1. Pension Investment Strategies (In a Low Return World) October 10, 2014 Allan Martin, Partner

2. All investors face the same fundamental challenge – Capital + Investment Earnings must equal to all total Obligations in the end – For Pensions, this is the classic equation: 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 a similar 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? Facing The Challenge of Lower Returns C + I = B + E 1 October 10, 2014 League of Arizona Cities and Towns

3. A Survey of Portfolio Approaches 2

4. 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 buckets or some blend of the two – An additional framework not considered here is a bond-centric LDI approach Heavily utilized by Corporate Defined Benefit plans, where benefits are known (not subject to inflation, and funded status already reflects low discount rate) 60/40 – Heavily invested in public equities and core bonds – Very liquid – Little or no alternatives exposure Risk Parity – Balance risk across different asset classes – May have leverage applied at portfolio level to increase returns – No alternatives, limited access to alpha – Global and liquid Endowment – Heavily focused on alternatives – hedge funds, privates – Using alpha and illiquidity to drive returns as much or more than beta exposure – Less US-centric, less liquid Derisked 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 Asset Allocation Frameworks 3 October 10, 2014 League of Arizona Cities and Towns

5. 60/40 Risk ParityEndowment Derisked Public Fund Total Equity 60%25%30%28% Total Fixed Income 35%85%30%33% Total Alternatives 0% 15%32% Total GAA 0% 15%0% Total Real Assets 5%34%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 0.430.47 Comparison of Asset Allocations 4 October 10, 2014 League of Arizona Cities and Towns

6. Comparison of Asset Allocations * - Represents proportional allocation of levered exposures 5 October 10, 2014 League of Arizona Cities and Towns

7. Comparison of Risk Allocations 6 October 10, 2014 League of Arizona Cities and Towns

8. Traditional approaches like 60/40 have worked historically but forward- looking returns prospects are muted, especially following significant equity bull markets With low yields, return expectations for all asset classes, and subsequently, all portfolios built up 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 Outcomes for Various Investment Approaches 7 October 10, 2014 League of Arizona Cities and Towns

9. Setting Asset Allocation 8

10. 2014 Challenges for Public Funds 9 October 10, 2014 League of Arizona Cities and Towns

11. Setting Five Year Expectations with Yield and Valuation – US vs. EM Equities 10 October 10, 2014 League of Arizona Cities and Towns

12. Historically, there is a high correlation between the YTM of the Barclays Aggregate Index and the benchmark’s 6-year forward return Forward Looking Returns – Barclays Aggregate Source: Barclays Live, as of 12/31/2013 11 October 10, 2014 League of Arizona Cities and Towns

13. Discipline and discretion are required despite markets moving higher Market conditions remain calm – Equity volatility remains near secular lows while prices continue to move higher – Credit spreads continue to tighten – Markets have been much more resilient to macro news recently Strong returns and tranquil markets can lead to a false sense of comfort – Rebalancing remains critical – A willingness to forgo some upside can lead to better outcomes over a full market cycle after markets correct Return expectations are even more compressed following strong rally – 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 NEPC 2014 Focused Actions for Public Funds Source: Bloomberg as of 11/30 Source: Shiller Data, Bloomberg, NEPC Nov 30, 2013: 4.0% expected for next 10 years 12 October 10, 2014 League of Arizona Cities and Towns

14. Diversification Wins In The Long Run Source: Bloomberg, NEPC Max Min LT Avg. Historically strong performance for one asset class does not signal the ruin of diversification – In fact, periods following these runs are often when diversification is most rewarded Discipline of diversification requires a long-term focus to withstand concentrated results – Both good (US Equities in 2013)… – And bad (2008) Over the long term, diversified portfolios will likely produce better risk-adjusted returns than concentrated ones Concentrated portfolios will correct after long bull runs Source: Morningstar as of 10/31 13 October 10, 2014 League of Arizona Cities and Towns

15. Asset allocation is the primary determinate of total fund returns Be forward–looking – Be Realistic about future returns – Look for opportunities to be dynamic Portfolio construction tools available when assessing strategic allocations – Mean-variance optimization – Risk Budgeting – Scenario Analysis – Liquidity Analysis – Factor Analysis – Active Risk Budgeting Each of these approaches offers insight into the risk and return characteristics of current and potential allocations Each approach also has limitations Building a mosaic through the useful insights of each perspective produces a more robust and resilient long-term strategy Recognizing pluses/minuses of each approach creates a framework for regular scrutiny – Can lead to further evolution and additional perspectives – Each model we utilize was built to address gaps of existing tools How to choose an appropriate allocation 14 October 10, 2014 League of Arizona Cities and Towns

16. Efficient Frontier Comparison 2014 2013 15 October 10, 2014 League of Arizona Cities and Towns

17. Potential Asset Mixes for Consideration 16 October 10, 2014 League of Arizona Cities and Towns

18. Active Risk Budgeting 17 October 10, 2014 League of Arizona Cities and Towns

19. Asset Allocation Mixes of Selected Public Funds 18 October 10, 2014 League of Arizona Cities and Towns

20. ASRS and PSPRS 19

21. Assumed Rate7.85% Funded Ratio 57.0% Earnings above 9% go to the Reserve Account to fund Pension Benefit Increases (PBI) Employee contribution capped Assumed Rate8% Funded Ratio75.9% Inflation adjustment based on funded ration Employee/Employer contribution split evenly ASRSPSPRS ASRS and PSPRS: A comparison 20 October 10, 2014 League of Arizona Cities and Towns

22. Arizona State Retirement System 21 October 10, 2014 League of Arizona Cities and Towns

23. Arizona Public Safety Retirement System Asset Allocation 22 October 10, 2014 League of Arizona Cities and Towns

24. Performance Comparison 23 October 10, 2014 League of Arizona Cities and Towns

25. POB’s 24

26. What are POB’s? 25 October 10, 2014 League of Arizona Cities and Towns

27. Who has issued POB’s? 26 October 10, 2014 League of Arizona Cities and Towns

28. Benefits 27 October 10, 2014 League of Arizona Cities and Towns

29. Concerns and Risks 28 October 10, 2014 League of Arizona Cities and Towns

30. Concerns and Risks (continued) 29 October 10, 2014 League of Arizona Cities and Towns

31. Pension Bonds: What Went Wrong – Timing is Everything 30 October 10, 2014 League of Arizona Cities and Towns

32. 31 What is the Benefit Bonds Window? *Source: PFM October 10, 2014 League of Arizona Cities and Towns

33. 32 Risks Associated with POB’s *Source: PFM October 10, 2014 League of Arizona Cities and Towns