Fresno County Employees’ Retirement Association Governance Roundtable October 18, 2006 Tom Iannucci, Cortex Applied Research

2 Agenda 1.Governance background 2.Board interviews/surveys 3.Discussions: 1. Roles and responsibilities 2. Committees 3. Policy to be prepared 4.Wrap up

2. Governance Background

4 Fiduciary Duties Loyalty to the beneficiaries as a group and prudence in managing the beneficiaries’ property and serving their interests.

5 Fiduciary Duties (cont’d) Loyalty:  Primary duty is to the participants/beneficiaries  Managing the different “hats” we wear

6 Duty of Loyalty Many forms of conduct permissible in a workaday world for those acting at arm’s length, are forbidden to those bound by fiduciary ties. A trustee is held to something stricter than the morals of the market place. Not honesty alone, but the punctilio of an honor the most sensitive, is then the standard of behavior. As to this there has developed a tradition that is unbending and inveterate. Uncompromising rigidity has been the attitude of courts of equity when petitioned to undermine the rule of undivided loyalty by the ‘disintegrating erosion’ of particular exceptions. Only thus has the level of conduct of fiduciaries been kept at a level higher than that trodden by the crowd. It will not consciously be lowered by any judgment of this court. Chief Judge Cardozo (Meihnard v. Salmon)

7 Demonstrating Prudence Prudence is process:  Clear delegation  Knowledgeable decision-makers  Sound policies  Due diligence process  Effective delegation

8 The Challenge Plan Operations Member Demographics Benefit Policy Wage Policy Funding Policy Actuarial Liabilities Actuarial Assets TRUSTEES Investment Policy Investment Structures Investment Activities Actuarial Adjustments to Assets Cash Flow Risk Tolerances Risk Management Turnover Mortality Retirements Age Married Client Services Records Payments Expenses Accounting Financial Reporting Indexing Benefits Inflation Growth ? Monthly Pension at Retirement Contributions Asset Mix Strategy Asset Classes Expected Performance In House External Active Passive Foreign Derivatives Purchases Sales Income Appreciation Custody Performance Accounting

9 The Answer  More involvement in decisions/operations?  More committees?  More meetings?  Longer meetings? Answer: A policy-focused board!

10 A Policy-focused Board …  Focuses on:  setting goals and direction,  controlling risk,  ensuring accountability, and  Building organizational infrastructure  It does above by getting educated, setting sound policies, and building reporting systems.

11 The Pension Business

12 Effective Boards Boards cannot be truly effective unless they understand the business they are governing:  What is the ultimate purpose?  What drives performance?  What are the biggest risks?  Which decisions are most important?  What needs to be measured?

13 The Purpose KCERAJanuary 1, 2003 Pay to Ms. X. Smith $ Seven Hundred Fifty Three------/100 Big Bank T. Paymaster KCERAFebruary 1, 2003 Pay to Ms. X. Smith $ Seven Hundred Fifty Three------/100 Big Bank T. Paymaster KCERAMarch 1, 2003 Pay to Ms. X. Smith $ Seven Hundred Fifty Three------/100 Big Bank T. Paymaster KCERAApril 1, 2003 Pay to Ms. X. Smith $ Seven Hundred Fifty Three------/100 Big Bank T. Paymaster KCERAJuly 1, 2003 Pay to Ms. B. Smith $ Seven Hundred Fifty Three------/100 Big Bank T. Paymaster KCERAMay 1, 2003 Pay to Ms. X. Smith $ Seven Hundred Fifty Three------/100 Big Bank T. Paymaster KCERAJune 1, 2003 Pay to Ms. B. Smith $ Seven Hundred Fifty Three------/100 Big Bank T. Paymaster

14 The Pension Business Discount Rate Low High Contributions Liabilities Risk High Efficient Frontier

15 The Pension Business Discount Rate Risk Low High Efficient Frontier High Contributions Liabilities

16 How Important is Asset Mix Policy? It depends:  It explains 90% of variability in return over time for a typical fund  It explains 100% of the absolute level of return Source: Brinson, Hood, Beebower; Determinants of Portfolio Performance

17 Arithmetic of Active Management

18 Distinguishing Skill vs. Luck Probability of Underperformance Expected Holding period Excess Return5 yrs10 yrs30 yrs 1%42.8%39.9%32.9% 2%36.0%30.6%18.9% 3%29.6%22.4% 9.4% Even if a manager has skill, there is a significant probability that the manager will under-perform for extended periods of time. * Adapted from: Jeremy Siegel, “Stocks for the Long Run”.

19 Major Risks – Funding & Investments  Affordability of benefits  Funding shortfall/contribution volatility  Actuarial assumption risk  Actuarial error  Concentration risk  Conflict of interest  Excessive costs  Imprudent manager selection process

20 Major Risks – Benefit Administration  Poor benefit policy  Inaccurate or late benefit payments  Loss of tax exempt status  Communications risk  Human resource risk  Malfeasance or fraud (internal controls)  Mismanagement of MIS projects  Disaster recovery

21 Hierarchy of Investment Decisions 1.Mission/Objective of the Fund 2.Risk tolerance level 3.Asset allocation 4.Benchmarks 5.Asset class strategies 6.Manager selection process/criteria 7.Other investment policies and risk parameters

22 Hierarchy of Benefit Administration Decisions  Actuarial methods and assumptions  Pension benefit policy  Service quality targets  Organizational structure  Budget  Business plan  Compensation policy  Staff performance evaluation measures

23 Major Risks - Governance  Conflicts of interest  Failure to demonstrate prudence  Lack of board knowledge/training  Excessive travel and other expenditures  Micro-management  Breakdown in group dynamics

24 Anatomy of Decisions  Boards often view multi-faceted activities as a single decision  In fact, most decisions involve different types of decisions:  Policy decisions  Strategy decisions  Implementation decisions  Some decisions should rest with the Board, some should rest with staff or agents

25 Anatomy of Decisions Annual Communications Plan Hire Communication Consultants Prepare Communication Materials Deliver Communications Communication Goals & Guidelines Policy Strategy Implementation Communications Budget

26 Accountability  In order to legitimately hold an individual accountable, one must provide:  Clear objectives/mandate  Authority to make the decisions necessary to carry out the mandate  Necessary resources  Can’t be the doer and the overseer

27 Effective Boards: Important vs. Urgent (A) Important & Not Urgent (B) Important & Urgent (C) Not Important & Urgent (D) Not Important & Not Urgent

28 Effective Boards (cont’d)  Effective Boards try to:  Maximize the time they spend in Box A  Spend no time in boxes C and D  By focusing on Box A, effective Boards hope to minimize the need to spend time in Box B.

29 Effective Use of Board’s Time Issue is not frequency of meetings, but quality:  The right agenda  Policy and oversight focus  Board member preparation  Meeting materials (quality and timing)  Education  Staff policy analysis and recommendations

2. Board Interviews/Surveys

31 The Good  Good mix of backgrounds and training among board members  High level of confidence in current Retirement Administrator  Board invests considerable time  Board practices significantly improved in recent years:  More engaged  More transparent  More information

32 The Not-so-good  Perceived lack of clarity regarding roles of board and staff  Dissatisfaction with meetings: – Long and inefficient – Heavy agendas – Too much materials – Seldom closure – Decisions are drawn out over numerous meetings – Repetitive discussions – User-friendliness of board packets  Mixed views on effectiveness of committees

33 The Not-so-good (cont’d)  Everyone acknowledges importance of education, but there are mixed views on implementation:  Conferences vs. in-house  Mandatory vs. encouraged  Stronger orientation needed  More focus on investments and ethics training  Need to review our policies periodically

34 Not-so-good (cont’d)  Numerous policy gaps:  Communications (vis-à-vis staff, members, vendors)  Planning  Retirement Administrator evaluation  Service provider evaluation/RFPs  Frustration with disability process:  Implementation vs. strategy

35 Cortex’s Assessment  Prior boards and administration left little in the way of a policy framework/institutional memory  Current board has been mired in fighting fires over past several years (i.e. reactive mode)  There is now a commitment to moving to a proactive governance approach  Challenges lie in both the lack of a framework and executing the existing framework

36 Cortex Assessment (cont’d) Multi-pronged action plan:  Find/create efficiencies  Policy work  Training and education  Information and reporting

4. Discussion

38 Roles & Responsibilities  Board, Chair, Committees, individual board members, Retirement Administrator  Discussion topics:  Vendor selection  Manager interviews  Staff hiring/firing  Strategic/business plans  Policy analysis/recommendations from RA

39 Vendor Selection  Which vendors/advisors does the Board consider to be primary advisors which the Board must select? (Other advisors/services presumably can be selected by the Retirement Admin.)  What level of involvement/information does the Board expect with respect to the selection of vendors/advisors by the Retirement Administrator?

40 Manager Interviews The Board currently interviews all investment managers on an 18 month cycle. Can the Board’s involvement in this area be reduced? If so, how?

41 Staff Hiring/Firing Please confirm the role the Board believes it should play with respect to the hiring and firing of staff other than the Retirement Administrator.  Senior management vs. staff

42 Planning  Does the Board expect formal strategic/ business plans be developed?  If so, what role should the Board and Retirement Administrator play in developing such plans?

43 Policy Analysis  What are the Board’s expectations of the Retirement Administrator with respect to policy analysis and recommendations?  Verbal vs. written report?  Analysis of alternatives?  Concrete recommendations?  What are the Board’s expectations of its committees with respect to the above?

44 Role of Chair  What are the primary functions of the Chair position?  Provide vision and leadership?  Run effective meetings?  Police the Board?  Other?  Provide supporting details

45 Board Member Expectations What are the key things the Board expects of individual board members in order to maximize the effectiveness of the Board as a whole?

46 Committees Please discuss any changes you would like to see regarding committees:  Number of committees  Mandates of committees  How committees operate  Other

47 Please select the 5 policies you would like Cortex to prepare 1.Trustee education 2.Policy development process 3.Board operations 4.Code of conduct 5.Service provider evaluation 6.Board communications  Board self-evaluation  Retirement Administrator performance evaluation  Planning policy  Monitoring & reporting  Other

5. Wrap-up