the near-term outlook remains highly uncertain despite the market rally off the November 20 low.

“We are clearly in uncharted waters,” John Linehan, manager of the Value Fund, says. “The stock market is attractive on various metrics, but the real question is, how deep is the valley? And no one knows for sure.

“Stocks are good buys if you look out several years—not just this year. There are a lot of dislocations

in the market. But there are a lot of corrective forces at work to help the economy. We see companies with rea-sonable balance sheets and good cash flow where even under a draconian scenario you feel comfortable with the business model of the company.”

Mr. Puglia adds, “Stocks are about as cheap as they have been in any post-World War II correction or bear market.”

Or as Robert Bartolo, manager of the Growth Stock Fund, puts it, “Investors can buy solid growth com-panies on sale.” He cites Danaher, a leading industrial firm, and pharmacy benefit manager Medco as examples of companies with strong earnings, cash flow potential, and reasonable valuations.

“The growth prospects for many of these large-cap growth com-panies are not reflected in current valuations,” Mr. Bartolo says. “You are now paying only for what they earned most recently.”

At the same time, he worries that in the economic environment expected over the next year or so, even the best growth companies will face difficulty boosting earnings.

Total Return Indexed to 100 as of December 31, 2007

S&P 500 Index

Russell Midcap Growth Index

Nasdaq Composite Index

S&P 500 Financial Sector

Russell 2000 Index


Greater StabilityIn addition to attractive valuations, large-cap stocks may offer investors more stability in what could be the worst economic environment since the Depression.

“If you are at sea, do you want to survive the passing storm in an ocean liner or a speed boat?” asks Robert Sharps, who manages growth stock portfolios for T. Rowe Price institu-tional clients. “It might not be quite as fast when you have glass-smooth waters, but you have to get through to the other side. That is what large-caps offer.

“The companies I invest in have very strong balance sheets and should be able to ride this out with limited exceptions because many of them have net cash.”

Historically, small-cap stocks have outperformed after bear markets, averaging a 48% return in the first 12 months of recovery compared with 33% for large-cap stocks based on 10 bear markets since 1962, according to Leuthold.

However, Mr. Sharps notes, small-caps have so significantly outperformed large-cap stocks in this decade that he sees a long-term change in leadership. “I don’t know if it will be in 2009, 2010, or 2011, but over the next 10 years the odds are high that there will be significant outperformance of large-cap stocks over small-cap stocks.”

Whatever their investment styles, however, T. Rowe Price managers are focused on the highest-quality companies, concentrating on those with healthy balance sheets, lots of cash, the ability to generate strong free cash flow, and the financial strength to withstand a potentially deep and prolonged economic reces-sion. (See related story on page 12.)

Technology Attractive

Looking ahead to economic improvement, perhaps in the latter half of 2009, both growth- and value-oriented managers consider the technology sector appealing. They note that the companies generally have strong balance sheets, above-average revenue growth, valuations that are near historic lows for many stocks, and that this sector has generally been among the better- performing sectors during bear market recoveries in the past.

“Technology is one of the most attractive sectors,” Mr. Sharps says. “First, many tech companies have net cash on their balance sheets. Second, their free cash flow yields are higher than they have been in a very long time. Technology stock valuations are lower relative to the cash flow they generate than they have been in 20 years.

“Unlike the consumer and hous-ing areas,” he adds, “many tech companies have already gone through the deleveraging process. There are also secular trends in terms of mobile communications, mobile data access, and Internet video where it takes heavy investment in network

technology to provide a high-quality experience. Finally, technology hasn’t always outperformed coming out of downturns, but, when it has, it has been by a wide margin. I think this will be one of those times.”

Although spending on technology has declined sharply in recent months and faces challenging conditions into 2009, “the underlying health of the industry is better than during the last downturn in 2000 because this down-turn wasn’t preceded by a bubble of spending,” says Ken Allen, manager of the Science & Technology Fund.

“When the global economy improves, tech spending should improve strongly,” Mr. Allen adds. “The value that can be gained from the use of technology, particularly leveraging the reach and capabili-ties of the Internet, should enable technology spending to grow faster than global gross domestic product (GDP) over time.”

While Mr. Allen says the magnitude and duration of the global economic downturn remains the biggest risk to investing in technology now, “valu-ations are generally appealing and reflect low expectations. Also, most

Valuations of Large-, Mid-, and Small-Cap Stocks Median Price/Earnings (P/E) Ratio as of December 31, 2008

% Below Historical Average Valuation

Growth Stocks

Value Stocks

Growth Stocks

Value Stocks

Royal Blues* 15.3x 7.7x -38% -24%

Large-Cap 17.8 8.8 -30 -23

Mid-Cap 20.5 8.0 -24 -27

Small-Cap 24.8 7.5 -22 -29

Large-cap growth stocks are considered undervalued relative to mid- and small-cap stocks, and all stock categories are cheap relative to their historical averages based on median P/E ratios since 1969.

*Royal Blue Growth consists of 33 mega-cap high P/E stocks and Royal Blue Value consists of 33 mega-cap low P/E stocks.

Source: The Leuthold Group.

Continued on page 10


managements are moving to better align their cost structures with the current reality. This cost discipline will partially offset the negative impact of weaker demand on earnings and cash flows and help to moderate downside risk in the stocks, while amplifying the upside.”

Financial Services Key

Perhaps one of the keys to a general market and economic recovery is restoring some stability and confi-dence in the much maligned financial services sector. Amid the high profile failures on Wall Street, devastation in earnings, and the global credit crunch, financial stocks on average declined 55% in 2008 after several years of market outperformance.

“Our economy is not going to contract indefinitely, and financials are the backbone and plumbing of the economy for the most part,” says Jeff Arricale, manager of the Financial Services Fund.

While he expects to see many more failures among relatively small banks, Mr. Arricale says the nation’s financial system, overall, is sound.

He remains optimistic that the liquidity infusions by the Federal Reserve Bank and U.S. Treasury and the global coordination by govern-ment authorities will help stimulate economic growth and investor confidence, despite what he consid-ers the “arbitrary” nature of the government’s decisions as to which companies get a lifeline and which ones don’t.

Mr. Arricale says the financial sector offers attractive opportuni-ties, “but you have to be selective and have a long-term horizon—at least two or three years—because in the near term the fundamentals are poor. Valuations are super—most insurance companies and investment banks are trading at discounts to

book value. But financials will prob-ably lose more money in 2009 as an industry [after record losses in 2008] due to further charges and write-offs and slow growth.”

Once an economic recovery takes hold, however, Mr. Arricale says the sector should benefit from growing earnings and book values, coupled with an expansion in price/earnings multiples. “That’s when you have the potential to double and triple your money,” he says.

Mr. Linehan sees opportunity but is concerned that financial services companies face more headwinds in the longer term. “I don’t think these companies can earn the types of returns they did before because they are likely to see more government regulation and we won’t see interest rates decline like we did for a number of years,” he observes.

Mr. Puglia favors some of the higher-quality companies in the sector but cautions that “for companies that

participate in the capital markets, whether it is a State Street Bank or a Northern Trust or Charles Schwab, you’re going to need to see stability in the credit markets and improved credit flows. For lenders like a J.P. Morgan or a Citigroup or a Wells Fargo, you need to see unemploy-ment levels stabilize.”

Looking at opportunities across the broad financial services arena, Mr. Arricale favors the property and casualty insurance companies, which represent the largest sector in the Financial Services Fund. “The balance sheets are generally quite strong, and the fundamental pros-pects are actually decent because we are seeing prices firm.”

The commercial banking industry is still profitable, but losses on mortgage and other loans are not expected to peak until late in 2009 or early 2010. Mr. Arricale says the near-term fundamentals “look very poor. For the banks, it’s about

Performance of U.S. Large- and Small-Cap Stocks After Bear Market Lows*

Performance Over Next 12 Months

Date of Bear MarketLow (Month-End)

Large-CapStocks

Small-CapStocks

Small-Cap“Beta”

June 30, 1962 31.2% 31.1% 1.00

September 30, 1966 30.6 78.4 2.56

May 31, 1970 34.7 42.8 1.23

September 30, 1974 38.1 47.9 1.26

February 28, 1978 16.6 33.8 2.03

July 31, 1982 59.4 96.2 1.62

November 30, 1987 23.2 24.4 1.05

October 31, 1990 33.5 49.5 1.48

August 31, 1998 39.8 29.8 0.75

September 30, 2002 24.4 46.4 1.90

Average 33.1% 48.0% 1.45

Small-Cap “Beta” represents the ratio of small-cap to large-cap total return in the first year following the bear market low.

*Based on performance of Ibbotson’s large- and small-company monthly total return indexes.

Source: The Leuthold Group.

Stock MarketsContinued from page 9


surviving, retaining earnings, and just growing their capital base.”

The steep declines in equity markets have dimmed near-term prospects for equity management firms, but Mr. Arricale says that the balance sheets for higher-quality firms like Charles Schwab and Franklin Resources are “top-notch” and their stocks should recover with the markets.

Finally, he considers life insurance stocks the most troubled, represent-ing the sector with the highest return potential but also the highest risk because they are the most leveraged financials and because it is uncertain how much, if any, government assistance they might receive.

Room for Optimism

T. Rowe Price managers are encouraged by the wide range of investment opportunities, but they acknowledge that 2009 could be another challenging year.

“The macroeconomic environment seems to be getting worse,” Mr. Puglia says. “We don’t necessarily need to see evidence that things are getting better, but we have to see some stabilization in credit markets and become more confident that growth in unemploy-ment is at least decelerating.”

“After a period where you had cheaper and easier credit and an asset price boom, there has to be a pretty significant adjustment,” Mr. Sharps adds. “We are probably a year into what is likely to be a multiyear adjust-ment process in terms of changes in savings rates and borrowing, and there is no easy fix for that.”

On the positive side, Mr. Sharps says that considering how far and how fast the stock markets fell toward the end of 2008, “there is a reasonable case to be made that we are at a trough.

“Sentiment is very negative— there is a lot of liquidity available to purchase stocks; valuations are very cheap even if you are conservative in your assumptions for earnings; corporate balance sheets in general are strong; and the dividend yield is relatively attractive. Once we see stabilization on the housing front, financial assets in general should offer very attractive returns,” Mr. Sharps says.

Mr. Puglia adds: “The risk/return equation favors the investor at this point. While still a longer-term concern, inflation in energy, com-modity, and many product prices has declined sharply and interest rates are likely to remain at low levels for

an extended period. Valuation of stocks is quite favorable. The third key is earnings, and overall earnings prospects have clearly deteriorated although there are some companies generating durable, consistent results.

“So, two of the three building blocks are very positive. In my view, large-cap stocks are capable of averaging a 12% to 15% annual return over the three years coming out of this downturn.”

Preston Athey, manager of the Small-Cap Value Fund, agrees.

“When you have an economic drop as severe as this one has been and with what’s been going on in the financial system, there is absolutely no way we are coming out of this recession in a meaningful way quickly,” he says. “But the stock market at some point will recover, as it always has. I feel very comfortable saying that buying stocks today should be a good invest-ment three years from now—and maybe even sooner than that.”

As of December 31, 2008, the securities mentioned by Mr. Bartolo represented 6.3% of the net assets of the Growth Stock Fund, those by Mr. Puglia represented 6.7% of the net assets of the Blue Chip Growth Fund, and those by Mr. Arricale represented 3% of the net assets of the Financial Services Fund.

Consumer Discretionary -33.38Financials -15.554Energy -34.869Utilities -55.315Information Technology -22.81Materials -39.824Industrials & Bus Svcs -43.248Telecomm Services -45.658S&P 500 Index (Total Return) -30.492Health Care -28.981Consumer Staples -37.01


Positioning Portfolios Following a Market MeltdownUsing T. Rowe Price’s rigorous approach to analyzing companies’ prospects, portfolio managers have been ever more intently focused on taking advantage of opportunities provided by extreme volatility and uncertainty in equity markets.

On the office walls of David Wal-lack, manager of the Mid-Cap Value Fund, two whiteboards underscore that effort. One lists groups of stocks that soured in 2008 relative to expectations. The other outlines the fundamental framework by which he invests in good and bad times—providing a checklist of the kinds of companies that Mr. Wallack and many other T. Rowe Price managers have sought out in this stressful environment.

These generally include firms operating in solid industries that have high barriers to entry and good profit margins, are leaders within those industries so that they have more scale and lower costs, have strong balance sheets with little debt that can withstand a pro-longed recession, have managements that pay attention to shareholders’ interests, and see opportunities to

improve their profitability in ways that aren’t difficult.

“In a way,” Mr. Wallack says, “nothing has really changed in our approach. Now is a more challeng-ing time, but we always keep good risk/reward trade-offs in mind.”

His top holdings, for example, include Nexen, Southwest Airlines, and Hershey Foods. Nexen, a Canadian oil and gas producer, has invested billions of dollars in infra-structure to eventually profit from oil sands extraction. Southwest is now the biggest U.S. airline and should take market share during this down-turn, Mr. Wallack believes. Hershey, a famous brand for more than a century, has been outperforming the market despite a recent history of management turmoil and could regain momentum with reinvestment in new products and marketing, he says.

Focus on QualityIn the large-cap arena, John Linehan, manager of the Value Fund, is taking a balanced approach, investing in such firms as Microsoft, Home Depot, 3M, and IBM. “The most defensive sec-tors are the least attractively valued,

but given the economic uncertainty it doesn’t make sense to be too aggres-sive right now either,” he says.

Larry Puglia, manager of the Blue Chip Growth Fund, also has com-bined such relatively defensive stocks as Coca-Cola and Wal-Mart with more cyclically sensitive ones, such as Hewlett-Packard and Nike, and with such quality financials as Franklin Resources and Charles Schwab.

Mr. Wallack, too, likes some finan-cials, such as “banks that didn’t get carried away in the housing bubble, always have had a strong credit culture, and have limited leverage on their balance sheet.” Among these are First Niagara Financial Group in Rochester, New York, and Com-merce Bancshares in St. Louis.

Additionally, technology stocks appeal to many T. Rowe Price man-agers across several equity classes because they are relatively cheap and may do well in a recovery. For example, Robert Sharps, who manages institutional growth stock portfolios, cites Apple, a leading innovator with good cash flow.

“Technology stocks never really recovered on a relative basis from the Internet bubble popping at the start of this decade,” Brian Berghuis, manager of the Mid-Cap Growth Fund, says. “In the United States, we have global leaders in this field that are particularly well managed.

“Right now the market is saying there is no growth prospectively for a long time,” Mr. Berghuis says. “Yet some companies have better growth prospects than others. Our aim is to position our portfolios to take advantage of that.”

Securities mentioned by Mr. Wallack make up 8.6% of the Mid-Cap Value Fund, by Mr. Linehan 5.8% of the Large-Cap Value Fund, by Mr. Puglia 6.8% of the Blue Chip Growth Fund, and by Mr. Sharps 3.1% of the Institutional Large-Cap Core Growth Fund.

Performance of Small-Cap Stocks vs. Large-Cap Stocks

move up 300 pts

100

200

300

400

600%

500

'08'06'04'02'00'98'96'94'92'90'88'86'84'82'80'78'76'74'72'70'68'66'64'62'60'58'56'54'52'50

Large-CapsBest

Recession Periods

The chart shows the relative performance of small-cap stocks to large-cap stocks. So, when the line is rising, small-caps are outperforming large-caps and when it is falling they are trailing large-caps. Small-caps have led most of this decade. Shaded areas represent periods of recession.Small-caps: Ibbotson 1950–1977; Russell 2000: 1978 to Present; Large-caps: S&P 500.Source: The Leuthold Group.

’08’02’98’94’90’86’82’78’74’70’66’62’58’54’50

Small-CapsBest

Large-CapsBest

Small-CapsGlory Days

Large-CapsBest

Small-CapsBest

Large-CapsBest

Small-CapsBest

Relative Total Return as of December 2008


International Markets Offer Attractive Valuations But Their Near-Term Outlook For Gains SubduedInternational markets fell dramati-cally and underperformed their U.S. counterparts last year for the first time since 2001 as contagion from the declining U.S. economy, frozen credit markets, and heightened risk aversion took their toll.

Developed markets overseas declined 43% on average (as mea-sured by the MSCI EAFE Index) compared with a loss of 37% in the S&P 500 Stock Index.

Part of the drop was due to cur-rency translation as most major currencies—in a reversal of the prior two years—weakened versus the U.S. dollar; the EAFE decline in local cur-rency terms was a slightly less abysmal 39.9%. (A stronger dollar on foreign exchange markets reduces interna-tional returns for U.S. investors.)

While the global outlook in 2009 faces the headwinds of decaying corporate profits and a sharp slowdown in many economies, T. Rowe Price managers believe the steep stock market downturn has generated compelling long-term investment opportunities abroad. Valuations are lower than they have been in decades and are also attractive relative to the U.S., which should ultimately lead to stronger performance for long-term investors.

“Compared with valuations historically, it’s hard to argue that stocks are not cheap now,” says Ray Mills, manager of the International Growth & Income and Overseas Stock Funds. “On most metrics they are as cheap as they were in the 1970s, and much of the credit contraction and associated economic downturn is already priced in.”

“What ultimately pulls you out of recession, of course, is growth,” Bob

Smith, manager of the International Stock Fund, says. “The timing of that in the current environment will depend on when liquidity flows back into the markets, but once the rebound comes, international equities should eventually perform far better than those in the U.S.

“Although the near-term earnings risk is slightly higher internationally—because most markets outside the U.S. didn’t start turning down until later—the international consumer has a stronger balance sheet, greater savings, and more income growth,” Mr. Smith adds. “So while market leadership could go either way in the short term, by the end of 2009, the tide should start turning. Over the next three to five years, growth outside the U.S. should be better.

“You also have to separate markets and economies,” he says, “because they don’t always move at the same time. In the same way that stock markets peaked before the economic downturn, they are likely to trough well ahead of an economic recovery. So the economy can be pretty bad for the next year or so, and the market could still go up.” He also

believes that the dollar could weaken again in 2009, boosting international returns for U.S. investors.

“Clearly, economic growth is slowing around the world,” Mr. Mills cautions, but the impact varies. “Some countries such as Germany and Japan, where exports tend to catalyze the economy and the markets, may face a tougher time than some of the more domestically oriented markets. We expect emerging market economies to continue grow-ing, albeit at a slower rate.”

Here’s a look at the outlook for various developed markets. (For a more detailed assessment of trends in emerging markets, see the story on page 15.)

Outlook for Europe

Europe’s performance in 2008 in U.S. dollars was slightly worse than the return for developed interna-tional markets overall, as the credit crunch, stressed financial companies, bursting property bubbles in some countries, and weakening global economies pushed European stocks into a tailspin. Adding insult to injury, the weakening of the euro

Total Return in U.S. Dollars Indexed to 100 as of December 31, 2007



against the U.S. dollar increased losses for U.S.-based investors.

“It was the magnitude of the financial crisis, however, rather than the region’s economic conditions, that drove European stock markets lower,” observes Dean Tenerelli, manager of the European Stock Fund.

“Nevertheless, Europe’s economic data have become discouraging, and we expect a contraction in growth this year—although markets with less consumer and government debt will be less affected. In addi-tion, little relief is being felt in the European markets from government and central bank stimulus packages, although this is partly a function of slow implementation.

“Meanwhile, credit markets remain tight and the lack of bank financing is strangling the corporate sector,” Mr. Tenerelli says. “While we do expect earnings downgrades, valuations should be somewhat supportive at these levels. If we adjust earnings downward for 2009, the market is trading below its long- term average.

“One positive sign is the strengthening dollar, which has made European goods and services more

attractive to U.S. consumers and busi-nesses. Unfortunately, with the U.S. contending with its own recession, there is not likely to be much demand from the other side of the Atlantic.”

Outlook for Japan

In a reversal of the prior two years, Japan outperformed other interna-tional markets and the U.S. market in 2008, reflecting a strong rise in the yen, even though it suffered a 29.1% decline in U.S. dollar terms. In local currency terms, however, Japan performed worse than developed markets overall, falling 42.5%.

Consumer and corporate debt lev-els in Japan are the lowest relative to gross domestic product (GDP) of the G7 group of industrialized nations. And, unlike the rest of the world, the domestic economy—outside the real estate sector—is not suffering from liquidity issues.

Nevertheless, the Japanese economy remains highly sensitive to global demand, which has slowed considerably. That has caused a contraction in Japan’s economy, a trend expected to continue over the next year amid slumping exports and shrinking capital expenditures.

Campbell Gunn, manager of the Japan Fund, further acknowledges Japan’s ample challenges. “Govern-ment debt levels are higher than the G7 average, constraining its leaders’ ability to provide fiscal stimulus. The legislature is split, making it harder to achieve the consensus that is often required in Japan to make radical changes. And, with Japan expected to return to deflation by the summer, it is hard to be optimistic about consumption for anything other than extreme value propositions and daily necessities.”

On a more positive note, Mr. Gunn notes that much of the negative sentiment is now factored into stock prices and valuations are extremely attractive, even allowing for a 25% decline in average operating profit. He also believes that foreign investors stand to benefit as the yen is poised to remain strong in response to a reduc-tion in leverage around the world.

“In the past, Japan has outper-formed as the world growth cycle bottoms and recovers, and this is likely to be repeated as the global economy comes out of its current downturn,” Mr. Gunn says. “Senti-ment is still poor but it is hard to see it getting any worse in the near term. This should support a modest recovery in equity prices.”

While international investing can provide diversification and attractive investment opportunities, investors should also realize that funds that invest overseas are generally more risky than funds that invest only in U.S. assets due to factors such as currency risk.

12/08'07'05'03'01'99'97'95'93'91'89'87'85'83'81'79'77'75

International MarketsContinued from page 13


Emerging Markets Poised to Benefit From Potential ReboundWhile all global markets suffered significant declines in 2008, the collapse of emerging markets was particularly brutal.

Decoupling—the notion that emerging markets had grown suf-ficiently independent to withstand a slowdown in developed economies—failed to take hold, and investors curbed their risk appetites.

As a result, emerging markets underperformed developed markets for the first time since 2000, falling 53.2% on average—the worst year since the index was started in 1988.

Looking ahead, T. Rowe Price managers believe the secular bull market in emerging markets will resume, although they acknowledge that this year will be a challenge in terms of economic growth, which could delay infrastructure spending and impact commodity-related segments of the market.

“Emerging markets are better positioned to withstand the slow-down than at any time in the past,” says Gonzalo Pángaro, co-manager of the Emerging Markets Stock Fund. “They have greater fiscal and monetary flexibility, and the under-lying drivers of industrialization and burgeoning consumer demand will reassert themselves. Given extremely attractive valuations, the upside is significant, though it’s hard to predict the timing.

“Unlike prior crises, the current global downturn originated in the developed world. So the key to the recovery is that we first need to see those markets begin to stabilize. Once that happens, the pace and extent of recovery in emerging markets should be larger. In three years we think investors will look back and see that 2009 was the time to be building exposure.”

Regional Review

China and India remain Asia’s growth engines, although the rapid and dramatic retreat of global capital from the region has caused damage that will take time to repair.

Their economies should benefit from falling energy prices. In addi-tion, they have stronger sovereign and corporate balance sheets than they did during the 1997 Asian financial crisis and compared with many developed markets today. Historically, earnings have also troughed earlier in Asia than in other regions.

With a sharp slowdown in global trade, China in particular needs to focus efforts on stimulating consumption to offset a slowdown in exports, says Frances Dydasco, manager of the New Asia Fund. “China remains a large and populous economy, and valuations have fallen to attractive levels. Although economic growth is slowing and won’t be as strong as investors have become accustomed to, it should remain positive and will likely be higher than in most other parts of the world.”

Latin American markets also succumbed to the global sell-off and dropped sharply last year. However, while the amount of debt and leveraging have been at the root of the problem around the world, consumer and corporate debt in Latin America’s two largest markets—Brazil and Mexico—are at much lower levels. Both countries also share proreformist governments.

“Valuations in the region’s equity markets look increasingly attractive,” says Jose Costa Buck, manager of the Latin America Fund. “We are forecasting strong earnings growth relative to other emerging market regions.”

In the Middle East, gross domestic product growth is expected to remain strong unless oil prices remain depressed, says Chris Alderson, manager of the Africa & Middle East Fund. “Valuations are at a slight pre-mium to emerging markets overall, but they have fallen significantly and are very attractive.”

Total Return in U.S. Dollars


Retirement Income: Recovering From Market Devastation

Personal Finance

The Impact of a Market Crash on Retirement Income Prospects

In the first year of retirement, portfolio losses can significantly reduce the chances of new retirees sustaining their assets over a 30-year retirement. But if retirees hold their withdrawals constant—not taking annual inflation adjustments—they can gain back a large degree of retirement security. And if stock market returns for the five years after a bear market are in line with prior rebounds from similar valuation levels (assume a 15% gross average annualized return for stocks), new retirees’ chances of not running out of money improve.

This study assumes a retiree started with a $1 million portfolio invested 55% in equities and 45% in bonds, with a planned initial withdrawal amount of $40,000— increased 3% each year thereafter. This strategy provides for a 90% likelihood of not running out of assets over a 30-year retirement.

The portfolio value drops 30% in the first year to $700,000. The retiree continues with the planned withdrawal amount of $40,000.

Likelihood That Retiree Will Not Run Out of Money

Portfolio

Increasing Withdrawals 3%

Annually for Inflation

Holding Annual Withdrawals Constant for

Next Five Years

55% Stock/45% Bond 40% 60%

Same Portfolio With Greater Equity Returns 56 74

Switch 100% to Bonds in Second Year 7 29

See important disclosures about market simulations on page 18. The overall odds of sustaining withdrawals represents the percentage of 10,000 simulations in which the investor does not run out of money during a 30-year retirement. For simulations, a gross return of 10% is used for stocks with annual fees of 1.211%. In the second scenario in the table, the assumed gross return for stocks in the second through sixth years is 15% and 10% thereafter. A gross return of 6.5% is used for bonds, with annual fees of 0.726%.

Having suffered devastating losses in their retirement nest eggs last year, those who have just retired, or are planning to, may believe that drastic action is the only way to recover a high level of retirement security—such prudent steps as going back to work or postponing retirement.

Not to downplay the negative impact of last year’s losses, but the good news remains that such drastic action may not be necessary.

A new T. Rowe Price retirement income study compared strategies for new retirees who just suffered a 30% decline in their portfolios in their first year of retirement under two different assumptions of future

stock market performance. It found they have a much higher chance of not outliving their assets over a full 30-year retirement period by holding their withdrawals constant for the next five years.

Moreover, if stock market returns in the wake of last year’s crash fol-low the historical post-bear market pattern—and are much higher than longer-term averages—holding with-drawals constant for the next five years would provide retirees an even greater probability of not running out of assets during retirement.

While not taking an annual 3% inflation adjustment in their with-drawals may be a hardship, it is a

relatively modest one compared with substantially cutting back withdraw-als after the first year (though that more aggressive action also would significantly improve retirees’ long-term security).

With inflation expected to remain modest or even decline for much of 2009 and with Social Security benefits increasing 5.8% in 2009 as a cost-of-living adjustment, this strategy may not put retirees behind in meeting their living costs—at least in the immediate term.

A similar T. Rowe Price analysis last year concluded that portfolio returns for retirees in their first five years of withdrawals are particularly crucial. The study showed, specifically, if annual cumulative returns average less than 5% for the first five years of retirement, it is much more likely that retirees may not be able to sustain their projected withdrawals for the duration of a 30-year retirement.

So, in light of last year’s more significant stock market losses, one of the firm’s senior financial planners, Christine Fahlund, examined the impact on new retirees’ chances of outliving their assets if their portfolios sustain overall losses as great as 30% in the first year of retirement. She then looked at the effectiveness of strategies for restoring retirement security after that degree of market misfortune.

The results are based on a prob-ability analysis simulating how the strategies performed under 10,000 potential market scenarios. (A detailed description of the study and important disclosures are provided on page 18.)


Coping With Big LossesThis new study examines the case of a retiree with a $1 million portfolio that remains invested 55% in equities and 45% in bonds. The retiree plans to withdraw 4% of the balance in the first year of retirement (or $40,000) and increase the annual withdrawal amount by 3% each year for infla-tion. That strategy would provide a 90% chance of not running out of assets over a 30-year retirement.

In general, Ms. Fahlund found that, if new retirees suffer first-year overall portfolio losses of 10% to 20%, they may be able to stick with their original withdrawal strategy and sustain a relatively high likeli-hood of not running out of money over the long run.

However, she found that coping with first-year losses greater than that may require a change in with-drawal strategy, such as holding withdrawals constant for at least five years or cutting back the initial withdrawal amount from what had been planned—or taking both steps together.

If this investor’s portfolio dropped by as much as 30% in the first year, for example, and she stuck to her original withdrawal plan, then her overall chance of not outliving her assets could fall from 90% to as low as 40%. But if she does not take 3% inflation adjustments for years two through six, she could restore her chances of not exhausting her assets to about 60%. (See chart on page 16.)

Banking on HistoryNo one can predict with any certainty potential market returns for 2009 and thereafter, but it may be useful to consider the possibility of higher than average stock returns in the five years immediately following last year’s big losses—in other words, simulating a stock return greater than 10%.

This analysis assumed a 15% gross average annual return over that five-year period, based on research by The Leuthold Group. That research shows that, when the stock market (as measured by the S&P 500 Index) is priced as relatively cheaply as it was near the end of 2008, the average annual return over the following

five-year period has been about 15%, based on valuation and normalized earnings patterns since 1957.

In that scenario, the probability of not running out of assets would rise to 56%—or 74% if withdrawals are held constant for five years—quite a large step back toward the level of security of 90% at which this retiree started.

Fleeing to Fixed IncomeOn the other hand, if this retiree abandoned stocks altogether for

bonds after suffering through the first-year decline, the chances of not exhausting her assets over the full retirement period would plummet to about 7%.

Even if she takes no inflation adjustments for five years, the probability with an all-bond portfolio would rise to only about

29%—more than a 70% likelihood of running out of money.

“After suffering a major market crash in their first year of retirement, it is understandable why new retirees may be frightened about staying committed to equities,” Ms. Fahlund says. “However, retirement planning is all about trade-offs—finding the right balance between an investment allocation and an appropriate withdrawal strategy.

Withdrawal Reductions Needed to Restore a 90% Chance of Sustaining Assets Over a 30-Year RetirementAfter a market crash in the first year of retirement reduces a $1 million portfolio by as much as 30%, a new retiree must reduce her planned initial withdrawal from $40,000 if she wants to restore a 90% chance of not outliving her assets. As noted in the other chart, this retiree had planned on withdrawing $40,000 at the end of the first year of retirement and increasing that amount by a 3% inflation adjustment every year thereafter.

Withdrawal Amount Needed to Restore a 90% Probability of Sustaining Assets Over

a 30-year Retirement if:

Balance of $1 Million Portfolio After One Year

Increase WithdrawalsAnnually for Inflation

Hold AnnualWithdrawals Constant

For Next Five Years

$900,000 $34,000 $39,000

800,000 31,000 35,000

700,000 27,000 30,000

See important disclosures about market simulations on page 18. For simulations, a gross return of 10% is used for stocks with annual fees of 1.211%. A gross return of 6.5% is used for bonds, with annual fees of 0.726%.

[ “…retirement planning is all about trade-offs—finding the right balance between an investment allocation and an appropriate withdrawal strategy.”

]


Monte Carlo simulations model future uncertainty. In contrast to tools generating average outcomes, Monte Carlo analyses produce outcome ranges based on probability—thus incorporating future uncertainty.

Material Assumptions Include:• Unless otherwise noted, underlying

long-term expected annual returns for the asset classes are not based on historical returns, but estimates, including reinvested dividends and capital gains.

• Expected returns—plus assumptions about asset class volatility and correlations with other classes—are used to generate random monthly returns for each class over specified time periods.

• These monthly returns are then used to generate thousands of scenarios, representing a spectrum of possible performance for the asset classes. Success rates are based on these scenarios.

• Taxes aren’t taken into account, nor are early withdrawal penalties or required minimum distributions. But fees—average expense ratios for typ-ical actively managed funds within each asset class—are subtracted from the expected annual returns.

Material Limitations Include:• Extreme market movements may

occur more often than in the model.

• Market crises can cause asset classes to perform similarly, lowering the accuracy of projected portfolio volatility and returns. Correlation assumptions are less reliable for short periods.

• The model assumes no month-to-month correlations among asset class returns. It does not reflect the average periods of “bull” and “bear” markets, which can be longer than those modeled.

• Inflation is assumed constant, so variations are not reflected in our calculations.

• The analysis does not use all asset classes. Other asset classes may be similar or superior to those used.

Model Portfolio ConstructionPortfolios used in the analysis were designed to illustrate certain prin-ciples—not necessarily for effective diversification among asset classes.

The initial withdrawal amount is the percentage of the initial value of the investments withdrawn on the first day of the year following the initial 30% drop in the portfolio’s market value. In subsequent years, the amount withdrawn grows by a 3% annual rate of inflation unless otherwise noted. Success rates are based on simulating 10,000 market scenarios and various asset allocation and withdrawal strategies. A “simula-tion success rate” is defined in these analyses as the likelihood that a par-ticular retirement income strategy will result in a portfolio with a nonzero value at the end of retirement (i.e., that will still have assets remaining in the portfolio at the end of the time horizon). The underlying long-term expected annual gross return assump-tions (without fees) are 10% for stocks (except in the scenario where a 15% gross annualized return for stocks is assumed for years two through six following a bear market) and 6.5% for intermediate-term, investment-grade bonds. Net-of-fee expected returns use these expense ratios: 1.211% for stock and 0.726% for intermediate-term, investment-grade bonds.

IMPORTANT: All information produced by the T. Rowe Price Investment Analysis Tool is a reasonable estimate and not reflective of actual investment results or predictive. The simulations are based on assumptions, so there is no guarantee that the projected results will be achieved or sustained; the potential for loss or gain may be greater than shown. The charts present a range of possible outcomes. Results may vary with each use over time and differ from the simulated scenarios.

The results are not predictions, but they should be viewed as reasonable estimates.

Explaining Monte Carlo Analysis Used in Retirement Study


Generally, we suggest that most retirees in these situations would be much better served by sticking with an allocation to equities.”

Reducing WithdrawalsHaving suffered a 30% portfolio loss in their first year of retire-ment, some new retirees still may not be satisfied with only partially restoring their original 90% chance of sustaining withdrawals during a 30-year retirement or with count-ing on a market rebound to do that for them.

In that case, they should consider reducing their annual withdrawals immediately, if feasible, to restore a 90% chance of not outliving their assets during their retirement.

As shown in the chart on page 17, a new retiree who suffered a 30% portfolio loss would have to drop her withdrawal in the second year from $40,000 to $27,000 (about 3.8% of the remaining $700,000 portfolio value) if she planned on taking annual inflation increases thereafter.

Or, the new retiree could take a slightly higher withdrawal amount in year two ($30,000 or 4.3% of the remaining $700,000) if she also were to forgo annual inflation adjustments for five years.

“This strategy involves essen-tially starting over in your retire-ment income planning based on a significantly lower nest egg value,” Ms. Fahlund says. “This simply may be unaffordable for many people and holding withdrawals constant offers a less costly and less disruptive approach that ought to be considered.”

For help in your retirement planning, we suggest you try our Retirement Income Calculator at troweprice.com/ric and request our free, comprehensive Retirement Readiness Guide by calling 1-800-638-5660.

Retirement IncomeContinued from page 17

Treasuries Rally as Stocks and Some Bond Sectors Suffer Steep Losses U.S. stocks plunged deep into bear market territory as the economic downturn and credit crunch intensified in the fourth quarter. The mid-September bankruptcy of Lehman Brothers triggered a massive sell-off in the equity market and some fixed-income sectors as investors rushed to the safety of U.S. Treasuries. The Federal Reserve and Treasury Department attempted to lessen the damage to the economy and the financial markets by taking several extraordinary actions intended to stimulate lending activity.

Very Few Segments Avoid Deep Losses

Small- and mid-cap stocks per-formed worse than their large-cap peers. As measured by various Russell indexes, growth stocks performed worse than value stocks across all market capitalizations, particularly among small-caps.

In the U.S. stock market, as measured by the Dow Jones Wilshire 5000 Composite Index, most major sectors fell sharply, but financials fared worst. Materials and energy stocks tumbled with commodity prices, while shares of information technology and industrials and business services companies, many of which depend on a healthy economy, also registered deep losses. Telecom-munication services stocks outper-formed with relatively small losses. Consumer staples and health care stocks also held up relatively well because the need for food, medicine, and other essentials is not cyclical.

Non-U.S. shares tumbled in the last three months. Stocks in emerging markets did worst, led by shares in emerging Europe. Among developed markets, European equities fell sharply, but Japanese stocks held up somewhat better in dollar terms as the yen strengthened versus the dollar.

-50 -45 -40 -35 -30 -25 -20 -15 -10 -5 0

1 year

3 mos.

Not Classified

Financials

Materials

Consumer Discretionary

Information Technology

Energy

Industrials and Business Services

Health Care

Consumer Staples

Utilities

Telecomm Services

Not Classified

Financials

Materials

Consumer Discretionary

Information Technology

Energy

Industrials and Business Services

Health Care

Consumer Staples

Utilities

Telecommunication Services

December 31, 2008T. Rowe Price Quarterly Performance Update

Equity Review



Fixed-Income Review

Flight to Safety Lifts Government-Backed Securities

Domestic bond returns were widely mixed in the fourth quarter of 2008. U.S. Treasuries performed best as the weak economy and investors’ fears of losses triggered a massive flight to safety and the Federal Reserve reduced the fed funds target rate to a range of 0% to 0.25%. Ginnie Mae mortgage-backed securities, which are backed by the full faith and credit of the U.S. government, and investment-grade corporate bonds produced moderate gains. Municipal bonds were flat, while asset-backed securities—which are backed by credit card, auto loan, or other debt payments—fell moderately. High-yield bonds plunged as credit spreads widened to record levels in anticipation of a significant increase in defaults.

Non-U.S. bonds were mixed in the fourth quarter. Emerging market debt declined sharply in dollar terms as global economic growth weakened and currencies of many developing countries tumbled versus the dollar. High-quality bonds issued in devel-oped markets produced moderate gains as investors sought relative safety in fixed-income securities.

T. Rowe Price Mutual FundsPerformance Summary

The performance information presented here includes changes in principal value, reinvested dividends, and capital gain distributions. Current performance may be lower or higher than the quoted past performance, which cannot guarantee future results. Share price, principal value, and return will vary, and you may have a gain or loss when you sell your shares. To obtain the most recent month-end performance, call us or visit our Web site. Funds are placed in general risk/return categories based on past performance or, for newer funds, on the performance of the types of securities in which they invest. There is no assurance past trends will continue.

Past Quarter, Year, and Average Annual Total ReturnsPeriods Ended December 31, 2008

TAx-EFFiciEnT FunDS

Domestic

Moderate Tax-Efficient Balanced

Returns before taxes PRTEX -11.59% -22.88% -5.32% -2.04% 0.85% (6/97) 1.0% 365 days 1.15% 2/29/08Returns after taxes on distributions – -22.92 – -2.09 0.78Returns after taxes on distributions and sale of fund shares – -14.27 – -1.42 0.99

Higher Tax-Efficient Growth

Returns before taxes PTEGX -24.91 -42.00 -12.78 -6.76 -4.17 (7/99) 1.0 365 days 1.07 2/29/08Returns after taxes on distributions – -42.02 – -6.80 -4.19Returns after taxes on distributions and sale of fund shares – -27.26 – -5.60 -3.43

Tax-Efficient Multi-Cap Growth

Returns before taxes PREFX -27.22 -43.45 -11.40 -3.66 -2.96 (12/00) 1.0 365 days 1.30 2/29/08Returns after taxes on distributions – -43.45 – -3.66 -2.96Returns after taxes on distributions and sale of fund shares – -28.24 – -3.07 -2.48

The returns presented in this table reflect the return before taxes; the return after taxes on dividends and capital gain distributions; and the return after taxes on dividends, capital gain distributions, and gains (or losses) from redemptions of shares held for 1-, 5-, and 10-year or since-inception periods, as applicable. After-tax returns reflect the highest federal income tax rate but exclude state and local taxes. The after-tax returns reflect the rates applicable to ordinary and qualified dividends and capital gains effective in 2003. During periods when a fund incurs a loss, the post-liquidation after-tax return may exceed the fund’s other returns because the loss generates a tax benefit that is factored into the result. An investor’s actual after-tax return will likely differ from those shown and depend on his or her tax situation. Past before- and after-tax returns do not necessarily indicate future performance.

Risk/R

eturn Potential

Ticker Symbol

3 Months 1 Year 3 Years 5 Years

10 Years or Since

InceptionInception

DateRedemp-tion Fee

Redemption Fee

PeriodExpense

Ratio

Expense Ratio As of Date

STock FunDS Domestic

Lower Capital Appreciation PRWCX -18.94% -27.17% -4.45% 1.45% 6.93% (6/86) 0.71% 12/31/07Dividend Growth PRDGX -20.61 -33.26 -5.94 -0.77 0.12 (12/92) 0.69 12/31/07Equity Income PRFDX -22.14 -35.75 -7.53 -1.05 2.16 (10/85) 0.67 12/31/07

Moderate Blue Chip Growth TRBCX -24.91 -42.62 -10.72 -3.81 -2.08 (6/93) 0.77 12/31/07Capital Opportunity PRCOX -21.96 -36.48 -8.06 -1.97 -1.45 (11/94) 0.74 12/31/07Equity Index 500 PREIX -21.94 -37.06 -8.58 -2.45 -1.64 (3/90) 0.5% 90 days 0.35 12/31/07Growth & Income PRGIX -22.35 -36.60 -8.30 -2.60 -0.54 (12/82) 0.70 12/31/07Growth Stock PRGFX -23.60 -42.26 -10.09 -3.11 -0.48 (4/50) 0.67 12/31/07Mid-Cap Value TRMCX -23.74 -34.57 -7.50 0.55 6.76 (6/96) 0.79 12/31/07New Era PRNEX -34.50 -50.18 -6.40 6.74 9.21 (1/69) 0.64 12/31/07Real Estate TRREX -38.77 -39.08 -12.21 1.18 7.89 (10/97) 1.0 90 days 0.74 12/31/07Small-Cap Value PRSVX -25.02 -28.61 -6.07 2.52 8.42 (6/88) 1.0 90 days 0.82 12/31/07Spectrum Growth PRSGX -24.66 -41.52 -9.57 -1.40 1.15 (6/90) 0.78 12/31/07Total Equity Market Index POMIX -22.84 -37.16 -8.59 -1.85 -0.80 (1/98) 0.5 90 days 0.40 12/31/07Value TRVLX -26.83 -39.76 -10.09 -2.28 2.18 (9/94) 0.85 12/31/07

Higher Extended Equity Market Index PEXMX -26.52 -38.50 -9.51 -0.72 1.42 (1/98) 0.5 90 days 0.40 12/31/07Financial Services PRISX -21.09 -40.06 -14.26 -5.56 2.09 (9/96) 0.91 12/31/07Mid-Cap Growth RPMGX -25.28 -39.69 -8.83 0.59 3.98 (6/92) 0.78 12/31/07New America Growth PRWAX -25.70 -38.31 -9.05 -2.70 -2.85 (9/85) 0.86 12/31/07Small-Cap Stock† OTCFX -23.83 -33.35 -9.61 -1.00 4.42 (6/56) 0.89 12/31/07

Highest Diversified Mid-Cap Growth PRDMX -27.57 -43.19 -11.14 -2.64 -2.64 (12/03) 1.16 12/31/07Diversified Small-Cap Growth PRDSX -25.70 -36.28 -10.37 -2.59 -0.59 (6/97) 1.0 90 days 1.24 12/31/07Health Sciences PRHSX -19.15 -28.77 -2.50 4.04 6.47 (12/95) 0.83 12/31/07Media & Telecommunications†† PRMTX -25.22 -46.46 -5.70 4.58 6.52 (10/93) 0.83 12/31/07New Horizons PRNHX -25.97 -38.78 -11.27 -1.62 2.47 (6/60) 0.80 12/31/07Science & Technology PRSCX -26.74 -43.80 -12.35 -6.86 -6.88 (9/87) 0.94 12/31/07

†Closed to new investors except for a direct rollover from a retirement plan into a T. Rowe Price IRA invested in this fund. ††Formerly the closed-end New Age Media Fund; converted to open-end status on 7/28/97 under a different expense structure.


T. Rowe Price Mutual FundsPerformance Summary Past Quarter, Year, and Average Annual Total ReturnsPeriods Ended December 31, 2008

Ticker Symbol


10 Years or Since

InceptionInception

DateRedemp-tion Fee

Redemption Fee

PeriodExpense

Ratio

Expense Ratio

As of Date

STock FunDS International Lower International Growth & Income TRIGX -21.75% -44.90% -8.02% 2.09% 2.57% (12/98) 2.0% 90 days 0.88% 10/31/07

Moderate European Stock PRESX -19.46 -43.35 -4.91 1.75 0.72 (2/90) 2.0 90 days 0.98 10/31/07Global Large-Cap Stock RPGEX – – – – 21.20 (10/08) 2.0 90 days 1.03 10/27/08Global Real Estate TRGRX – – – – 7.99 (10/08) 2.0 90 days 1.08 10/27/08International Equity Index PIEQX -20.09 -42.56 -6.74 1.85 0.40 (11/00) 2.0 90 days 0.51 10/31/07International Stock PRITX -26.02 -48.02 -11.07 -1.42 -1.38 (5/80) 2.0 90 days 0.85 10/31/07Overseas Stock TROSX -21.65 -45.06 – – -22.41 (12/06) 2.0 90 days 0.93 10/31/07Spectrum International PSILX -22.45 -46.39 -8.72 1.09 1.48 (12/96) 2.0 90 days 0.93 12/31/07

Higher Japan PRJPX -10.27 -31.42 -15.13 0.00 0.81 (12/91) 2.0 90 days 1.02 10/31/07

Highest Africa & Middle East TRAMX -37.91 -53.32 – – -31.86 (9/07) 2.0 90 days 1.92 10/31/07

Emerging Europe & Mediterranean

TREMX -55.04 -75.85 -25.33 -2.96 0.75 (8/00) 2.0 90 days 1.24 10/31/07

Emerging Markets Stock PRMSX -34.23 -60.54 -9.37 5.58 9.48 (3/95) 2.0 90 days 1.21 10/31/07

International Discovery PRIDX -25.11 -49.93 -9.34 3.35 10.22 (12/88) 2.0 90 days 1.21 10/31/07

Latin America PRLAX -36.35 -55.70 -0.07 17.18 14.97 (12/93) 2.0 90 days 1.20 10/31/07New Asia PRASX -22.70 -60.99 -4.05 5.78 8.66 (9/90) 2.0 90 days 0.93 10/31/07Global

Lower Global Stock PRGSX -33.53 -53.66 -11.92 -0.83 -0.09 (12/95) 2.0 90 days 0.87 10/31/07

Highest Global Technology PRGTX -24.87 -44.02 -11.28 -3.11 -9.82 (9/00) 1.19 12/31/07

BEnch- MARkS Domestic Stock

S&P 500 Stock Index -21.94% -37.00% -8.36% -2.19% -1.38%S&P MidCap 400 Index -25.55 -36.23 -8.76 -0.08 4.46Nasdaq Composite Index (principal only) -24.27 -40.54 -10.58 -4.67 -3.24Russell 2000 Index -26.12 -33.79 -8.29 -0.93 3.02Lipper IndexesLarge-Cap Core Funds -22.16 -37.07 -8.71 -2.73 -1.90Equity Income Funds -20.34 -35.40 -7.65 -1.19 0.50Small-Cap Core Funds -25.49 -35.59 -9.29 -1.01 4.06

International StockMSCI EAFE Index -19.90 -43.06 -6.92 2.10 1.18Lipper AveragesEmerging Markets Funds -29.91 -55.47 -6.77 6.04 9.16

International Large-Cap Growth Funds -21.68 -44.78 -7.79 0.79 0.75

International Small-/Mid-Cap Growth Funds -24.59 -50.53 -11.28 2.25 4.27

Risk/R

eturn Potential

BonD FunDS International

Higher Emerging Markets Bond PREMX -11.39% -17.71% -1.00% 5.49% 10.82% (12/94) 2.0% 90 days 0.96% 12/31/07International Bond RPIBX 4.58 1.77 6.40 4.26 4.39 (9/86) 2.0 90 days 0.82 12/31/07

BEnch- MARkS International Bond

Barclays Capital Global Aggregate ex U.S. Dollar Bond Index 5.66% 4.39% 7.83% 5.21% 4.73%

J.P. Morgan Emerging Markets Bond Index–Global -6.01 -10.91 1.32 5.18 10.17

Lipper AveragesEmerging Markets Debt Funds -11.34 -17.46 -1.17 3.42 10.17International Income Funds 3.65 2.00 5.00 3.93 4.99



Ticker Symbol


10 Years or Since

InceptionInception

DateRedemp-tion Fee

Redemption Fee

PeriodExpense

Ratio

Expense Ratio

As of Date

BonD FunDS Domestic Taxable

Lower Short-Term Bond PRWBX 0.02% 1.23% 3.68% 2.85% 4.23% (3/84) 0.58% 5/31/08

Moderate GNMA* PRGMX 3.19 5.62 5.34 4.50 5.23 (11/85) 0.63 5/31/08Inflation Protected Bond PRIPX -2.81 -1.82 2.95 3.71 4.73 (10/02) 0.74 5/31/08New Income PRCIX 1.62 1.41 3.94 3.85 4.96 (8/73) 0.64 5/31/08Spectrum Income RPSIX -5.40 -9.43 1.39 2.83 4.75 (6/90) 0.68 12/31/07Summit GNMA* PRSUX 3.54 6.34 5.66 4.63 5.28 (10/93) 0.60 10/31/07U.S. Bond Index PBDIX 4.57 5.44 5.35 4.41 5.65 (11/00) 0.5% 90 days 0.30 10/31/07U.S. Treasury Intermediate PRTIX 8.51 14.10 8.74 5.71 5.80 (9/89) 0.54 5/31/08

Higher Corporate Income PRPIX -1.43 -9.99 -0.69 1.46 4.07 (10/95) 0.75 5/31/08High Yield PRHYX -18.45 -24.45 -5.08 -0.49 2.80 (12/84) 1.0 90 days 0.76 5/31/08Strategic Income PRSNX – – – – 3.25 (12/08) 1.00 12/15/08U.S. Treasury Long-Term* PRULX 17.84 23.26 11.07 8.90 7.30 (9/89) 0.53 5/31/08

Domestic Tax-Free** Lower Maryland Short-Term Tax-Free

BondPRMDX 1.10 3.35 3.33 2.34 3.02 (1/93) 0.59 2/29/08

Tax-Free Short-Intermediate PRFSX 1.62 3.00 3.37 2.53 3.50 (12/83) 0.51 2/29/08

Moderate Summit Municipal Intermediate

PRSMX 1.12 0.16 2.66 2.65 3.92 (10/93) 0.50 10/31/07

Higher California Tax-Free Bond PRXCX -2.47 -6.18 0.25 1.68 3.41 (9/86) 0.52 2/29/08Georgia Tax-Free Bond GTFBX -0.74 -5.38 0.22 1.56 3.37 (3/93) 0.61 2/29/08Maryland Tax-Free Bond MDXBX -3.41 -6.67 -0.19 1.23 3.29 (3/87) 0.47 2/29/08New Jersey Tax-Free Bond NJTFX -2.02 -5.20 0.38 1.70 3.45 (4/91) 0.55 2/29/08New York Tax-Free Bond PRNYX -1.64 -5.54 0.48 1.73 3.45 (8/86) 0.53 2/29/08Summit Municipal Income PRINX -4.15 -8.04 -0.47 1.57 3.52 (10/93) 0.50 10/31/07Tax-Free High Yield PRFHX -15.99 -21.49 -6.05 -1.23 1.41 (3/85) 0.72 2/29/08Tax-Free Income PRTAX -2.17 -5.81 0.41 1.83 3.54 (10/76) 0.52 2/29/08Virginia Tax-Free Bond PRVAX 0.23 -3.82 0.93 2.01 3.73 (4/91) 0.49 2/29/08

* The market value of shares is not guaranteed by the U.S. government. ** Some income from the tax-free funds may be subject to state and local taxes and the federal alternative minimum tax.

BEnch- MARkS Domestic Bond

Barclays Capital U.S. Aggregate Index 4.58% 5.24% 5.51% 4.65% 5.63%

Barclays Capital Municipal Bond Index 0.74 -2.47 1.86 2.71 4.26

Credit Suisse High Yield -18.79 -26.17 -5.34 -0.59 2.87Lipper AveragesShort Investment-Grade Debt -2.88 -5.77 0.44 0.84 3.16Corporate Debt Funds A Rated -1.62 -5.88 0.52 1.53 3.70GNMA 2.68 5.24 5.07 4.15 4.94High Current Yield -18.31 -25.86 -6.13 -1.50 1.20Short Municipal Debt -0.75 0.12 1.92 1.66 2.85Intermediate Municipal Debt 0.02 -1.79 1.62 1.85 3.35General Municipal Debt -4.12 -9.09 -1.44 0.53 2.44

The performance information shown does not reflect the deduction of the redemption fee (if applicable); if it did, the performance would be lower. Request a prospectus or a briefer profile by calling 1-800-225-5132; each includes investment objectives, risks, fees, expenses, and other information that you should read and consider carefully before investing.

Indexes included in this update track the following: S&P 500 — 500 large-company U.S. stocks; S&P MidCap 400 — stocks of 400 mid-size U.S. companies; Nasdaq Composite (principal only) — U.S. stocks traded in the over-the-counter market; Russell 2000 — stocks of 2,000 small U.S. companies; Russell 2000 Growth — Russell 2000 companies with higher price-to-book ratios and higher forecasted growth values; Russell 1000 Growth — stocks of the 1,000 largest companies in the Russell 3000 Index with higher price-to-book ratios and higher forecasted growth values; Russell 1000 Value — stocks of the 1,000 largest companies in the Russell 3000 Index with lower price-to-book ratios and lower forecasted growth values; Russell 2000 Value — Russell 2000 companies with lower price-to-book ratios and lower forecasted growth values; MSCI EAFE — stocks of about 1,000 companies in Europe, Australasia, and the Far East; Barclays Capital U.S. Aggregate — investment-grade corporate and government bonds; Barclays Capital Municipal Bond — tax-free, investment-grade U.S. bonds; Credit Suisse High Yield — noninvestment-grade corporate U.S. bonds; Barclays Capital Global Aggregate ex U.S. Dollar Bond Index — investment-grade government, corporate, agency, and mortgage-related bonds in markets outside the U.S.; J.P. Morgan Emerging Markets Bond Index–Global — U.S. dollar-denominated Brady Bonds, Eurobonds, traded loans, and local market debt instruments issued by sovereign and quasi-sovereign entities; Lipper averages — all funds in each investment objective category; Lipper indexes — equally weighted indexes of typically the 30 largest mutual funds within their respective investment objective categories.

Risk/R

eturn Potential



Editor: Steven E. norwitz Associate Editor: Robert BenjaminStaff Writers: Brian Lewbart and heather McDonoldEditorial Board: christine Fahlund, Alan Levenson, Joseph Lynagh, Darrell Riley, Tom Siedell, Brian Sullam, Jerome Tuccille

charts and examples in this issue showing investment performance (excluding those in the Performance Update section) are for illustrative purposes only and do not reflect the performance of any T. Rowe Price fund or security. A manager’s view of the attractiveness of a company may change, and the fund could sell the holding at any time. This material should not be deemed a recommendation to buy or sell shares of any of the securities discussed. Past performance cannot guarantee future results.

T. Rowe Price Investment Services, Inc., Distributor. copyright © 2009 by T. Rowe Price Associates, Inc. All Rights Reserved.

04779_UD 78557M00-065 1/09

Risk/R

eturn Potential

Ticker Symbol

7- Day Yield


10 Years or Since

InceptionInception

DateRedemp-tion Fee

Redemp-tion Fee Period

Expense Ratio

Expense Ratio

As of Date

MonEy MARkET Taxable

Prime Reserve PRRXX 1.24% 0.52% 2.55% 3.99% 3.09% 3.20% (1/76) 0.56% 5/31/08Summit Cash Reserves TSCXX 1.36 0.56 2.69 4.12 3.23 3.36 (10/93) 0.45 10/31/07U.S. Treasury Money PRTXX 0.48 0.17 1.53 3.32 2.63 2.86 (6/82) 0.47 5/31/08

Tax-FreeCalifornia Tax-Free Money PCTXX 0.51 0.25 1.66 2.53 2.03 1.91 (9/86) 0.61 2/29/08Maryland Tax-Free Money TMDXX 0.88 0.40 1.82 2.63 2.09 1.76 (3/01) 0.53 2/29/08New York Tax-Free Money NYTXX 0.63 0.36 1.74 2.58 2.06 2.02 (8/86) 0.59 2/29/08Summit Municipal Money Market

TRSXX 0.97 0.40 2.00 2.76 2.23 2.24 (10/93) 0.45 10/31/07

Tax-Exempt Money PTEXX 0.86 0.39 1.94 2.71 2.17 2.15 (4/81) 0.47 2/29/08

An investment in money market funds is not insured or guaranteed by the FDIC or any other government agency. Although the funds seek to preserve the value of your investment at $1.00 per share, it is possible to lose money by investing in the funds. Money fund yields more closely reflect current earnings than do total returns.

BLEnDED ASSETS

Lower Personal Strategy Income PRSIX -10.97% -20.38% -2.17% 1.60% 3.45% (7/94) 0.66% 5/31/08Retirement Income TRRIX -10.00 -18.39 -1.62 1.46 4.37 (9/02) 0.55 5/31/08

Moderate Balanced RPBAX -15.68 -28.43 -4.45 0.31 2.02 (12/39) 0.66 12/31/07Personal Strategy Balanced TRPBX -16.51 -29.32 -5.20 0.41 2.67 (7/94) 0.76 5/31/08Retirement 2005 TRRFX -12.02 -22.24 -2.57 – 0.95 (2/04) 0.58 5/31/08Retirement 2010 TRRAX -14.78 -26.71 -4.10 0.81 5.13 (9/02) 0.61 5/31/08Retirement 2015 TRRGX -17.19 -30.22 -5.38 – -0.36 (2/04) 0.65 5/31/08

Higher Personal Strategy Growth TRSGX -22.24 -37.58 -8.42 -1.00 1.66 (7/94) 0.83 5/31/08Retirement 2020 TRRBX -19.28 -33.48 -6.63 -0.32 4.89 (9/02) 0.68 5/31/08Retirement 2025 TRRHX -20.90 -35.90 -7.54 – -1.38 (2/04) 0.70 5/31/08Retirement 2030 TRRCX -22.19 -37.79 -8.27 -0.97 4.76 (9/02) 0.72 5/31/08Retirement 2035 TRRJX -22.97 -38.88 -8.80 – -2.06 (2/04) 0.73 5/31/08Retirement 2040 TRRDX -22.96 -38.85 -8.78 -1.30 4.52 (9/02) 0.73 5/31/08Retirement 2045 TRRKX -22.98 -38.83 -8.78 – -5.00 (5/05) 0.73 5/31/08Retirement 2050 TRRMX -22.92 -38.80 – – -19.10 (12/06) 0.73 5/31/08Retirement 2055 TRRNX -23.02 -38.89 – – -19.16 (12/06) 0.73 5/31/08

T. RowE PRicE no-LoAD VARiABLE AnnuiTy

Blue Chip Growth Portfolio -24.89% -42.82% -11.26% -4.45% -5.32% (12/00) 0.85% 12/31/07Equity Income Portfolio -22.59 -36.46 -8.26 -1.83 1.42 (3/94) 0.85 12/31/07Equity Index 500 Portfolio -22.21 -37.69 -9.26 -3.08 -4.24 (12/00) 0.40 12/31/07Health Sciences Portfolio -19.40 -29.37 -3.58 3.06 1.20 (12/00) 0.95 12/31/07International Stock Portfolio -26.81 -48.99 -12.11 -2.38 -2.41 (3/94) 1.05 12/31/07Limited-Term Bond Portfolio 0.11 1.03 3.12 2.21 3.61 (5/94) 0.70 12/31/07Mid-Cap Growth Portfolio -25.40 -40.08 -9.44 -0.05 3.37 (12/96) 0.85 12/31/07New America Growth Portfolio -25.63 -38.58 -9.48 -3.20 -3.35 (3/94) 0.85 12/31/07Personal Strategy Balanced Portfolio -17.26 -30.26 -6.02 -0.29 2.09 (12/94) 0.90 12/31/07Prime Reserve Portfolio 1.86% 0.49 2.14 3.48 2.59 2.72 (12/96) 0.55 12/31/07

Request a prospectus for the portfolios or the T. Rowe Price Variable Annuity contract by calling 1-800-225-5132; each includes investment objectives, risks, fees, expenses, and other information that you should read and consider carefully before investing. The T. Rowe Price No-Load Variable Annuity is issued by Security Benefit Life Insurance Company (Form V6021). In New York, it is issued by First Security Benefit Life Insurance and Annuity Company of New York, White Plains, New York (FSB201(11-96)). (Security Benefit Life is not licensed in New York and does not solicit business in New York.) Variable Annuity subaccount performance reflects a hypothetical contract and includes the effects of mortal-ity and expense risk charges. The inception date relates to the date the portfolios were available as investment options in the Variable Annuity. The Variable Annuity, which has been available since April 1995, and in New York since November 1995, has limitations; contact your representative. It is distributed by T. Rowe Price Investment Services, Inc., T. Rowe Price Insurance Agency, Inc., and T. Rowe Price Insurance Agency of Texas, Inc. The underlying portfolios are managed by T. Rowe Price (T. Rowe Price International for the International Stock Portfolio). The Security Benefit Group of companies and the T. Rowe Price companies are not affiliated. The Variable Annuity may not be available in all states.


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epo RiceRt - T. Rowe Price · Horizons Fund—a small-cap growth portfolio—observes, “The bottom-ing process can be brutal for inves-tors. But I am relatively optimistic. Investors