Metropolitan St. Louis Sewer District 457 Deferred Compensation Plan

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1 Metropolitan St. Louis Sewer District 457 Deferred Compensation Plan 4 th Quarter 2008 Investment Performance Analysis February 2009 Doris Ewing, CAIA Partner Dion Stevens Consultant Michael J. Valchine Consultant Carrie Johnston Analyst NEPC, LLC One Main Street, Cambridge, MA Tel: Fax: CAMBRIDGE I CHARLOTTE I DETROIT LAS VEGAS I SAN FRANCISCO Registered Investment Advisors

2 Industry Headlines The Investment Company Institute (ICI) reports that only 3 percent of participants stopped contributions in They also report that fewer than one in seven participants changed the asset allocation of their account balances, and fewer than one in ten changed their deferral elections. In other news, suspended payments to 401(k) plans were announced by Sears, GM, Ford, FedEx, Denver Post, Motorola, Unisys, Saks and others. 1

3 A Year to Remember or Forget? 2008 Domestic Stock Market: The S&P 500 Index 2008 Notable Events Source: Bloomberg Economic Stimulus Act of 2008 Bear Stearns bailout Oil prices hit record highs ($147.30/barrel) Freddie and Fannie taken into conservatorship Lehman files for bankruptcy; Merrill acquired by Bank of America AIG taken over by government WaMu enters receivership, taken over by JP Morgan $700 Billion Troubled Asset Relief Program Federal Funds Target Rate lowered to a range of 0.00% % Presidential Election Oil prices end year at $43.55/barrel Almost 2.6 million jobs were lost in 2008, with 1.9 million disappearing in the past 4 months (7.2% unemployment rate nationally) 2 Source: NEPC

4 2008: The Year in Review 3

5 2009 NEPC Capital Market Observations & Expectations Global recession persists into 2009 Deleveraging process will continue Recovery may not follow past patterns Just like the recession, we may not recognize the upturn until some time has passed There is a small but credible risk of a long-term deflationary spiral Volatility will continue Markets need to assess the emerging financial capital and governance landscape Low short term inflation expectations, with risk of deflation Longer term risks of high inflation Unprecedented global central banks actions to generate liquidity Regulation of markets will increase, bringing some benefits but more frictional costs Long term weakening of US Dollar may be matched by other currencies As markets stabilize, opportunities for attractive returns will be available Providers of liquidity and patient capital will be in the best position to capitalize Fundamentals will matter once again Future-looking risk premiums should be the highest in decades, but are unlikely to recover 2008 losses for many years 4

6 2009 General Actions for Clients Position for opportunities but size risk positions appropriately High forward-looking risk premiums are attractive in most assets Pricing of potential rebound in credit looks attractive relative to the upside in equity Allocate to strategies most likely to capitalize on return to fundamentals skilled traditional and alternative managers and credit opportunities Consider strategies with lock-ups to protect capital flight Consider broader risks of the total investment program Examine portfolio performance under different economic scenarios and tilt allocation to better protect capital in unfavorable environments Where appropriate, allocate to interest rate and/or inflation sensitive securities to better match liabilities or spending needs Prepare for continued market volatility Rebalance towards targets, but consider the tradeoffs of high transaction costs Dollar-cost average to mitigate market timing risk Consider strategies with broad diversification that can stabilize returns in uncertain environments risk parity and global asset allocation Assess liquidity needs and commit capital accordingly Balance long-term investment opportunities with near-term spending needs 5

7 2009 Focused Actions for Defined Contribution Clients Wholesale plan design changes are not required Target date funds are still the answer There is still a place for active management Capital preservation and fixed income products are not without risk Inflation protection and guaranteed income solutions are the next horizon Anticipate a changing regulatory environment In the meantime, continue to Reinforce the importance of savings: save more, save early, diversify Implement Auto-Features Auto-Enrollment Auto-Escalate Auto-Rebalance Invite your record keeper in for employee meetings 6

8 Asset Summary 7

9 Performance Summary Plan default: Vanguard Money Market Auto-enrollment: No Auto-increase: N/A 8

10 NEPC Quarterly Observations This quarter, NEPC has re-categorized the Monitor rating to Watch. This was done in order to be consistent with our internal NEPC Due Diligence Committee ( DD Committee ) categories. Investment Options Changes/ Announcements Performance Concerns DD Committee Recommendation Plan Specific Action Taken Lifecycle Options Vanguard LifeStrategy Income Y Vanguard LifeStrategy Conserv Growth Y Vanguard LIfeStrategy Moderate Growth Y Vanguard LifeStrategy Growth Y Core Options Vanguard Federal Money Market Y: All MM funds on Watch W Vanguard Retirement Savings Trust Y: All SV funds on Watch W Vanguard Total Bond Market Idx Vanguard Balanced Index Vanguard 500 Index Vanguard Windsor II Vanguard U.S. Growth Vanguard Mid Cap Index Vanguard Small Cap Index Vanguard International Growth Y W NEPC Due Diligence Committee Recommendation Key No Action NA Watch W Client Review CR Terminate T Informational items have surfaced; no action is recommended. Issues have surfaced to be concerned over; manager can participate in future searches, but current and prospective clients must be made aware of the issues. Serious issues surface with an Investment Manager; manager cannot be in futures searches unless a client specifically requests. Current clients must be advised to review the manager. Serious issues surface with an Investment Manager; manager would not be recommended for searches and clients would be discouraged from using. The manager cannot be in futures searches unless a client specifically requests. Current clients must be advised to replace the manager. 9

11 NEPC Quarterly Observations Changes/Announcements Vanguard Federal Money Market Vanguard announced in December 2008 that their money market funds are participating in the extension of the Treasury Guarantee Program until April 30, Vanguard stated that trustees of the funds made the decision to continue participating in the program because they believe that it has helped to stabilize the credit markets, to the benefit of investors in all money market funds. Please see the Fund Profile page for facts about the product and how it is currently invested. All Money Market Funds are on Watch at NEPC. Vanguard Retirement Savings Trust Please see the Fund Profile page for facts about the product and how it is currently invested. All Stable Value Funds are on Watch at NEPC. Vanguard International Growth: NEPC issued a Client Review recommendation on Vanguard International Growth in 2004 following a string of weak performance years for the Fund and Vanguard s move to a multimanager approach. In 2003, Baille Gifford was appointed to manage 20% to 25% of the Fund s assets, while Schroder Investment Management continued to manage the remainder. Over the following years, Baille Gifford s share of the Fund has risen to almost 40%. In March of 2008, M&G Investment Management Limited was added as a sub-advisor, with a modest 2% allocation. NEPC holds a Watch rating on the Fund in light of past performance shortfalls and sub-advisor changes. Performance Concerns Vanguard LifeStrategy Funds The LifeStrategy Funds have lagged their custom benchmarks across all time periods. Recall the LifeStrategy funds are risk-based, funds of Vanguard funds that use both active and passive management. The primary contributor to the underperformance of the LifeStrategy Funds versus their benchmarks was active management, specifically the Vanguard Asset Allocation fund. This is a tactical asset allocation fund that was invested 100% in equities for most of 2008 whereas its custom benchmark maintained a static asset allocation of 65% equities and 35% bonds (each of the LifeStrategy Funds' benchmarks is also static with a fixed allocation to stocks, bonds, and cash). The Vanguard Asset Allocation Fund's overweight to equities led each Vanguard LifeStrategy Fund to be overweight equities relative to its benchmark. Since equity markets severely underperformed bond markets over recent periods, the equity overweight was a significant drag on the performance of all of the Vanguard LifeStrategy Funds. 10

12 Style Analysis Vanguard 500 Windsor II Balanced Index US Growth Mid Cap Index Small Cap Index The above snail trail displays changes to a fund s style over time as determined by Morningstar s holdingsbased analysis over the prior three years. The smallest circled plot point represents the furthest period; the largest circled plot point represents the current period. The number of plot points is a function of the frequency of each fund s release of holdings data. 11

13 Risk Analysis S&P 500 Vanguard 500 Russell 1000 Value Windsor II Russell 1000 Growth Russell Midcap Mid Cap Index US Growth 12

14 Risk Analysis LB Agg. Bond Total Bond LS Income LS Conserv Growth 60/40 S&P 500/LB Agg Balanced Index LS Moderate Growth LS Growth Citi PMI EPAC MSCI EAFE Intl Growth Russell 2000 Small Cap Index 13

15 Vanguard Federal Money Market Portfolio FAQs Asset Allocation (as of 12/31/08) Vehicle: Mutual fund Bankers Acceptances: 0% Inception: 7/13/1981 Certificates of Deposit: 0% Valuation as of 2/06/09: $1 Commercial Paper: 0% SEC yield at 2/06/2009: Participation in Treasury Guarantee program: 1.20% Y US Govt and Agency: Yankee Foreign: Structured Product Exposure (inc. ABS): 96.3% 0% 0% Structured Product Exposure (inc. ABS): N Other 3.7% Average Maturity as of 12/31/08: 81 days Average Quality as of 12/31/08: Aaa Provided a suggested communication to participants? No separate communication, but information is available through the Vanguard web page 14

16 Vanguard Retirement Savings Trust Vehicle: Pooled Fund Inception: 1/2/1989 Valuation: MV/BV ratio of 98.67% Yield 3.74% Duration: 2.4 years Total AUM $16.9 Billion Fixed Income Characteristics Average Duration: Average Quality: 2.6 years Aa1 BBB Securities: 0.86% Wrap Providers: Manager's Preferred Benchmark: RABO JPMorgan State Street Bank AIG Bank of America Natixis Hueler Stable Value Pooled Index Below Investment Grade Securities: 0.53% Asset Allocation Traditional Investment Contracts (GICs, BICs, etc): Constant Duration Contracts (Synthetics): 10.1% 79% Cash Investments: 10.4% Other:.5% Data as of 12/31/08 15

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41 Glossary of Terms & Symbols Batting Average - measures a fund s ability to consistently beat the market. Beta - risk measure based on a comparison of the volatility of the fund s returns and the benchmark s returns. Down Capture Ratio - measures a fund s performance in down markets. It provides the percentage of a down market that is captured by the manager. Excess Beta - measures a fund s volatility in excess of its benchmark. Excess Return - measures a fund s return in excess of its benchmark. Information Ratio - measures a fund s performance against risk and return relative to the benchmark. Jensen s Alpha - a risk adjusted performance measure that represents the average return of a fund over and above that predicted by the capital asset pricing model, given the fund s beta and the average market return. R-Squared - reflects the percentage of a fund s movements that can be explained by movements in its benchmark. Sharpe Ratio - measures risk adjusted performance of a fund based on total risk (standard deviation). Tracking Error - measures the volatility of a fund s excess returns relative to its benchmark. Treynor Ratio - measures returns earned in excess of that which could have been earned on a riskless investment per each unit of market risk. It measures returns on a risk adjusted basis using systematic risk. Up Capture Ratio - measures a fund s performance in up markets relative to the market (benchmark) itself. 40