OHIO PUBLIC EMPLOYEES RETIREMENT SYSTEM 277 EAST TOWN STREET, COLUMBUS, OH PERS (7377)

Transcription

1 OHIO PUBLIC EMPLOYEES RETIREMENT SYSTEM 277 EAST TOWN STREET, COLUMBUS, OH PERS (7377) MEMORANDUM DATE: March 3, 2004 TO: FROM: Cc: RE: OPERS Retirement Board Members Farouki Majeed- Deputy Director of Investments Neil Toth Director of Investments Laurie Hacking Executive Director Healthcare Fund Investment Policy Action requested: Select an asset allocation policy mix for the healthcare fund from the options presented by Ennis Knupp & Associates (EKA). The selected asset allocation will be incorporated in the final Investment Policy to be presented by staff in April with an implementation schedule. Summary At the February 2004 meeting of the Investment Committee EKA presented recommendations for the Healthcare Fund Investment Policy. These recommendations included a) adoption of a separate asset allocation policy for the healthcare fund b) segregation of assets for investment purposes and c) exclusion of illiquid asset classes (Private Real Estate and Private Equity) from the asset mix for the healthcare fund. The Board directed staff and EKA to present specific recommendations for the asset allocation policy and evaluate implementation issues. Discussion A memo from EKA regarding asset allocation options is attached. The asset mix consists of liquid asset types only and includes Treasury Inflation Protected Securities (TIPS) and REITS as new asset categories. The Board may select one of the options presented as the new asset allocation policy for the healthcare fund. 1

2 A draft Statement Of Investment Objectives and Policies for the Healthcare Fund is also attached. The form of this document is similar to the existing Policy for the pension fund. New text that is specific to the healthcare fund is highlighted in bold italics for easy reference. A final version incorporating Board comments will be presented in April. Staff has discussed the implementation issues with regard to segregation of the healthcare assets from current investment portfolios with the custodian bank. We expect that this can be implemented within a 3-6 month time frame. The additional costs for custody and accounting will be provided in April. 2

3 MEMORANDUM To: Investment Committee Ohio Public Employees Retirement System From: Richard Ennis, CFA Brady O Connell, CFA Date: March 3, 2004 Re: Health Care Fund Asset Allocation At the January and February Investment Committee meetings, we discussed the health care portfolio and the possibility of investing these assets under an investment policy that is separate and distinct from the pension fund. Our memo from February concluded: The financial analysis of the probable solvency of the HC fund indicates to us that an equity allocation of 50-60% is more appropriate than the current policy of approximately 75%. Upon further analysis, it may be appropriate to shorten bond durations as well. The analysis also indicates phasing private market investments out of the HC fund, owing to its shorter investment horizon and, as demonstrated in recent years, a high level of volatility in the horizon period itself. These changes, in turn, indicate a separation of HC and pension assets for investment purposes. This memorandum explores in more detail alternative asset allocations that the Committee may consider for the health care assets. In addition to discussing alternative asset allocations, we also discuss the asset classes included in the analysis and the reasons for the inclusion of classes not explicitly used in the pension portfolio. Asset Classes Included The estimated solvency period in the analysis presented last month was approximately 20 years. Because of the short time period relative to the pension fund and the potential need to make major liquidations to fund benefit payments, we recommend that illiquid assets be avoided. We removed Private Equity as an asset class because of its illiquid nature. In addition, when we refer to Real Estate, we mean the very liquid real estate investment trusts (REITS) and not the illiquid direct property holdings that constitute the vast majority of the Real Estate asset class for the commingled pension and health care assets. Ennis Knupp + Associates vox South Riverside Plaza, Suite 700 fax Chicago, Illinois

4 While Private Equity was removed and Real Estate modified, we added several asset classes as well. First, we included Treasury inflation protected securities, or TIPS, as a separate asset class. These income-generating securities provide an explicit hedge against inflation as their interest payments fluctuate based on the consumer price index. In addition, we have broken out short term bonds as a separate asset class in acknowledgement of the current low interest rate environment. Should interest rates rise, short term bonds provide a better return than bonds with long durations. Explicitly modeling short term bonds (one to three years in maturity) allows us to position the health care portfolio against the negative impact of rising interest rates on the fixed income portion of the portfolio. Based on these additional considerations that are unique to the health care portfolio relative to the pension fund, we arrived at the following asset classes to include in the analysis: U.S. equities (Russell 3000 Index) Non-U.S. Equities (MSCI All Country World Ex-U.S. Index) Fixed Income (broad market Lehman Aggregate Index) Short-Term Fixed Income (Lehman 1-3 Year Government Bond Index) TIPS (Lehman US TIPS Index) Real Estate (Wilshire Real Estate Securities Index) Efficient Frontier Analysis After deciding upon a broad target allocation between risky assets and bonds, we now go into more detail on what the specific allocations to different asset classes would be. Efficient frontier analysis incorporates three characteristics of the asset classes listed above in arriving at the ideal mix of assets for a given level of risk: expected asset class returns, correlations among the asset classes and the expected risk of the different asset classes. The inputs used here are consistent with those used for the review of the pension fund s asset allocation. Based on these inputs we modeled the different optimal allocations among different asset classes for different levels of return. The allocation among the asset classes of these portfolios is shown below relative to the associated level of risk for each mix of assets. We have arbitrarily constrained the real estate allocation such that it may not exceed 5% of the overall portfolio. Ennis Knupp + Associates 2

5 Given our earlier recommendation that the Committee consider equity allocations between 50% and 60%, we intend to focus on the portfolios between the lines in the chart below. These range in equity exposure from approximately 44% to approximately 63% of total assets. Efficient Portfolio Allocations 100% 80% % Allocation 60% 40% 20% 0% 3.51% 3.75% 3.99% 4.23% 4.46% 4.68% 4.90% 5.10% 5.31% 5.51% 5.70% 5.88% Expected Return (%) 6.06% 6.23% 6.39% 6.54% 6.68% 6.81% 6.93% 6.57% U.S.-Equity Non-U.S.-Equity (ACWI) U.S.-Bonds-(LBAG) 1-3-Year-Gov't-Bonds TIPS REITs The individual portfolios within the range illustrated in the previous chart are detailed below. The table below shows the allocation to different asset class, the expected return for each hypothetical portfolio, the associated level of risk, as well as the Sharpe ratio (a measure of risk-adjusted returns). Portfolio U.S. Equity Non-U.S. Equity (ACWI) U.S. Bonds (LBAG) REITs Year Government Bonds TIPS Total Equity (including RE) Total Bonds Total Geometric Mean Return 5.70% 5.88% 6.06% 6.23% 6.39% Real Risk 8.49% 9.26% 10.06% 10.85% 11.65% Sharpe Ratio Ennis Knupp + Associates 3

6 Although the efficient frontier excludes an allocation to 1-3-year Treasuries, we might want to consider an allocation of up to half of the non-tips bonds as a hedge against rising interest rates. This would have the effect of reducing the expected return of Portfolio 13 by approximately 10 basis points. Sensitivity of Asset Allocation to Solvency Period The chart below illustrates how the health care fund s asset allocation might be expected to evolve under the assumptions currently employed in making solvency forecasts. In other words, if all the assumptions are realized, the solvency period would shorten each year by exactly one year. Were this to be the OPERS experience in fact, staying with an equity allocation of 50-60% equities would not be appropriate indefinitely. This graph also indicates the sensitivity of asset allocation to the health care fund s solvency period. As the fund becomes closer to insolvency, the amount of the portfolio ideally invested in fixed income securities increases. On the other hand, if the health care plan has a favorable experience, receives greater funding than anticipated, or the plan of benefits is modified further, the solvency period may be maintained at or near 20 years, in which case no subsequent change in investment policy would be indicated. Declining Equity Allocation with Lower Solvency Periods 100% 90% 80% 70% % Allocation 60% 50% 40% 30% 20% 10% 0% Solvency Period Equities Bonds Conclusion This memorandum is meant to move us closer towards the identification of a target asset allocation for the health care fund. The next steps in this analysis include addressing any suggestions offered by staff and the Board and the finalization of a recommended target asset allocation. Ennis Knupp + Associates 4

7 APPENDIX Capital Market Return Assumptions The tables below detail the expected returns, risks and standard deviations used in our capital markets modeling. The return forecasts shown are geometric, and thus represent the return that would be experienced over a period of time (incorporating the dampening effect of volatility). One-year return forecasts and arithmetic return averages are slightly higher as they do not include the impact of volatility. Return Risk U.S. Equity 6.90% 16.74% Non-U.S. Equity (ACWI) U.S. Bonds (LBAG) REITs Year Government Bonds TIPS Asset Classes U.S. Equity Non-U.S. Equity (ACWI) U.S. Bonds (LBAG) REITs 1-3 Year Gov t Bonds U.S. Equity 1 Non-U.S. Equity (ACWI) U.S. Bonds (LBAG) REITs Year Government Bonds TIPS TIPS G:\March 2004\I.A. Healthcare Asset Allocation - EKA.doc Ennis Knupp + Associates 5

8 DRAFT Ohio Public Employees Retirement System Statement of Investment Objectives and Policies Health Care Fund 2004

9 TABLE OF CONTENTS I. GENERAL PROVISION...1 II. A. PURPOSE...1 B. INVESTMENT OBJECTIVE...1 LEGAL AUTHORITY...1 III. IV. ROLES AND RESPONSIBILITIES...2 A. BOARD OF TRUSTEES...2 B. INVESTMENT COMMITTEE...3 C. STAFF...3 D. CUSTODIAN...4 E. INVESTMENT ADVISOR...4 F. ACTUARY...4 INVESTMENT PHILOSOPHY...5 V. ASSET ALLOCATION POLICY...5 A. PURPOSE...5 B. TARGETS AND RANGES...5 C. REBALANCING...6 D. PERIODIC REVIEW...7 VI. ANNUAL REVIEW PROCESS...7 VII. RISK CONTROL...7 A. DIVERSIFICATION...7 B. PORTFOLIO GUIDELINES...8 C. RISK BUDGETING...8 D. COMPLIANCE MONITORING...8 VIII. PERFORMANCE OBJECTIVES...8 IX. A. TOTAL FUND...8 B. ASSET CLASSES...8 MONITORING AND REPORTING...9 X. REVIEW AND MODIFICATION OF THIS STATEMENT...1 XI. ADOPTION...9 Revision History

10 I. GENERAL PROVISION A. Purpose The purpose of the Ohio Public Employees Retirement System ( OPERS ) Statement of Investment Objectives and Policies for the Health Care Fund is to: Establish OPERS Investment Objective. Identify Key Roles and Responsibilities. Articulate the Board of Trustees Investment Philosophy. Establish Asset Allocation Policy. Establish Risk Controls. Establish Performance Objectives. B. Investment Objective The primary investment objective of the Health Care Fund is to secure health care benefits for eligible members, which is provided as a discretionary benefit. The assets of the Health Care Fund shall be invested with the objectives of a) preservation of capital and b) maintaining a reasonable solvency period as defined by the Board from time to time. II. LEGAL AUTHORITY The OPERS Board of Trustees has established a Health Care Fund under Internal Revenue Code Sec 401(H) to provide health care benefits to eligible members. Under the provisions of this IRC section the health care fund may be used only for providing healthcare benefits. In the event the healthcare fund is terminated the assets in the healthcare fund must be refunded to the employer(s). The investment powers and fiduciary responsibilities of the Board are specified in Section of the Revised Code of Ohio. Section specifies that the Board and other fiduciaries shall discharge their duties: Solely in the interest of participants and beneficiaries. For the exclusive purpose of providing benefits and defraying reasonable expenses of administering OPERS. With care, skill, prudence, and diligence of a prudent person. By diversifying the investments. In addition, the staff responsible for investment decisions or who are involved in the management of the fund s assets shall be governed in their personal investment activities 1

11 by the Standards of Professional Conduct established by the Association for Investment Management and Research (AIMR), and applicable state statutes. III. ROLES AND RESPONSIBILITIES A. Board of Trustees The Board of Trustees is ultimately responsible for the investment of OPERS assets. Specific responsibilities of the Board include: 1. Asset Allocation a. Establishing the asset allocation policy for the portfolio, including target percentages and ranges. b. Approving asset classes for inclusion in the portfolio. c. Establishing a policy for rebalancing asset classes to conform to the assetallocation policy. d. Reviewing annually this Statement of Investment Objectives and Policies. 2. Asset Management a. Approving an Annual Plan to strategically manage the investments as described in Section 7 (Annual Review Process), including: i. Establishment of each new portfolio, as well as the dissolution of portfolios. ii. Investment guidelines for all internally managed portfolios and modifications thereto. b. Making all delegations of authority in connection with investment management, including to staff as well as to external investment managers. c. Approving the process of hiring, retention, or termination of external investment managers based on an established and Board-approved staff evaluation process, and ensuring adequate supervision of externally managed portfolios. d. Establishing a proxy-voting policy. 3. Risk Control and Administration a. Ensuring adequate risk controls are in place. 2

12 b. Ensuring compliance with all of its policies and directives. c. Ensuring, within its power, that securities custody and other ancillary investment functions are performed satisfactorily. d. Establishing policies related to securities lending. 4. Monitoring and Evaluation a. Establishing performance benchmarks and expectations. b. Monitoring the performance of investments. c. Evaluating the staff s capability and performance. B. Investment Committee The Investment Committee monitors investment activity. It evaluates proposals requiring Board action and makes recommendations for consideration by the Board. Through its activities, it represents the interests of the Board in all investment-related matters. In addition to chairing meetings of the Committee, the Investment Committee chair serves as liaison between the Board, staff, and external advisors in the interim between meetings of the Committee/Board. In this capacity, the Committee chair works with the Director-Investments in establishing the agenda for Committee meetings. The chair is also the staff s principal point of contact in the interim between meetings. If matters come to the attention of the Committee chair that he or she believes are important to communicate to the Board before the next regularly scheduled meeting, the chair has the responsibility to inform the Board Chair accordingly. C. Staff The role of the staff is to assist the Board in managing OPERS investments. Staff authority derives from the Board. Notwithstanding its ultimate responsibility for OPERS investments, the Board expects staff to take a leadership role in investment management. Recognizing that most of its members are laypersons with respect to investments and all operate under a very high standard of care, the Board expects to rely heavily on the staff to assist it in discharging its fiduciary responsibilities and in managing OPERS investments successfully and efficiently. In this regard, the Board expects the staff to: Advise the Board when the staff believes action relative to investment policy or execution is required of the Board. 3

13 Establish and conduct an appropriate process for monitoring OPERS investments and implementing the Board s decisions. Inform the Board of any and all matters the staff believes to be of sufficient materiality as to warrant the Board s attention. Operate at all times in the best and exclusive interest of OPERS. All members of the investment staff are accountable to the Director-Investments. The Director-Investments is responsible for all staff actions relative to the management of OPERS investments. In this regard, it is the responsibility of the Director- Investments to satisfy himself/herself that all policies and directives of the Board are carried out faithfully. D. Custodian The Ohio State Treasurer acts as custodian of OPERS as specified in Section of the revised Code of Ohio. The State Treasurer may employ subcontractors to provide certain safekeeping functions. OPERS staff shall be responsible for reviewing OPERS custodial needs and reporting on such needs to the Investment Committee as requested. E. Investment Advisor The Board may appoint a party otherwise unaffiliated with OPERS to advise it on various aspects of investment. The advisor, or general investment consultant, which will be appointed by the Board and report to it, shall: Advise the Board in the management of OPERS investments. Critically evaluate investment proposals that come before the Board and advise the Board accordingly, including the Annual Plan. Monitor OPERS investments, internal investment activities, and external managers. Report independently to the Board on the performance of OPERS investments. Conduct periodic and special studies on behalf of the Board. Assist and support the staff in various projects; e.g., developing proposals for consideration by the Board, manager searches, evaluations of external managers and other service providers, etc. F. Actuary OPERS employs an actuary for the purpose of forecasting asset and liability growth and the many complex factors included in estimating future health care costs and the solvency period of the fund. These factors include, but are not limited 4

14 to, interest rates, inflation, investment earnings, mortality rates, healthcare costs and employee turnover. These actuarial assumptions are then used to prepare a Health Care Projection Report. The actuary shall provide periodic reports on the healthcare fund and shall provide recommendations to the Board including, among other things, the estimated level of contributions necessary to maintain a target solvency period as determined by the Board. The actuary is appointed by and serves at the pleasure of the Board. IV. INVESTMENT PHILOSOPHY The Board believes OPERS assets should be managed in a fashion that reflects OPERS unique liabilities, funding resources and portfolio size, by incorporating accepted investment theory and reliable, empirical evidence. Specifically, OPERS has adopted the following principles: Asset allocation is the key determinant of return and, therefore, commitments to asset allocation ranges will be maintained through a disciplined rebalancing program. Diversification, both by and within asset classes, is the primary risk control element. The pursuit of returns in excess of risk-free alternatives entails the distinct probability of disappointing results over very short periods of time and, therefore, the assets will be invested with a sufficient long-term perspective. However, the Board may review this policy and the asset allocation on an annual basis and adopt appropriate changes depending on the status of the healthcare fund and cost increases. The Healthcare Fund may be invested in liquid securities in view of the greater need for liquidity and the shorter duration of the healthcare fund. Inflation protected securities (TIPS) may be included in the asset mix as a hedge against observed high inflation in healthcare costs. Passive alternatives (index funds) to actively managed portfolios are suitable investment strategies, especially in highly efficient markets. V. ASSET ALLOCATION POLICY A. Purpose The purpose of the asset allocation policy is to establish an investment policy framework for OPERS that has a high likelihood, in the judgment of the Board, of realizing OPERS investment objective. (See Section I.B., Investment Objective, above.) B. Targets and Ranges The principal components of the investment policy are target allocation percentages for various areas of investment, known as asset classes, and minimum and 5

15 maximum percentages for each asset class. The table below contains OPERS target allocation percentages and ranges for the healthcare fund. Asset Class Target Allocation Range Domestic Equity Non-U.S. Equity Fixed Income-Broad Fixed Income - Short TIPS REITS Cash Total 100% The Domestic Equity and Non-U.S Equity asset classes will have the same portfolio structures and be managed in the same way as in the pension fund assets. The fixed income asset class may have a different portfolio structure depending on the use of high yield and emerging market debt. The REIT portfolio will be identical to that used in the pension plan. C. Rebalancing The staff shall ensure conformance with the asset allocation policy through monthly review. In conducting rebalancing activities, the Board expects the staff to operate under these guidelines: 1. Whenever asset-class allocation percentages fall outside the indicated range for that asset class, the staff shall initiate rebalancing transactions to bring all percentages to values that do not exceed the range limits. 2. At any time and in its discretion, the staff may bring the actual allocation to, or nearer to, the target percentages. 3. At a minimum, the staff will ensure that as a result of a rebalancing review, no asset-class allocation is outside the allowable range. 4. To the extent that it is possible to bring the actual allocation nearer to the target percentages without incurring transactions costs, or while incurring transaction costs, which in the judgment of the staff are unusually low, the staff shall do so. The spirit of this policy is to ensure compliance with the target asset allocation percentages at a reasonable cost, recognizing that overly precise administration of policy targets can result in transaction costs that are not economically justified. Recognizing the complexity of achieving this result with a portfolio the size and complexity of OPERS, as well as the vagaries of transacting in investment markets, the Board accords the staff discretion to take those actions, which in the judgment of the staff are within the spirit of these guidelines and in the best interest of OPERS. 6

16 D. Periodic Review The Board establishes the asset allocation targets and ranges and reviews them periodically. In view of the uncertain cost structure of healthcare benefits and the variability of benefits, and the need for contribution rate levels to be set by the Board within statutory limits, the Board will annually review the investment policy and asset allocation target and ranges of the healthcare fund in conjunction with the actuarial assessment of the solvency of the fund. VI. ANNUAL REVIEW PROCESS Annually the staff shall present to the Board for its consideration an Annual Plan. The principal functions of the Annual Plan are to: Define the essential asset management characteristics for the total portfolio and the principal asset classes, which include but are not necessarily limited to, target percentages and ranges, benchmarks, investment strategy, policies concerning utilization of active and passive management, and proposed changes in investment guidelines. Specify expected excess (active-management) return and risk, provisions for risk control, and investment expense. Clarify delegations of authority by the Board to the staff for various aspects of investment management. Identify resource (staffing and budgetary) requirements. Describe key initiatives for the year. The Annual Plan is the principal, although not exclusive, vehicle by which the staff will seek approval of new investment strategies, revisions to the asset allocation policy, revisions to investment guidelines, and revisions of performance benchmarks. The Annual Plan will also be the principal vehicle by which the staff seeks approval for the creation of new portfolios, as well as identify the need for appointment of new or replacement portfolios, managers, or advisors. VII. RISK CONTROL The Board ensures adequate risk control through the following means: A. Diversification Investments shall be diversified to minimize the impact of the loss from individual investments. In addition to achieving diversification by asset class, careful attention shall be paid to diversification within each asset category (e.g.,) and subcategory 7

17 B. Portfolio Guidelines Every portfolio that is a part of OPERS overall investment portfolio shall operate under written guidelines approved by the Board, which are designed to ensure the portfolio meets its objective and operates within acceptable risk parameters. C. Risk Budgeting A formal process shall be established whereby the total active risk (risk of achieving performance different than the total fund benchmark) shall be within a margin approved by the Board. The Board shall approve the risk budget by which total active risk is apportioned among the various asset classes as part of the Annual Plan. Estimates of active risk shall be performed periodically and reported to the Board to ensure compliance with the risk budget established. D. Compliance Monitoring A process shall be established by which compliance with all elements of the investment policy and portfolio guidelines shall be monitored with exceptions being reported promptly to the Board. VIII. PERFORMANCE OBJECTIVES A. Total Fund The primary performance objective for the total fund is to exceed the return of the policy benchmark for the healthcare fund. The Benchmark combines designated market indexes for asset classes, weighted by asset-allocation targets. Currently, the indexes are: Asset Class Domestic Equity Non-U.S. Equity Fixed Income- Broad Fixed Income -Short TIPS REITS Market Index Russell 3000 Stock Index MSCI All Country World Free Index Ex-U.S. Lehman U.S. Universal Index Lehman 1-3 Yr Govt. Bond Index Lehman U.S TIPS Index Wilshire REIT Index B. Asset Classes Each asset class shall be measured relative to its designated market index. It is expected that the active management of individual asset classes will provide an investment return in excess of the index, net of expenses, over five year periods. The margin of superior performance for each asset class and the total fund are specified in the Annual Plan. 8

18 In all aspects of investing, the Board expects that results will be competitive. Total fund performance is expected to exceed OPERS Performance Benchmark over the longer term (five years or more). Active management within individual asset classes is expected to achieve returns in excess of the return available through passive investment within the asset class as indicated by the asset class benchmark. In all respects and measures, the Board expects to earn a return that compensates OPERS for the risk taken. IX. MONITORING AND REPORTING The following reports will be reviewed with the Board periodically to ensure monitoring and compliance with the Board s policies and guidelines: Monthly review of asset allocation relative to targets staff Quarterly Performance Report Investment Consultant and staff Quarterly report on compliance staff Quarterly review of active risk estimates staff Quarterly report on proxy voting / monthly reporting on a case-by-case voting staff Quarterly report on derivatives held in each of the asset classes staff Semi-annual report of commissions with detail by asset classes and broker staff Annual report on securities litigation and settlements Legal Additional reports will be provided as needed X. REVIEW AND MODIFICATION OF THIS STATEMENT The Board shall review this Statement at least annually. XI. ADOPTION The Board adopted this Statement at the meeting. 9