December 16, 2014 Police & Fire Retirement Plan Board Police - PowerPoint PPT Presentation

Police & Fire Department Retirement Plan Special Board Meeting December 16, 2014

Police & Fire Retirement Plan Board Police & Fire Retirement Plan IC NEPC Albourne Investment Program Global Inflation Global Private Absolute Fixed Linked Equity Equity Return Income Assets Mgr Mgr Mgr Mgr Mgr Mgr Mgr Mgr Mgr Mgr Mgr Mgr Mgr Mgr Mgr Mgr Mgr Mgr Mgr Mgr Mgr Mgr Mgr Mgr Mgr Mgr Mgr Mgr Mgr Mgr Mgr 2

 The Plan will be managed as an ongoing concern with a long-term investment time horizon, consistent with the demographic profile of the Plan’s members and beneficiaries.  The primary objective of the investment portfolio is to satisfy the Plan’s obligations to pay benefits to members of the Plan and their beneficiaries. Police & Fire Investment Policy 3

 The investment portfolio also seeks to achieve a risk-adjusted long-term rate of return that exceeds the return of a composite benchmark of the respective long-term target asset mix weighting of the major asset classes.  The Plan will take into consideration the actuarial investment return assumption, which is developed by the Plan’s Actuary, with the goal of choosing an assumed rate that the Plan can be expected to achieve with a probability greater than 50%. Police & Fire Investment Policy 4

 Investments shall be diversified with the intent to minimize the risk of large investment losses. Consequently, the total portfolio will be constructed and maintained to provide prudent diversification with regard to the concentration of holdings in individual issues, issuers, or industries. Furthermore, assets will be assigned to a variety of investment managers that employ a range of investment management strategies Police & Fire Investment Policy 5

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 Asset Allocation  Asset Class Structuring  Manager Selection & Monitoring  Risk Management  Portfolio Positioning and Strategy 8

City of San Jose Police and Fire Department Retirement Plan Pension Investment Strategies (In a Low Return World) December 16, 2014 Allan Martin, Partner Dan LeBeau, Consultant

Facing the Challenge of Lower Returns All investors face the same fundamental challenge • Capital + Investment Earnings must equal total obligations in the end – For pensions, this is the classic equation: – C + I = B + E If investment return is lower than expected, adjustments are required • to balance the equation Contributions must be higher; – Benefits + Expenses must be lower; or – More risk must be taken in an effort to earn the expected return – Adjusting investment return and risk is the most fluid of these three • levers Staying unchanged and accepting lower returns puts more pressure on contributions – and payouts How does one increase risk efficiently while staying within an appropriate risk – tolerance? 10

A Survey of Portfolio Approaches 11

Asset Allocation Frameworks Each plan sponsor’s asset allocation is unique, based on funded status, maturity • of plan, payout structures, etc. For simplicity, we can think of a few broad frameworks for investing • Most plan sponsors can be easily identified as fitting into one of the approaches below or some blend – two approaches An additional framework not considered here is a bond-centric liability-driven investing (LDI) approach – Heavily utilized by Corporate Defined Benefit plans, where benefits are known (not subject to inflation; • funded status already reflects low discount rate) 60/40 • Heavily invested in public equities and core fixed income securities – U.S.-centric, very liquid – Little or no alternatives exposure (typically real estate) – Risk Parity • Balance risk across different asset classes – May need to apply leverage at portfolio level to increase returns – No alternatives, limited access to alpha – Global and liquid – Endowment • Heavily focused on alternatives – hedge funds, private markets (private equity, real estate, real assets) – Using alpha and illiquidity to drive returns as much as or more than beta exposure – Less U.S.-centric, less liquid – De-risked Public Plan • Diversified globally – Looks more like Endowment model than 60/40 or Risk Parity – Capturing some illiquidity premium – Participating in economic growth but substituting significant credit exposure for equity – While not Risk Parity, attempting to capture some element of risk balancing – 12

Comparison of Asset Allocations Risk De-risked 60/40 Parity Endowment Public Plan Total Equity 60% 25% 30% 28% Total Fixed Income 35% 72% 30% 33% Total Alternatives 0% 0% 30% 32% Total Real Assets 5% 47% 10% 5% Cash/Leverage Financing 0% -44% 0% 2% Expected Return (5-7 Yr) 5.9% 5.2% 6.5% 7.9% Expected Volatility (5-7 Yr) 11.9% 10.0% 11.6% 13.8% Sharpe Ratio 0.37 0.37 0.43 0.47 Note: Total Alternatives includes Private Equity, Real Estate and Hedge Funds. Total Real Assets includes Commodities, TIPS and private real assets investments such as infrastructure, farmland, energy, timber, etc. 13

Comparison of Asset Allocations 60/40 Risk Parity* * - Represents proportional allocation of levered exposures Endowment De-risked Public Plan 14

Comparison of Risk Allocations De De-ri risk sked Public Plan 15

Outcomes for Various Investment Approaches Traditional approaches like 60/40 have worked historically, but prospects • for forward-looking returns are muted, especially following significant equity bull markets With low yields, return expectations for all asset classes, and • subsequently, all portfolios constructed from asset classes, are lower All of these approaches can earn positive returns for investors over the • long-term Variations occur for many reasons • Concentration versus diversification/balance – Liquidity – Risk tolerance/volatility levels – Portfolio efficiency – Implementation (active vs. passive, tilts relative to market exposure within asset classes) – Luck – 16

Setting Asset Allocation 17

How Much Further Can U.S. Equities Run? S&P 500 has gained almost • 54% cumulatively over the last two years (as of 12/31/2013) Historically, this has led to subdued – performance looking forward We Are Her e Strength of corporate profits • (Eq. Risk Premium is over cash) Source: Bloomberg, NEPC has supported equity rally – Corporate profits have historically shown mean reversion • Supported in the short-term by low financing costs to corporations With accommodative monetary • policy, U.S. stock market could continue to grind higher – Further upside (likely driven by continued valuation expansion) seems unsustainable given how far markets have run Source: Bloomberg as of 6/30/2013 18

2014 NEPC Assumption Development – U.S. Large Cap Equity Sources of Return • Valuation – Starting Expected Forecast Return Return Source Value Values Contribution Real Earnings Growth 2.5% 2.5% -- Earnings growth – -1.0% 1.5% Profit Margin Adjustment Adjusted for changes in • Dividend Yield 2.0% 2.0% 2.0% margin Inflation 3.0% 3.0% 3.0% Valuation & Other* 16.3 16 -0.25% Dividend yield – Total Expected Return 6.25% Inflation – Equity Risk Premium over 10 year • Treasury is volatile Long-term average of 2.9% – Stock and bond forecasts imply an Equity Risk – Premium of 4.25% While high relative to the long-term average, – almost 40% of observations exceed this level over the last 50 years Downward adjustment reflects higher • but still low interest rates supportive of an elevated equity risk premium Source: Ibbotson as of 11/30/2013 *Valuation & Other incorporates adjustment for P-E ratios as well as other factors such as rounding, geometric compounding, etc. 19

Forward Looking Returns – Barclays Capital U.S. Aggregate Bond Index 20% 18% 16% Starting Yield 6 Year Forward Return 14% 12% 10% 8% 6% 4% 2% 0% 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 Historically, there is a high correlation between the YTM of the Barclays • Aggregate Index and the benchmark’s 6 -year forward return Source: Barclays Live, as of 12/31/2013 20

NEPC 2014 Focused Actions for Public Funds Discipline and discretion are • required despite markets moving higher Return expectations are even • more compressed following strong rally Nov 30, 2013: 4.0% expected for next 10 years – Low yields limit potential return – Diversification, active management and risk management can be used to navigate challenging environment rather than simply stretching for returns through increased risk How to achieve 7.125% when • 60/40 earns 4% Diversification – Source: Shiller Data, Bloomberg, NEPC Tactical Allocation – Be Opportunistic – Manager selection in areas where – manager outperformance is a variable 21