**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON, D.C. 20549**

 

**FORM 10-Q**

 

**(Mark One)**

 
| **ý** **QUARTERLY REPORT  PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF  1934** |
|-------------------------------------------------------------------------------------------------------------------------|
|                                                                                                                    |
| **For the  quarterly period ended December 31, 2005**                                                              |
|                                                                                                                    |
| **Or**                                                                                                                  |
|                                                                                                                    |
| **o****TRANSITION REPORT PURSUANT TO  SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**            |

 

**For the transition period from                                                             to                                                                         **

 

**CommissionFile Number: 001-16159**

 

**WATSON WYATT WORLDWIDE, INC.**

(Exact name of registrant asspecified in its charter)

 
| **Delaware**                                                    | ** ** | **52-2211537**                        |
|-----------------------------------------------------------------|------------|---------------------------------------|
| (State or  other jurisdiction of incorporation or organization) |       | (I.R.S.  Employer Identification No.) |
|                                                            |       |                                  |
| **901 N.  Glebe Rd., Arlington, VA**                            | ** ** | **22203**                             |
| (Address of  principal executive offices)                       |       | (Zip Code)                            |

 

**703-258-8000**

(Registrant’s telephone number,including area code)

 

**Watson Wyatt & Company Holdings**

(Former name, former addressand former fiscal year, if changed since last report)

 

Indicate by check mark whether the registrant(1) has filed all reports required to be filed by Section 13 or 15(d) ofthe Securities Exchange Act of 1934 during the preceding 12 months (or for suchshorter period that the registrant was required to file such reports), and (2) hasbeen subject to such filing requirements for the past 90 days.

 

Yes  ý             No  o

 

Indicate by check mark whetherthe registrant is a large accelerated filer, an accelerated filer, or anon-accelerated filer.  See definition of “accelerated filer and largeaccelerated filer” in Rule 12b-2 of the Exchange Act.  (Check one):

 
| Large  accelerated filer ý |   | Accelerated  filer o |   | Non-accelerated  filer o |
|---------------------------------|--------|----------------------|--------|--------------------------|

 

Indicate by check mark whether the registrantis a shell company (as defined in Rule 12b-2 of the Exchange Act).

 

Yes o             No  ý

 

Indicate the number of shares outstanding ofeach of the issuer’s classes of common stock, as of the latest practicabledate.

 
| **Class**                                 | ** ** | **Outstanding at January 31, 2006** |
|-------------------------------------------|------------|------------------------------------------|
| Class A Common Stock, $.01 par value |       | 42,214,646 shares                        |

 

 

----

 

**WATSONWYATT WORLDWIDE, INCINDEX TO FORM 10-Q**

 

For the Three and Six MonthsEnded December 31, 2005

 
| PART I.   | FINANCIAL INFORMATION                                                                                        |   |
|----------------|--------------------------------------------------------------------------------------------------------------|--------|
|           |                                                                                                         |   |
| Item 1.        | Financial Statements (Unaudited)                                                                             |   |
|           |                                                                                                         |   |
|           | Consolidated Statements of Operations—Three and six months ended December 31,  2005 and 2004       |   |
|           |                                                                                                         |   |
|           | Consolidated Balance Sheets—December 31, 2005 and June 30,  2005                              |   |
|           |                                                                                                         |   |
|           | Consolidated Statements of Cash Flows—Six months ended  December 31, 2005 and 2004                 |   |
|           |                                                                                                         |   |
|           | Consolidated Statement of Changes in Stockholders’ Equity—Six months  ended December 31, 2005 |   |
|           |                                                                                                         |   |
|           | Notes to the Consolidated Financial Statements                                                               |   |
|           |                                                                                                         |   |
| Item 2.        | Management’s Discussion and Analysis of  Financial Condition and Results of Operations                  |   |
|           |                                                                                                         |   |
| Item 3.        | Quantitative and Qualitative Disclosures  About Market Risk                                                  |   |
|           |                                                                                                         |   |
| Item 4.        | Controls and Procedures                                                                                      |   |
|           |                                                                                                         |   |
|           |                                                                                                         |   |
| PART II.  | OTHER INFORMATION                                                                                            |   |
|           |                                                                                                         |   |
| Item 1.        | Legal Proceedings                                                                                            |   |
|           |                                                                                                         |   |
| Item 1A.       | Risk Factors                                                                                                 |   |
|           |                                                                                                         |   |
| Item 2.        | Unregistered Sales of Equity Securities and  Use of Proceeds                                                 |   |
|           |                                                                                                         |   |
| Item 3.        | Defaults Upon Senior Securities                                                                              |   |
|           |                                                                                                         |   |
| Item 4.        | Submission of Matters to a Vote of Security  Holders                                                         |   |
|           |                                                                                                         |   |
| Item 5.        | Other Information                                                                                            |   |
|           |                                                                                                         |   |
| Item 6.        | Exhibits                                                                                                     |   |
|           |                                                                                                         |   |
| Signatures     |                                                                                                         |   |
|           |                                                                                                         |   |
| Certifications |                                                                                                         |   |

 

----

 

**WATSON WYATT WORLDWIDE, INC.**

**Consolidated Statements of Operations**

(Thousandsof U.S. Dollars, Except Per Share Data)

 
| ** **                                                                                                                                       | ** ** | **Three months ended December 31** | ** ** | **Six months ended December 31** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------------|------------|----------------------------------|------------|
| ** **                                                                                                                                       | ** ** | **2005**                           | ** ** | **2004**                         | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                                                                                                                       | ** ** | **(Unaudited)**                    | ** ** | **(Unaudited)**                  | ** ** |
|                                                                                                                                             |       |                               |       |                             |       |   |   |   |   |
| Revenue                                                                                                                                          |       | $                                  | 315,764    |                             | $          | 175,849 |   | $ | 581,650 |   | $ | 351,240 |   |
|                                                                                                                                             |       |                               |       |                             |       |   |   |   |   |
| Costs of providing services:                                                                                                                     |       |                               |       |                             |       |   |   |   |   |
| Salaries and employee benefits                                                                                                                   |       | 175,207                            |       | 95,194                           |       | 322,757 |   | 192,270 |   |
| Professional and subcontracted services                                                                                                          |       | 19,595                             |       | 11,544                           |       | 38,606 |   | 23,523 |   |
| Occupancy, communications and other                                                                                                              |       | 43,687                             |       | 27,901                           |       | 76,540 |   | 52,001 |   |
| General and administrative expenses                                                                                                              |       | 37,206                             |       | 19,481                           |       | 68,595 |   | 36,369 |   |
| Depreciation and amortization                                                                                                                    |       | 11,132                             |       | 4,810                            |       | 20,809 |   | 9,493 |   |
|                                                                                                                                             |       | 286,827                            |       | 158,930                          |       | 527,307 |   | 313,656 |   |
|                                                                                                                                             |       |                               |       |                             |       |   |   |   |   |
| Income from operations                                                                                                                           |       | 28,937                             |       | 16,919                           |       | 54,343 |   | 37,584 |   |
|                                                                                                                                             |       |                               |       |                             |       |   |   |   |   |
| Income from affiliates                                                                                                                           |       | 71                                 |       | 2,724                            |       | 1,422 |   | 4,930 |   |
| Interest (expense)/income, net                                                                                                                   |       | (974                               | )          | 407                              |       | (1,062 | ) | 862 |   |
| Other non-operating loss                                                                                                                         |       | (288                               | )          | (56                              | )          | (2,150 | ) | (28 | ) |
|                                                                                                                                             |       |                               |       |                             |       |   |   |   |   |
| Income from continuing operations before  income taxes                                                                                           |       | 27,746                             |       | 19,994                           |       | 52,553 |   | 43,348 |   |
|                                                                                                                                             |       |                               |       |                             |       |   |   |   |   |
| Provision for income taxes                                                                                                                       |       | 10,571                             |       | 8,939                            |       | 21,486 |   | 18,542 |   |
|                                                                                                                                             |       |                               |       |                             |       |   |   |   |   |
| Income from continuing operations                                                                                                                |       | 17,175                             |       | 11,055                           |       | 31,067 |   | 24,806 |   |
|                                                                                                                                             |       |                               |       |                             |       |   |   |   |   |
| Discontinued operations:                                                                                                                         |       |                               |       |                             |       |   |   |   |   |
|                                                                                                                                             |       |                               |       |                             |       |   |   |   |   |
| Sublease income from discontinued  operations, less applicable income tax expense for the three and six months  ended December 31, 2005 and 2004 |       | 8                                  |       | 6                                |       | 17 |   | 8 |   |
|                                                                                                                                             |       |                               |       |                             |       |   |   |   |   |
| Net income                                                                                                                                       |       | $                                  | 17,183     |                             | $          | 11,061 |   | $ | 31,084 |   | $ | 24,814 |   |
|                                                                                                                                             |       |                               |       |                             |       |   |   |   |   |
| Basic earnings per share:                                                                                                                        |       |                               |       |                             |       |   |   |   |   |
| Income from continuing operations                                                                                                                |       | $                                  | 0.41       |                             | $          | 0.34 |   | $ | 0.77 |   | $ | 0.76 |   |
| Income from discontinued operations                                                                                                              |       | —                             |       | —                           |       | — |   | — |   |
| Net income                                                                                                                                       |       | $                                  | 0.41       |                             | $          | 0.34 |   | $ | 0.77 |   | $ | 0.76 |   |
|                                                                                                                                             |       |                               |       |                             |       |   |   |   |   |
| Diluted earnings per share:                                                                                                                      |       |                               |       |                             |       |   |   |   |   |
| Income from continuing operations                                                                                                                |       | $                                  | 0.41       |                             | $          | 0.34 |   | $ | 0.76 |   | $ | 0.76 |   |
| Income from discontinued operations                                                                                                              |       | —                             |       | —                           |       | — |   | — |   |
| Net income                                                                                                                                       |       | $                                  | 0.41       |                             | $          | 0.34 |   | $ | 0.76 |   | $ | 0.76 |   |
|                                                                                                                                             |       |                               |       |                             |       |   |   |   |   |
| Weighted average shares of common stock, basic  (000)                                                                                            |       | 42,147                             |       | 32,516                           |       | 40,494 |   | 32,437 |   |
| Weighted average shares of common stock, diluted  (000)                                                                                          |       | 42,391                             |       | 32,807                           |       | 40,748 |   | 32,737 |   |

 

Seeaccompanying notes to the

consolidatedfinancial statements

 

1

----

 

**WATSON WYATT WORLDWIDE, INC.**

**Consolidated Balance Sheets**

(Thousandsof U.S. Dollars, Except Share and Per Share Data)

 
| ** **                                                                                                | ** ** | **December 31,** | ** ** | **June 30,** | ** ** |
|-----------------------------------------------------------------------------------------------------------|------------|------------------|------------|--------------|------------|
| ** **                                                                                                | ** ** | **2005**         | ** ** | **2005**     | ** ** |
| ** **                                                                                                | ** ** | **(Unaudited)**  | ** ** | ** **   | ** ** |
| **Assets**                                                                                                | ** ** | ** **       | ** ** | ** **   | ** ** |
| Cash and cash equivalents                                                                                 |       | $                | 79,822     |         | $          | 168,076 |   |
| Receivables from clients:                                                                                 |       |             |       |         |       |
| Billed, net of allowances of $4,807 and  $2,114                                                           |       | 176,823          |       | 95,977       |       |
| Unbilled, net of allowances of $5,664 and  $264                                                           |       | 105,474          |       | 62,840       |       |
|                                                                                                      |       | 282,297          |       | 158,817      |       |
| Deferred income taxes                                                                                     |       | 12,809           |       | 24,718       |       |
| Other current assets                                                                                      |       | 52,130           |       | 12,599       |       |
| Total current assets                                                                                      |       | 427,058          |       | 364,210      |       |
|                                                                                                      |       |             |       |         |       |
| Investment in affiliates                                                                                  |       | 9,774            |       | 30,857       |       |
| Fixed assets, net                                                                                         |       | 122,327          |       | 94,033       |       |
| Deferred income taxes                                                                                     |       | 119,074          |       | 92,915       |       |
| Goodwill                                                                                                  |       | 303,278          |       | 21,888       |       |
| Intangible assets                                                                                         |       | 178,393          |       | 776          |       |
| Other assets                                                                                              |       | 6,673            |       | 14,000       |       |
|                                                                                                      |       |             |       |         |       |
| **Total Assets**                                                                                          |       | $                | 1,166,577  |         | $          | 618,679 |   |
| ** **                                                                                                | ** ** | ** **       | ** ** | ** **   | ** ** |
| **Liabilities**                                                                                           | ** ** | ** **       | ** ** | ** **   | ** ** |
| Accounts payable and accrued liabilities,  including discretionary compensation                           |       | $                | 233,653    |         | $          | 122,621 |   |
| Deferred income taxes                                                                                     |       | —           |       | 283          |       |
| Income taxes payable                                                                                      |       | 13,544           |       | 4,648        |       |
| Total current liabilities                                                                                 |       | 247,197          |       | 127,552      |       |
|                                                                                                      |       |             |       |         |       |
| Note payable                                                                                              |       | 75,000           |       | —       |       |
| Accrued retirement benefits                                                                               |       | 257,911          |       | 205,029      |       |
| Deferred rent and accrued lease losses                                                                    |       | 20,855           |       | 18,701       |       |
| Deferred income taxes                                                                                     |       | 353              |       | 370          |       |
| Other noncurrent liabilities                                                                              |       | 69,170           |       | 32,824       |       |
|                                                                                                      |       |             |       |         |       |
| **Total Liabilities**                                                                                     |       | 670,486          |       | 384,476      |       |
|                                                                                                      |       |             |       |         |       |
| Commitments and contingencies                                                                             |       |             |       |         |       |
|                                                                                                      |       |             |       |         |       |
| **Stockholders’ Equity**                                                                             |       |             |       |         |       |
| Preferred Stock - No par value:                                                                           |       |             |       |         |       |
| 1,000,000 shares authorized; none issued  and outstanding                                                 |       | —           |       | —       |       |
| Class A Common Stock - $.01 par value:                                                                    |       |             |       |         |       |
| 99,000,000 shares authorized; 42,463,451  and 33,372,880 issued and 42,146,298 and 32,627,226 outstanding |       | 425              |       | 334          |       |
| Additional paid-in capital                                                                                |       | 386,491          |       | 147,948      |       |
| Treasury stock, at cost - 317,153 and  745,654 shares                                                     |       | (8,094           | )          | (18,705      | )          |
| Retained earnings                                                                                         |       | 192,841          |       | 168,075      |       |
| Accumulated other comprehensive loss                                                                      |       | (75,572          | )          | (63,449      | )          |
| **Total Stockholders’ Equity**                                                                       |       | 496,091          |       | 234,203      |       |
|                                                                                                      |       |             |       |         |       |
| **Total Liabilities and Stockholders’ Equity**                                                       |       | $                | 1,166,577  |         | $          | 618,679 |   |

 

See accompanying notes to the

consolidated financial statements

 

2

----

 

**WATSON WYATT WORLDWIDE, INC.**

**Consolidated Statements of Cash Flows**

(Thousands of U.S. Dollars)

 
| ** **                                                                     | ** ** | **Six months ended December 31** | ** ** |
|--------------------------------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                                                     | ** ** | **2005**                         | ** ** | **2004** | ** ** |
| ** **                                                                     | ** ** | **(Unaudited)**                  | ** ** |
| Cash flows from (used in) operating  activities:                               |       |                             |       |   |   |
| Net income                                                                     |       | $                                | 31,084     |   | $ | 24,814 |   |
| Adjustments to reconcile net income to net  cash used in operating activities: |       |                             |       |   |   |
| Loss on foreign currency forward contract                                      |       | 3,602                            |       | — |   |
| Provision for doubtful receivables from  clients                               |       | 4,014                            |       | 3,841 |   |
| Depreciation                                                                   |       | 17,099                           |       | 9,344 |   |
| Amortization of intangible assets                                              |       | 3,710                            |       | 149 |   |
| Provision for deferred income taxes                                            |       | 11,337                           |       | 3,689 |   |
| Income from affiliates                                                         |       | (1,422                           | )          | (4,930 | ) |
| Distributions from affiliates                                                  |       | 1,599                            |       | 3,069 |   |
| Other, net                                                                     |       | (670                             | )          | 200 |   |
| Changes in operating assets and liabilities  (net of discontinued operations)  |       |                             |       |   |   |
| Receivables from clients                                                       |       | (14,395                          | )          | 1,435 |   |
| Other current assets                                                           |       | (10,101                          | )          | (11,598 | ) |
| Other assets                                                                   |       | (605                             | )          | 984 |   |
| Accounts payable and accrued liabilities                                       |       | (33,297                          | )          | (18,566 | ) |
| Income taxes payable                                                           |       | (4,181                           | )          | (15,715 | ) |
| Accrued retirement benefits                                                    |       | (3,472                           | )          | 4,419 |   |
| Deferred rent and accrued lease losses                                         |       | 1,570                            |       | 203 |   |
| Other noncurrent liabilities                                                   |       | 2,099                            |       | (887 | ) |
| Cash flows from operating activities:                                          |       | 7,971                            |       | 451 |   |
|                                                                           |       |                             |       |   |   |
| Cash flows (used in) from investing  activities:                               |       |                             |       |   |   |
| Purchases of marketable securities                                             |       | —                           |       | (306,500 | ) |
| Sales and maturities of marketable  securities                                 |       | —                           |       | 296,250 |   |
| Acquisitions                                                                   |       | (134,137                         | )          | (517 | ) |
| Purchases of fixed assets                                                      |       | (14,397                          | )          | (12,057 | ) |
| Capitalized software costs                                                     |       | (14,982                          | )          | (6,727 | ) |
| Proceeds from divestitures                                                     |       | 1,452                            |       | (28 | ) |
| Cash flows used in investing activities:                                       |       | (162,064                         | )          | (29,579 | ) |
|                                                                           |       |                             |       |   |   |
| Cash flows from (used in) financing  activities                                |       |                             |       |   |   |
| Borrowings                                                                     |       | 102,000                          |       | — |   |
| Repayments of borrowings                                                       |       | (27,000                          | )          | — |   |
| Foreign currency forward contract                                              |       | (8,405                           | )          | — |   |
| Dividends paid                                                                 |       | (6,318                           | )          | (4,857 | ) |
| Repurchases of common stock                                                    |       | (2,470                           | )          | (4,188 | ) |
| Issuances of common stock - exercises of  stock options                        |       | 1,380                            |       | 1,148 |   |
| Issuances of common stock - employee stock  purchase plan                      |       | 3,333                            |       | 3,632 |   |
| Cash flows from (used in) financing  activities                                |       | 62,520                           |       | (4,265 | ) |
|                                                                           |       |                             |       |   |   |
| Effect of exchange rates on cash                                               |       | 3,319                            |       | 1,285 |   |
|                                                                           |       |                             |       |   |   |
| Decrease in cash and cash equivalents                                          |       | (88,254                          | )          | (32,108 | ) |
|                                                                           |       |                             |       |   |   |
| Cash and cash equivalents at beginning of  period                              |       | 168,076                          |       | 136,940 |   |
|                                                                           |       |                             |       |   |   |
| Cash and cash equivalents at end of period                                     |       | $                                | 79,822     |   | $ | 104,832 |   |

 

See accompanying notes to the

consolidated financial statements

 

3

----

 

**WATSON WYATT WORLDWIDE, INC.**

**Consolidated Statement of Changes in Stockholders' Equity**

(Thousandsof U.S. Dollars)

 
| ** **                                                       | ** ** | **Class A**     | ** ** | ** **  | ** ** | ** **     | ** ** | ** **   | ** ** | ** **   | ** ** | ** **        | ** ** | ** ** | ** ** |
|------------------------------------------------------------------|------------|-----------------|------------|-------------|------------|----------------|------------|--------------|------------|--------------|------------|-------------------|------------|------------|------------|
| ** **                                                       | ** ** | **Common**      | ** ** | ** **  | ** ** | ** **     | ** ** | ** **   | ** ** | ** **   | ** ** | ** **        | ** ** | ** ** | ** ** |
| ** **                                                       | ** ** | **Stock**       | ** ** | ** **  | ** ** | ** **     | ** ** | ** **   | ** ** | ** **   | ** ** | **Accumulated**   | ** ** | ** ** | ** ** |
| ** **                                                       | ** ** | **Outstanding** | ** ** | **Class A** | ** ** | **Additional** | ** ** | **Treasury** | ** ** | ** **   | ** ** | **Other**         | ** ** | ** ** | ** ** |
| ** **                                                       | ** ** | **(number  of** | ** ** | **Common**  | ** ** | **Paid-in**    | ** ** | **Stock,**   | ** ** | **Retained** | ** ** | **Comprehensive** | ** ** | ** ** | ** ** |
| ** **                                                       | ** ** | **shares)**     | ** ** | **Stock**   | ** ** | **Capital**    | ** ** | **at Cost**  | ** ** | **Earnings** | ** ** | **(Loss)/Income** | ** ** | **Total**  | ** ** |
| Balance at June  30, 2005                                        |       | 32,627          |       | $           | 334        |           | $          | 147,948      |       | $            | (18,705    | )                 | $          | 168,075    |       | $ | (63,449 | ) | $ | 234,203 |   |
|                                                             |       |            |       |        |       |           |       |         |       |         |       |              |       |       |       |
| Comprehensive  income:                                           |       |            |       |        |       |           |       |         |       |         |       |              |       |       |       |
| Net income                                                       |       |            |       |        |       |           |       |         |       | 31,084       |       |              |       | 31,084     |       |
| Additional  minimum pension liability                            |       |            |       |        |       |           |       |         |       |         |       | 213               |       | 213        |       |
| Foreign currency  translation adjustment                         |       |            |       |        |       |           |       |         |       |         |       | (12,336           | )          | (12,336    | )          |
| Total  comprehensive income                                      |       |            |       |        |       |           |       |         |       |         |       |              |       | 18,961     |       |
| Cash dividends  declared                                         |       |            |       |        |       |           |       |         |       | (6,318       | )          |              |       | (6,318     | )          |
| Repurchases of  common stock                                     |       | (92             | )          |        |       |           |       | (2,470       | )          |         |       |              |       | (2,470     | )          |
| Issuances of  common stock - employee stock purchase plan shares |       | 131             |       |        |       | 39             |       | 3,295        |       |         |       |              |       | 3,334      |       |
| Issuances of  common stock - deferred stock units                |       | 177             |       |        |       | 329            |       | 4,448        |       |         |       |              |       | 4,777      |       |
| Issuances of  common stock to outside directors                  |       | 11              |       |        |       | 10             |       | 282          |       |         |       |              |       | 292        |       |
| Issuances of  common stock - stock options                       |       | 108             |       |        |       | (1,348         | )          | 2,728        |       |         |       |              |       | 1,380      |       |
| Acquisition of  WWLLP                                            |       | 9,091           |       | 91          |       | 238,627        |       |         |       |         |       |              |       | 238,718    |       |
| Other business  acquisition                                      |       | 93              |       |        |       | 172            |       | 2,328        |       |         |       |              |       | 2,500      |       |
| Non-qualified  stock option expense                              |       |            |       |        |       | 261            |       |         |       |         |       |              |       | 261        |       |
| Tax benefit of  exercises of stock options                       |       |            |       |        |       | 453            |       |         |       |         |       |              |       | 453        |       |
|                                                             |       |            |       |        |       |           |       |         |       |         |       |              |       |       |       |
| Balance at  December 31, 2005 (unaudited)                        |       | 42,146          |       | $           | 425        |           | $          | 386,491      |       | $            | (8,094     | )                 | $          | 192,841    |       | $ | (75,572 | ) | $ | 496,091 |   |

 

See accompanying notes to the

consolidated financial statements

 

4

----

 

**WATSONWYATT WORLDWIDE, INC.**

** **

**Notes to the Consolidated Financial Statements**(Tabular amounts are in thousands, except per sharedata)

(Unaudited)

 

**Note 1 – Basis of Presentation.**

 

The accompanying unaudited quarterly consolidated financial statementsof Watson Wyatt Worldwide, Inc. and our subsidiaries (collectivelyreferred to as “we,” “Watson Wyatt,” “Watson Wyatt Worldwide” or the “company”)are presented in accordance with the rules and regulations of theSecurities and Exchange Commission (“SEC”) for quarterly reports on Form 10-Q.  In the opinion of management, these financialstatements reflect all adjustments, consisting only of normal recurringadjustments, which are necessary for a fair presentation of the consolidatedfinancial statements for the interim periods. The consolidated financial statements should be read in conjunction withthe audited consolidated financial statements and notes thereto contained inthe company’s Annual Report on Form 10-K for the fiscal year ended June 30,2005, which is filed with the SEC and may be accessed via EDGAR on the SEC’sweb site at www.sec.gov.

 

The results of operations for the six months ended December 31,2005 are not necessarily indicative of the results that can be expected for theentire fiscal year ending June 30, 2006. The results reflect certain estimates, including estimated bonuses andanticipated tax liabilities.

 

**Note 2 – Business Combination.**

 

On July 31,2005, the company acquired substantially all of the assets and assumed mostliabilities of Watson Wyatt LLP (the “aquisition of WWLLP”), a leading UnitedKingdom-based actuarial, benefits and human resources consultingpartnership.  The company and WWLLP hadjointly offered services since 1995 pursuant to alliance agreements and as aresult, have business segments that are very similar in nature.  See Note 3 for further information regardingthe operating segments of the combined company.

 

WWLLP’soperations were assumed by the company’s principal U.K. subsidiary, WatsonWyatt Limited, thereby strengthening Watson Wyatt’s global market presence. Thepurchase price of $432.6 million consisted of £88.3 million in cash, or $156.1million at the exchange rate in effect at August 1, 2005, the issuance of9,090,571 shares of the company’s common stock valued at $238.7 million,transaction costs of $14.6 million and additional consideration including debtforgiveness and investment elimination. The shares paid were valued at $26.26 per share, the average marketprice of the company’s stock over the two-day period before and after the termsof the acquisition were agreed to and announced on January 18, 2005.  In addition, a further 1,950,000 shares maybe paid as additional consideration after June 30, 2007, contingent uponthe achievement by the acquired business of certain agreed-upon financialperformance goals.  Watson Wyatt Limited’sresults of operations are included in the consolidated financial statementsbeginning August 1, 2005.

 

*Accountingand Goodwill Allocation*

 

The businesscombination has been accounted for using the purchase method of accounting asprescribed in Statement of Financial Accounting Standards No. 141, “BusinessCombinations” (SFAS 141), where the assets acquired and liabilities assumed arerecorded at their respective fair values as of the combination date.  As of the date of combination, the companydetermined the following estimated fair values for the proportionate assetspurchased and liabilities assumed.  Thedetermination of estimated fair value requires management to make significantestimates and assumptions. The company hired an independent third party toassist in the valuation of assets. Although the company does not anticipate any significant adjustments, tothe extent that the estimates used need to be refined, the company will do soupon making that determination but not later than one year from the date ofcombination.

 

5

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| ** **                              | ** ** | **August 1, 2005** | ** ** |
|-----------------------------------------|------------|-------------------------|------------|
| ** **                              | ** ** | **(in thousands)**      | ** ** |
| Total  purchase price                   |       |                    |       |   | $ | 432,618 |   |
| Less net assets acquired:               |       |                    |       |   |   |
| Trademark and trade name                |       | $                       | 108,000    |   |   |   |
| Customer related intangibles            |       | 60,600                  |       |   |   |
| Core/developed technology               |       | 17,500                  |       |   |   |
| Cash and cash equivalents               |       | 26,419                  |       |   |   |
| Client receivables and unbilled revenue |       | 94,324                  |       |   |   |
| Other current assets                    |       | 40,892                  |       |   |   |
| Fixed assets                            |       | 11,270                  |       |   |   |
| Other assets                            |       | 3,368                   |       |   |   |
| Current liabilities                     |       | (138,785                | )          |   |   |
| Accrued retirement benefits             |       | (43,064                 | )          |   |   |
| Other non current liabilities           |       | (29,240                 | )          |   |   |
|                                    |       |                    |       | 151,284 |   |
| Preliminary  allocation of goodwill     |       |                    |       | $ | 281,334 |   |

 

Thepreliminary allocation of the purchase price resulted in the allocation of$280.7 million to goodwill, which has been assigned to our segments as follows:

 
| ** **                                     | ** ** | **Goodwill** | ** ** |
|------------------------------------------------|------------|--------------|------------|
| Benefits                                       |       | $            | 136,166    |   |
| Technology  and Administration Solutions Group |       | 39,949       |       |
| Human  Capital Group                           |       | 16,036       |       |
| Insurance &  Financial Services Group |       | 52,047       |       |
| Investment  Consulting Group                   |       | 37,136       |       |
| Allocation  of goodwill to business segments   |       | $            | 281,334    |   |

 

The majorityof the goodwill will be deductible in the U.S. and the U.K.

 

*HedgeTreatment*

 

During thethird quarter of fiscal year 2005, the company entered into a foreign currencyforward contract to offset the risk associated with the foreign exchange(British Pound) exposure inherent in the combination.  The forward contract provided for thepurchase of £88 million at a fixed price of $164.5 million, with a settlementdate of July 29, 2005.  Inaccordance with Statement of Financial Accounting Standards No. 133, “Accountingfor Derivative Instruments and Hedging Activities” (SFAS 133), as amended andinterpreted, since the forward contract was associated with a businesscombination that is subject to the provisions of SFAS 141 and the combinationinvolved an equity method investment, the forward contract did not qualify forhedge accounting.  As a result, changesin fair value associated with the forward contract were required to be recognizedin the Consolidated Statement of Operations. Consequently, a loss of $3.6 million was recognized during the firstquarter of fiscal year 2006 and included in other non-operating income.  Losses recognized under this forward contractsince inception of the contract totaled $8.4 million.

 

6

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*Pro FormaFinancial Information*

 

The followingunaudited pro forma combined statements of operations have been provided topresent illustrative combined unaudited statements of operations for the threeand six month periods ended December 31, 2005 and 2004, giving effect tothe combination as if it had been completed on July 1, 2005 and 2004,respectively.  The unaudited historicalcombined statement of operations for the three month period ended December 31,2005 reflects the actual financial results of the combined company.  The three month period ended December 31,2004 combines the historical financial results of Watson Wyatt for the threemonths ended December 31, 2004 with the pro forma historical financialresults from WWLLP for the three months ended December 31, 2004.  The six month period ended December 31,2005 includes historical financial results from July 2005 of Watson Wyatt,pro forma results of WWLLP for the month of July 2005, combined with theresults of the consolidated entity from August 1 through December 31,2005.  The six month period ended December 31,2004 combines the historical financial results of Watson Wyatt for the sixmonths ended December 31, 2004 with the pro forma historical financialresults from WWLLP for the six months ended December 31, 2004.

 

The unauditedpro forma combined financial information shows the impact of the combinationwith WWLLP on Watson Wyatt’s historical results of operations.  The unaudited pro forma combined incomestatements are presented for illustrative purposes only and are not indicativeof the results of operations that might have occurred had the combinationactually taken place as of the dates specified, or that may be expected tooccur in the future.  They do not assumeany benefits from any cost savings or synergies and do not reflect anyintegration costs that the combined company realized or incurred after thecombination.

 

7

----

 

**Pro-FormaCombined Statements of Operations**

(in thousands, except per sharedata)

 
| ** **                                              | ** ** | **Three Months Ended December 31,** | ** ** | **Six Months Ended December 31,** | ** ** |
|---------------------------------------------------------|------------|------------------------------------------|------------|----------------------------------------|------------|
| ** **                                              | ** ** | ** **                               | ** ** | ** **                             | ** ** | **%** | ** ** | ** ** | ** ** | ** ** | ** ** | **%** | ** ** |
| ** **                                              | ** ** | **2005**                                 | ** ** | **2004**                               | ** ** | **Change** | ** ** | **2005** | ** ** | **2004** | ** ** | **Change** | ** ** |
|                                                    |       | **(Unaudited)**                          |       |                                   |       | **(Unaudited)** |   |   |   |
|                                                    |       |                                     |       |                                   |       |   |   |   |   |   |   |   |   |
| Revenue                                                 |       | $                                        | 315,764    |                                   | $          | 299,779 |   | 5.3 | % | $ | 618,569 |   | $ | 584,572 |   | 5.8 | % |
|                                                    |       |                                     |       |                                   |       |   |   |   |   |   |   |   |   |
| Costs of providing services:                            |       |                                     |       |                                   |       |   |   |   |   |   |   |   |   |
| Salaries and employee benefits                          |       | 175,207                                  |       | 168,799                                |       | 3.8 |   | 346,797 |   | 331,293 |   | 4.7 |   |
| Professional and subcontracted services                 |       | 19,595                                   |       | 16,420                                 |       | 19.3 |   | 39,797 |   | 32,536 |   | 22.3 |   |
| Occupancy, communications and other                     |       | 43,687                                   |       | 40,740                                 |       | 7.2 |   | 79,731 |   | 74,824 |   | 6.6 |   |
| General and administrative expenses                     |       | 37,206                                   |       | 38,249                                 |       | (2.7 | ) | 75,193 |   | 73,874 |   | 1.8 |   |
| Depreciation and amortization                           |       | 11,132                                   |       | 9,395                                  |       | 18.5 |   | 22,234 |   | 18,564 |   | 19.8 |   |
|                                                    |       | 286,827                                  |       | 273,603                                |       |   |   | 563,752 |   | 531,091 |   |   |   |
|                                                    |       |                                     |       |                                   |       |   |   |   |   |   |   |   |   |
| Income from operations                                  |       | 28,937                                   |       | 26,176                                 |       | 10.5 |   | 54,817 |   | 53,481 |   | 2.5 |   |
|                                                    |       |                                     |       |                                   |       |   |   |   |   |   |   |   |   |
| Income from affiliates                                  |       | 71                                       |       | 705                                    |       | (89.4 | ) | 934 |   | 1,045 |   | (10.5 | ) |
| Interest expense, net                                   |       | (974                                     | )          | (931                                   | )          | 4.6 |   | (1,475 | ) | (1,654 | ) | (10.8 | ) |
| Other non-operating (loss)/income                       |       | (288                                     | )          | (56                                    | )          | 414.3 |   | 1,452 |   | (28 | ) | (5,285.7 | ) |
|                                                    |       |                                     |       |                                   |       |   |   |   |   |   |   |   |   |
| Income from continuing operations before  income taxes  |       | 27,746                                   |       | 25,894                                 |       | 7.2 |   | 55,728 |   | 52,844 |   | 5.5 |   |
|                                                    |       |                                     |       |                                   |       |   |   |   |   |   |   |   |   |
| Provision  for income taxes                             |       | 10,571                                   |       | 9,865                                  |       | 7.2 |   | 22,782 |   | 21,603 |   | 5.5 |   |
|                                                    |       |                                     |       |                                   |       |   |   |   |   |   |   |   |   |
| Income from  continuing operations                      |       | $                                        | 17,175     |                                   | $          | 16,029 |   | 7.2 | % | $ | 32,946 |   | $ | 31,241 |   | 5.5 | % |
|                                                    |       |                                     |       |                                   |       |   |   |   |   |   |   |   |   |
| Basic  earnings per share:                              |       | $                                        | 0.41       |                                   | $          | 0.39 |   |   |   | $ | 0.81 |   | $ | 0.75 |   |   |   |
| Diluted  earnings per share:                            |       | $                                        | 0.41       |                                   | $          | 0.38 |   |   |   | $ | 0.81 |   | $ | 0.75 |   |   |   |
|                                                    |       |                                     |       |                                   |       |   |   |   |   |   |   |   |   |
| Weighted  average shares of common stock, basic (000)   |       | 42,147                                   |       | 41,607                                 |       |   |   | 40,494 |   | 41,528 |   |   |   |
| Weighted  average shares of common stock, diluted (000) |       | 42,391                                   |       | 41,898                                 |       |   |   | 40,748 |   | 41,828 |   |   |   |

 

8

----

 

**Note 3 – Segment Information.**

 

In North America and Europe, the company is primarily organized andmanaged by practice.  Although ourconsultants in our Asia-Pacific and Latin America offices provide services inthese same practice areas, their operations as a whole are managedgeographically and comprise a single operating segment.  As a result, we have seven reportableoperating segments or practice areas as follows:

 

(1)        Benefits Group

 

(2)        Technology and Administration SolutionsGroup

 

(3)        Human Capital Group 

 

(4)        Insurance & Financial ServicesGroup 

 

(5)        Investment Consulting Group

 

(6)        International – Comprising Asia Pacificand Latin America

 

(7)        Other (including Communication)

 

The company evaluates the performance of its segments and allocatesresources to them based on net operating income on a pre-bonus, pre-tax basis.

 

The table below presents specified information about reported segmentsas of and for the three months ended December 31, 2005.  As a result, it includes the consolidatedresults from Watson Wyatt Limited:

 
| ** **                              | ** ** | **Benefits  Group** | ** ** | **Technology  and  Administration Solutions  Group** | ** ** | **Human  Capital  Group** | ** ** | **Insurance &  Financial  Services Group** | ** ** | **Investment  Consulting Group** | ** ** | **International  - Asia Pacific/  Latin America** | ** ** | **Other** | ** ** | **Total** | ** ** |
|-----------------------------------------|------------|---------------------|------------|------------------------------------------------------|------------|---------------------------|------------|-----------------------------------------------------|------------|----------------------------------|------------|---------------------------------------------------|------------|-----------|------------|-----------|------------|
| Revenue (net of  reimbursable expenses) |       | $                   | 167,698    |                                                 | $          | 36,140                    |       | $                                                   | 29,455     |                             | $          | 22,349                                            |       | $         | 18,547     |      | $          | 22,952 |   | $ | 7,338 |   | $ | 304,479 |   |
| Net operating  income (loss)            |       | 36,711              |       | 10,169                                               |       | 5,387                     |       | 2,862                                               |       | 2,077                            |       | 1,657                                             |       | (1,900    | )          | 56,963    |       |
| Receivables                             |       | 168,031             |       | 19,364                                               |       | 30,142                    |       | 23,314                                              |       | 11,919                           |       | 21,466                                            |       | 3,123     |       | 277,359   |       |
|                                         |            |                     |            |                                                      |            |                           |            |                                                     |            |                                  |            |                                                   |            |           |            |           |            |  |  |  |  |  |  |  |  |

 

The table below presents specified information about reported segmentsas of and for the three months ended December 31, 2004.  As a result, it does not include results fromWatson Wyatt Limited since the combination was not completed until July 31,2005:  

 
| ** **                              | ** ** | **Benefits  Group** | ** ** | **Technology  and  Administration  Solutions  Group** | ** ** | **Human  Capital  Group** | ** ** | **Insurance &  Financial  Services  Group** | ** ** | **Investment  Consulting Group** | ** ** | **International  -  Asia Pacific/  Latin America** | ** ** | **Other** | ** ** | **Total** | ** ** |
|-----------------------------------------|------------|---------------------|------------|-------------------------------------------------------|------------|---------------------------|------------|------------------------------------------------------|------------|----------------------------------|------------|----------------------------------------------------|------------|-----------|------------|-----------|------------|
| Revenue (net of  reimbursable expenses) |       | $                   | 95,135     |                                                  | $          | 19,573                    |       | $                                                    | 14,303     |                             | $          | —                                             |       | $         | 4,675      |      | $          | 22,244 |   | $ | 11,218 |   | $ | 167,148 |   |
| Net operating  income                   |       | 15,356              |       | 5,376                                                 |       | 4,000                     |       | —                                               |       | 430                              |       | 1,193                                              |       | 1,114     |       | 27,469    |       |
| Receivables                             |       | 89,828              |       | 9,253                                                 |       | 12,747                    |       | —                                               |       | 3,987                            |       | 20,163                                             |       | 5,956     |       | 141,934   |       |
|                                         |            |                     |            |                                                       |            |                           |            |                                                      |            |                                  |            |                                                    |            |           |            |           |            |  |  |  |  |  |  |  |  |

 

9

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The table below presents specified information about reported segmentsas of and for the six months ended December 31, 2005. As a result, itincludes the consolidated results from Watson Wyatt Limited since August 1,2005.  Net operating income (loss) presented belowhas been adjusted to correct amounts that were inadvertently misstatedprimarily in the Technology and Administration Solutions Group for thequarter ended September 30, 2005, improving margins in the Technology andAdministration Solutions Group from what was previously reported.

 
| ** **                              | ** ** | **Benefits  Group** | ** ** | **Technology  and  Administration Solutions  Group** | ** ** | **Human  Capital  Group** | ** ** | **Insurance &  Financial  Services Group** | ** ** | **Investment  Consulting Group** | ** ** | **International  -  Asia Pacific/  Latin America** | ** ** | **Other** | ** ** | **Total** | ** ** |
|-----------------------------------------|------------|---------------------|------------|------------------------------------------------------|------------|---------------------------|------------|-----------------------------------------------------|------------|----------------------------------|------------|----------------------------------------------------|------------|-----------|------------|-----------|------------|
| Revenue (net of  reimbursable expenses) |       | $                   | 316,393    |                                                 | $          | 60,847                    |       | $                                                   | 52,847     |                             | $          | 37,602                                             |       | $         | 31,891     |      | $          | 44,423 |   | $ | 18,265 |   | $ | 562,268 |   |
| Net operating  income (loss)            |       | 75,106              |       | 15,631                                               |       | 8,748                     |       | 5,524                                               |       | 3,738                            |       | 675                                                |       | (1,216    | )          | 108,206   |       |
| Receivables                             |       | 168,031             |       | 19,364                                               |       | 30,142                    |       | 23,314                                              |       | 11,919                           |       | 21,466                                             |       | 3,123     |       | 277,359   |       |
|                                         |            |                     |            |                                                      |            |                           |            |                                                     |            |                                  |            |                                                    |            |           |            |           |            |  |  |  |  |  |  |  |  |

 

The table below presents specified information about reported segmentsas of and for the six months ended December 31, 2004.  As a result, it does not include results fromWatson Wyatt Limited since the combination was not completed until July 31,2005:  

 
| ** **                              | ** ** | **Benefits  Group** | ** ** | **Technology  and  Administration  Solutions  Group** | ** ** | **Human  Capital  Group** | ** ** | **Insurance &  Financial  Services  Group** | ** ** | **Investment  Consulting Group** | ** ** | **International  -  Asia Pacific/  Latin America** | ** ** | **Other** | ** ** | **Total** | ** ** |
|-----------------------------------------|------------|---------------------|------------|-------------------------------------------------------|------------|---------------------------|------------|------------------------------------------------------|------------|----------------------------------|------------|----------------------------------------------------|------------|-----------|------------|-----------|------------|
| Revenue (net of  reimbursable expenses) |       | $                   | 196,021    |                                                  | $          | 36,755                    |       | $                                                    | 27,365     |                             | $          | —                                             |       | $         | 8,700      |      | $          | 43,297 |   | $ | 22,728 |   | $ | 334,866 |   |
| Net operating   income             |       | 38,587              |       | 8,102                                                 |       | 6,967                     |       | —                                               |       | 490                              |       | 1,811                                              |       | 3,513     |       | 59,470    |       |
| Receivables                             |       | 89,828              |       | 9,253                                                 |       | 12,747                    |       | —                                               |       | 3,987                            |       | 20,163                                             |       | 5,956     |       | 141,934   |       |
|                                         |            |                     |            |                                                       |            |                           |            |                                                      |            |                                  |            |                                                    |            |           |            |           |            |  |  |  |  |  |  |  |  |

 

Information about interest income and tax expense is not presented as asegment expense because such items are not considered a responsibility of thesegments’ operating management.  Prioryear data has been reclassified to be consistent with current segments forcomparative purposes.

 

10

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Reconciliations of the information reported by segment to thehistorical consolidated amounts follow for the three and six-month periodsended December 31, 2005 and 2004:

 
| ** **                                                                                  | ** ** | **Three Months Ended December 31,** | ** ** | **Six Months Ended December 31,** | ** ** |
|---------------------------------------------------------------------------------------------|------------|------------------------------------------|------------|----------------------------------------|------------|
| ** **                                                                                  | ** ** | **2005**                                 | ** ** | **2004**                               | ** ** | **2005** | ** ** | **2004** | ** ** |
|                                                                                        |       |                                     |       |                                   |       |   |   |   |   |
| Revenue:                                                                                    |       |                                     |       |                                   |       |   |   |   |   |
| Total segment revenue                                                                       |       | $                                        | 304,479    |                                   | $          | 167,148 |   | $ | 562,268 |   | $ | 334,866 |   |
| Reimbursable expenses not included in total  segment revenue                                |       | 11,020                                   |       | 8,038                                  |       | 19,955 |   | 16,279 |   |
| Other, net                                                                                  |       | 265                                      |       | 663                                    |       | (573 | ) | 95 |   |
| Consolidated revenue                                                                        |       | $                                        | 315,764    |                                   | $          | 175,849 |   | $ | 581,650 |   | $ | 351,240 |   |
|                                                                                        |       |                                     |       |                                   |       |   |   |   |   |
| Net Operating Income:                                                                       |       |                                     |       |                                   |       |   |   |   |   |
| Total segment net operating income                                                          |       | $                                        | 56,963     |                                   | $          | 27,469 |   | $ | 108,206 |   | $ | 59,470 |   |
| Income from affiliates                                                                      |       | 71                                       |       | 2,724                                  |       | 1,422 |   | 4,930 |   |
| Differences in allocation methods for depreciation,  G&A, medical and pension costs (1) |       | (2,909                                   | )          | (2,712                                 | )          | (6,387 | ) | (4,012 | ) |
| (Loss)/Gain on sale of business units                                                       |       | (288                                     | )          | (56                                    | )          | 1,452 |   | (28 | ) |
| Interest expense                                                                            |       | (1,483                                   | )          | —                                 |       | (2,359 | ) | — |   |
| Loss on hedge                                                                               |       | —                                   |       | —                                 |       | (3,602 | ) | — |   |
| Discretionary compensation                                                                  |       | (25,912                                  | )          | (9,413                                 | )          | (47,232 | ) | (20,413 | ) |
| Other, net                                                                                  |       | 1,304                                    |       | 1,982                                  |       | 1,053 |   | 3,401 |   |
| Consolidated income before income taxes                                                     |       | $                                        | 27,746     |                                   | $          | 19,994 |   | $ | 52,553 |   | $ | 43,348 |   |
|                                                                                        |       |                                     |       |                                   |       |   |   |   |   |
| Receivables:                                                                                |       |                                     |       |                                   |       |   |   |   |   |
| Total segment receivables - billed and  unbilled                                            |       | $                                        | 277,359    |                                   | $          | 141,934 |   | $ | 277,359 |   | $ | 141,934 |   |
| Net valuation differences (2)                                                               |       | 4,938                                    |       | 2,624                                  |       | 4,938 |   | 2,624 |   |
| Total billed and unbilled receivables                                                       |       | 282,297                                  |       | 144,558                                |       | 282,297 |   | 144,558 |   |
| Assets not reported by segment                                                              |       | 884,280                                  |       | 374,742                                |       | 884,280 |   | 374,742 |   |
| Consolidated assets                                                                         |       | $                                        | 1,166,577  |                                   | $          | 519,300 |   | $ | 1,166,577 |   | $ | 519,300 |   |

 

----

(1) Depreciation,general and administrative, pension, and medical costs are allocated to oursegments based on budgeted expenses determined at the beginning of the fiscalyear as management believes that these costs are largely uncontrollable to thesegment.  To the extent that the actualexpense base upon which allocations are made differs from the forecast/budgetamount, a reconciling item will be created between internally allocatedexpenses and the actual expense that we report for GAAP purposes.

 

(2) Totalsegment receivables, which reflects the receivable balances used by managementto make business decisions, are included for management reporting purposes netof deferred revenues – cash collections and invoices generated in excess of revenuerecognized in the segment revenues and cash held in suspense.

 

(3) Assetsnot reported by segment for management reporting purposes include goodwill andintangible assets of $481.7 million.

 

11

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**Note 4 – Share-based Compensation.**

 

InDecember 2004, the Financial Accounting Standards Board (FASB) publishedrevisions to Statement of Financial Accounting Standards No. 123, “Accountingfor Stock-Based Compensation” (SFAS 123R). SFAS 123(R) requires companies to account for share-based paymenttransactions with employees using a fair-value based method, therebyeliminating the disclosure-only provisions of SFAS 123.  SFAS 123(R)became effective for the company as of July 1, 2005.

 

Thecompany has four share-based compensation plans, which are describedbelow.  These compensation plans includethe 2001 Employee Stock Purchase Plan, the 2001 Deferred Stock Unit Plan forSelected Employees, the Amended Compensation Plan for Outside Directors and the2000 Long-Term Incentive Plan.  All fourplans have been approved by stockholders.

 

*2001 Employee Stock Purchase Plan*

 

Theemployee stock purchase plan enables employees to purchase shares of thecompany’s stock.  No compensation expensewas recognized in fiscal year 2006 as a result of this plan. Pro formacompensation expense of $0.7 million was disclosed for the six months ended December 31,2005.

 

##### *2001 Deferred Stock UnitPlan for Selected Employees*

##### * *

The2001 Deferred Stock Unit Plan for Selected Employees is intended to provideselected associates of the company with additional incentives by permitting thecompany to grant them an equity interest in the company in the form ofrestricted stock units, in lieu of a portion of their annual fiscal year endbonus.  Shares under this plan areawarded during the first quarter of each fiscal year.  During the first quarter of fiscal year 2006,177,300 shares of common stock, at a market price of $26.94 were awarded for atotal fair value of $4.8 million.  Duringthe first quarter of fiscal year 2005, 151,610 shares of common stock, at amarket price of $26.68 were awarded, for a total fair value of $4.0 million.

 

On November 19, 2004, the Board of Directors ofthe company approved a long-term bonus arrangement pursuant to the company’s2001 Deferred Stock Unit Plan for Selected Employees.  The arrangement,called the Performance Share Bonus Incentive Program (the “SBI Program”), is along-term stock bonus arrangement for senior executives of the company and itsaffiliates that is designed to strengthen incentives and align behaviors togrow the business in a way that is consistent with the strategic goals of thecompany.

 

Incentives under the SBI Program are providedthrough grants of deferred stock units pursuant to the company’s 2001 DeferredStock Unit Plan for Selected Employees.  Grants of deferred stock unitsare based on the value of the cash portion of the eligible participant’s fiscalyear-end bonus target and a multiplier, which is then converted into a targetnumber of deferred stock units based upon the company’s stock price as of thefiscal year-end prior to grant.  Participants may vest between zero and170% of the target number of deferred stock units based on the extent to whichfinancial and strategic performance metrics are achieved over a three fiscalyear period.  The financial and strategic performance metrics areestablished at the beginning of each performance period.  For the fiscal2004 through 2007 performance period, the vesting criteria are based upon earningsper share growth, market penetration and cross-selling ratios.

 

Nocompensation expense was recorded pursuant to this plan through the first sixmonths of fiscal year 2006.  Expenses forthis plan will be recognized when awards are both probable and reasonablyestimable and compensation expense will be recognized as a component of thediscretionary annual bonus recorded in salaries and employee benefits.

 

12

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##### *Amended Compensation Planfor Outside Directors*

##### * *

TheAmended Compensation Plan for Outside Directors (the “Outside Director’s Plan”)provides for the cash and stock compensation of outside Directors.  Under the Outside Director’s Plan, outsideDirectors are initially paid in shares of the company’s common stock, or in acombination of cash and shares, quarterly for services provided during thepreceding quarter.  Approximately $0.3million of compensation expense was recorded relative to this plan during thefirst six months of fiscal year 2006 compared to $0.1 million in the first sixmonths of fiscal year 2005.

 

##### *2000 Long-Term IncentivePlan*

##### * *

Thecompany issued non-qualified stock options under the 2000 Long-Term IncentivePlan (the “Stock Option Plan”) in conjunction with its initial public offering.  No options have been granted under the stockoption plan since fiscal year 2001 and the company does not currently intend toissue further stock options under the Stock Option Plan. For the first sixmonths of fiscal year 2006, the company recognized $0.3 million in compensationexpense related to the Stock Option Plan, in accordance with SFAS 123(R).  For the first six months of fiscal year 2005,the company disclosed pro forma compensation cost of $0.5 million, related tothe Stock Option Plan.

 

**Note 5 – Retirement Benefits.**

 

*Defined Benefit Plans*

 

We sponsor both qualified and non-qualified, non-contributory definedbenefit pension plans covering substantially all of our associates.  Under our plans in North America and HongKong, benefits are based on the number of years of service and the associates’compensation during the five highest paid consecutive years of service (subjectto grandfathering provisions under which benefits would be determined based onthe three highest paid consecutive years of service).  The non-qualified plan, which exists only inNorth America, provides for pension benefits that would be covered under thequalified plan but are limited by the Internal Revenue Code.  The non-qualified plan has no assets andtherefore is an unfunded arrangement. The benefit liability is reflected on the balance sheet.  The measurement date for the plans is June 30.

 

As a result of the business combination described in Note 2, we haveincluded the defined benefit pension plan disclosures for our newly acquiredU.K. operations.  The disclosures forthis plan, along with our historical U.K. plan, are shown separately becausethe amounts are significant relative to all plans and the assumptions used aresignificantly different than all other plans. Under our plans in the U.K.,benefits are based on the number of years of service and the associates’compensation during the three years before leaving the plan. The measurementdate for the plan is July 31.

 

13

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*Components of Net Periodic Benefit Cost forDefined Benefit Pension Plans*

 

The following table sets forth the components of net periodic benefitcost for the company’s defined benefit pension plan for North America and HongKong for the three and six month periods ended December 31, 2005 and 2004,and for the newly acquired U.K. defined benefit pension plan for the three andfive months ended December 31, 2005:

 
| ** **                             | ** ** | **Three  Months Ended December 31,** | ** ** | **Six  Months Ended December 31,** | ** ** |
|----------------------------------------|------------|-------------------------------------------|------------|-----------------------------------------|------------|
| ** **                             | ** ** | **2005**                                  | ** ** | **2004**                                | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                             | ** ** | **North  America &  Hong Kong**  | ** ** | **U.K.**                                | ** ** | **Total** | ** ** | **North  America &  Hong Kong** | ** ** | **North  America &  Hong Kong** | ** ** | **U.K.** | ** ** | **Total** | ** ** | **North  America &  Hong Kong** | ** ** |
| Service Cost                           |       | $                                         | 7,837      |                                    | $          | 3,136 |   | $ | 10,973 |   | $ | 6,173 |   | $ | 15,219 |   | $ | 5,226 |   | $ | 20,445 |   | $ | 12,612 |   |
| Interest Cost                          |       | 9,493                                     |       | 4,172                                   |       | 13,665 |   | 8,919 |   | 18,670 |   | 6,616 |   | 25,286 |   | 17,663 |   |
| Expected Return  on Plan Assets        |       | (11,142                                   | )          | (3,978                                  | )          | (15,121 | ) | (10,541 | ) | (22,278 | ) | (6,287 | ) | (28,565 | ) | (20,679 | ) |
| Amortization of  Transition Obligation |       | (2                                        | )          | —                                  |       | (2 | ) | (2 | ) | (4 | ) | — |   | (4 | ) | (3 | ) |
| Amortization of  Net Loss              |       | 4,287                                     |       | —                                  |       | 4,287 |   | 1,662 |   | 8,063 |   | — |   | 8,063 |   | 3,398 |   |
| Amortization of  Prior Service Cost    |       | (448                                      | )          | —                                  |       | (448 | ) | (540 | ) | (860 | ) | — |   | (860 | ) | (1,081 | ) |
| Net Periodic  Benefit Cost             |       | $                                         | 10,025     |                                    | $          | 3,330 |   | $ | 13,354 |   | $ | 5,671 |   | $ | 18,810 |   | $ | 5,555 |   | $ | 24,365 |   | $ | 11,910 |   |

 

The fiscal year 2006 net periodic benefit cost is based, in part, onthe following rate assumptions as of June 30, 2005 for the North Americaand Hong Kong plans and July 31, 2005 for the U.K. plans:

 
| ** **                                   | ** ** | **North America  & Hong Kong** | ** ** | **U.K.** | ** ** |
|----------------------------------------------|------------|------------------------------------|------------|----------|------------|
| Discount  rate                               |       | 5.25                               | %          | 5.00     | %          |
|                                         |       |                               |       |     |       |
| Expected  long-term rate of return on assets |       | 9.00                               | %          | 5.63     | %          |
|                                         |       |                               |       |     |       |
| Rate of  increase in compensation levels     |       | 3.34                               | %          | 4.75     | %          |

 

The discount rate applicable to the various plans varies in accordancewith the interest rate environment in the respective host country.  The expected long-term rate of return onassets attributable to the various plans in based on the allocation of assetswithin each specific plan.  Assets in theNorth America and Hong Kong plans are heavily weighted in equities, which areexpected to generate a higher return than bonds, which constitute the majorityof investments for the UK plans.

 

14

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*Employer contributions*

 

The company made $15.0 million in contributions to the U.S. plan and $1million in contributions to the non-U.S. plans during the second quarter offiscal year 2006.  We anticipate making$1.7 million in contributions to the non-U.S. plans in the last two quarters offiscal year 2006.  We do not anticipatemaking additional contributions to the U.S. plan for the remainder of fiscalyear 2006.

 

The company made $2.2 million in contributions to the U.K. plans duringthe second quarter of fiscal year 2006 and anticipates making $6.2 million incontributions over the remainder of the fiscal year.

 

*Defined Contribution Plans*

 

In the U.S.,we sponsor a savings plan that provides benefits to substantially all U.S.associates with a match to employee contributions at a rate of 50 percent ofthe first 6 percent up to $60,000 of associates’ eligible compensation.  The company may also make an annual profitsharing contribution to the plan in an amount that is dependant upon thecompany’s financial performance during the fiscal year.

 

In the U.K., wesponsor a savings plan that provides benefits to substantially all U.K.associates.  The company provides a basiccontribution and a match to employee contributions, both of which depend onage.  The maximum employer contributionis 10% up to £91,000.

 

*Health Care Benefits*

 

In the U.S., we sponsor a contributory health care plan that provideshospitalization, medical and dental benefits to substantially all U.S.associates.  We accrue a liability forestimated incurred but unreported claims based on projected use of the plan aswell as prior plan history.

 

In the U.K., we sponsor a non-contributory medical insurance plan thatprovides hospitalization and medical benefits and a contributory dental planthat provides dental benefits to substantially all U.K. associates.

 

*Postretirement Benefits*

 

We provide certain health care and life insurance benefits for retiredassociates.  The principal plans coverassociates in the U.S. and Canada who have met certain eligibilityrequirements. Our principal post-retirement benefit plans are unfunded.  We accrue a liability for thesebenefits.  We do not have apostretirement benefit plan in the U.K.

 

15

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*Components of Net Periodic Benefit Cost forOther Postretirement Plans*

 

The following table sets forth the components of net periodic benefitcost for the company’s healthcare and post-retirement plans for the three andsix months ended December 31, 2005 and 2004:

 
| ** **                             | ** ** | **Three Months Ended December 31,** | ** ** | **Six Months Ended December 31,** | ** ** |
|----------------------------------------|------------|------------------------------------------|------------|----------------------------------------|------------|
| ** **                             | ** ** | **2005**                                 | ** ** | **2004**                               | ** ** | **2005** | ** ** | **2004** | ** ** |
|                                   |       |                                     |       |                                   |       |   |   |   |   |
| Service Cost                           |       | $                                        | 456        |                                   | $          | 423 |   | $ | 908 |   | $ | 836 |   |
| Interest  Cost                         |       | 606                                      |       | 614                                    |       | 1,209 |   | 1,219 |   |
| Expected  return on plan assets        |       | —                                   |       | —                                 |       | — |   | — |   |
| Amortization  of transition obligation |       | —                                   |       | 13                                     |       | — |   | 25 |   |
| Amortization  of net loss              |       | (81                                      | )          | (141                                   | )          | (164 | ) | (284 | ) |
| Amortization  of prior service cost    |       | (165                                     | )          | (106                                   | )          | (330 | ) | (212 | ) |
| Net periodic  benefit cost             |       | $                                        | 816        |                                   | $          | 803 |   | $ | 1,623 |   | $ | 1,584 |   |

 

*Employer contributions*

 

The company made contributions in the form of premiums and medicalclaim payments to its healthcare and post-retirement plans of $800,000 and$700,000 in the three months ended December 31, 2005 and 2004,respectively, and contributions of $1.6 million and $1.3 million in the sixmonths ended December 31, 2005 and 2004, respectively.  We plan to make additional payments estimatedto total $1.6 million through June 30, 2006.

 

16

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**Note 6 – Goodwill & IntangibleAssets.**

 

The increases in goodwill and intangible assets outlined below for thesix months ended December 31, 2005 are principally attributable to theacquisition of WWLLP during the first quarter. See Note 2 for further details regarding the acquisition.   

 
| ** **                           | ** ** | **Benefits  Group** | ** ** | **Technology  and  Administration   Solutions  Group** | ** ** | **Human  Capital  Group** | ** ** | **Insurance &  Financial  Services  Group** | ** ** | **Investment  Consulting  Group** | ** ** | **Asia Pacific/  Latin  America** | ** ** | **Other** | ** ** | **Total** | ** ** |
|--------------------------------------|------------|---------------------|------------|--------------------------------------------------------|------------|---------------------------|------------|------------------------------------------------------|------------|-----------------------------------|------------|-----------------------------------|------------|-----------|------------|-----------|------------|
| Balance as of June 30, 2005     |       | $                   | 16,790     |                                                   | $          | 1,449                     |       | $                                                    | 77         |                              | $          | —                            |       | $         | —     |      | $          | 2,358 |   | $ | 1,214 |   | $ | 21,888 |   |
|                                 |       |                |       |                                                   |       |                      |       |                                                 |       |                              |       |                              |       |      |       |      |       |
| Goodwill acquired during the year    |       | 143,487             |       | 39,949                                                 |       | 16,036                    |       | 52,047                                               |       | 37,136                            |       | 590                               |       | —    |       | 289,245   |       |
|                                 |       |                |       |                                                   |       |                      |       |                                                 |       |                              |       |                              |       |      |       |      |       |
| Impairment losses                    |       | —              |       | —                                                 |       | —                    |       | —                                               |       | —                            |       | —                            |       | —    |       | —    |       |
|                                 |       |                |       |                                                   |       |                      |       |                                                 |       |                              |       |                              |       |      |       |      |       |
| Translation Adjustment               |       | (3,637              | )          | (1,156                                                 | )          | (460                      | )          | (1,506                                               | )          | (1,074                            | )          | (22                               | )          | —    |       | (7,855    | )          |
|                                 |       |                |       |                                                   |       |                      |       |                                                 |       |                              |       |                              |       |      |       |      |       |
| Balance as of December 31, 2005 |       | $                   | 156,640    |                                                   | $          | 40,242                    |       | $                                                    | 15,653     |                              | $          | 50,541                            |       | $         | 36,062     |      | $          | 2,926 |   | $ | 1,214 |   | $ | 303,278 |   |

 

The following table reflects changes in the net carrying amount of thecomponents of intangible assets for the six months ended December 31,2005:

 
| ** **                                 | ** ** | **Pension** | ** ** | **Trademark  & trade  name** | ** ** | **Customer  related  intangible** | ** ** | **Core/  developed  technology** | ** ** | **Non-  compete  agreements** | ** ** | **Total** | ** ** |
|--------------------------------------------|------------|-------------|------------|----------------------------------|------------|-----------------------------------|------------|----------------------------------|------------|-------------------------------|------------|-----------|------------|
| Balance as of June 30, 2005           |       | $           | 608        |                             | $          | —                            |       | $                                | 84         |                          | $          | —    |       | $ | 84 |   | $ | 776 |   |
| Intangible assets acquired during the year |       | 28          |       | 108,000                          |       | 60,600                            |       | 17,582                           |       | —                        |       | 186,210   |       |
| Amortization expense                       |       | —      |       | —                           |       | (2,189                            | )          | (1,479                           | )          | (42                           | )          | (3,710    | )          |
| Translation adjustment                     |       | 22          |       | (2,902                           | )          | (1,577                            | )          | (426                             | )          | —                        |       | (4,883    | )          |
|                                       |       |        |       |                             |       |                              |       |                             |       |                          |       |      |       |
| Balance as of December 31, 2005       |       | $           | 658        |                             | $          | 105,098                           |       | $                                | 56,918     |                          | $          | 15,677    |       | $ | 42 |   | $ | 178,393 |   |

 

17

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The following table reflects the carrying value of intangible assets atDecember 31, 2005 and June 30, 2005:

 
| ** **                                            | ** ** | **December 31, 2005** | ** ** | **June 30, 2005** | ** ** |
|-------------------------------------------------------|------------|----------------------------|------------|------------------------|------------|
| ** **                                            | ** ** | **Gross  Carrying**        | ** ** | **Accumulated**        | ** ** | **Gross  Carrying** | ** ** | **Accumulated** | ** ** |
| ** **                                            | ** ** | **Amount**                 | ** ** | **Amortization**       | ** ** | **Amount** | ** ** | **Amortization** | ** ** |
| Intangible  assets and intangible pension asset:      |       |                       |       |                   |       |   |   |   |   |
| Trademark &  trade name                      |       | $                          | 105,098    |                   | $          | — |   | $ | — |   | $ | — |   |
| Customer  related intangibles                         |       | 60,021                     |       | 3,103                  |       | 1,001 |   | 917 |   |
| Core/developed  technology                            |       | 17,156                     |       | 1,479                  |       | — |   | — |   |
| Non-compete                                           |       | 671                        |       | 629                    |       | 672 |   | 588 |   |
| Intangible  pension asset                             |       | 658                        |       | —                 |       | 608 |   | — |   |
| Total  intangible assets and intangible pension asset |       | $                          | 183,604    |                   | $          | 5,211 |   | $ | 2,281 |   | $ | 1,505 |   |

 

Acomponent of the change in the gross carrying amount of trademark &trade name, customer related intangibles, core/developedtechnology and theintangible pension asset reflects translation adjustments between June 30,2005 and December 31, 2005.  Theseintangible assets are denominated in the currencies of our subsidiaries outsidethe United States, and are translated into our reporting currency, the U.S.dollar, based on exchange rates at the balance sheet date.

 

The weighted average remaining life of amortizable intangible assets atDecember 31, 2005, was 10.0 years. Estimated amortization expense for the remainder of 2006 and thereafteris as follows:
| **Fiscal year ending  June 30:** | ** ** | **Amount** | ** ** |
|---------------------------------------|------------|------------|------------|
| 2006                                  |       | $          | 4,211      |   |
| 2007                                  |       | 8,366      |       |
| 2008                                  |       | 8,320      |       |
| 2009                                  |       | 8,320      |       |
| 2010                                  |       | 8,320      |       |
| Thereafter                            |       | 35,099     |       |
|                                       |            |            |            |  |

 

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**Note 7 – Earnings Per Share.**

 

Basic earnings per share is calculated on the basis of the weightedaverage number of common shares outstanding during the three and six monthsended December 31, 2005 and 2004. Diluted earnings per share is calculated on the basis of the weightedaverage number of common shares outstanding plus the effect of outstandingstock options and employee stock purchase plan shares using the “treasury stock”method.  The components of basic anddiluted earnings per share are as follows:
| ** **                                                                         | ** ** | **Three Months Ended December 31,** | ** ** | **Six Months Ended December 31,** | ** ** |
|------------------------------------------------------------------------------------|------------|------------------------------------------|------------|----------------------------------------|------------|
| ** **                                                                         | ** ** | **2005**                                 | ** ** | **2004**                               | ** ** | **2005** | ** ** | **2004** | ** ** |
|                                                                               |       |                                     |       |                                   |       |   |   |   |   |
| Income from continuing operations                                                  |       | $                                        | 17,175     |                                   | $          | 11,055 |   | $ | 31,067 |   | $ | 24,806 |   |
| Discontinued operations                                                            |       | 8                                        |       | 6                                      |       | 17 |   | 8 |   |
| Net income                                                                         |       | $                                        | 17,183     |                                   | $          | 11,061 |   | $ | 31,084 |   | $ | 24,814 |   |
|                                                                               |       |                                     |       |                                   |       |   |   |   |   |
| Weighted average outstanding shares of common  stock                               |       | 42,147                                   |       | 32,516                                 |       | 40,494 |   | 32,437 |   |
| Dilutive effect of employee stock options and  employee stock purchase plan shares |       | 244                                      |       | 291                                    |       | 254 |   | 300 |   |
|                                                                               |       |                                     |       |                                   |       |   |   |   |   |
| Common stock and stock equivalents                                                 |       | 42,391                                   |       | 32,807                                 |       | 40,748 |   | 32,737 |   |
|                                                                               |       |                                     |       |                                   |       |   |   |   |   |
| Basic earnings per share:                                                          |       |                                     |       |                                   |       |   |   |   |   |
| Income from continuing operations                                                  |       | $                                        | 0.41       |                                   | $          | 0.34 |   | $ | 0.77 |   | $ | 0.76 |   |
| Discontinued operations                                                            |       | —                                   |       | —                                 |       | — |   | — |   |
| Net income                                                                         |       | $                                        | 0.41       |                                   | $          | 0.34 |   | $ | 0.77 |   | $ | 0.76 |   |
|                                                                               |       |                                     |       |                                   |       |   |   |   |   |
| Diluted earnings per share:                                                        |       |                                     |       |                                   |       |   |   |   |   |
| Income from continuing operations                                                  |       | $                                        | 0.41       |                                   | $          | 0.34 |   | $ | 0.76 |   | $ | 0.76 |   |
| Discontinued operations                                                            |       | —                                   |       | —                                 |       | — |   | — |   |
| Net income                                                                         |       | $                                        | 0.41       |                                   | $          | 0.34 |   | $ | 0.76 |   | $ | 0.76 |   |

 

19

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**Note 8 – Variable Interest Entities.**

 

In January 2003, the FASB issued FASB Interpretation No. 46, “Consolidationof Variable Interest Entities,” which was later revised in December 2003(FIN 46(R)) and effective March 31, 2004 for the company.  FIN 46(R) expands existing accountingguidance about when a company should include in its consolidated financialstatements the assets, liabilities, and activities of another entity.  In general, FIN 46(R) requires a variableinterest entity (VIE), as defined by FIN 46(R), to be consolidated by itsprimary beneficiary.  The primarybeneficiary is defined as the company that will absorb a majority of the VIE’sexpected losses or residual returns if they occur.

 

Wehave evaluated under FIN 46(R) our consolidated subsidiaries as listed in Exhibit 21of the Form 10-K for the year ended June 30, 2005, all of ouraffiliates as listed in Note 4 of the same Form 10-K, and both Wellspringand Gabriel, Roeder, Smith & Company (“GRS”), and believe that our accounting anddisclosure is in compliance with the pronouncement.  Therefore, the adoption of FIN 46(R)had no effect on the company.

 

The company’s Investment in Affiliates has historically consisted ofinvestments in three entities:  WWLLP,Watson Wyatt (Europe) Limited (WWHE) and Professional Consultants InsuranceCompany, Inc. (PCIC), our investment in each of which was accounted forunder the equity method.  As a result ofour acquisition of substantially all of the assets and most liabilities ofWWLLP, effective August 1, 2005, the company owns 100% of the operationsof WWLLP and WWHE through our Watson Wyatt Limited subsidiary.  For the six months ended December 31,2005 the company has accounted for its share of earnings from WWLLP and WWHEfor the month of July 2005 under the equity method and has consolidatedresults from Watson Wyatt Limited for the months of August throughDecember, 2005.

 

As of December 31, 2005, our Investment in Affiliate consists solelyof an equity investment in PCIC, which will continue to be accounted for underthe equity method.  The company evaluatedthis investment based on FIN 46(R)’s criteria in order to determine theapplicability of FIN 46(R).  Since thecompany is not obligated to absorb a majority of expected losses or residualreturns in this entity, the company is not required to consolidate this entity.

 

PCIC was organized in 1987 as a captive insurance company under thelaws of the State of Vermont.  PCICprovides professional liability insurance on a claims-made basis to WatsonWyatt and two other actuarial and management consulting firms, all of whichparticipate in the program as both policyholders and stockholders.  The company currently owns 34.15 percent ofPCIC.  Capital contributions to PCIC arerequired when approved by a majority of its stockholders.  Management believes that the company’smaximum financial statement exposure to loss is limited to the carrying valueof the company’s investment in PCIC of $8.8 million, combined with letters ofcredit totaling $8.0 million for which PCIC has been designated as beneficiary,for a total maximum exposure of $16.8 million.

 

**Note 9 – Comprehensive Income.**

 

Comprehensive income includes net income, changes in the additionalminimum pension liability resulting from translation adjustments and changes inthe cumulative translation adjustment gain or loss.  For the three months ended December 31,2005, comprehensive income totaled $6.6 million, compared with $14.1 million forthe three months ended December 31, 2004. For the six months ended December 31, 2005, comprehensive incometotaled $19.0 million, compared with $28.7 million for the six months ended December 31,2004.

 

20

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**Note 10 – Revision in the Classification ofCertain Securities.**

 

Asof the end of the third quarter of fiscal year 2005, in connection with thenrecent interpretations regarding the classification of auction rate securities,the company concluded that it was appropriate to classify its auction ratesecurities as marketable securities instead of cash and cash equivalents, whichwas the historical classification. Auction rate securities are investments that are typically backed bypreferred stock or long-term, variable-rate debt instruments whose interestrates are reset at predetermined short-term intervals through an auctionprocess.

 

AtDecember 31, 2005 and June 30, 2005, the company had no auction ratesecurities compared to $20.0 million at June 30, 2004 and $30.3 million atDecember 31, 2004.  Accordingly, thecompany has revised the Consolidated Statements of Cash Flows for the first sixmonths of fiscal year 2005 to reflect the gross purchases of $306.5 million andsales and maturities of these securities of $296.3 million as cash flowsfrom/used in investing activities, rather than as a component of cash and cashequivalents.  This change inclassification does not affect cash flows from operations or financingactivities in the company’s previously reported Consolidated Statements of CashFlows.  This change in classificationdoes not affect the company’s Consolidated Statements of Operations orConsolidated Balance Sheets for any period presented.

 

**Note 11 – Restricted Shares.**

 

In conjunction with our initial public offering in October 2000,we entered into agreements providing for additional transfer restrictions withmajor stockholders, executive officers and employee directors.  At each of the first four anniversaries ofour initial public offering, an equal portion of these shares became freelytransferable.  The final 1,665,400 Class Ashares became freely transferable in October, 2004.

 

In conjunction with our business acquisition of WWLLP on July 31,2005, we issued 9,090,571 Class A shares, 4,749,797 of which are subjectto sale restrictions.  Sale restrictionswill expire on 2,339,761 shares on the first anniversary and 2,410,036 shareson the second anniversary of the business acquisition.  The payment of up to an additional 1,950,000 Class Ashares after June 30, 2007 is contingent upon achievement by the acquiredbusiness of certain financial performance goals.  Sale of these shares, if issued, will berestricted until the fourth anniversary of the business combination.  See Note 2 of this report for furtherinformation regarding the acquisition of WWLLP.

 

**Note 12 – Guarantees.**

 

The company historically has provided guarantees on an infrequent basisto third parties in the ordinary course of business.  The guarantees described below are currentlyin effect and could require the company to make payments to third parties undercertain circumstances.

 

*Acquisition of WWLLP*.  On July 31,2005, the company completed the acquisition of substantially all the assets andassumption of most liabilities of WWLLP, the company’s long-time alliancepartner.  The company entered intoindemnity arrangements with WWLLP relating to the acquisition and also agreedthat certain indemnity obligations relating to the alliance arrangements willcontinue after the acquisition.  In theacquisition agreement, Watson Wyatt Limited, the company’s principal U.K.subsidiary, has agreed to indemnify Watson Wyatt LLP against liabilitiesarising with respect to certain liabilities assumed in the acquisition byWatson Wyatt Limited and also with respect to certain tax liabilities.

 

Aspart of the original alliance arrangements in 1995, the company sold itsthen-existing businesses in the U.K. and Europe to the predecessor of WWLLP orits subsidiaries.  The company agreed toindemnify the buyers against liabilities arising with respect to prior acts oromissions of the businesses transferred. Furthermore, the company agreed to indemnify Watson Wyatt LLP againstliabilities arising with respect to acts or omissions of the company and itssubsidiaries during the alliance arrangements. These indemnities will continue following the acquisition.

 

21

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Thecompany is unable to estimate an amount of any potential future payments underthese arrangements because the occurrence of any of the events to which theindemnities apply is entirely speculative and the amount of any payment woulddepend upon the nature of the event triggering such indemnity. Managementbelieves that any potential for payment under such indemnities should declinewith the passage of time.  The companyhas insurance to cover liabilities arising from acts or omissions by thecompany and its subsidiaries, and such insurance may cover some or all of itsindemnity obligations relating to prior acts or omissions.  Except for such insurance, there are noprovisions for recourse to third parties, nor are any assets held by any thirdparties that the company as indemnitor can liquidate to recover amounts paidunder such indemnities.

 

Aportion of the consideration payable to WWLLP for the assets acquired iscontingent upon the achievement of agreed-upon financial performance targets bythe acquired business for the fiscal year ended June 30, 2007. Thecontingent consideration consists of up to 1,950,000 shares of the company’scommon stock, all, some, or none of which may become payable depending on thetargets achieved. The value of all the contingent stock was $59.4 million basedon the NYSE closing price on January 31, 2006. The contingentconsideration is payable by Watson Wyatt Limited and Watson Wyatt Worldwide, Inc.has guaranteed the payment obligations.

 

Underthe acquisition agreement, Watson Wyatt Limited is obligated to make paymentsto members of WWLLP representing profits and tax payments relating to periodsbefore the closing date of the transaction. The company has guaranteed theseobligations and has properly reflected them on the company’s consolidatedfinancial statements as of December 31, 2005.

 

*Letters of Credit*.  The company has outstanding letters of creditto two beneficiaries totaling $10.6 million under our existing credit facility to guarantee payment in theevent that the company fails to meet its financial obligations to thesebeneficiaries.  One letter of credit for$2.6 million will expire in October 2006, while the remaining letters ofcredit totaling $8.0 million will remain outstanding as long as we retain anownership share of our affiliated captive insurance company, PCIC.  The estimated fair market value of theseletters of credit is nominal because they have never been used, and the companybelieves that future usage is remote.

 

*Indemnification Agreements*.  The company has various agreements thatprovide that it may be obligated to indemnify the other party with respect tocertain matters.  Generally, theseindemnification clauses are included in contracts arising in the normal courseof business and in connection with the purchase and sale of certain businesses.  Although it is not possible to predict themaximum potential amount of future payments under these indemnificationagreements due to the conditional nature of the company’s obligations and theunique facts of each particular agreement, the company does not believe thatany potential liability that might arise from such indemnity provisions isprobable or material.  There are noprovisions for recourse to third parties, nor are any assets held by any thirdparties that any guarantor can liquidate to recover amounts paid under suchindemnities.

 

*Wellspring Leases*.  We continue to guarantee three leases foroffice premises for Wellspring Resources, LLC (“Wellspring”), the benefitsadministration outsourcing business that we exited from in fiscal year1998.  At December 31, 2005, minimumremaining payments guaranteed under these leases, which expire at various datesthrough 2007, total $8.3 million, excluding anticipated future subleaseincome.  See Note 14 for more informationregarding our obligation to guarantee Wellspring’s leases.

 

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**Note 13 – Contingent Liabilities.**

 

Fromtime to time, we are a party to various lawsuits, arbitrations or mediationsthat arise in the ordinary course of business. We have received subpoenas and requests for information in connectionwith government investigations.  Thematters reported on below involve the most significant pending or potentialclaims against us.

 

Wereserve for contingent liabilities based on Statement of Financial AccountingStandards No. 5, “Accounting for Contingencies” (SFAS 5) when it isdetermined that a liability, inclusive of defense costs, is probable andreasonably estimable.

 

*Government Investigations:*

 

*Department of Justice AntitrustInvestigation*.  In September 2005 an Amended Final Judgmentwas entered between the United States Department of Justice (DOJ) andProfessional Consultants Insurance Company, (PCIC), in an investigationrelating to contractual limitations of liability.  PCIC is a captive malpractice insurancecarrier that provides some of our malpractice coverage.  PCIC settled without admitting to anyviolation of antitrust laws.  No actionhas been brought against Watson Wyatt or any of the PCIC members, and wecontinue to be a stockholder of and to obtain insurance from PCIC. The AmendedFinal Judgment was ratified by the court in November 2005.

 

*New York State Attorney General*.  On December 17,2004, the New York State Attorney General issued a subpoena to Watson Wyattseeking information about “override” and other insurance placementcompensation.   Preliminary data indicatethat such payments accounted for less than 0.2 percent of Watson Wyatt’srevenue over the past four years. Watson Wyatt has provided information to theNew York State Attorney General’s office in response to the subpoena in January 2005.We have received no further inquiries from the New York State Attorney Generalsince responding.

 

*SEC Investigation of General Motors Corporation:*

 

In October 2005, theSecurities and Exchange Commission (SEC) elevated its inquiry into AccountingIssues Involving Pensions and Other Post-Employment Benefits at General MotorsCorporation from an informal inquiry to a formal investigation. On October 31,2005, the SEC issued Watson Wyatt, as General Motors actuary, a subpoena fordocuments and testimony related to the investigation. Watson Wyatt hasprovided, and will continue to provide, information to the SEC in response tothe subpoena and will cooperate in this investigation.

 

*Professional Liability Claims:*

 

*IronWorkers Local 25 et al. v. Watson Wyatt & Co. *On July 8, 2004, Watson Wyatt was served with an amended complaintfiled by a former client in the United States District Court for the EasternDistrict of Michigan.  The complaintalleged malpractice, breach of contract, and related claims in the performanceof actuarial consulting.  The complaintstated that the plaintiff’s pension fund is underfunded as a result of thealleged deficiencies in our work.  Inresponse to a discovery request, in January 2005 the plaintiffs disclosedthat their minimum damage claim is $53.7 million.  Discovery is continuing. We have establisheda loss and loss expense reserve in the amount of our professional liabilityinsurance self-retention for this case.

 

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*SBC Holdings, Inc. *On July 23, 2004, we received a demandletter from counsel for a client alleging that errors in valuations for 2001and subsequent years understated the liabilities of its pension plan andoverstated its net worth.  As a result,the client claimed it did not annuitize its defined benefit plan and redeemedits stock at an inflated price.  On April 15,2005 we filed a declaratory action in the U.S. District Court for the EasternDistrict of Michigan to compel arbitration of the matter.  On May 5, 2005, SBC filed an answer andcounterclaim to the declaratory judgment action, alleging damages in excess of$46 million.  The Motion to CompelArbitration is pending. We have established a loss and loss expense reserve inthe amount of our professional liability insurance self-retention for thiscase.

 

*Client Demand Letter.* On February 8, 2005, we received ademand letter from counsel for a client alleging failure to ensure that themethod for performing certain benefit calculations under the pensionadministration system developed by Watson Wyatt for the client was consistentwith the method required under the client’s pension equity plan and the summaryplan description, and failure to advise the client of the discrepancies betweenthe plan documents and the pension system. The client has claimed $14 million in damages and also sought to holdthe client’s outside ERISA counsel responsible for the damages.  On March 3, 2005, we entered into atolling agreement with the client and the client’s ERISA counsel in order topursue resolution of this matter through mediation. A mediation has taken placeand a tentative settlement has been reached. We have established a loss andloss expense reserve within our self-insured retention for this matter.

 

*Client Demand Letter (Canada*).  On December 22, 2005,Watson Wyatt Canada received a demand letter from counsel representing a formerclient demanding CAD20 million for losses alleged to be attributable to WatsonWyatt’s investment consulting advice.  Wehave established a loss and loss expense reserve in the amount of ourprofessional liability insurance self-retention for this matter.

 

**Note 14 –Discontinued Operations.**

 

As discussed in Note 12, the company continues to guarantee three leasesfor office premises for Wellspring.  Inaccordance with the contractual arrangements pursuant to which Watson Wyattdivested its interest in Wellspring, Watson Wyatt agreed to share with StateStreet either costs or benefits arising from these facilities leased byWellspring.  Since one of the threeWellspring leases is currently sub-leased at rates in excess of the lease rate, thecompany is contractually entitled to a share of the benefit of the excess cashflow from the sub-leases.  Through thefirst six months of fiscal year 2006, the company received sublease income ofapproximately $17,000, net of taxes, in excess of lease payments related tothis business.  Since the second quarterof fiscal year 2003, the leases have been generating positive cash flows ofless than $100,000 per fiscal year.  Thecompany’s current assessment is that the positive cash flow from the sub-leaseswill continue until they expire in December 2006. The company has nodirect cash obligation to Wellspring in the sense that its obligation iscontingent upon the remaining space being vacated.

 

Duringthe third quarter of fiscal years 2004 and 2005, the company evaluated itsaccrual for the estimated remaining future obligations and costs related to theexit from Wellspring.  The evaluationsincluded an analysis of occupancy rates of the three guaranteed leases, alongwith an analysis of real estate market conditions in cities in which the leasesexist and an assessment of probable future sublease income for these leases.  As a result of the analysis performed, thecompany reduced its accrual during fiscal year 2004 by $1.0 million and by$1.25 million during fiscal year 2005, less the associated income taxexpenses.  Such adjustments are reflectedin the Consolidated Statement of Operations for the third quarter of fiscalyears 2004 and 2005 in the line “Adjustment to reduce estimated loss ondisposal of discontinued operations.” The remaining non-current liability of $1.75 million representsmanagement’s estimate of potential future cash outflows related to guaranteesassociated with Wellspring leases.

 

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**Note 15 – RecentAccounting Pronouncements.**

** **

In June 2004, the Emerging Issues Task Force (EITF) issued EITF 02-14****“Whether an Investor Should Apply the Equity Method ofAccounting to Investments Other Than Common Stock if the Investor Has theAbility to Exercise Significant Influence Over the Operating and FinancialPolicies of the Investee.”  This EITFindicates that an investor should only apply the equity method of accountingwhen it has investments in either common stock or in-substance common stock ofa corporation, provided that the investor has the ability to exercisesignificant influence over the operating and financial policies of theinvestee.  The issuance of EITF 02-14 hasnot had an effect on our accounting for equity investments which has been inaccordance with EITF 02-14.

 

In December 2004, the Financial Accounting Standards Board (FASB)published revisions to Statement of Financial Accounting Standards No. 123,“Accounting for Stock-Based Compensation” (SFAS 123R).  SFAS 123(R) requires companies to account forshare-based payment transactions with employees using a fair-value basedmethod, thereby eliminating the disclosure-only provisions of SFAS 123.  The company implemented SFAS 123(R) duringthe first quarter of fiscal year 2006 under the modified prospectivemethod.  As a result, during the firstsix months of fiscal year 2006, compensation expense totaling $0.3 millionrelated to the outstanding stock options as of July 1, 2005 has beenrecognized based on the fair values of the awards previously calculated inpreparing the pro forma disclosures in accordance with the provisions of SFAS123, less adjustments for forfeitures.  The adoption of SFAS 123(R) has not had amaterial impact on the financial condition or results of operations for thecompany.  Refer to Note 4 of theConsolidated Financial Statements for more information about SFAS 123(R).

 

In April 2005, the Securities and Exchange Commission (SEC) issuedStaff Accounting Bulletin No. 107, “Share-Based Payments” (SAB 107) inwhich the SEC expressed views regarding the interaction between SFAS 123(R) andcertain SEC rules and regulations and provide the staff’s views regardingthe valuation of share-based payment arrangements for public companies.

 

On October 22, 2004, the American Jobs Creation Act (AJCA) wassigned into law.  The AJCA includes a provision that allows a one-timeelection to exclude up to 85 percent of its foreign unrepatriated earnings. Thecompany continues to evaluate the effect of the repatriation provision. As aresult, it is currently not practical to estimate the potential tax impact ofany repatriation.

 

**ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSISOF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.**

 

**Overview**

 

Watson Wyatt Worldwide, Inc., including its subsidiaries, is aglobal consulting firm focusing on human capital and financial management. Wehelp our clients enhance business performance by improving their ability toattract, retain, and motivate qualified employees. We focus on deliveringvalue-added consulting services that help our clients anticipate, identify andcapitalize on emerging opportunities in human capital management.  We also provide independent financial adviceregarding all aspects of life assurance and general insurance, as well asinvestment advice to assist our clients in developing disciplined and efficientinvestment strategies to meet their investment goals.  Our target market clients include thosecompanies in the Fortune 1000, Pension & Investments (P&I) 1000,the FTSE 100, and locally-defined equivalent organizations.

 

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As leading economies worldwide become more services-oriented, humancapital and financial management has become increasingly important to companiesand other organizations. The heightened competition for skilled employees,unprecedented changes in workforce demographics, regulatory changes related tocompensation and retiree benefits and rising employee-related costs haveincreased the importance of effective human capital management. Insurance andinvestment decisions become increasingly complex and important in the face ofchanging economies and dynamic financial markets.  We help our clients address these issues bycombining our expertise in human capital and financial management withconsulting and technology, to improve the design and implementation of varioushuman resources and financial programs, including compensation, retirement,health care, insurance and investment plans.

 

**General**

 

Effective as of July 31, 2005, the company completed theacquisition of substantially all of the assets and assumption of most of theliabilities of WWLLP, a privately held limited liability partnership registeredin the U.K. (See Note 2 for additional information regarding the company’sacquisition of WWLLP).  Prior to thisdate, the company and WWLLP jointly offered services under the Watson WyattWorldwide brand, sharing resources, technologies, processes and businessreferrals through an alliance established in 1995.  The combined company now maintains 92 officesin 30 countries and employs 6,050 associates as follows: 

 
| Benefits Group                                                  |   | 2,320 |   |
|-----------------------------------------------------------------|--------|-------|--------|
| Technology  and Administration Solutions Group                  |   | 720   |   |
| Human  Capital Group                                            |   | 400   |   |
| Insurance &  Financial Services Group                  |   | 330   |   |
| Investment  Consulting Group                                    |   | 270   |   |
| International  – Comprising Asia Pacific and Latin America |   | 900   |   |
| Other  (including Communication)                                |   | 550   |   |
| Corporate                                                       |   | 560   |   |
| Total                                                           |   | 6,050 |   |

 

**Principal Services**

 

We design, develop and implement human resource and risk managementstrategies and programs through the following closely-interrelated practiceareas:

 

**Benefits Group**

 

•                  Retirementplans, including pension, 401(k) and executive benefit plans

•                  Healthcare, disability and other group benefit plans

•                  Compensation,benefits, expatriate and HR practice strategy, implementation andadministration

•                  Actuarialservices

•                  Strategicworkforce planning

 

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**Technology and Administration Solutions Group**

 

•                  Web-basedapplications for health and welfare, pension and compensation administration

•                  Administrationoutsourcing solutions for health and welfare and pension benefits

•                  Callcenter strategy, design and tools

•                  Strategichuman resource technology and service delivery consulting

•                  Targetedonline compensation and benefits statements, content management and call centercase management solutions

 

**Human Capital Group**

 

•                  Compensationplans, including broad-based and executive compensation,  stock and other long-term incentive programs

•                  Strategiesto align workforce performance with business objectives

•                  Organizationeffectiveness consulting, including talent management

•                  Strategiesfor attracting, retaining and motivating employees

•                  Dataservices

 

**Insurance & Financial Services Group**

 

•                  Independentactuarial and strategic advice

•                  Assessmentand advice regarding financial condition and risk management

•                  Financialmodeling software tools for product design and pricing, planning andprojections, reporting, valuations and risk management

 

**Investment Consulting Group**

 

•                  Investmentconsulting services to pension plans and foundations

•                  Governanceand regulatory issues

•                  Assetallocation strategies

•                  Investmentstructure analysis, selection and evaluation of managers, and performancemonitoring

 

**International – Comprising Asia-Pacific andLatin America Operations**

 

Outside of North America and Europe, our consultants, working inAsia-Pacific and Latin America, operate on a geographic basis from 25 officesin 16 countries and provide consulting services in the practice areas describedabove.

 

**Other**

 

While we focus our consulting services in the areas described above,management believes that one of our primary strengths is our ability to drawupon consultants from our different practices to deliver integrated services tomeet the needs of our clients.  Thisincludes communication and change management implementation support services.

 

Our clients include many of the world’s largest corporations as well asemerging growth companies, public institutions and nonprofit organizations.

 

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**Executive Overview**

 

Watson Wyatt is a global provider of human capital and financialmanagement consulting services.  Weprovide services in five principal practice areas: Benefits, Technology andAdministration Solutions, Human Capital Consulting, Insurance &Financial Services, and Investment Consulting operating from 92 offices in 30countries throughout North America, Europe, Asia Pacific and LatinAmerica.  We design, develop andimplement human resource and risk management strategies and programs through thefollowing closely-interrelated practice areas:

 

*Benefits Group –*TheBenefits Group, accounting for 53 percent of our total second quarter 2006revenues, is the foundation of our business. Retirement, the core of our Benefits business, is less impacted bydiscretionary spending reductions than our other segments, mainly due to therecurring nature of client relationships. Our corporate client retention rate within our target market hasremained very high.

 

*Technology and Administration Solutions Group–*Our Technology and Administration Solutions Group,accounting for 11 percent of our total second quarter fiscal year 2006revenues, provides information technology services to our customers.

 

*Human Capital Group –*Our**Human Capital Group, accounting for 9 percent of our totalsecond quarter fiscal year 2006 revenues, generally encompasses short-termprojects and as a result is most sensitive to economic conditions.

 

*Insurance & Financial Services Group–*Our Insurance & Financial Services Groupaccounts for 7 percent of our total second quarter fiscal year 2006 revenues.This business is characterized by ongoing relationships with our clients whowill typically use our skills on a number of different projects.

 

*Investment Consulting Group –*OurInvestment Consulting Group, accounts for 6 percent of our total second quarterfiscal year 2006 revenues.  Thisbusiness, although relationship based, can be impacted by volatility ininvestment returns, particularly as clients look to us for assistance inmanaging that volatility.

 

In the short term, our revenues are driven by many factors includingthe general state of the global economy and the resulting level ofdiscretionary spending by our clients, the ability of our consultants toattract new clients or cross-sell to existing clients, and the impact of newregulations in the legal and accounting fields that most recently increaseddemand for our executive compensation and benefits practices.

 

The human resources consulting industry, although highly fragmented, ishighly competitive and is comprised of major human capital consulting firms,specialist firms, consulting arms of accounting firms and informationtechnology consulting firms.  While theenvironment and pricing remain competitive, we believe that with our combinedresources the company is in a position to attract new clients and better serveexisting clients.

 

In the long term, we believe that benefits spending will continue to bethe largest component of corporate spending around the world.  We believe that the aging workforce, theprojected shortfall in workers over the next decade and changing regulationswill translate into opportunities for us. We believe that the company’s financial results will depend in largepart upon how well we succeed in deepening our existing client relationships throughthought leadership and focus on cross-practice solutions, actively pursuing newclients in our target markets, cross selling and strategic acquisitions.  We also forsee tremendous opportunities forgrowth as we expand our financial management services in North America.  We believe that the highly fragmentedindustry in which we operate represents tremendous growth opportunities for us,because we offer a unique combination of benefits and human capital consulting,financial management and strategic technology and administration solutions.

 

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**Financial Statement Overview**

 

Watson Wyatt’s fiscal year ends June 30. The financial statementscontained in this quarterly report reflect Consolidated Balance Sheets as ofthe end of the second quarter of fiscal year 2006 (December 31, 2005) andas of the end of fiscal year 2005 (June 30, 2005), Consolidated Statementsof Operations for the three and six-month periods ended December 31, 2005and 2004, Consolidated Statements of Cash Flows for the six-month periods endedDecember 31, 2005 and 2004 and a Consolidated Statement of Changes inStockholders’ Equity for the six-month period ended December 31, 2005.

 

The acquisition of substantially all of the assets and assumption ofmost of the liabilities of two of its affiliates, WWLLP and WWHE, was effectiveJuly 31, 2005 and as a result, our financial statements reflect theconsolidation of the European operations through Watson Wyatt Limited beginningAugust 1, 2005.  Prior to July 31,2005, or for one month of the first quarter, the company recorded its share ofthe results of WWLLP and WWHE using the equity method of accounting.  This income is reflected in the “Income fromaffiliates” line on our income statement.  Our share of the results of our affiliatedcaptive insurance company, PCIC, continues to be recorded using the equitymethod of accounting, and is also reflected in the “Income from affiliates”line.

 

Wederive substantially all of our revenue from fees for consulting services,which generally are billed based on time and materials or on a fixed-feebasis.  Clients are typically invoiced ona monthly basis with revenue generally recognized as services are performed. Beforethe company’s business combination, for the most recent three fiscal years,revenue from U.S. consulting operations has comprised approximately 80 percentof consolidated revenue.  For the secondquarter of fiscal year 2006, U.S. Consulting operations comprised approximately50 percent of consolidated revenue. Before and after the business combination, no single client accountedfor more than 2 percent of our consolidated revenue for any of the most recentthree fiscal years.

 

In delivering consulting services, our principal direct expenses relateto compensation of personnel. Salaries and employee benefits are comprised ofwages paid to associates, related taxes, benefit expenses such as pension,medical and insurance costs and fiscal year-end incentive bonuses.

 

Professionaland subcontracted services represent fees paid to external service providersfor employment, marketing and other services. Before the company’s business combination, for the most recent threefiscal years, approximately 60 to 70 percent of these professional and subcontractedservices were directly incurred on behalf of our clients and were reimbursed bythem, with such reimbursements being included in revenue.  For the second quarter of fiscal year 2006,approximately 60 percent of professional and subcontracted services representthese reimbursable services.

 

Occupancy, communications and other expenses represent expenses forrent, utilities, supplies and telephone to operate office locations as well asnon-client-reimbursed travel by associates, publications and professionaldevelopment. This line item also includes miscellaneous expenses, includinggains and losses on foreign currency transactions.

 

General and administrative expenses include the operational costs,professional fees and insurance paid by corporate management, general counsel,marketing, human resources, finance, research and technology support.

 

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**CriticalAccounting Policies and Estimates**

 

The preparation of financial statements in conformity with accountingprinciples generally accepted in the United States of America requiresmanagement to make estimates and assumptions that affect the reported amountsof assets and liabilities, disclosures of contingent assets and liabilities atthe date of the financial statements and the reported amounts of revenue andexpenses during the reporting period. Our estimates, judgments and assumptions are continually evaluated basedon available information and experience. Because of the use of estimates inherent in the financial reportingprocess, actual results could differ from those estimates.  The accounting policies discussed below arecritical to the understanding of the use of estimates in the company’sfinancial statements.

 

*   **Revenue Recognition***

 

Revenue includes fees primarily generated from consulting servicesprovided in the areas of employee benefits, human capital strategies,technology and administration solutions and financial management.  We recognize revenue from these consultingengagements when hours are worked, either on a time-and-materials basis or on afixed-fee basis, depending on the terms and conditions defined at the inceptionof an engagement with a client.  The terms of our contracts with clients arefixed and determinable and can only be changed based on agreement of bothparties.  Individual consultants’ billingrates are principally based on a multiple of salary and compensation costs.

 

Revenue for fixed-fee arrangements, which span multiple months, isbased upon the percentage of completion method.* *The company typically has threetypes of fixed-fee arrangements:  annualrecurring projects, projects of a short duration, and non-recurring systemprojects.  Annual recurring projects andthe projects of short duration are typically straightforward and highlypredictable in nature.  As a result, theproject manager and financial staff are able to identify, as the project statusis reviewed and bills are prepared monthly, the rare occasion when cost overrunscould lead to the recording of an unexpected loss accrual.

 

Our non-recurring system projects are typically found in our Technologyand Administration Solutions Group.  Theytend to be more complex, to incur changes in scope as the project progressesand to be longer-term projects.  We evaluateat least quarterly, and more often as needed, project managers’estimates-to-complete to assure that the projects’ current status is accountedfor properly.  Contracts are written such that, in theunexpected event that the client terminates a contract, the company is entitledto payment for services performed through termination.

 

Revenue recognition for fixed-fee engagements is affected by a numberof factors that change the estimated amount of work required to complete theproject such as changes in scope, the staffing on the engagement and/or thelevel of client participation.  Theperiodic engagement evaluations require us to make judgments and estimatesregarding the overall profitability and stage of project completion that, inturn, affect how we recognize revenue. The company recognizes a loss on an engagement when estimated revenue tobe received for that engagement is less than the total estimated direct andindirect costs associated with the engagement. Losses are recognized in the period in which the loss becomes probableand the amount of the loss is reasonably estimable.  The company has experienced certain costs in excess ofestimates from time to time.  Managementbelieves that it is rare, however, for these excess costs to result in overallproject losses.

 

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The companyhas developed various software programs and technologies that we provide toclients in connection with consulting services. In most instances, such software is hosted and maintained by the companyand ownership of the technology and rights to the related code remain with thecompany.  Software developed to beutilized in providing services to a client, but for which the client does nothave the contractual right to take possession, is capitalized in accordancewith the AICPA’s Statement of Position 98-1 “Accounting for the Costs ofComputer Software Developed or Obtained for Internal Use.”  Revenue associated with the related contract,together with amortization of the related capitalized software, is recognizedover the service period.  As a result,and in accordance with EITF 00-3, we do not recognize revenue during thecustomization phase of an engagement.

 

Revenuerecognized in excess of billings is recorded as unbilled accountsreceivable.  Cash collections andinvoices generated in excess of revenue recognized are recorded as deferredrevenue until the revenue recognition criteria are met.  Client reimbursable expenses, including thoserelating to travel, other out-of-pocket expenses and any third-party costs, areincluded in revenue, and an equivalent amount of reimbursable expenses areincluded in professional and subcontracted services as a cost of revenue.

 

***Valuation of Billed andUnbilled Receivables from Clients***

 

We maintain allowances for doubtful accounts to reflect estimatedlosses resulting from our clients’ failure to pay for our services after theservices have been rendered, including allowances when customer disputes mayexist.  The related provision is generallyrecorded as a reduction to revenue.  Ourallowance policy is based on the aging of our billed and unbilled clientreceivables and has been developed based on our write-off history.  Facts and circumstances such as the averagelength of time the receivables are past due, general market conditions, currenteconomic trends and our clients’ ability to pay may cause fluctuations in ourvaluation of billed and unbilled receivables.

 

***Discretionary Compensation***

 

The company’s compensation program includes a discretionary annualbonus that is determined by management and paid once per fiscal year in theform of cash and/or deferred stock units after the company’s annual operatingresults are finalized.

 

An estimated annual bonus amount is initially developed at thebeginning of each fiscal year in conjunction with our budgeting process.  Quarterly, estimated annual operatingperformance is reviewed by the company and the discretionary annual bonusamount is then adjusted, if necessary, by management to reflect changes in theforecast of pre-bonus profitability for the year.   After determining the estimated annual bonusamount, the bonus is then allocated to remaining quarterly reporting periods asa constant percentage of estimated pre-bonus profitability.  In those quarters where the estimated annualbonus level changes, the remaining estimated annual bonus is accrued over theremaining quarters as a constant percentage of estimated future pre-bonusprofitability.  Annual bonus levels mayvary from current expectations as a result of changes in the company’s forecastof pre-bonus profitability and competitive employment market conditions.

 

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***Income Taxes***

 

Determining the consolidated provision for income tax expense, deferredtax assets and liabilities and the related valuation allowance involvesjudgment.  As a global company, we arerequired to calculate and provide for estimated income tax liabilities for eachof the tax jurisdictions in which we operate. This process involves estimating current tax obligations and exposuresin each jurisdiction as well as making judgments regarding the futurerecoverability of deferred tax assets. The company does not provide deferred taxes on cumulative earnings offoreign subsidiaries that have been reinvested indefinitely as asserted underAPB 23. Due to the availability of foreign tax credits, it is not practicableto estimate the company’s income tax liability that might be payable if suchearnings were not reinvested indefinitely, however, deferred taxes are providedfor earnings of foreign subsidiaries which the company plans to remit. Taxcosts can involve complex issues and may require an extended period toresolve.  Changes in the geographic mixor estimated level of annual pre-tax income, limitations on the use of thecompany’s foreign subsidiary losses, changes in tax laws and changes resultingfrom tax audits can all affect the overall effective income tax rate which, inturn, impacts the overall level of income tax expense and net income.

 

*** Pension Assumptions***

 

We sponsor both qualified and non-qualified, non-contributory definedbenefit pension plans covering substantially all of our associates.  Under our plans in North America and HongKong, benefits are based on the number of years of service and the associates’compensation during the five highest paid consecutive years of service.  The non-qualified plan, which exists only inNorth America, provides for pension benefits that would be covered under thequalified plan but are limited by the Internal Revenue Code.  The non-qualified plan has no assets andtherefore is an unfunded arrangement. The benefit liability is reflected on the balance sheet.  The measurement date for the plans is June 30.

 

As a result of the business combination described in Note 2, we haveincluded the defined benefit pension plan disclosures for our newly acquiredU.K. operations.  The disclosures forthis plan, along with our historical U.K. plan, are shown separately becausethe amounts are significant relative to all plans and the assumptions used inthe plan are significantly different than those used in all other plans. Underour newly acquired plan in the U.K., benefits are based on the number of yearsof service and the associates’ compensation during the three years beforeleaving the plan. The measurement date for the plan is July 31.

 

Determination of our obligations and annual expense under the plans isbased on a number of assumptions that, given the longevity of the plans, arelong-term in focus.  A change in one or acombination of these assumptions could have a material impact on our pensionbenefit obligation and related expense. For this reason, management employs a long-term view so that assumptionsdo not change frequently in response to short-term volatility in theeconomy.  Any difference between actualand assumed results is amortized into our pension expense over the averageremaining service period of participating employees.  We consider several factors prior to thestart of each fiscal year when determining the appropriate annual assumptions,including economic forecasts, historical trends, portfolio composition and peercomparisons.

 

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*North America and Hong Kong*

 

The following assumptions were used at the end of the past three fiscalyears in the valuation of our North American plans, which comprises themajority of the North America and Hong Kong defined benefit pension plans:

 
| ** **                                   | ** ** | **Year Ended June 30** | ** ** |
|----------------------------------------------|------------|-----------------------------|------------|
| ** **                                   | ** ** | **2005**                    | ** ** | **2004** | ** ** | **2003** | ** ** |
| Discount  rate                               |       | 5.25                        | %          | 6.25 | % | 6.00 | % |
| Expected  long-term rate of return on assets |       | 9.00                        | %          | 9.00 | % | 9.00 | % |
| Rate of  increase in compensation levels     |       | 3.34                        | %          | 3.34 | % | 3.09 | % |

 

The 5.25 percent discount rate assumption used at the end of fiscalyear 2005 represents a 100 basis point decrease from the 6.25 percent discountrate used at the end of fiscal year 2004 and represents a 75 basis pointreduction from the 6.00 percent discount rate used at the end of fiscal year2003.  The company’s 2005 discount rateassumption was determined by matching future pension benefit payments withexpected future AA bond yields for the same periods.

 

The expected long-term rate of return on assets assumption remained at9.00 percent per annum for the past three fiscal years. The rate of return waslowered in fiscal year 2003 to 9.00 percent from 10.00 percent at the end offiscal year 2002.  Selection of thereturn assumption at 9.00 percent per annum was supported by an analysis performedby the company of the weighted average yield expected to be achieved with theanticipated makeup of investments.  Theinvestment makeup is heavily weighted towards equities.  The return on assets through the first sixmonths of fiscal year 2006 has been 1.0 percent, compared to a return of 7.8percent in the first six months of fiscal year 2005.

 

The following informationillustrates the sensitivity to a change in certain assumptions for the U.S.pension plans:

 
| **Change in Assumption**                              | ** ** | **Effect on FY2006   Pre-Tax Pension Expense** | ** **               |
|-------------------------------------------------------|------------|------------------------------------------------|--------------------------|
| 25 basis  point decrease in discount rate             |       |                                           | +$ 3.3 million      |   |
| 25 basis  point increase in discount rate             |       |                                           | –$ 3.2 million |   |
| 25 basis  point decrease in expected return on assets |       |                                           | +$ 1.0 million      |   |
| 25 basis  point increase in expected return on assets |       |                                           | –$ 1.0 million |   |

 

Theabove sensitivities reflect the impact of changing one assumption at a time. Itshould be noted that economic factors and conditions often affect multipleassumptions simultaneously and the effects of changes in key assumptions arenot necessarily linear. The company’s U.S. Other Postretirement EmployeeBenefits Plan is relatively insensitive to discount rate changes due to theplan provisions that have been established to control costs and as such nosensitivity results are shown in this display.

 

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*United Kingdom*

 

The following assumptions were used at April 30, 2005, the formerWWLLP fiscal year end, and July 31, the date of the business combinationand the valuation of our U.K. plan:

 
| ** **                                   | ** ** | **July 31,** | ** ** | **April 30,** | ** ** |
|----------------------------------------------|------------|-------------------|------------|--------------------|------------|
| ** **                                   | ** ** | **2005**          | ** ** | **2005**           | ** ** |
| Discount  rate                               |       | 5.00              | %          | 5.30               | %          |
| Expected  long-term rate of return on assets |       | 5.63              | %          | 5.76               | %          |
| Rate of  increase in compensation levels     |       | 4.75              | %          | 4.75               | %          |

 

The 5.00 percent discount rate assumption used at the end of July 31,2005 represents a 30 basis point reduction from the discount rate at April 30,2005. The discount rate is set having regard to yields on AA corporate bonds atthe measurement date and this reduction reflects the reduction in yieldsbetween these two dates.

 

The expected long-term rate of return on assets assumption was reducedslightly from April 30, 2005 to July 31, 2005 and was supported by ananalysis performed by the company of the weighted average return expected to beachieved with the anticipated makeup of investments which is heavily weightedtowards bonds.  The return on assetsthrough the first five months of fiscal year 2006 has been 8.2 percent.

 

The following informationillustrates the sensitivity to a change in certain assumptions for the U.K.pension plans:

 
| **Change in Assumption**                              | ** ** | **Effect on FY2006   Pre-Tax Pension Expense** | ** **          |
|-------------------------------------------------------|------------|------------------------------------------------|---------------------|
| 25 basis  point decrease in discount rate             |       |                                           | +$ 1.3 million |   |
| 25 basis  point increase in discount rate             |       |                                           | -$ 1.2 million |   |
| 25 basis  point decrease in expected return on assets |       |                                           | +$ 0.5 million |   |
| 25 basis  point increase in expected return on assets |       |                                           | -$ 0.5 million |   |

 

***  Incurred But Not Reported Claims***

 

The company uses actuarialassumptions to estimate and record a liability for incurred but not reported(IBNR) professional liability claims and engaged an external actuarial firm toassist in the calculation of these estimates. Our estimated IBNR liability is based on long-term trends and averages,and considers a number of factors, including changes in claim reportingpatterns, claim settlement patterns, judicial decisions, and legislation andeconomic decisions, but excludes the effect of claims data for large cases dueto the insufficiency of actual experience with such cases.  Management does not currently expectsignificant fluctuations in the IBNR liability, based on the company’shistorical claims experience.  However,our estimated IBNR liability will fluctuate if claims experience changes overtime.

 

34

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**Results of Operations**

 

The table below sets forth our historical Consolidated Statements ofOperations data for continuing operations for the periods indicated:  

 

**ConsolidatedStatements of Operations**

(in thousands, except per sharedata)

 
| ** **                                             | ** ** | **Three Months Ended December 31,** | ** ** | **Six Months Ended December 31,** | ** ** |
|--------------------------------------------------------|------------|------------------------------------------|------------|----------------------------------------|------------|
| ** **                                             | ** ** | ** **                               | ** ** | ** **                             | ** ** | **%** | ** ** | ** ** | ** ** | ** ** | ** ** | **%** | ** ** |
| ** **                                             | ** ** | **2005**                                 | ** ** | **2004**                               | ** ** | **Change** | ** ** | **2005** | ** ** | **2004** | ** ** | **Change** | ** ** |
| ** **                                             | ** ** | **(Unaudited)**                          | ** ** | ** **                             | ** ** | **(Unaudited)** | ** ** | ** ** | ** ** |
|                                                   |       |                                     |       |                                   |       |   |   |   |   |   |   |   |   |
| Revenue                                                |       | $                                        | 315,764    |                                   | $          | 175,849 |   | 79.6 | % | $ | 581,650 |   | $ | 351,240 |   | 65.6 | % |
|                                                   |       |                                     |       |                                   |       |   |   |   |   |   |   |   |   |
| Costs of providing services:                           |       |                                     |       |                                   |       |   |   |   |   |   |   |   |   |
| Salaries and employee benefits                         |       | 175,207                                  |       | 95,194                                 |       | 84.0 |   | 322,757 |   | 192,270 |   | 67.9 |   |
| Professional and subcontracted services                |       | 19,595                                   |       | 11,544                                 |       | 70.4 |   | 38,606 |   | 23,523 |   | 64.3 |   |
| Occupancy, communications and Other                    |       | 43,687                                   |       | 27,901                                 |       | 56.6 |   | 76,540 |   | 52,001 |   | 47.1 |   |
| General and administrative expenses                    |       | 37,206                                   |       | 19,481                                 |       | 90.8 |   | 68,595 |   | 36,369 |   | 88.5 |   |
| Depreciation and amortization                          |       | 11,132                                   |       | 4,810                                  |       | 131.3 |   | 20,809 |   | 9,493 |   | 118.9 |   |
|                                                   |       | 286,827                                  |       | 158,930                                |       |   |   | 527,307 |   | 313,656 |   |   |   |
|                                                   |       |                                     |       |                                   |       |   |   |   |   |   |   |   |   |
| Income from operations                                 |       | 28,937                                   |       | 16,919                                 |       |   |   | 54,343 |   | 37,584 |   |   |   |
|                                                   |       |                                     |       |                                   |       |   |   |   |   |   |   |   |   |
| Income from affiliates                                 |       | 71                                       |       | 2,724                                  |       | (96.3 | ) | 1,422 |   | 4,930 |   | (71.4 | ) |
| Interest (expense)/income, net                         |       | (974                                     | )          | 407                                    |       | (350.0 | ) | (1,062 | ) | 862 |   | (222.2 | ) |
| Other non-operating loss                               |       | (288                                     | )          | (56                                    | )          | 200.0 |   | (2,150 | ) | (28 | ) | (7578.6 | ) |
|                                                   |       |                                     |       |                                   |       |   |   |   |   |   |   |   |   |
| Income from continuing operations before  income taxes |       | 27,746                                   |       | 19,994                                 |       |   |   | 52,553 |   | 43,348 |   |   |   |
|                                                   |       |                                     |       |                                   |       |   |   |   |   |   |   |   |   |
| Provision  for income taxes                            |       | 10,571                                   |       | 8,939                                  |       | (19.1 | ) | 21,486 |   | 18,542 |   | 16.2 |   |
|                                                   |       |                                     |       |                                   |       |   |   |   |   |   |   |   |   |
| Income from  continuing operations                     |       | $                                        | 17,175     |                                   | $          | 11,055 |   | 55.0 | % | $ | 31,067 |   | $ | 24,806 |   | 25.4 | % |

 

**Three and Six Months Ended December 31,2005 Compared to the Three and Six Months Ended December 31, 2004**

 

As a result of the August 1, 2005 effective date of ouracquisition of WWLLP, the three months ended December 31, 2005 includesthe consolidated operating results of Watson Wyatt Limited, whereas theoperating results for the three months ended December 31, 2004 do notinclude comparative consolidated operating results.  The six months ended December 31, 2005includes the consolidated operating results of Watson Wyatt Limited for themonths of August through December 2005, whereas the operating resultsfor the six months ended December 31, 2004 do not include comparativeconsolidated results.  The analysis belowhighlights the changes between the consolidated statements of operations forthe quarters ended December 31, 2005 and 2004 and segregates the effectsof the acquisition from the company’s results without the impact of WatsonWyatt Limited’s consolidated results (the historical company).

 

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*   **Revenue.***

 

Revenue from operations forthe second quarter of fiscal year 2006 was $315.8 million, an increase of$140.0 million, or 80 percent, from $175.8 million in the prior period.  Of the increase, $120.4 million relates tothe acquisition of WWLLP.  The remainingincrease of $19.5 million relates to the historical company.  The Benefits Group increased revenues $11.6million, or 12 percent over prior-year second quarter revenues, related toincreased demand from existing clients around plan design and administration aswell as revenues from new clients. Revenue from our Technology and Administration Solutions Group increased$2.2 million or 11 percent as compared to prior-year second quarter revenues,largely due to a number of projects which went into service during the quarterand for which the company was able to begin recognizing revenues.  In accordance with EITF 00-3, “Application ofAICPA Statement of Position 97-2 to Arrangements that Include the Right to UseSoftware Stored on Another Entity’s Hardware” (EITF 00-3), revenue for certaincontracts for which the company provides a hosting arrangement is recognizedover the hosting period.  Revenue fromour Human Capital Group increased $4.9 million during the second quarter offiscal year 2006, partially due to the $3.1 million reclassification of WatsonWyatt Data Services revenues, as well as continuing demand for executivecompensation consulting.  Revenue fromour Investment Consulting practice was up $0.7 million or 14 percent due to anincrease in pension funding and asset performance consulting.  Our International segment, comprisingAsia-Pacific and Latin America, finished the quarter with revenue growth of$0.7 million or 3 percent.  However,revenue increased only 2 percent on a constant currency basis. Results werestrong in Australia, Taiwan and China, and were partially offset by the company’sdivestiture of its New Zealand operations in the first quarter of fiscal 2006.Revenue for other practice areas decreased $4.0 million from the prior-yearsecond quarter largely reflecting the reclassification of Watson Wyatt DataServices.  Reimbursable expenses andother, net increased $3.4 million as compared to prior-year second quarter.

 

Revenue from operations forthe first six months of fiscal year 2006 was $581.7 million, an increase of$230.5 million, or 66 percent, from $351.2 million in the prior period.  Of the increase, $199.2 million relates tothe acquisition of WWLLP.  The remainingincrease of $31.3 million relates to the historical company.  The Benefits Group increased revenues $20.1million, or 10 percent during the first six months of fiscal year 2006revenues, related to new client wins that occurred in the prior year andincreasing demand for plan design work. Revenue from our Technology and Administration Solutions Group increased$0.3 million as compared to the first six months of fiscal year 2005.  In accordance with EITF 00-3, “Application ofAICPA Statement of Position 97-2 to Arrangements that Include the Right to UseSoftware Stored on Another Entity’s Hardware” (EITF 00-3), revenue for certaincontracts for which the company provides a hosting arrangement is recognizedover the hosting period.  Revenue fromour Human Capital Group increased $9.3 million partiallydue to the $6.5 million reclassification of Watson Wyatt Data Services revenues,as well as continuing demand for executive compensation consulting.  Revenue from our Investment Consultingpractice was up $1.5 million or 18 percent due to an increase in pensionfunding and asset performance consulting. Our International segment, comprising Asia-Pacific and Latin America,had revenue growth of $1.1 million or 3 percent during the first six months offiscal 2006.  However, revenue increasedonly 1 percent on a constant currency basis, reflecting growth in Taiwan andChina partially offset by the divestiture of our New Zealand operations in thefirst quarter of fiscal 2006.  Revenuefor other practice areas decreased $4.6 million from the first six months offiscal year 2005largelyreflecting the reclassification of Watson Wyatt Data Services.  Reimbursable expenses and other increased$3.4 million from the first six months of fiscal year 2005.

 

36

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***  Salariesand Employee Benefits*.**

 

Salaries and employee benefit expenses for the second quarter of fiscalyear 2006 were $175.2 million compared to $95.2 million for the second quarterof fiscal year 2005, an increase of $80.0 million or 84 percent.  The increase was mainly due to additionalsalary expenses of $72.8 million related to the acquisition of WWLLP. Theincrease in the historical company was due to higher salaries of $5.0 million,increased pension costs of $3.6 million, a higher accrual for discretionarycompensation of $1.2 million and higher other benefits of $0.9 million, partiallyoffset by the increased capitalization of time spent customizing in-houseadministration systems of $3.5 million, in accordance with AICPA’s Statement ofPosition 98-1, “Accounting for the Costs of Computer Software Developed orObtained for Internal Use.”  As apercentage of revenue, salaries and employee benefits increased to 55.5 percentfrom 54.1 percent.

 

Salaries and employee benefit expenses for the first six months offiscal year 2006 were $322.8 million compared to $192.3 million for the firstsix months of fiscal year 2005, an increase of $130.5 million or 68percent.  The increase was mainly due toadditional salary expenses of $118.9 million related to the acquisition ofWWLLP. The increase in the historical company was due to higher salaries of$9.4 million, increased pension costs of $6.2 million, a higher accrual fordiscretionary compensation of $3.0 million and higher other benefits of $2.9million including profit sharing and the re-instatement of the 401(k) match,partially offset by the increased capitalization of time spent customizingin-house administration systems of $10.0 million, in accordance with AICPA’sStatement of Position 98-1, “Accounting for the Costs of Computer SoftwareDeveloped or Obtained for Internal Use.” As a percentage of revenue, salaries and employee benefits increased to55.5 percent from 54.7 percent.

 

*** Professional and Subcontracted Services*.**

 

Professional and subcontracted services used in consulting operationsfor the second quarter of fiscal year 2006 were $19.6 million, compared to$11.5 million for the second quarter of fiscal year 2005, an increase of $8.1million or 70 percent.  The increase waspartially due to additional expenses of $1.1 million related to the acquisitionof WWLLP. The increase in the historical company was attributable to $2.9million higher reimbursable expenses incurred on behalf of clients as well as a$2.2 million increase in legal expense. As a percentage of revenue,professional and subcontracted services decreased from 6.6 percent to 6.2percent.

 

Professional and subcontracted services used in consulting operationsfor the first six months of fiscal year 2006 were $38.6 million, compared to$23.5 million for the first six months of fiscal year 2005, an increase of$15.1 million or 64 percent.  Theincrease was mainly due to additional expenses of $6.0 million related to theacquisition of WWLLP. The increase in the historical company was attributableto $3.6 million higher reimbursable expenses incurred on behalf of clients aswell as a $3.4 million increase in legal expense. As a percentage of revenue,professional and subcontracted services decreased from 6.7 percent to 6.6percent.

 

***Occupancy, Communications andOther.***

 

Occupancy, communications and other expenses for the second quarter offiscal year 2006 were $43.7 million compared to $27.9 million for the secondquarter of fiscal year 2005, an increase of $15.8 million or 56.6 percent.  The increase is mainly due to additional expensesof $14.2 million related to the acquisition of WWLLP. The increase of $1.6million associated with the historical company was principally attributable tomiscellaneous expenses such as travel, insurance, dues and entertainment, andgeneral office.  These increases wereoffset by decreases in equipment rental, telephone/fax, and promotion. As apercentage of revenue, occupancy, communications and other decreased from 15.9percent to 13.8 percent.

 

37

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Occupancy, communications and other expenses for the first six monthsof fiscal year 2006 were $76.5 million compared to $52.0 million for the firstsix months of fiscal year 2005, an increase of $24.5 million or 47.1percent.  The increase was mainly due toadditional expenses of $20.8 million related to the acquisition of WWLLP. Theincrease of $3.7 million associated with the historical company was principallyattributable to miscellaneous expenses such as travel, repairs and maintenance,dues and entertainment, and general office, offset by decreases in equipmentrental and promotion. As a percentage of revenue, occupancy, communications andother decreased from 14.8 percent to 13.1 percent.

 

***General and AdministrativeExpenses.***

 

General and administrative expenses for the second quarter of fiscalyear 2006 were $37.2 million, compared to $19.5 million for the second quarterof fiscal year 2005, an increase of $17.7 million or 91 percent.  The increase is mainly due to additionalexpenses of $18.8 million related to the acquisition of WWLLP. The decrease of$1.1 million in the historical company is mainly due to lower professionalservices fees associated with, legal fees and tax research of $1.0 million, adecrease in travel and general office expenses of $0.8 million offset byincreased salaries and benefits of $1.2 million. As a percentage of revenue,general and administrative expense increased from 11.1 percent to 11.8 percent.

 

General and administrative expenses for the first six months of fiscalyear 2006 were $68.6 million, compared to $36.4 million for the first sixmonths of fiscal year 2005, an increase of $32.2 million or 88 percent.  The increase is mainly due to additionalexpenses of $31.8 million related to the acquisition of WWLLP. The increase of$0.4 million in the historical company is mainly due to higher salaries andbenefits of $1.7 million offset by a decrease in rent, telephone, and repairsand maintenance costs of $0.5 million and a decrease in general office expensesof $0.8 million.  As a percentage ofrevenue, general and administrative expense increased from 10.4 percent to 11.7percent.

 

  ***  Depreciation and Amortization.***

 

Depreciation and amortization for the second quarter of fiscal year2006 was $11.1 million, compared to $4.8 million for the second quarter offiscal year 2005, an increase of $6.3 million or 131 percent.  The increase is due to additional expense of$4.4 million related to the acquisition of WWLLP, which includes $2.1 millionin amortization of intangible assets associated with the acquisition, and a $1.9million increase in the historical company expense due to depreciation ofinternally developed software used to support our Benefits Group and Technologyand Administration Solutions Group.  As apercentage of revenue, depreciation and amortization increased from 2.7 percentto 3.5 percent.

 

Depreciation and amortization for the first six months of fiscal year2006 was $20.8 million, compared to $9.5 million for the first six months offiscal year 2005, an increase of $11.3 million or 119 percent.  The increase is due to additional expense of$7.2 million related to the acquisition of WWLLP and a $4.1 million increase inthe historical company expense due to depreciation of internally developedsoftware used to support our Benefits Group and Technology and AdministrationSolutions Group.  As a percentage ofrevenue, depreciation and amortization increased from 2.7 percent to 3.6percent.

 

***  Income From Affiliates.***

 

Income from affiliates for the second quarter of fiscal year 2006 was$0.1 million, compared to $2.7 million for the second quarter of fiscal year2005, a decrease of $2.6 million.  Incomefrom affiliates for the first six months of fiscal year 2006 was $1.4 million,compared to $4.9 million for the first six months of fiscal year 2005, a decreaseof $3.5 million.  The decrease in bothcases was due to the absence of income from affiliate related to WWLLP due tothe acquisition of WWLLP in the first quarter of fiscal year 2006.

 

38

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***Interest (Expense)/Income, Net.***

 

Interest expense, net for the second quarter of fiscal year 2006 was$1.0 million, compared to interest income, net of $0.4 million for the secondquarter of fiscal year 2005.  Interestexpense, net for the first six months of fiscal year 2006 was $1.1 million,compared to interest income, net of $0.9 million for the first six months offiscal year 2005.  The net expense inboth periods was due to debt incurred as a result of the acquisition of WWLLPand the net income in the prior period relates to interest income earned on theinvestment of cash balances.

 

***Other Non-Operating Loss.***

 

Other non-operating loss for the first six months of fiscalyear 2006 includes a loss of $3.6 million on a foreign exchange forwardcontract entered into in conjunction with the acquisition of WWLLP, partiallyoffset by a $1.4 million gain recognized by the company on the sale of its NewZealand operations.

 

***Provision for Income Taxes.***

 

Provision for income taxes for the first six months of fiscal year 2006was $21.5 million, compared to $18.5 million for the first six months of fiscalyear 2005. Our effective tax rate was 40.9 percent for the first six months offiscal year 2006 and 42.8 percent for the first six months of fiscal year 2005.  The tax rate decrease is due to thegeographic mix of income and utilization of foreign tax credits.  The company has not provided U.S. deferredtaxes on cumulative earnings of foreign subsidiaries that have been reinvestedindefinitely, which also includes foreign subsidiaries affiliated with ourrecent combination with WWLLP.  We recorda tax benefit on foreign net operating loss carryovers and foreign deferredexpenses only if it is more likely than not that a benefit will be realized.

 

***Income From ContinuingOperations.***

 

Income from continuing operations for the second quarter of fiscal year2006 was $17.2 million, compared to $11.1 million for the second quarter offiscal year 2005.  As a percentage ofrevenue, income from continuing operations decreased from 6.3 percent to 5.4percent.  Income from continuingoperations for the first six months of fiscal year 2006 was $31.1 million,compared to $24.8 million for the first six months of fiscal year 2005.  As a percentage of revenue, income fromcontinuing operations decreased from 7.1 percent to 5.3 percent.

 

***Earnings Per Share, Income FromContinuing Operations.***

 

Diluted earnings per share, income from continuing operations for thesecond quarter of fiscal year 2006 was $0.41, compared to $0.34 for the secondquarter of fiscal year 2005.  Dilutedearnings per share, income from continuing operations for the first six monthsof fiscal year 2006 was $0.76, as well as for the first six months of fiscalyear 2005.

 

***Discontinued Operations.***

 

The company received sublease income through the first six months offiscal year 2006 of approximately $17,000, net of taxes, in excess of leasepayments related to Wellspring, compared to $8,000, net of taxes, in the priorperiod.

 

39

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**Pro Forma Analysis**

 

For a more meaningful comparison of financial results, the followingtable presents the company’s unaudited historical results for the three monthsended December 31, 2005 and the unaudited pro forma results for the sixmonths ended December 31, 2005 compared with the unaudited pro formaresults for the three and six months ended December 31, 2004 as if thecombination and consolidation had occurred at the beginning of each period.

 

In our opinion, information for the six months ended December 31,2005 and the pro forma results for the six months ended December 31, 2004contain all adjustments, consisting only of normal recurring adjustmentsnecessary to fairly present this information. Operating results for any periodare not necessarily indicative of results for any future periods. The unauditedpro forma combined income statement is presented for illustrative purposes onlyand is not indicative of the results of operations that might have occurred hadthe combination actually taken place as of the dates specified, or that may beexpected to occur in the future.

 

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**Pro-FormaCombined Statements of Operations**

(in thousands, except per sharedata)

 
| ** **                                              | ** ** | **Three Months Ended December 31,** | ** ** | **Six Months Ended December 31,** | ** ** |
|---------------------------------------------------------|------------|------------------------------------------|------------|----------------------------------------|------------|
| ** **                                              | ** ** | ** **                               | ** ** | ** **                             | ** ** | **%** | ** ** | ** ** | ** ** | ** ** | ** ** | **%** | ** ** |
| ** **                                              | ** ** | **2005**                                 | ** ** | **2004**                               | ** ** | **Change** | ** ** | **2005** | ** ** | **2004** | ** ** | **Change** | ** ** |
|                                                    |       | **(Unaudited)**                          |       |                                   |       | **(Unaudited)** |   |   |   |
|                                                    |       |                                     |       |                                   |       |   |   |   |   |   |   |   |   |
| Revenue                                                 |       | $                                        | 315,764    |                                   | $          | 299,779 |   | 5.3 | % | $ | 618,569 |   | $ | 584,572 |   | 5.8 | % |
|                                                    |       |                                     |       |                                   |       |   |   |   |   |   |   |   |   |
| Costs of providing services:                            |       |                                     |       |                                   |       |   |   |   |   |   |   |   |   |
| Salaries and employee benefits                          |       | 175,207                                  |       | 168,799                                |       | 3.8 |   | 346,797 |   | 331,293 |   | 4.7 |   |
| Professional and subcontracted services                 |       | 19,595                                   |       | 16,420                                 |       | 19.3 |   | 39,797 |   | 32,536 |   | 22.3 |   |
| Occupancy, communications and other                     |       | 43,687                                   |       | 40,740                                 |       | 7.2 |   | 79,731 |   | 74,824 |   | 6.6 |   |
| General and administrative expenses                     |       | 37,206                                   |       | 38,249                                 |       | (2.7 | ) | 75,193 |   | 73,874 |   | 1.8 |   |
| Depreciation and amortization                           |       | 11,132                                   |       | 9,395                                  |       | 18.5 |   | 22,234 |   | 18,564 |   | 19.8 |   |
|                                                    |       | 286,827                                  |       | 273,603                                |       |   |   | 563,752 |   | 531,091 |   |   |   |
|                                                    |       |                                     |       |                                   |       |   |   |   |   |   |   |   |   |
| Income from operations                                  |       | 28,937                                   |       | 26,176                                 |       | 10.5 |   | 54,817 |   | 53,481 |   | 2.5 |   |
|                                                    |       |                                     |       |                                   |       |   |   |   |   |   |   |   |   |
| Income from affiliates                                  |       | 71                                       |       | 705                                    |       | (89.4 | ) | 934 |   | 1,045 |   | 10.5 |   |
| Interest expense, net                                   |       | (974                                     | )          | (931                                   | )          | 4.6 |   | (1,475 | ) | (1,654 | ) | (10.8 | ) |
| Other non-operating (loss)/income                       |       | (288                                     | )          | (56                                    | )          | 414.3 |   | 1,452 |   | (28 | ) | (5285.7 | ) |
|                                                    |       |                                     |       |                                   |       |   |   |   |   |   |   |   |   |
| Income from continuing operations before  income taxes  |       | 27,746                                   |       | 25,894                                 |       | 7.2 |   | 55,728 |   | 52,844 |   | 5.5 |   |
|                                                    |       |                                     |       |                                   |       |   |   |   |   |   |   |   |   |
| Provision  for income taxes                             |       | 10,571                                   |       | 9,865                                  |       | 7.2 |   | 22,782 |   | 21,603 |   | 5.5 |   |
|                                                    |       |                                     |       |                                   |       |   |   |   |   |   |   |   |   |
| Income from  continuing operations                      |       | $                                        | 17,175     |                                   | $          | 16,029 |   | 7.2 | % | $ | 32,946 |   | $ | 31,241 |   | 5.5 | % |
|                                                    |       |                                     |       |                                   |       |   |   |   |   |   |   |   |   |
| Basic  earnings per share:                              |       | $                                        | 0.41       |                                   | $          | 0.39 |   |   |   | $ | 0.81 |   | $ | 0.75 |   |   |   |
| Diluted earnings  per share:                            |       | $                                        | 0.41       |                                   | $          | 0.38 |   |   |   | $ | 0.81 |   | $ | 0.75 |   |   |   |
|                                                    |       |                                     |       |                                   |       |   |   |   |   |   |   |   |   |
| Weighted  average shares of common stock, basic (000)   |       | 42,147                                   |       | 41,607                                 |       |   |   | 40,494 |   | 41,528 |   |   |   |
| Weighted  average shares of common stock, diluted (000) |       | 42,391                                   |       | 41,898                                 |       |   |   | 40,748 |   | 41,828 |   |   |   |

 

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**Pro Forma Three and Six Months Ended December 31,2005 Compared to the Three and Six Months Ended December 31, 2004**

 

***Revenue***

 

Pro forma revenue for thesecond quarter of fiscal year 2006 was $315.8 million, an increase of 5.3percent or $16.0 million from $299.8 million in the prior period.

 

The Benefits Group increasedrevenue $9.0 million or 6 percent during the second quarter of fiscal year 2006due to new client wins that occurred in the prior year and increasing demandfor plan design work.  Revenue from ourTechnology and Administration Solutions Group increased $2.4 million or 7percent as compared to prior-year pro forma second quarter revenues, largelydue to a number of projects which went into service during the quarter and forwhich the company was able to begin recognizing revenues as well as continuedgrowth of the European administration operations.  In accordance with EITF 00-3, “Application ofAICPA Statement of Position 97-2 to Arrangements that Include the Right to UseSoftware Stored on Another Entity’s Hardware” (EITF 00-3), revenue for certaincontracts for which the company provides a hosting arrangement is recognizedover the hosting period. Revenue from our Human Capital Group increased $4.2million or 17 percent during the second quarter of fiscal year 2006, partiallydue to the reclassification of Watson Wyatt Data Services revenues, as well ascontinuing demand for executive compensation consulting.  Revenue from our Insurance &Financial Services group was up $0.8 million, due to continuing work aroundlegislative changes and new client wins. Revenue from our Investment Consulting practice was up $0.3 million or 2percent due to an increase in work related to pension funding and assetperformance.  Our International segment,comprising Asia Pacific and Latin America, finished the quarter with revenuegrowth of $0.7 million or 3 percent. However, revenue increased only 2 percent on a constant currency basis. Resultswere strong in Australia, Taiwan and China, and were partially offset by thedivestiture from New Zealand in the first quarter of fiscal year 2006. Revenuefor other practice areas decreased $3.8 million largely due to thereclassification of Watson Wyatt Data Services into the Human CapitalGroup.   Reimbursable expenses and otherrevenue adjustments increased $2.4 million over the prior-year second quarter.

 

Pro forma revenue for thefirst six months of fiscal year 2006 was $618.6 million, an increase of 5.8percent or $34.0 million from $584.6 million in the prior period.

 

The Benefits Group increasedrevenue $18.9 million or 6 percent during the first six months of fiscal year2006 due to new client wins that occurred in the prior year and increasingdemand for plan design work.  Revenuefrom our Technology and Administration Solutions Group increased $0.9 millionor 1 percent as compared to prior-year pro forma revenues for the first sixmonths, largely due to a number of projects which went into service during the periodand for which the company was able to begin recognizing revenues as well ascontinued growth of the European administration operations.  In accordance with EITF 00-3, “Application ofAICPA Statement of Position 97-2 to Arrangements that Include the Right to UseSoftware Stored on Another Entity’s Hardware” (EITF 00-3), revenue for certaincontracts for which the company provides a hosting arrangement is recognizedover the hosting period. Revenue from our Human Capital Group increased $7.9million or 17 percent during the first six months of fiscal year 2006,partially due to the reclassification of Watson Wyatt Data Services revenues,as well as continuing demand for executive compensation consulting.  Revenue from our Insurance &Financial Services group was up $3.9 million, due to continuing work aroundlegislative changes and new client wins. Revenue from our Investment Consulting practice was up $2.1 million or 6percent due to an increase in work related to pension funding and assetperformance.  Our International segment,comprising Asia Pacific and Latin America, had revenue growth of $1.1 millionor 3 percent during the first six months of fiscal year 2006.  However, revenue increased only 1 percent ona constant currency basis, reflecting growth in Taiwan and China partially dueto the divestiture of selected administration operations in New Zealand in thefirst quarter of

 

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fiscal year 2006. Revenuefor other practice areas decreased $4.8 million largely due to thereclassification of Watson Wyatt Data Services into the Human CapitalGroup.   Reimbursable expenses and other revenueadjustments increased $4.0 million over the first six months of fiscal year2005.

 

***Salaries and Employee Benefits*.**

 

Salaries and employee benefit expenses for the second quarter of fiscalyear 2006 were $175.2 million, compared to $168.8 million for the secondquarter of fiscal year 2005, an increase of $6.4 million or 4 percent.  The increase was mainly due to highersalaries of $4.8 million, increased pension and post-retirement costs of $3.8million, increase in benefit costs of $0.7 million, a higher accrual fordiscretionary compensation of $0.6 million, partially offset by thecapitalization of time spent customizing in-house administration systems of$3.5 million, in accordance with AICPA’s Statement of Position 98-1, “Accountingfor the Costs of Computer Software Developed or Obtained for Internal Use.”  As a percentage of revenue, salaries andemployee benefits decreased from 56.3 percent to 55.5 percent.

 

Salaries and employee benefit expenses for the first six months offiscal year 2006 were $346.8 million, compared to $331.3 million for the firstsix months of fiscal year 2005, an increase of $15.5 million or 5 percent.   The increase was mainly due to highersalaries of $13.4 million, a higher accrual for discretionary compensation of$5.6 million, increased pension and post-retirement costs of $2.6 million,higher benefits of $3.9 million, partially offset by the capitalization of timespent customizing in-house administration systems of $10.0 million, inaccordance with AICPA’s Statement of Position 98-1, “Accounting for the Costsof Computer Software Developed or Obtained for Internal Use.”  As a percentage of revenue, salaries andemployee benefits decreased from 56.7 percent to 56.1 percent.

 

***Professional and SubcontractedServices*.**

 

Professional and subcontracted services used in consulting operationsfor the second quarter of fiscal year 2006 were $19.6 million, compared to$16.4 million for the second quarter of fiscal year 2005, an increase of $3.2million or 19 percent.  Professional andsubcontracted services used in consulting operations for the first six monthsof fiscal year 2006 were $39.8 million, compared to $32.5 million for the firstsix months of fiscal year 2005, an increase of $7.3 million or 22 percent. As apercentage of revenue, professional and subcontracted services increased from5.5 percent to 6.4 percent.  For bothperiods the increase is principally attributable to higher reimbursableexpenses incurred on behalf of clients, as well as increased recruiting feesand temporary staff.

 

***Occupancy, Communications andOther.***

 

Occupancy, communications and other expenses for the second quarter offiscal year 2006 were $43.7 million compared to $40.7 million for the secondquarter of fiscal year 2005, an increase of $3.0 million or 7 percent.  The increase is principally attributable tomiscellaneous expenses such as travel, repairs and maintenance, and othergeneral office expenses partially offset by a decrease in rent andutilities.  As a percentage of revenue,occupancy, communications and other increased from 13.6 percent to 13.8percent.

 

Occupancy, communications and other expenses for the first six monthsof fiscal year 2006 were $79.7 million compared to $74.8 million for the firstsix months of fiscal year 2005, an increase of $4.9 million or 7 percent.  The increase is principally attributable tomiscellaneous expenses such as travel, repairs and maintenance, general office,and dues partially offset by a decrease in rent and utilities.  As a percentage of revenue, occupancy,communications and other decreased from 12.9 percent to 12.8 percent.

 

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***General and AdministrativeExpenses.***

 

General and administrative expenses for the second quarter of fiscalyear 2006 were $37.2 million, compared to $38.2 million for the second quarterof fiscal year 2005, a decrease of $1.0 million or 3 percent.  The decrease is mainly due to reducedprofessional services fees associated with Sarbanes-Oxley compliance of $1.2million and a decrease in general office expenses of $1.0 million offset by anincrease in salaries and benefits of $1.2 million. As a percentage of revenue,general and administrative expenses decreased from 12.8 percent to 11.8percent.

 

General and administrative expenses for the first six months of fiscalyear 2006 were $75.2 million, compared to $73.9 million for the first sixmonths of fiscal year 2005, an increase of $1.3 million or 2 percent.  The increase is mainly due to increasedsalaries and benefits of $2.8 million offset by a decrease of $0.7 million intechnology services and a decrease in general office expense of $0.8million.  As a percentage of revenue,general and administrative expenses decreased from 12.6 percent to 12.1percent.

 

***Depreciation and Amortization.***

 

Depreciation and amortization for the second quarter of fiscal year2006 was $11.1 million, compared to $9.4 million for the second quarter offiscal year 2005, an increase of $1.7 million or 19 percent. As a percentage ofrevenue, depreciation and amortization increased from 3.1 percent to 3.5percent.

 

Depreciation and amortization for the first six months of fiscal year2006 was $22.2 million, compared to $18.6 million for the first six months offiscal year 2005, an increase of $3.6 million or 19 percent.   As a percentage of revenue, depreciation andamortization increased from 3.2 percent to 3.6 percent. For both periods theincrease is mainly due to depreciation on internally developed software used tosupport our Benefits and Technology and Administration Solutions Groups.

 

***Income From Affiliates.***

 

Income from affiliates for the second quarter of fiscal year 2006 was$0.1 million, compared to $0.7 million for the second quarter of fiscal year2005, a decrease of $0.6 million.  Incomefrom affiliates for the first six months of fiscal year 2006 was $0.9 million,compared to $1.0 million for the first six months of fiscal year 2005, adecrease of $0.1 million.  The decreasein both periods relates to our share of operating results of PCIC.

 

***Interest Expense, Net.***

 

Interest expense, net for the second quarter of fiscal year 2006 was$1.0 million, compared to $0.9 million for the second quarter of fiscal year2005. Interest expense, net for the first six months of fiscal year 2006 was$1.5 million, compared to $1.7 million for the first six months of fiscal year2005.   The net expense in both periodswas due to debt incurred as a result of the combination with WWLLP net ofinterest income earned on remaining cash balances.

 

***Other Non-operating Expenses.***

 

Other non-operating expenses in the first six months offiscal year 2006 includes a $1.4 million gain recognized by the company on thesale of its New Zealand operations.

 

***Provision for Income Taxes.***

 

Provision for income taxes for the first six months of fiscal year 2006was $22.8 million, compared to $21.6 million for the first six months of fiscalyear 2005. Our effective tax rate was 40.9 percent for both periods.  The company has not provided U.S. deferredtaxes on cumulative earnings of foreign subsidiaries that have been reinvestedindefinitely, which also includes foreign subsidiaries affiliated with ourrecent combination with WWLLP.  We recorda tax benefit on foreign net operating loss carryovers and foreign deferredexpenses only if it is more likely than not that a benefit will be realized.

 

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***Income From ContinuingOperations.***

 

Income from continuing operations for the second quarter of fiscal year2006 was $17.2 million, compared to $16.0 million for the second quarter offiscal year 2005.  As a percentage ofrevenue, income from continuing operations increased from 5.4 percent to 5.5percent.  Income from continuingoperations for the first six months of fiscal year 2006 was $32.9 million,compared to $31.2 million for the first six months of fiscal year 2005.  As a percentage of revenue, income fromcontinuing operations was 5.3 percent in both periods.

 

***Earnings Per Share, Income FromContinuing Operations.***

 

Diluted earnings per share, income from continuing operations for thesecond quarter of fiscal year 2006 was $0.41, compared to $0.38 for the secondquarter of fiscal year 2005.  Dilutedearnings per share, income from continuing operations for the first six monthsof fiscal year 2006 was $0.81, compared to $0.75 for the first six months offiscal year 2005.

 

***Discontinued Operations.***

 

The company received sublease income through the first six months offiscal year 2006 of approximately $17,000, net of taxes, in excess of leasepayments related to Wellspring, compared to $8,000, net of taxes, in the priorperiod.

 

**Liquidity and Capital Resources**

 

The following analysis is based on the company’s historicalconsolidated financial statements.

 

Our cash and cash equivalents at December 31, 2005, totaled $79.8million, compared to $168.1 million at June 30, 2005.  The decrease in cash from June 30, 2005to December 31, 2005 was mainly attributable to our acquisition of WWLLP(see Note 2 of Notes to the Consolidated Financial Statements), representing acash use of approximately $130 million. Cash flows from July 1, 2005 through December 31, 2005 alsoreflects a typical pattern of cash flow for the company due to the payment ofpreviously accrued discretionary compensation which totaled $73.7 millionduring the first six months of fiscal year 2006. We also repaid $27 million ofborrowings under our credit facility during the second quarter of fiscal year2006, paid $13.3 million in corporate taxes, spent $29.4 million in capitalexpenditures and $6.3 million in dividends during the first six months offiscal year 2006.  These outflows of cashwere funded by cash flow from current consulting operations, from existing cashbalances and from borrowings under our revolving credit facility.  Consistent with the company’s liquidityposition, management considers various alternative strategic uses of cashreserves including acquisitions, dividends and stock buybacks, or anycombination of these options. The company believes that it has sufficientresources to fund operations through the next twelve months.  On January 30, 2006, the company paid$29.9 million of accrued bonuses in accordance with the WWLLP purchaseagreement.

 

Our non U.S. operations do not materially impact liquidity or capitalresources as they are substantially self-sufficient for their working capitalneeds.  At December 31, 2005, $58.0million of the total cash balance of $79.8 million was held outside of NorthAmerica, which we have the ability to utilize, if necessary. There are nosignificant repatriation restrictions other than local or U.S. taxes associatedwith repatriation.

 

***Cash From Operating Activities.***

 

Cash from operating activities for the first six months of fiscal year2006 was $8.0 million, compared to cash from operating activities of $0.5million for the first six months of fiscal year 2005.

 

The allowance for doubtful accounts increased $2.7 million and theallowance for work in process increased $5.4 million from June 30, 2005,to December 31, 2005, which is mainly due to the acquisition in the firstquarter. The number of days of accounts receivable and work in processoutstanding was 85 at

 

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December 31, 2005, compared to 80 at June 30, 2005.

 

***Cash Used in InvestingActivities.***

 

Cash used in investing activities for the first six months of fiscalyear 2006 was $162.1 million, compared to $29.6 million used in investingactivities for the first six months of fiscal year 2005.  The difference can be primarily attributed toacquisition and contingent consideration payments of $134.1 million, higherpurchases of fixed assets of $2.3 million and higher costs associated with thecapitalization of time spent customizing in-house administration systems of$8.3 million, in accordance with AICPA’s Statement of Position 98-1.  We have made reclassifications to ourConsolidated Statement of Cash Flows for the six months ended December 31,2004 to reflect the gross purchases of $306.5 million and sales of $296.3million of Dutch auction rate securities as investing activities rather than asa component of cash and cash equivalents. Refer to Note 10 of the Notes to the Consolidated Financial Statementsfor additional information regarding this reclassification.

 

Capital expenditures were $21.0 million for the first six months offiscal year 2006.  Anticipatedcommitments of capital expenditures are estimated at $25 million for theremainder of fiscal year 2006, mainly for dividends, computer hardwarepurchases, office relocations and renovations, development and upgrade offinancial and retirement systems and acquisition-related payments. We expectcash from operations to adequately provide for these cash needs.  The company anticipates that future annualcommitments of capital funds will include approximately $10 million individends and $30 million in purchases of fixed assets.

 

***Cash From/(Used in) FinancingActivities.***

 

Cash from financing activities for the first six months of fiscal year2006 was $62.5 million, compared to cash used in financing activities of $4.3million for the first six months of fiscal year 2005.  The increase can be attributed to $102.0million of borrowings related to the acquisition of WWLLP, net of repayments of$27.0 million, lower repurchases of common stock of $1.7 million, offset by$8.4 million recognized under the forward contract discussed in Note 2 of theNotes to the Consolidated Financial Statements, and $1.5 million in higherdividends paid during the first six months of fiscal year 2006.

 

**Off-Balance Sheet Arrangements andContractual Obligations**

 

***Operating Leases***.  We lease office space, furniture and selectedcomputer equipment under operating lease agreements with terms ranging from oneto ten years.  Future expected paymentsare as follows: 

 
| ** **                        | ** ** | **Remaining payments by fiscal year due as of December 31, 2005** | ** ** |
|-----------------------------------|------------|------------------------------------------------------------------------|------------|
| **Contractual Cash  Obligations** | ** ** | **Total**                                                              | ** ** | **Remaining  2006** | ** ** | **2007  through  2008** | ** ** | **2009  through  2010** | ** ** | **Thereafter** | ** ** |
| Lease  commitments                |       | $                                                                      | 369,585    |   | $ | 27,563 |   | $ | 97,257 |   | $ | 79,351 |   | $ | 165,414 |   |
|                                   |            |                                                                        |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

Management has determined that there is not a large concentration ofleases that will expire in any one fiscal year. Consequently, management anticipates that any increase in future rentexpense will be mainly market driven.

 

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***Guarantees***

 

*Wellspring Leases*.  The company continues to guarantee certainleases for office premises and equipment for Wellspring.  At December 31, 2005, minimum remainingpayments guaranteed under these leases, which expire at various dates through2007, totaled $8.3 million, excluding anticipated sublease income.  The leases are currently generating positivecash flows of less than $100,000 per fiscal year.  Management will continue to evaluate theadequacy of these provisions and make adjustments as appropriate.  See Notes 12 and 14 of the Notes to theConsolidated Financial Statements for more information related to Wellspring.

 

*Acquisition of WWLLP*.  On July 31,2005, the company completed the acquisition of substantially all the assets andmost liabilities of WWLLP, the company’s long-time alliance partner.  The company entered into indemnityarrangements with WWLLP relating to the acquisition and also agreed thatcertain indemnity obligations relating to the alliance arrangements willcontinue after the acquisition.  In theacquisition agreement, Watson Wyatt Limited, the company’s principal U.K.subsidiary, has agreed to indemnify WWLLP against liabilities arising withrespect to certain liabilities assumed in the acquisition by Watson WyattLimited and also with respect to certain tax liabilities.

 

Aspart of the original alliance arrangements in 1995, the company sold itsthen-existing businesses in the U.K. and Europe to the predecessor of WatsonWyatt LLP or its subsidiaries.  Thecompany agreed to indemnify the buyers against liabilities arising with respectto prior acts or omissions of the businesses transferred.  Furthermore, the company agreed to indemnifyWWLLP against liabilities arising with respect to acts or omissions of thecompany and its subsidiaries during the alliance arrangements.  These indemnities continue following theacquisition.

 

Thecompany is unable to estimate an amount of any potential future payments underthese arrangements because the occurrence of any of the events to which theindemnities apply is entirely speculative and the amount of any payment woulddepend upon the nature of the event triggering such indemnity. Managementbelieves that any potential for payment under such indemnities should declinewith the passage of time.  The companyhas insurance to cover liabilities arising from acts or omissions by thecompany and its subsidiaries, and such insurance may cover some or all of itsindemnity obligations relating to prior acts or omissions.  Except for such insurance, there are noprovisions for recourse to third parties, nor are any assets held by any thirdparties that the company as indemnitor can liquidate to recover amounts paidunder such indemnities.

 

Aportion of the consideration payable to WWLLP for the assets acquired iscontingent upon the achievement of agreed-upon financial performance targets bythe acquired business for the fiscal year ended June 30, 2007. Thecontingent consideration consists of up to 1,950,000 shares of the company’scommon stock, all, some, or none of which may become payable depending on thetargets achieved. The value of all the contingent stock was $59.4 million basedon the NYSE closing price on January 31, 2006. The contingentconsideration is payable by Watson Wyatt Limited and the company has guaranteedthe payment obligations.

 

Underthe acquisition agreement, Watson Wyatt Limited is obligated to make paymentsto members of WWLLP representing profits and tax payments relating to periodsbefore the closing date of the transaction. The company has guaranteed theseobligations and has properly reflected them on the company’s consolidatedfinancial statements as of December 31, 2005.

 

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**Credit Agreement**

 

DuringJuly 2005 the company amended and restated its credit facility to providefor a new revolving credit facility in an aggregate principal amount of $300million provided by a syndicate of banks. The credit facility was further amended effective September 2005 inorder to correct the wording of a definition in the credit agreement. Interestrates associated with this facility vary with LIBOR and/or the Prime Rate andare based on our leverage ratio, as defined by the credit agreement.  We are charged a quarterly commitment fee,currently 0.20 percent of the facility for this quarter, which varies with ourfinancial leverage and is paid on the unused portion of the creditfacility.  Borrowings under this facilitywere $75.0 million as of December 31, 2005.  Credit under the facility is available upondemand, although the credit facility requires us to observe certain covenants(including requirements for minimum net worth, which act to restrict dividends,cash flow leverage ratio and a fixed coverage charge) and is collateralizedwith a pledge of stock of material subsidiaries.  We were in compliance with all covenantsunder the credit facility as of December 31, 2005. This facility isscheduled to mature on June 30, 2010.

 

Aportion of the revolving facility is used to support required letters of creditissued under the credit line.  As aresult, $10.6 million of the facility was unavailable for operating needs as ofDecember 31, 2005.  We are alsocharged a fee for outstanding letters of credit that also fluctuates based onour leverage ratio.

 

**Risk Management**

 

Asa part of our overall risk management program, we carry customary commercialinsurance policies, including commercial general liability, employmentpractices liability, and claims-made professional liability insurance with aself-insured retention of $1 million per claim, which provides coverage for professionalliability claims against the companyand its non-European subsidiaries not previously owned by WWLLP**,**including the cost of defendingsuch claims.  Our primary insurancecoverage beyond this retention is written by an affiliated captive insurance company(PCIC) owned by us and two other professional services firms.

 

Informulating its premium structure, PCIC estimates the amount it expects to payfor losses (and loss expenses) for all the members as a whole and thenallocates that amount to the member firms based on the individual member’sexpected losses.  PCIC bases premiumcalculations, which are determined annually based on experience through March ofeach year, on relative risk of the various lines of business performed by eachof the owner companies, past claim experience of each owner company, growth ofeach of those companies, industry risk profiles in general and the overallinsurance markets.  As of July 1,2005, the captive insurance company carries reinsurance for 100% of losses itinsures above $25 million, in any reasonably forseeable loss scenarios.

 

Ouragreements with PCIC could require additional payments to PCIC in the eventthat the company decided to exit PCIC and adverse claims significantly exceedprior expectations.  If these circumstanceswere to occur, the company would record a liability at the time it becomesestimable and probable.

 

Thecompany will continue to provide for the self-insured retention where specificestimated losses and loss expenses for known claims in excess of $1 million areconsidered probable and reasonably estimable.****In addition, oursubsidiary, Watson Wyatt Limited, maintains customary commercial insurancepolicies, including claims-made professional liability insurance covering ourEuropean subsidiaries as well as certain predecessor companies, including WWLLPand Watson Wyatt Partners.  This programcarries a self-insured retention of £2 million in the aggregate and £100,000per claim, including the cost of defending such claims.

 

Althoughthe company maintains professional liability insurance coverage, this insurancedoes not cover claims made after expiration of our current insurancecontracts.  Generally accepted accountingprinciples require that we record a liability for incurred but not reported (IBNR)professional liability claims if they are estimable and probable, and for whichwe have not yet contracted for insurance coverage.  The company uses actuarial assumptions toestimate and record its IBNR liability and has a $31.8 million IBNR liabilityrecorded as of December 31, 2005.

 

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Recentinsurance market conditions for our industry include increases in overallpremium cost, higher self-insured retentions and constraints on aggregateexcess coverages, trends that are anticipated to continue.  We expect these recent conditions to recurperiodically and to be reflected in our future annual insurance renewals.  As a result, we will continue to assess ourability to secure future insurance coverage. In anticipation of the possibility of future reductions in risk transferfrom PCIC to re-insurers, as well as the hardening insurance market conditionsin recent years, the firms that own PCIC, including the company, have increasedPCIC’s capital in recent years, with the most recent capital contribution beingmade in July 2005 in the form of $1.5 million in cash and a letter ofcredit for $3.1 million.

 

Inlight of increasing worldwide litigation, including litigation againstprofessionals, the company has established a policy that all clientrelationships be documented by engagement letters containing specific riskmitigation clauses that were not included in all historical clientagreements.  Nearly 100 percent of thecompany’s U.S.****and U.K.****corporateclients have signed engagement letters including mitigation clauses, andinitiatives to maintain that process in the United States and the UnitedKingdom and complete it elsewhere are underway. The company has disengaged from certain client relationships wheresatisfactory engagement terms could not be achieved.

 

**Disclaimer Regarding Forward-lookingStatements**

 

This filing contains certain statements that are “forward-lookingstatements” within the meaning of the Private Securities Litigation Reform Actof 1995, including, but not limited to the following: Note 5 -  Retirement Benefits on pages 13 through16; Note 6 – Goodwill and Intangible Assets on pages 17 and 18; Note 12 –Guarantees on pages 21 and 22; Note 13 – Contingent Liabilities on pages 23and 24; the Executive Overview on page 28; Critical Accounting Policiesand Estimates on pages 30 through 34; the discussion of our capitalexpenditures on pages 45 and 46; Off-Balance Sheet Arrangements andContractual Obligations on page 46 and 47; Risk Management on pages 48and 49; and Part II, Item 1 “Legal Proceedings” on pages 51 and52.  In some cases, you can identifythese statements and other forward-looking statements in this filing by wordssuch as “may”, “will,”, “expect”, “anticipate”, “believe”, “estimate”, “plan”, “intend”,“continue”, or similar words. You should read these statements carefullybecause they contain projections of our future results of operations orfinancial condition, or state other “forward-looking” information. A number ofrisks and uncertainties exist which could cause actual results to differmaterially from the results reflected in these forward-looking statements.  Such factors include but are not limited toour ability to integrate the business of Watson Wyatt LLP into our ownbusiness, processes and systems, and achieve the anticipated results; ourcontinued ability to recruit and retain qualified associates; the success ofour marketing, client development and sales programs after the acquisition; ourability to maintain client relationships and to attract new clients after theacquisition; declines in demand for our services; outcomes of litigation; theability of the Company to obtain professional liability insurance; asignificant decrease in the demand for the consulting, actuarial and otherservices we offer as a result of changing economic conditions or other factors;actions by competitors offering human resources consulting services, includingpublic accounting and consulting firms, technology consulting firms and Internet/intranetdevelopment firms; our ability to achieve cost reductions after theacquisition; foreign currency exchange and interest rate fluctuations; exposureto Watson Wyatt LLP liabilities that have not been expressly assumed; generaleconomic and business conditions that adversely affect us or our clients afterthe acquisition; the level of capital resources required for futureacquisitions; regulatory, legislative and technological developments that mayaffect the demand for or costs of our services; and other factors discussedunder “Risk Factors” in the Company’s Annual Report on Form 10-K dated August 24,2005, and the proxy statement/prospectus filed on June 23, 2005, both ofwhich are on file with the Securities and Exchange Commission.  These statements are based on assumptionsthat may not come true.  Allforward-looking disclosure is speculative by its nature.  The Company undertakes no obligation toupdate any of the forward-looking information included in this report, whetheras a result of new information, future events, changed expectations orotherwise.

 

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**ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.**

 

We are exposed to market risks in the ordinary course of business.These risks include interest rate risk and foreign currency exchange risk. Wehave examined our exposure to these risks and concluded that none of ourexposures in these areas are material to fair values, cash flows or earnings*.*

 

See Note 2 forfurther information regarding our handling of risk associated with the businesscombination.

 

**ITEM 4.  CONTROLS AND PROCEDURES.**

 

**Evaluationof Disclosure Controls and Procedures**

 

An evaluation was performed under the supervision andwith the participation of our management, including the chief executiveofficer, or CEO, and chief financial officer, or CFO, of the effectiveness ofthe design and operation of our disclosure controls and procedures. Based onthat evaluation, our management, including the CEO and CFO, concluded that ourdisclosure controls and procedures were effective at a reasonable assurancelevel as of December 31, 2005.

 

**Changes in Internal Control Over FinancialReporting**

 

There were no significant changes in our internal control overfinancial reporting in the quarter ended December 31, 2005 that materiallyaffected, or are reasonably likely to materially affect, our internal controlover financial reporting.

 

**Limitations on the Effectiveness of Controls**

 

Our management, including the CEO and CFO, does not expect that our disclosure controls and procedures will necessarily prevent all error and all fraud.  However, our management does expect that the control system provides reasonable assurance that its objectives will be met.  A control system, no matter how well designed and operated, cannot provide absolute assurance that the control system’s objectives will be met.   In addition, the design of such internal controls must take into account the costs of designing and maintaining such a control system.  Certain inherent limitations exist in control systems to make absolute assurances difficult, including the realities that judgments in decision-making can be faulty, that breakdowns can occur because of a simple error or mistake, and that individuals can circumvent controls.  The design of any control system is based in part upon existing business conditions and risk assessments. There can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions.  Over time, controls may become inadequate because of changes in business conditions or deterioration in the degree of compliance with policies or procedures.  As a result, they may require change or revision.  Because of the inherent limitations in a control system, misstatements due to error or fraud may occur and may not be detected.  Nevertheless, the disclosure controls and procedures are designed to provide reasonable assurance of achieving their stated objectives, and the CEO and CFO have concluded that the disclosure controls and procedures are effective at a reasonable assurance level.

 

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**PART II.  OTHER INFORMATION**

 

**ITEM 1.  LEGAL PROCEEDINGS.**

 

Fromtime to time, we are a party to various lawsuits, arbitrations or mediationsthat arise in the ordinary course of business. We have received subpoenas and requests for information in connectionwith government investigations.  Thematters reported on below involve the most significant pending or potentialclaims against us.

 

Wereserve for contingent liabilities based on Statement of Financial AccountingStandards No. 5, “Accounting for Contingencies” (SFAS 5) when it isdetermined that a liability, inclusive of defense costs, is probable andreasonably estimable.

 

*Government Investigations:*

 

*Department of Justice AntitrustInvestigation. *In September 2005 an Amended FinalJudgment was entered between the United States Department of Justice (DOJ) andProfessional Consultants Insurance Company, (PCIC), in an investigationrelating to contractual limitations of liability.  PCIC is a captive malpractice insurancecarrier that provides some of our malpractice coverage.  PCIC settled without admitting to anyviolation of antitrust laws.  No actionhas been brought against Watson Wyatt or any of the PCIC members, and wecontinue to be a stockholder of and to obtain insurance from PCIC. The AmendedFinal Judgment was ratified by the court in November 2005.

 

*New York State Attorney General*.  On December 17, 2004, the New York StateAttorney General issued a subpoena to Watson Wyatt seeking information about “override”and other insurance placement compensation.  Preliminary data indicate that such payments accounted for less than 0.2percent of Watson Wyatt’s revenue over the past four years.  Watson Wyatt has provided information to theNew York State Attorney General’s office in response to the subpoena in January 2005.We have received no further inquiries from the New York State Attorney Generalsince responding.

 

*SEC Investigation of General Motors Corporation:*

 

In October 2005, theSecurities and Exchange Commission (SEC) elevated its inquiry into AccountingIssues Involving Pensions and Other Post-Employment Benefits at General MotorsCorporation from an informal inquiry to a formal investigation. On October 31,2005, the SEC issued Watson Wyatt, as General Motors actuary, a subpoena fordocuments and testimony related to the investigation. Watson Wyatt hasprovided, and will continue to provide, information to the SEC in response tothe subpoena and will cooperate in this investigation.

 

*Professional Liability Claims*

 

*Iron Workers Local 25 et al. v.Watson Wyatt & Co. *On July 8,2004, Watson Wyatt was served with an amended complaint filed by a formerclient in the United States District Court for the Eastern District ofMichigan.  The complaint allegedmalpractice, breach of contract, and related claims in the performance ofactuarial consulting.  The complaintstated that the plaintiff’s pension fund is underfunded as a result of thealleged deficiencies in our work.  Inresponse to a discovery request, in January 2005 the plaintiffs disclosedthat their minimum damage claim is $53.7 million.  Discovery is continuing. We have established a lossand loss expense reserve in the amount of our professional liability insuranceself-retention for this case.

 

*SBC Holdings, Inc. *On July 23, 2004, we received a demandletter from counsel for a client alleging that errors in valuations for 2001and subsequent years understated the liabilities of its pension plan andoverstated its net worth.  As a result,the client claimed it did not annuitize its defined benefit plan and redeemedits stock at an inflated price.  On April 15,2005 we filed a declaratory action in the U.S. District Court for the EasternDistrict of Michigan to compel arbitration of the matter.  On May 5, 2005, SBC filed an answer andcounterclaim to the declaratory judgment action, alleging damages in excess of

 

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$46million.  The Motion to CompelArbitration is pending. We have established a loss and loss expensereserve in the amount of our professional liability insurance self-retentionfor this case.

 

*Client Demand Letter.* On February 8, 2005, we received ademand letter from counsel for a client alleging failure to ensure that themethod for performing certain benefit calculations under the pensionadministration system developed by Watson Wyatt for the client was consistentwith the method required under the client’s pension equity plan and the summaryplan description, and failure to advise the client of the discrepancies betweenthe plan documents and the pension system. The client has claimed $14 million in damages and also sought to holdthe client’s outside ERISA counsel responsible for the damages.  On March 3, 2005, we entered into atolling agreement with the client and the client’s ERISA counsel in order topursue resolution of this matter through mediation.  A mediation has taken place and a tentativesettlement has been reached. We have established a loss and loss expensereserve within our self-insured retention for this matter.

 

*Client Demand Letter (Canada*).  On December 22, 2005,Watson Wyatt Canada received a demand letter from counsel representing a formerclient demanding CAD20 million for losses alleged to be attributable to WatsonWyatt’s investment consulting advice.  Wehave established a loss and loss expense reserve in the amount of ourprofessional liability insurance self-retention for this matter.

 

**ITEM 1A.  RISK FACTORS**

 

There are no materialchanges from risk factors as previously disclosed in our Annual Report on Form 10-K(File No. 001-16159) filed on August 24, 2005.

 

**ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS.**

 

The company did not engage in any unregistered salesof equity securities during the quarter.

 

**Issuer Purchases of Equity Securities**

 

The table below presents specified information aboutthe Company’s stock repurchases and repurchase plans:

 
| **Period**                                            | ** ** | **Total Number of  Shares  Purchased** | ** ** | **Average Price  Paid per Share** | ** ** | **Total Number of  Shares Purchased  as Part of Publicly  Announced Plans  or Programs** | ** ** | **Maximum Number of  Shares that May Yet  Be Purchased Under  the Plans or Programs** | ** ** |
|-------------------------------------------------------|------------|----------------------------------------|------------|-----------------------------------|------------|-----------------------------------------------------------------------------------------------|------------|--------------------------------------------------------------------------------------------|------------|
| October 1, 2005 through  October 31, 2005   |       | —                                 |       | $                                 | —     |                                                                                          | —     |                                                                                       | 563,934    |   |
| November 1, 2005 through  November 30, 2005 |       | 29,000                                 |       | 27.11                             |       | 29,000                                                                                        |       | 534,934                                                                                    |       |
| December 1, 2005 through  December 31, 2005 |       | 62,700                                 |       | 26.85                             |       | 62,700                                                                                        |       | 472,234                                                                                    |       |
| Total                                                 |       | 91,700                                 |       | $                                 | 26.93      |                                                                                          | 91,700     |                                                                                       |       |   |

 

Inaddition, during the first quarter of fiscal year 2006, the company’s Board ofDirectors approved the repurchase of up to 75,000 shares of our Class Acommon stock to be re-issued in connection with our Amended Compensation Planfor Outside Directors.

 

52

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Shares that the company repurchases are generallyissued in connection with the company’s employee benefit plans.

 

**ITEM 3. DEFAULTS UPON SENIOR SECURITIES.**

 

**None.**

** **

**ITEM4.  SUBMISSION OF MATTERS TO A VOTE OFSECURITY HOLDERS.**

 

Atthe sixth annual meeting of the stockholders of the Company, held on November 11,2005, the following matters were submitted to a vote of stockholders: (1) theelection of five members of the Board of Directors; (2) a proposal toapprove the Watson Wyatt & Company Holdings Incentive CompensationPlan; and (3) a proposal to increase the number of shares which may beissued under the Amended Compensation Plan for Outside Directors.

 

Proxiesrepresenting 40,694,739 shares were received (total shares outstanding as ofthe Record Date were  42,044,751), andthe results of the meeting were as follows with respect to each mattersubmitted to a vote of stockholders.

 

 *Election of Directors*

 

Pursuantto the Company’s Amended and Restated Certificate of Incorporation, thedirectorships are divided into three classes, Class I, Class II and Class III.The directorships in Class I expire as of the annual stockholders’ meetingin 2007 and will expire every three years thereafter; the directorships in Class IIexpire as of the annual stockholders’ meeting in 2005 and every three yearsthereafter; and the directorships in Class III will expire as of theannual stockholders’ meeting in 2006 and every three years thereafter. As theterm of each of the classes of directors expires, directors of the Company willbe elected to serve for a three-year period and until their respectivesuccessors have been duly elected and qualified.  Of the proxies received,the votes were as follows:

 
| **Nominees for Directors**                                     | ** **   | **For**      | ** **   | **Withheld** | ** **   |
|----------------------------------------------------------------|--------------|--------------|--------------|--------------|--------------|
| *Term  expiring at the annual meeting of stockholders in 2006* |         |         |         |         |         |
| * *                                                       |         |         |         |         |         |
| Gene H.  Wickes                                                |         | 37,895,863   |         | 2,798,877    |         |
| *Term  expiring at the annual meeting of stockholders in 2007* |         |         |         |         |         |
|                                                           |         |         |         |         |         |
| John J.  Gabarro                                               |         | 37,530,436   |         | 3,164,304    |         |
| *** ***                                                   | *** *** | *** *** | *** *** | *** *** | *** *** |
| *Term  expiring at the annual meeting of stockholders in 2008* |         |         |         |         |         |
|                                                           |         |         |         |         |         |
| John J.  Haley                                                 |         | 38,118,764   |         | 2,575,975    |         |
| Linda D.  Rabbitt                                              |         | 37,524,919   |         | 3,169,821    |         |
| John C.  Wright                                                |         | 37,678,470   |         | 3,016,270    |         |

 

53

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Thedirectors serving in Class I and Class III and their remaining termsare as follows:

 
| **Class I Directors**                                     | ** ** |
|----------------------------------------------------------------|------------|
| *Term  expiring at the annual meeting of stockholders in 2007* | * *   |
| * *                                                       | * *   |
| R. Michael  McCullough                                         |       |
| Paul N.  Thornton*                                             |       |

 
| **Class III Directors**                                   | ** ** |
|----------------------------------------------------------------|------------|
| *Term  expiring at the annual meeting of stockholders in 2006* | * *   |
|                                                           |       |
| Chandrasekhar  Ramamurthy                                      |       |
| Gilbert T.  Ray                                                |       |
| John B.  Shoven                                                |       |

 

----

* Mr. Thornton advised the company of his resignation as adirector effective as of January 23, 2006.

 

*Approval of a proposal to approve the Watson Wyatt & CompanyHoldings Incentive Compensation Plan*

 

OnNovember 11, 2005, the stockholders of Watson Wyatt & CompanyHoldings (the “Company”) approved the Watson Wyatt & Company HoldingsIncentive Compensation Plan (the “Plan”) to govern the award and payment ofbonuses to certain Company executives. The Plan was approved and adopted by the board of directors, uponrecommendation by the Compensation Committee of the board (the “Committee”), onSeptember 28, 2005.  The purpose ofthe Plan is to provide a framework that is consistent with Section 162(m)of the Internal Revenue Code (the “Code”) under which the Company can operatecertain executive bonus programs. Accordingly, the Company has structured the Plan to satisfy therequirements of Section 162(m) of the Code for “performance-based”compensation.  The bonus programs aredesigned to enhance the Company’s ability to attract and retain qualifiedexecutives and to provide financial performance incentives to those executives.

 

ThePlan will be administered by the Committee. Each executive officer of the Company who is employed by the Company orone of its affiliates on the last day of the Company’s fiscal year or of anyother performance period established by the Committee is automatically a participantin the Plan.  Not later than 90 daysafter the commencement of each fiscal year of the Company (or, if earlier, theexpiration of 25% of a performance period), the Committee, in writing, maydesignate one or more performance periods (which may overlap or runconcurrently) and may affirm the applicability of the Plan’s formula fordetermining the maximum incentive award for each participant for suchperformance period(s).  The maximumincentive award payable to the CEO under the Plan with respect to a givenperformance period is 2.5% of the Company’s Net Income (as defined in the Plan)for that period and for any other participant is 1.5% of the Company’s NetIncome for the performance period.

 

Ofthe proxies received, the votes were as follows:

 
| **For**    | ** ** | **Against** | ** ** | **Abstain** | ** ** | **Broker Non-Votes** | ** ** |
|------------|------------|-------------|------------|-------------|------------|----------------------|------------|
| 20,252,045 |       | 5,697,441   |       | 885,925     |       | 13,859,328           |       |

 

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*Approval of**a proposal to increase the number of shares which may be issued underthe Amended Compensation**Plan for Outside Directors*

 

OnNovember 11, 2005, the stockholders of the Company approved an amendmentto the Watson Wyatt & Company Holdings Amended Compensation Plan forOutside Directors (“Outside Directors’ Plan”) to increase the number of sharesof common stock available for issuance under the Outside Directors’ Plan to150,000 (from 75,000), subject to adjustments for stock splits, stock dividendsand similar transactions, including extraordinary distributions of cash orstock.  The board of directors approvedthis amendment on September 28, 2005.

 

 TheAmended Compensation Plan for Outside Directors is intended to providecompensation for the Company’s outside directors through a combination of cashand stock grants.  Under the plan, outside directors are paid a quarterlyretainer, committee and meeting fees and receive an annual stock grant forservices rendered as directors.

 

 Ofthe proxies received, the votes were as follows:

 
| **For**    | ** ** | **Against** | ** ** | **Abstain** | ** ** | **Broker Non-Votes** | ** ** |
|------------|------------|-------------|------------|-------------|------------|----------------------|------------|
| 24,355,575 |       | 1,604,660   |       | 875,176     |       | 13,859,328           |       |

 

**ITEM 5. OTHER INFORMATION.**

 

On January 1, 2006, thecompany changed its name to “Watson Wyatt Worldwide, Inc.”  Thechange in name was effected pursuant to a merger of Watson Wyatt Worldwide, Inc.,a Delaware corporation and wholly-owned subsidiary of the company, with andinto the company, with the company surviving.  In connection with themerger, the name of the company was changed to “Watson Wyatt Worldwide, Inc.”   The Company will continue to trade on theNYSE under its existing symbol, WW.

 

55

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**ITEM 6.EXHIBITS.**

 
| 3.1   |   | Amended and Restated Certificate of  Incorporation of Watson Wyatt Worldwide, Inc.(1)                                                                                                                                                                                                                                                                                                                                  |
|-------|--------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 3.2   |   | Amended and Restated Bylaws of Watson Wyatt  Worldwide, Inc.(1)                                                                                                                                                                                                                                                                                                                                                        |
| 4     |   | Form of Certificate Representing  Common Stock(1)                                                                                                                                                                                                                                                                                                                                                                      |
| 10.1  |   | Credit Agreement Among Suntrust Bank and  Others dated July 11, 2005(10)                                                                                                                                                                                                                                                                                                                                               |
| 10.2  |   | Senior Officer Deferred Compensation Plan(3)                                                                                                                                                                                                                                                                                                                                                                                |
| 10.3  |   | 2001 Deferred Stock Unit Plan for Selected  Employees(4)                                                                                                                                                                                                                                                                                                                                                                    |
| 10.4  |   | Amended Compensation Plan for Outside  Directors(12)                                                                                                                                                                                                                                                                                                                                                                        |
| 10.5  |   | Lease between Watson Wyatt &  Company and Arlington Office, LLC, dated April 27, 2004(5)                                                                                                                                                                                                                                                                                                                      |
| 10.6  |   | Watson Wyatt & Company Performance  Share Bonus Incentive Program(6)                                                                                                                                                                                                                                                                                                                                               |
| 10.7  |   | First Amendment to Deed of Lease between  Watson Wyatt & Company and Arlington Office L.L.C., dated  April 22, 2005(7)                                                                                                                                                                                                                                                                                        |
| 10.8  |   | Business Transfer Agreement, dated as of  April 15, 2005, by and among Watson Wyatt & Company Holdings,  Watson Wyatt LLP, Watson Wyatt (UK) Acquisitions 2 Limited and The Wyatt  Company Holdings Limited(8)                                                                                                                                                                                                |
| 10.9  |   | Form of Employment Agreement between  Watson Wyatt Limited and each of Chandrasekhar Ramamurthy, Paul N. Thornton  and Roger C. Urwin(8)                                                                                                                                                                                                                                                                               |
| 10.10 |   | Distribution Agreement, dated as of  April 15, 2005, by and among Watson Wyatt LLP, The Wyatt Company  Holdings Limited, The Wyatt Company (UK) Limited, Wyatt Trustee Limited and  Watson Wyatt Limited(8)                                                                                                                                                                                                            |
| 10.11 |   | Deed of Termination and Amendment and  Restatement of Indemnities Relating to the Alliance Documents, dated as of  April 15, 2005, by and among The Wyatt Company Holdings Limited, Watson  Wyatt LLP, Watson Wyatt & Company, Watson Wyatt Holdings Limited,  Watson Wyatt Holdings (Europe) Limited, The Wyatt Company (UK) Limited and  Wyatt Trustee Limited (in its capacity as Wyatt Partner)  (8) |
| 10.12 |   | Deed of Contribution, dated as of  April 15, 2005, by and among Watson Wyatt LLP, Watson Wyatt Limited and  Watson Wyatt & Company Holdings(9)                                                                                                                                                                                                                                                                |
| 10.13 |   | Bonuses Deed, dated as of April 15,  2005, by and among Watson Wyatt LLP, Watson Wyatt Limited and Watson  Wyatt & Company Holdings(8)                                                                                                                                                                                                                                                                        |
| 10.14 |   | Form of P.I. Claims Deed by and among  the P.I. Trustees, Watson Wyatt LLP, Watson Wyatt Limited and Watson  Wyatt & Company Holdings(9)                                                                                                                                                                                                                                                                      |
| 10.15 |   | Form of Stock Transfer Agreement by  and between Watson Wyatt & Company Holdings, Watson Wyatt (UK)  Acquisitions 2 Limited and Watson Wyatt Limited and each of Watson Wyatt LLP  and each voting member(8)                                                                                                                                                                                                  |
| 10.16 |   | Watson Wyatt Share Incentive Plan 2005(11)                                                                                                                                                                                                                                                                                                                                                                                  |
| 10.17 |   | Form of Indemnification Agreement  among Watson Wyatt & Company Holdings and each of its directors and  Section  16 officers(12)                                                                                                                                                                                                                                                                         |
| 10.18 |   | Amendment to the Credit Agreement Among  Suntrust Bank and Others dated September 30, 2005(13)                                                                                                                                                                                                                                                                                                                         |
| 10.19 |   | First Amendment to Lease Between Watson  Wyatt & Company and Arlington Office LLC dated November 14,  2005(14)                                                                                                                                                                                                                                                                                                |
| 21    |   | Subsidiaries of Watson Wyatt  Worldwide, Inc.(14)                                                                                                                                                                                                                                                                                                                                                                      |
| 31.1  |   | Certification of Chief Executive Officer  Pursuant to Securities Exchange Act Rules 13a-14 and 15d-14, as adopted  pursuant to Section 302 of the Sarbanes-Oxley Act of 2002(14)                                                                                                                                                                                                                                  |
| 31.2  |   | Certification of Chief Financial Officer  Pursuant to Securities Exchange Act Rules 13a-14 and 15d-14, as adopted  pursuant to Section 302 of the Sarbanes-Oxley Act of 2002(14)                                                                                                                                                                                                                                  |
| 32    |   | Certification of Chief Executive Officer  and Chief Financial Officer Pursuant to Title 18, U.S.C. Section 1350,  adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002(14)                                                                                                                                                                                                                           |

 

56

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| (1)  |   | Incorporated by reference from Registrant’s  Form 8-K, filed on January 3, 2006                                                  |
|------|--------|-------------------------------------------------------------------------------------------------------------------------------------------------|
| (2)  |   | Incorporated by reference from Registrant’s  Form 10-Q, filed on May 2, 2001                                                     |
| (3)  |   | Incorporated by reference from Registrant’s  Form 10-K, filed on August 15, 2001                                                 |
| (4)  |   | Incorporated by reference from Registrant’s  Form DEF14A, filed on October 5, 2001                                               |
| (5)  |   | Incorporated by reference from Registrant’s  Form 10-Q, filed on May 7, 2004                                                     |
| (6)  |   | Incorporated by reference from Registrant’s  Form 10-Q, filed on February 9, 2005                                                |
| (7)  |   | Incorporated by reference from Registrant’s  Form 10-Q, filed on May 10, 2005                                                    |
| (8)  |   | Incorporated by reference from Registrant’s  Form S-4 (File No. 33-3124629), filed on May 4, 2005                           |
| (9)  |   | Incorporated by reference from Registrant’s  Form S-4/A, Amendment No. 1 (File No. 33-3124629) filed on  June 13, 2005 |
| (10) |   | Incorporated by reference from Registrant’s  Form 8-K, filed on July 14, 2005                                                    |
| (11) |   | Incorporated by reference from Registrant’s  Form 8-K, filed on August 25, 2005                                                  |
| (12) |   | Incorporated by reference from Registrant’s  Form 8-K, filed on October 4, 2005                                                  |
| (13) |   | Incorporated by reference from Registrant’s  Form 10-Q, filed on November 9, 2005.                                               |
| (14) |   | Filed with this Form 10-Q                                                                                                                  |

 

57

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**Signatures**

 

Pursuant to the requirements of the Securities and Exchange Act of1934, the registrant has duly caused this report to be signed on its behalf bythe undersigned thereunto duly authorized.

 

Watson Wyatt Worldwide, Inc.(Registrant)

 

 
| /s/ John J. Haley   |                    | February 9,  2006     |   |
|---------------------|-------------------------|-----------------------|--------|
| Name:               | John J. Haley           | Date                  |   |
| Title:              | President and           |                  |   |
|                | Chief Executive Officer |                  |   |
|                |                    |                  |   |
|                |                    |                  |   |
| /s/ Carl D. Mautz   |                    | February 9, 2006 |   |
| Name:               | Carl D. Mautz           | Date                  |   |
| Title:              | Vice President and      |                  |   |
|                | Chief Financial Officer |                  |   |
|                |                    |                  |   |
|                |                    |                  |   |
| /s/ Peter L. Childs |                    | February 9,  2006     |   |
| Name:               | Peter L. Childs         | Date                  |
| Title:              | Controller              |                  |
|                     |                         |                       |        |  |

 

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