State Universities Retirement System Fiscal Year Agenda 2012 Investment Plan

Transcription

1 State Universities Retirement System Fiscal Year 2012 Agenda 2012 Investment Plan September 2011

2 September 2, 2011 State Universities Retirement System of Illinois Serving Illinois Community Colleges and Universities 1901 Fox Drive Champaign, IL (217) (217) (FAX) Investment Department Board of Trustees State Universities Retirement System 1901 Fox Drive Champaign, IL RE: Agenda 2012 Dear Board of Trustees: The Investment Staff is pleased to provide the SURS Investment Plan for Fiscal Year This plan was developed in order to formalize the strategic plans for the investment portfolio for the coming year and provide transparency of the planning process. The Investment Plan for Fiscal Year 2012 is the first such formal plan for the SURS investment program. The Investment Plan reviews the results of Fiscal Year 2011 and defines the strategy for Fiscal Year 2012 in accordance with the Board-approved asset/liability study and Investment Policy. Since financial markets are dynamic, revisions to the plan may be required and will be communicated to the Board in a timely manner. The SURS investment program completed a successful Fiscal Year The Fund s investment portfolio experienced its highest rate of return in 25 years for the Fiscal Year ending June 30, The stellar 23.8% return, net of investment management fees, increased assets to $14.3 billion and assisted in increasing the Fund s asset valuation by nearly $2.1 billion. This follows last year s above average 15.0% investment return. In addition to boasting its highest return since 1986, the portfolio also outperformed its policy portfolio return of 23.4%, by approximately 40 basis points. Other major Fiscal Year 2011 accomplishments included the restructuring of the fixed income portfolio and the completion of an investment consultant search, resulting in the retention of Callan Associates (Callan). One of Callan s first projects with SURS was the initiation and completion of an asset/liability study, with Board approval provided in June The newly approved strategic policy targets set the course for SURS during the coming fiscal year (and beyond). Another significant accomplishment in Fiscal Year 2011 was the expansion of the Manager Diversity Program (MDP). The MDP focuses on qualified investment management firms owned by minorities, females, or persons with a disability (MFDB). As of June 30, 2011, the MDP is valued at approximately $909 million. In total, assets under management with firms owned by minorities, females or persons with a disability are approaching $2.8 billion or 19.3% of the Total Fund.

3 The overarching strategy for Fiscal Year 2012 will be to move the investment portfolio closer to the new strategic policy targets approved by the Board at the June 2011 meeting. The most significant changes to the asset allocation structure will be a minor shift from U.S. to non-u.s. equities and an increase in real estate from the current level of 6.7% to 10.0%. Implementation of the new policy targets will begin during Fiscal Year 2012 and will occur gradually over time. Prior to implementing the new policy targets, Callan Associates will work with the investment staff to complete a structure analysis of each of the public asset class portfolios. The structure analysis will carefully review the investment portfolio structure and manager lineup to determine if any changes are warranted. The continuing challenge to SURS remains the funding status of the Plan. Despite the 23.8% return for Fiscal Year 2011, SURS is approximately 45% funded, as of June 30, Meanwhile, the System s cash needs continue to increase. Gabriel Roeder Smith & Company estimates that SURS will pay approximately $1.75 billion in benefit payments during Fiscal Year Investment performance alone cannot bridge the funding gap. The Investment Plan for Fiscal Year 2012 contains additional details on Fiscal Year 2011 accomplishments and investment strategies for Fiscal Year I look forward to discussing Agenda 2012 at future meetings. Sincerely, Daniel L. Allen Chief Investment Officer cc: William E. Mabe, Executive Director.

4 FY 2012 Investment Plan Table of Contents I. Purpose..1 Page II. Overview 2 Background Fiscal Year 2011 Performance Review Fiscal Year 2011 Accomplishments Challenges Fiscal Year 2012 Objectives Trustee Education Staffing III. IV. Asset Allocation / Risk Management 8 Economic Outlook.12 V. Investment Strategies 14 Total Fund Equity Fixed Income Real Estate Private Equity Opportunity Fund VI. VII. Manager Diversity Program 18 Self-Managed Plan...20 Wellington Management Asset Allocation Outlook.APPENDIX A Northern Trust U.S. Economic & Interest Rate Outlook APPENDIX B

5 I. Purpose The Investment Plan reviews the results of Fiscal Year 2011 and defines the strategy for Fiscal Year 2012 in accordance with the Board-approved asset/liability study and Investment Policy 1. This Plan is intended to be a living document. Since financial markets are dynamic, revisions to the plan may be required during the year. In the event of changing circumstances or opportunities during the year, items will be discussed with the Board as necessary. 1 The SURS Investment Policies can be found at 1 F Y2012 Investment Plan

6 II. Overview Background The State Universities Retirement System (SURS) is the administrator of a cost-sharing, multiple employer public employee retirement system. SURS membership includes employees of the public universities and other affiliated organizations. Currently, SURS membership totals more than 208,000 active, inactive and retired participants. SURS maintains both a defined benefit and a defined contribution plan, known as the Self-Managed Plan (SMP). As of June 30, 2011, the defined benefit plan is valued at just over $14 billion while the SMP is valued at approximately $956 million. The investment portfolio is broadly diversified across equities, fixed income, real estate, private equity and other opportunistic investments. Approximately 45% of the portfolio is managed in passive or structured active strategies while the remaining 55% is managed in active strategies. Fiscal Year 2011 Performance Review Fiscal Year 2011 was marked by continued recovery of the financial markets after the market crisis. Equity markets were the primary drivers of performance during fiscal Both U.S. and non-u.s. equity markets advanced sharply, and fixed income markets provided modest returns. The program also experienced successful investment performance in the real estate asset class, especially in the Real Estate Investment Trust Securities (REITS) allocation. The table below illustrates the performance of the SURS investment portfolio relative to the policy portfolio, as of June 30, Investment Performance* As of June 30, Year 3 Years 5 Years 10 Years 20 Years 25 Years SURS 23.8% 4.6% 5.3% 6.1% 8.5% 8.8% Policy Portfolio 23.4% 4.6% 5.0% 6.0% 8.0% 8.1% *Net of investment management fees The 23.8% net-of-fee return for fiscal 2011 is the highest return earned by the portfolio in 25 years and the fourth best return in the history of SURS. During fiscal year 1986, the portfolio returned 26.7%. It is noteworthy that SURS has historically demonstrated robust investment performance over longer time periods, earning an 8.8% annualized rate of return over the past 25 years, well in excess of both the policy portfolio return and the 7.75% 2 assumed rate of return. 2 On October 28, 2010, the Board reduced the long-term assumed rate of investment return from 8.5% to 7.75%, effective with the valuation period as of June 30, F Y2012 Investment Plan

7 When compared to a universe of other large public funds, the SURS return ranks near the top decile for the year ending June 30, 2011, as illustrated in the chart that follows. The portfolio also ranks favorably in the peer universe over longer time periods. SURS Total Fund vs. Public Funds > $1 Billion Periods Ending 6/30/11 (1 = Best, 100 = Worst) Universe Ranking th 25th 32nd 27th 32nd 25th 33rd 37th Year 3 Years 5 Years 10 Years TUCS Universe > $1 B (GOF) Callan > $1B Universe (GOF) Fiscal Year 2011 Accomplishments The following projects were completed during Fiscal Year 2011: Restructuring of the fixed income portfolio to increase liquidity and enhance the portfolio structure Completion of investment consultant search, which resulted in retention of Callan Associates Completion of Asset/Liability Study with minor changes recommended Slight shift (2%) from U.S. to non-u.s. equity recommended Increase in direct real estate recommended to further diversify the portfolio Expansion of Manager Diversity Program, which focuses on qualified investment management firms owned by minorities, females or persons with a disability (MFDB) Allocated an additional $225 million to three new MFDB firms and four existing MFDB firms during FY 2011 Total assets under management with MFDB firms approaching $2.8 billion or 19.3% of the Total Fund Expansion of Minority Brokerage Policy to further encourage utilization of brokerage firms owned by minorities, females or persons with a disability Development of risk management policy Completion of search for proxy voting services provider 3 F Y2012 Investment Plan

8 Challenges The continuing challenge to SURS remains the funding status of the Plan. Despite the 23.8% return for Fiscal Year 2011, SURS remains substantially underfunded. SURS is approximately 45% funded as of June 30, 2011 (using the market value of assets method). The unfunded liability is approximately $17.2 billion. The Plan continues to be significantly underfunded due to a long history of the state s failure to pay annually required state contributions, said SURS Executive Director William Mabe, and we simply cannot expect investment performance alone to address the shortfall. The Plan s cash needs continue to increase. SURS expects to pay approximately $1.75 billion in benefit payments in Fiscal Year 2012, per the Fiscal Year 2010 actuarial valuation report prepared by SURS actuary, Gabriel Roeder Smith & Company. Benefit payments rise by three percent per year as a result of the cost-of-living adjustment. 4 F Y2012 Investment Plan

9 Fiscal Year 2012 Objectives The newly approved asset allocation policy targets set the course for SURS in the coming fiscal year. Prior to implementing the new policy targets, Callan Associates will work with SURS investment staff to complete a structure analysis. The structure analysis will carefully review the investment portfolio structure and manager lineup in each asset class to determine if any changes are warranted. Diversification and risk control are of paramount importance. Once the structure analysis is complete, an implementation plan will be developed to move the portfolio from its current asset allocation toward the new policy targets. Projects planned for Fiscal Year 2012 include the following: Structure Analysis to be performed by Callan Associates and SURS investment staff Presentation of asset allocation implementation plan to Board of Trustees for consideration Potential search for direct real estate managers with the goal of increasing real estate exposure to 10% over time Additional funding to non-u.s. equity portfolio to shift allocation from 18% to 20% of total portfolio Issuance of Request for Proposal for Master Custody & Securities Lending Consideration of increased commitment to private equity Transition Management Search Continued involvement in corporate governance issues, including membership in the Council of Institutional Investors (CII) and signatory status in the Principles for Responsible Investment (PRI) Annual manager reviews Trustee education Trustee Education SURS strives to provide high quality continuing education for the Board of Trustees. Educational topics are routinely included on Investment Committee agendas. In addition, longer, more in-depth educational sessions, often faciliated by guest speakers, are provided in an annual Investment Forum. These sessions provide Trustees the opportunity to expand their investment knowledge and keep current with new trends in the marketplace. Input is sought from Trustees on topics of interest for future educational sessions. A key focus is on identifying potential investment opportunities that could positively impact the investment portfolio. Potential educational topics being considered for the coming year include: Real estate strategies Private equity investment opportunities Absolute return strategies Active emerging market strategies Transition practices 5 F Y2012 Investment Plan

10 Staffing The Investment Department is made up of eight professionals, including six investment professionals, one compliance and governance professional and one administrative professional. In total, the eight staff members have a total of 105 years of investment experience and 54 years with SURS. Approximately 88% of investment team members have undergraduate degrees, and 75% have graduate degrees. Professional certifications among the team members include two CPAs, two CFAs, one Series 7 and one Series 63 license. The table below lists the individuals on the SURS Investment Team and their tenure with SURS. Name Title Years with SURS Daniel L. Allen Chief Investment Officer 11 Douglas C. Wesley, CPA, CFA Deputy Chief Investment Officer 14 Kimberly K. Pollitt, CFA Senior Investment Officer 8 Marilyn J. Branson Corporate Governance & Compliance Officer 8 Lou Ann Fillingham, CPA Investment Officer 6 Tony J. Lee Investment Officer 4 Stefanie S. Rice Investment Executive Assistant 2 Joseph M. Duncan Investment Officer 1 An organizational chart of the Investment Department is shown on the following page. 6 F Y2012 Investment Plan

11 SURS Investment Department Organization Chart June 30, 2011

12 III. Asset Allocation / Risk Management Asset Allocation The purpose of the asset allocation policy is to establish an Investment Policy framework for SURS that has a high likelihood, in the judgment of the Board, of realizing SURS investment objective. In June 2011, SURS completed an asset/liability study with the assistance of Callan Associates. When selecting the optimal asset mix for SURS, the following considerations are key. Investment policy alone cannot close the SURS plan deficit. The deficit is too large. SURS faces the real risk that the assets could be depleted in less than ten years. The investment and contribution experience in the next five years will be crucial in determining whether the Plan will remain sustainable or shift to depletion. The asset allocation decision depends, in large part, on expected State contributions. Statutory rate contributions are expected to sustain the funded ratio; flat rate contributions will not. Differing expectations lead to dramatically different asset allocation decisions. Liquidity Considerations Callan Associates suggests the SURS Board of Trustees has an obligation to prepare for the risk of depletion. Although it is reasonable to plan to receive the statutory contributions from the State, it is important to acknowledge there is a risk of receiving a level of contributions less than the required amount. SURS believes continued substantial exposure to risk assets, including modest exposure to illiquid investments, is appropriate. Risk assets provide the potential for investment returns meeting or exceeding the Plan s return objectives. To acknowledge the funding and capital market uncertainties, however, illiquid asset class exposures should be limited to current target levels. Liquidity to pay benefits and respond to adverse funding or financial market downturns is critical. New asset classes and strategies such as absolute return will continue to receive consideration. However, funding a new strategy with so much uncertainty regarding the Plan s financial condition may not be optimal. It also may be appropriate to consider the creation of a liquidity reserve, carved out of the fixed income allocation, to meet expected outflows. Capital Market Assumptions The projected return and risk assumptions used in the process were developed by Callan Associates and are shown in the table on the following page. Most capital market expectations represent passive exposure (i.e., beta only), except for hedge funds and private equity, which include an active management premium. Return expectations are net of passive fees. 8 F Y2012 Investment Plan

13 Callan Associates Capital Market Assumptions Projected Return and Risk ( )

14 New Strategic Policy Targets The new strategic policy targets resulting from the asset/liability study are shown in the following table. A passive portfolio composed in such a manner is projected to produce a geometric return of 7.5% and a real return of 5.0% over time. Although the projected geometric return is slightly lower than the 7.75% actuarial return assumption, the projected 5.0% real return matches the actuarial real return assumption. It is important to note that active management is projected to add additional value over and above passive implementation. Asset/Liability Study Outputs New Policy Asset Class Targets U.S. Equity 30% Non-U.S. Equity 20% Global Equity 10% Fixed Income 19% TIPS 4% REITS 4% Real Estate 6% Private Equity 6% Opportunity Fund Total 1% 100% Geometric Returns (Nominal) 7.5% Real Return 5.0% Standard Deviation of Nominal Return 14.1% Sharpe Ratio Equity 60% Fixed Income/Cash 24% REITS 4% Alternatives/Illiquid 12% Risk Management Risk is monitored through various forms of analysis and reporting in an attempt to understand risk within the Fund, and to ensure adequate compensation for the risk that is taken. Analysis will occur on various levels from individual manager portfolios up through and including the total Fund level. In addition to relative performance evaluation, an analysis of diversification, tracking error, standard deviation, and other risk measures will be conducted and reported. Staff will review portfolios, asset classes, and total Fund information periodically for compliance within the overall risk budget. Portfolios or asset classes out of compliance with guidelines will be brought into compliance immediately, or a plan for doing so will be developed. Alternatively, justification for maintaining the exposure will be provided to the Investment Committee. 10 F Y2012 Investment Plan

15 TOTAL FUND (NET) TOTAL FUND VS. TARGET RISK ANALYSIS Risk Analysis The graphs below analyze the performance and risk of the fund relative to the appropriatetarget mix. Thisrelative performance is compared to a peer group of funds wherein each member fund is measured against its own target mix. The first scatter chart illustratesthe relationship,called Excess Return Ratio, between excess return and tracking error relative to the target. The second scatter chart displays the relationship, sometimes called Information Ratio, between alpha (market-riskor "beta" adjusted return) and residual risk (non-market or "unsystematic"risk). The third chart shows tracking error patterns over time compared to the range of tracking error patterns for the peer group. The last two charts show the ranking of the fund's risk statistics versus the peer group Risk Analysis vs CAI Public Fund - Large (>1B) Five Years Ended June 30, Excess Return (0.5 ) (1.0 ) Total Fund (Net) Alpha (0.5 ) (1.0 ) Total Fund (Net) (1.5 ) (1.5 ) (2.0 ) Tracking Error (2.0 ) Residual Risk Tracking Error Rolling 20 Quarter Tracking Error vs Targets Compared to CAI Public Fund - Large (>1B) Total Fund (Net) Risk Statistics Rankings vs Targets Rankings Against CAI Public Fund - Large (>1B) Five Years Ended June 30, % 4% 3% 2% 1% 0% (1%) (2%) (39) (40) Excess Alpha Tracking Return Error 10th Percentile th Percentile Median th Percentile (0.34) (0.46) th Percentile (1.33) (1.33) 0.81 Total Fund (Net) State Universities Retirement System of Illinois (87) (0.5) (1.0) (65) (65) (33) (37) Rel. Std. Beta Excess Info. Deviation Rtn. Ratio Ratio 10th Percentile th Percentile Median th Percentile (0.17) (0.19) 90th Percentile (0.51) (0.55) Total Fund (Net) F Y2012 Investment Plan 5

16 IV. Economic Outlook A variety of sources were used to develop this outlook for Fiscal Year Consideration was given to information from investment consultants, investment managers, discussions with peers and informational publications. Summary: Although the global financial crisis of is now history, the global recovery is slowing. Unemployment will continue to remain stubbornly high during the near to intermediate-term. Debt issues in the U.S. and elsewhere threaten to constrain consumer and government spending and will continue to act as a drag to global GDP growth. Macro issues will continue to dominate financial markets. High levels of economic uncertainty will lead to continued market volatility. As the chart of the CBOE S&P 500 Volatility Index illustrates, volatility has already spiked in recent days in reaction to the U.S. credit rating downgrade and continued global economic weakness. Source: Bloomberg 12 F Y2012 Investment Plan

17 Interest rates in the U.S. will continue to remain low, as seen in the yield curve charts below. The Federal Reserve is not expected to begin raising interest rates until mid Current Yield as of US Treasury Market June 30, 2010 June 30, 2011 % Change 3-Month Treasury Bill 0.17% 0.01% -0.16% 2-Year Treasury Note 0.60% 0.46% -0.14% 5-Year Treasury Note 1.77% 1.76% -0.01% 10-Year Treasury Bond 2.93% 3.16% 0.23% 30-Year Treasury Bond 3.89% 4.37% 0.48% 5.0% US Treasury Yield Curve Yield to Maturity 4.0% 3.0% 2.0% 1.0% 0.0% Month 2 Year 5 Year 10 Year 30 Year Years to Maturity 6/30/2010 6/30/2011 The sovereign debt crisis in peripheral Europe jeopardizes the welfare of core European banks and risks a significant ripple effect if not effectively contained. Although the massive injection of monetary and fiscal stimulus into global economies creates potential risks, inflation is not likely to be a problem in the developed world in Fiscal Year The emerging world, though, is a different story, and emerging market governments will likely continue efforts to contain rising inflation. 13 F Y2012 Investment Plan

18 V. Investment Strategies Investment Objectives The assets of the System will be invested solely for the benefit of participants and beneficiaries within the constraints of applicable Illinois Statutes and the guidelines contained in this document. In addition, the following investment objectives for the SURS plan have been established: Seek annualized investment returns, net of investment management fees, in excess of the market goal (as described later in this document) for 1, 3, 5, and 10 year periods. Maintain sufficient liquidity to pay benefits. Fiscal Year 2012 Total Fund Strategy The overarching strategy for Fiscal Year 2012 will be to move the investment portfolio closer to the new strategic policy targets approved by the Board at the June 2011 Board meeting. The table below illustrates the portfolio s current asset allocation (as of June 30, 2011) relative to the new strategic policy targets. $ s (in millions) Actual % New Strategic Policy % Difference (%) U.S. Equity $ 4, % 30.0% -1.9% Private Equity 1, % 6.0% -2.1% Non-U.S. Equity 2, % 20.0% +1.9% Global Equity 1, % 10.0% -0.4% Fixed Income 2, % 19.0% -0.8% TIPS % 4.0% +0.3% Real Estate % 10.0% +3.3% Opportunity Fund % 1.0% -0.3% Total Fund $ 14, % 100.0% Implementation of the new policy targets will begin during Fiscal Year 2012 and will occur gradually over time. The following actions are planned for the coming fiscal year, many of which are designed to shift the portfolio toward the new targets. A structure analysis will be conducted by Callan Associates with the assistance of SURS investment staff to evaluate the existing structure and manager lineup in each public market asset class. Recommendations for any enhancements will be presented to the SURS Board for consideration. An implementation plan will be developed to move the portfolio from its current asset allocation to the new strategic policy targets. The implementation plan will be presented to the SURS Board in the coming months for discussion and consideration. A request for initiation of a search for private opportunistic real estate managers will be presented to the Board in September As illustrated in the previous table, the real 14 F Y2012 Investment Plan

19 estate portfolio is the asset class farthest away from its new policy targets, as of June 30, 2011, and so should be addressed in a timely manner. SURS staff will request Board approval to issue a Request for Proposal for Master Custody, Related Services & Securities Lending. The last formal search for these services concluded in SURS will make continued efforts to enhance and expand the Manager Diversity Program (MDP). As of June 30, 2011, the MDP is valued at approximately $909 million and includes 18 investment management firms 3 owned by minorities, females and persons with a disability (MFDB). SURS will also continue to strive to enhance and expand its relationships with MFDB managers outside the scope of the MDP. Overall, SURS contracts with 24 MFDB investment management firms. Assets managed for SURS by these 24 firms are nearly $2.8 billion, or 19.3% of the Total Fund. SURS staff and Callan Associates will complete formal reviews on each investment manager in the SURS portfolio. SURS staff and Callan Associates will complete formal reviews of the Self-Managed Plan (SMP). A search for firms qualified to provide transition management services will be resumed. Trustee education will continue to be a priority during Fiscal Year Fiscal Year 2012 Equity Strategy Assets are expected to be reallocated from the U.S. equity portfolio to the non-u.s. equity portfolio as a result of the completion of the asset/liability study in June This shift in assets is expected to provide additional diversification to the equity portfolio as well as opportunities for enhanced return. Assets may also be sourced from the equity asset classes to increase the Plan s exposure to private real estate. Callan Associates, the general investment consultant for SURS, is currently in the process of conducting a structure analysis. Results will be presented to the Board in the coming months. Additional actions involving the portfolio structure for the U.S., non-u.s. and global equity portfolios are possible pending the outcomes of the structure analysis. US Equity 32% Non-US Equity 18% Global Equity 10% Fiscal Year 2012 Fixed Income Strategy Major changes to the fixed income portfolio are not anticipated during Fiscal Year A restructuring of the fixed income portfolio concluded in late Revisions were made to the investment manager lineup to improve relative returns and increase the liquidity of the portfolio. The allocations for both the core fixed income and TIPS portfolios are close to the new strategic policy targets so major reallocations will be unnecessary. Increasing the allocation to the private real estate portfolio, however, may require the transfer of some assets from the fixed income portfolio. TIPS 4% Fixed Income 20% 3 Funding of a new MFDB manager after June 30, 2011, brings the total number of managers in the MDP to F Y2012 Investment Plan

20 The pending structure analysis may result in modest enhancements to the core fixed income and TIPS portfolios. Alternative Strategies Fiscal Year 2012 Real Estate Strategy As of June 30, 2011, investments in real estate investment trust securities (REITS) comprise 4.1% of the total portfolio, and investments in private real estate investments total 2.6% of the portfolio. The new strategic policy target mix allocates 4% to REITS and 6% to private real estate. Staff intends to request authorization for a private real estate search at the September 2011 Board meeting. The search will likely be focused on the opportunistic segment of the real estate market. The chart below illustrates the diversification of the real estate portfolio by type, as of June 30, Real Estate 7% SURS Real Estate Portfolio Diversification by Type Opportunistic Real Estate* 11% Value Added Real Estate 1% Core Real Estate 33% REITS 55% *The allocation to opportunistic strategies shown above represents the commitment made to each fund, not the current market value. Fiscal Year 2012 Private Equity Strategy The total portfolio remains overweight to the private equity asset class although the overweight has lessened considerably over the past two years. The June 30, 2011, allocation of 8.1% exceeds the 6.0% strategic policy target. SURS has not made new commitments to this asset class in almost three years. New commitments will be considered during Fiscal Year 2012 to maintain vintage year diversification in the private equity portfolio. The chart that follows illustrates the diversification of the private equity portfolio by type, as of June 30, Private Equity 8% 16 F Y2012 Investment Plan

21 Mezzanine 2% Secondaries 3% SURS Private Equity Portfolio Diversification by Type Other 7% Fund of Funds 28% Buyouts 45% Venture Capital 15% Fiscal Year 2012 Opportunity Fund Strategy At this time, no new investments are currently being considered for the Opportunity Fund. Potential opportunities arising during Fiscal Year 2012 may be brought to the Board s attention, if appropriate. Opportunity Fund 1% 17 F Y2012 Investment Plan

22 VI. Manager Diversity Program Overview The Manager Diversity Program (MDP) is a manager of managers program that is overseen by SURS Staff. The primary goal of the MDP is identifying highly successful minority-, female-, and persons with a disability-owned (MFDB) investment managers that can then be awarded meaningful allocations in the actively managed portfolio. Key items of note: Developed in 2004 to identify and retain MFDB firms Managers contract directly with SURS Market Value of $909 million, as of June 30, components: Number of MFDB Firms Commitment Amount (Private Equity & Real Estate Only) Market Value* Asset Class as of June 30, 2011 U.S. Equity 8 $342 million N/A Core Fixed Income 4 $210 million N/A TIPS 2 $194 million N/A Non-U.S. Equity 3 $133 million N/A Private Equity 1 $29 million $50 million Real Estate 1** -- $75 million Total 18 $909 million *Totals may not add due to rounding. ** Funding of a new real estate manager after June 30, 2011, brings the total number of managers in the MDP to 19. Performance Objectives The performance objective of the MDP is to seek annualized investment returns, net of investment management fees, in excess of the market goal for 1, 3, 5, and 10 year periods. While individual investment managers may underperform in any given year, the diversification within the program should limit the underperformance at the program level. Fiscal Year 2011 Performance Review The MDP lagged its benchmark during Fiscal Year 2011 primarily due to manager underperformance in the U.S. and non-u.s. equity portfolios. For longer term periods, the program s returns exceed those of the benchmark, as shown in the table below. Investment Performance* As of June 30, Year 3 Years 5 Years Since Inception SURS MDP 18.2% 4.8% 4.5% 5.3% Benchmark 19.5% 4.1% 4.0% 5.1% *Net of investment management fees 18 F Y2012 Investment Plan

23 Fiscal Year 2011 Accomplishments The Manager Diversity Program expanded meaningfully during Fiscal Year As of June 30, 2011, the MDP is valued at approximately $909 million. A summary of MDP activities follows. As part of the restructuring of the fixed income portfolio, one new MFDB manager was hired with an initial allocation of $50 million, and another existing manager earned an additional allocation of $25 million. Two existing MFDB non-u.s. equity managers were allocated an additional $65 million, in total. A U.S. equity search was completed, and initial mandates were funded to two existing firms for a total of $50 million. In addition, one existing MFDB U.S. equity manager was allocated an additional $15 million. Contract negotiations were completed with a real estate fund-of-funds manager, whose mandate is to identify capable emerging, minority- and female-owned real estate funds for SURS. SURS will be investing in this strategy with a consortium of other pension plans, including the Illinois Municipal Retirement Fund and the Public School Teachers Pension and Retirement Fund of Chicago. SURS commitment amount is $75 million. As of June 30, 2011, total assets under management with MFDB firms are approaching $2.8 billion or 19.3% of the Total Fund. Fiscal Year 2012 MDP Strategy Plans for the MDP in FY 2012 include the following: Continue diligent monitoring of the overall program, manager structure, and risk parameters within the program Provide a thorough review of the MDP to the Board at the March 2012 Board meeting Identify potential opportunities to increase/decrease funding for existing qualified investment managers Allocate initial funding to the private real estate portion of the program Consider continued expansion of the private equity portion of the MDP Increased interaction with system consultant, Callan Associates, via more frequent discussions regarding managers within the MDP 19 F Y2012 Investment Plan

24 VII. Self-Managed Plan Overview The Self-Managed Plan (SMP) is a defined contribution option available to SURS participants. The SMP has grown steadily since the plan s inception in April To date, over 23,200 participants have participated in the plan. Highlights of the plan include: $956 Million in Assets as of June 30, 2011 (including the SMP forfeiture and disability reserves of more than $65 million) Two Service Providers Fidelity Investments ($508 million in assets) TIAA-CREF ($382 million in assets) 31 investment options as of June 30, 2011 Includes family of lifecycle funds in both TIAA-CREF and Fidelity lineups Over 16,000 Participants Fiscal Year 2012 SMP Strategy Given the diversity and number of investment options in the SMP, there are no plans to expand the offerings. However, SURS staff continually monitors them for performance and cost effectiveness. If there were an opportunity to replace an option, SURS would look to consider another SRI/ESG fund for inclusion. Also, SURS takes into consideration that the SMP is a primary retirement plan, as well as participant inquiries and requests, when determining what funds to potentially include in the lineup. Participant education will also continue to be a priority in the coming year. 20 F Y2012 Investment Plan

25 Appendix A

26 WELLINGTON MANAGEMENT MANAGEMENT third quarter 2011 Asset Allocation Allocation Outlook Outlook Still a Macro Market Evan Grace Asset Allocation Portfolio Manager and Strategist We are more than two years beyond the most acute phase of the global financial crisis. Yet cross-asset correlations remain remarkably high, and macro forces continue to dominate investor attention. While bottom-up fundamentals certainly remain relevant, there is an unusually strong focus on top-down forces such as the behavior of central banks, the appropriate application of fiscal policy, and the implications of elevated sovereign risk. This broad characterization of high macro risk is not new, as it has been a persistent feature of this post-crisis era, but the extent to which it is reflected in prices is inconsistent across asset classes. Specifically, I will discuss three views. The first is that equities look attractive relative to commodities, and therefore commodity-related assets are less likely to be market leaders. A second view is that while emerging markets remain attractive relative to developed markets on a structural basis, it may still be too early to move in this direction until the near-term dynamics of relative earnings growth change. And thirdly, equities may outperform other major asset classes if investors continue to evaluate assets on the basis of their ability to produce a positive real return. However, this scenario will likely produce higher volatility as relative-value arguments rest on weaker ground than fundamental arguments. Top-Down Remains Top of Mind Macro factors are always an important part of the investment discussion, but the degree of attention they are now receiving from investors is unusually high for this phase of the economic cycle. We see top-down forces driving markets on four fronts. Central Banks I have written in past Asset Allocation Outlooks about the tremendous influence that government policy exerts on financial-asset returns, and that remains true today. The Fed KEY POINTS Macro forces continue to exert an unusually high influence on financial markets. Monetary and fiscal policy, negotiations on European sovereign debt, and the cyclical outlook are all key market drivers today. The current consensus outlook on such matters as central-bank policy and currency movements is plausible, but now so uniform that any changes to it would materially affect the relative fortunes of asset classes. Equities remain an attractive potential source of real long-term gains, but building the case for equities on the basis of relative value is risky.

27 Still a Macro Market just ended its second wave of quantitative easing (QE2) in the US, but the central bank has effectively instituted QE 2.5 by maintaining an enlarged post-crisis balance sheet, albeit without continuing to expand it with new asset purchases (Figure 1). This partial exit from the market by a major buyer is causing uncertainty in US government bond pricing. The European Central Bank (ECB) has already begun to tighten, and has not retreated in its rhetoric despite softening eurozone data and rising sovereign pressures centered on Greek debt. This increases the risk premium on European assets. Figure 1 Monetary Policy Remains Accommodative US Dollars, Billions US Federal Reserve Balance Sheet, 3/04 6/11 3,000 2,500 2,000 1,500 1, /04 4/05 4/06 4/07 4/08 4/09 4/10 4/11 China has been tightening since late last year, and Chinese Premier Wen Jiabao caused a stir by suggesting that inflation in China would soon moderate. This triggered speculation that China might ease policy at the margin, counter to the biases of the US and European central banks. Fiscal Policy The austerity versus stimulus debate continues in Greece, the UK, and most recently in the US in the context of the debate on raising the federal debt ceiling. The recent austerity votes in Greece had repercussions well beyond that country, as the sovereign yields of other highly indebted countries have been moving in tandem with shifts in expectations about the probability of a Greek default. Similarly, the economic pain that the UK is experiencing as a result of its recently enacted austerity plan is affecting the debate over what sort of austerity the US ought to implement (Figure 2). In the debate over the US debt ceiling, the central issue may not be whether the ceiling should be raised, but rather the implications of the associated negotiations. Essentially, this is a debate about the degree of austerity the US should undertake, and the best mix of tax increases and spending cuts to achieve it. The debt ceiling calendar and the magnitude of the deficit suggest that something must be done (Figure 3). But the experience of the UK and Ireland with austerity measures, along with limited market pressure on the US, suggest that measures to reduce the federal budget Source: Bloomberg Figure 2 Feeling Austerity's Pinch in the UK Q/Q Percent Change UK Household Final Consumption Expenditures, 9/95 3/ /95 3/98 9/00 3/03 9/05 3/08 9/10 Figure 3 Fiscal Tightening Likely in US % of Nominal GDP US Federal Budget Deficit/Surplus, 12/69 4/ Source: Bloomberg Source: Bloomberg Wellington Management 2 Asset Allocation Outlook

28 Still a Macro Market deficit are unlikely to be severe. That said, some incremental fiscal tightening is likely, which could provide moderate support for the US dollar. European Sovereign Risk While Greece avoided the short-term worst-case scenario with its recent votes, there is widespread concern that the focus on liquidity making sure that Greece can pay its debts for the next few months has done nothing to change the fact that the country still has a solvency problem that ultimately will require some degree of debt forgiveness. Since much peripheral European debt is held by core European banks, the macro ripple effects of an uncoordinated default would be substantial (Figure 4). This dynamic is broadly understood, but the manner in which Greek debt would be written off is both vital and uncertain. Much effort is now being focused on structuring a default under a different name, the current euphemism of choice being reprofiling, so that credit default swaps (CDS) contracts written against Greek sovereign debt will not be triggered. This is another example of how policy choices are driving asset prices much more than they have in the past, and thus far the results are not encouraging. Mid-Cycle (We Hope) Slowdown The final macro component that has captured investor interest is the most conventional. Economic data from many countries have shown significant slowing. With low rates of growth already prevailing in much of the world, and leading indicators suggesting more weak growth ahead (Figure 5), the question of the slowdown s magnitude takes on greater importance. A theme of the past year has been cyclical strength, structural weakness, and while the structural concerns are clearly less acute than a year or two ago, they are still pertinent. When the cycle weakens amid structural concerns, the worries are amplified relative to a typical cycle. When the cyclical picture improves, the upside is similarly magnified, which leads to higher volatility. The Regime Remains (Mostly) the Same Given these dynamics, what looks attractive, and what should one s strategy be? First, it is important to remember that the overall regime high liquidity, structural challenges, weaker but respectable cyclical strength, and managed exchange rates between many emerging and developed markets remains intact. That suggests that a major valuation adjustment for the primary asset classes is unlikely. That said, the regime may be changing at the margin at a time when some consensus opinions are fairly uniform. It appears that investors generally believe the following: Central banks will remain accommodative in general, but will have a tightening bias in emerging markets. The US dollar will weaken further, as the Fed has signaled an inclination to remain Figure 4 Figure 5 Greece Crisis: Broad Impact More Anemic Growth Ahead? Basis Points Greece 5-Year Sovereign CDS Spread, 3/04 7/11 2,400 2,000 1,600 1, /04 1/05 10/05 8/06 6/07 3/08 1/09 11/09 8/10 6/11 OECD Index of Leading Economic Indicators, 4/06 4/ /06 10/06 4/07 10/07 4/08 10/08 4/09 10/09 4/10 10/10 4/11 Source: Bloomberg Source: Bloomberg Wellington Management 3 Asset Allocation Outlook

29 Still a Macro Market looser for longer than other central banks. Accommodative policy and strong bottom-up forces will continue to support commodity prices and the prices of other risk assets such as equities and high yield bonds. Emerging markets will grow faster than developed markets on a structural basis. These conclusions are all perfectly reasonable and likely to be generally correct as long as the current regime holds. Whenever consensus opinion becomes uniform, however, asset prices become vulnerable. The following asset class relationships appear ripe for change. Equities Versus Commodities Despite a generally positive environment for equities and other risk assets, commodities have been strong outperformers for over a year, with equities only recently taking the lead (Figure 6). The overwhelming consensus view is that central bank liquidity and strong demand from emerging markets represent powerful drivers that will support commodity markets. If this view is correct, as I believe it is, commodities should continue to provide absolute returns competitive with inflation and other asset classes. In terms of equity-relative comparisons, if the recent economic slowdown is indeed a soft patch in the context of a longer cycle, then liquidity should be viewed as less of a driver than growth, and equities should be advantaged, even if commodity returns remain robust. Emerging Versus Developed Markets For the better part of the past decade, emerging market assets have handily outperformed developed market assets thanks to attractive starting valuations, sound economic policies, higher economic and earnings growth, and fewer structural problems such as high financial-sector and consumer debt. Since the fourth quarter of 2010, however, emerging markets have underperformed, primarily due to cyclical factors such as central bank tightening. We continue to prefer emerging over developed markets on structural grounds. Furthermore, if inflation pressures in China are in fact receding and the government can shift to a less-restrictive policy bias, that could remove an impediment to stronger emerging market relative performance. That said, until short-term relative earnings growth looks more compelling in emerging markets as a group, they may continue to lag even if the overall risk environment remains supportive (Figure 7). In contrast to the period, emerging and developed market corporate earnings growth are currently expected to be roughly equivalent for the next 12 months. While economic growth is widely expected to be much higher in emerging markets, that has yet to show up in earnings estimates. Figure 6 Commodity/Equity Relative Performance S&P GSCI Equal-Weighted Commodity/MSCI AC World Return Indexes, 7/01 7/ /01 7/02 7/03 7/04 7/05 7/06 7/07 7/08 7/09 7/10 7/11 Figure 7 Earnings Growth in Emerging and Developed Markets Y/Y Percent Change Expected 12-Month EPS Growth, 12/98 6/11 40 Emerging Developed Source: Bloomberg Data is median of MSCI Indexes; Emerging: Brazil, Mexico, South Korea, Taiwan, Turkey, South Africa, Russia, India, China; Developed: Europe, UK, Japan, Australia, Canada; S&P 500 Source: Thomson Datastream Wellington Management 4 Asset Allocation Outlook

30 Still a Macro Market The Search for Real Returns We often look to fundamentals when thinking about relative asset class attractiveness. This is appropriate, but not the entire story, as other forces are important drivers of returns. For example, looking at equities from a fundamental perspective, there is cyclical risk from slowing economic growth, valuations are supportive, but not compelling, and earnings growth expectations look broadly reasonable. The larger problem facing equities is likely a structural one: If growth is sufficiently impaired that it will remain below historical averages for some time, or if mild stagflation descends on the developed world, then valuations at or below current levels would be warranted. Beyond fundamentals, another measure of the attractiveness of an asset is its ability to produce a positive return net of expected inflation. While risk, time horizon, and diversification benefits are important considerations, most institutions and individuals define investment success as the growth of capital in real terms, after some level of spending. So what asset classes can produce attractive real returns? Equities carry risk of capital loss from valuation change, but they offer a yield in terms of dividends and expected future earnings. Dividends alone are unlikely to produce a real return in most markets, but they may help you pull even with inflation. The dividend yield for global equities stands at roughly 2.5% a reasonable long-term expectation for global inflation and one that is broadly consistent with expectations embedded in inflation-linked bond markets. However, on an earnings basis, many equity markets are yielding between 6% and 8%, which compares favorably to expected inflation. There is obvious risk to this as a low-growth/high-debt environment is consistent with structurally high earnings yields. But research shows that over a long horizon, earnings yields are a key determinant of future returns, and these levels are attractive. In terms of other asset classes with the potential to outpace inflation, US high yield bonds fit this bill, as do many fixed income spread sectors, select government bond markets, and many commodities. The 10-year and shorter segments of most government bond markets offer little prospect of a high real return, but there are important exceptions, such as government bonds in Australia, New Zealand, and the more troubled countries in Europe. Additionally, the 30-year segment of some developed markets, including the US, also offers the prospect of out-yielding inflation, which gives it value as a positive-real-return, low-volatility asset that is also a good weak-growth hedge. A word of caution is warranted here, especially as it relates to equity markets. While it is important to consider the degree to which investors are attracted to equities by dint of low expected real returns elsewhere, it is risky if the investment thesis is too reliant on this argument. If bond yields are low as a result of poor expected growth, then a relativevalue argument for stocks isn t a strong one as low growth and high earnings yields are fully consistent. If stock prices rise for relative-value reasons that are not supported by fundamentals, then we are setting up for a deeper valuation correction down the road. Conclusion While we continue to watch for the declining correlation environment we have written about in the past, in many ways it has not materialized. While correlations should decline with time, we remain focused on the current powerful macro drivers as their influence is a prime determinant of asset prices right now. Changes at the margin within the current regime suggest potential leadership changes in the coming months, and the prospects for a broader change in the overall regime over time will eventually have profound effects. About the Author Evan Grace, CFA, is an asset allocation portfolio manager and strategist and a member of the Asset Allocation Strategies Group at Wellington Management. In these roles, he manages or co-manages a number of asset allocation portfolios and performs top-down asset class and macroeconomic research that is employed by investors across the firm. Wellington Management 5 Asset Allocation Outlook

31 Wellington Management Company, llp Boston Chicago Radnor, PA San Francisco Wellington Global Investment Management Ltd Hong Kong Beijing Representative Office Wellington International Management Company Pte Ltd Singapore Sydney Tokyo Wellington Management International Ltd London Frankfurt About Wellington Management Tracing our roots to 1928, Wellington Management is one of the largest independent investment management firms in the world. We are a private firm whose sole business is investment management, and we serve as investment adviser for institutional clients in over 50 countries. Our most distinctive strength is our commitment to proprietary, independent research the foundation upon which our investment approaches are built. Our commitment to investment excellence is evidenced by our significant presence and long-term track records in nearly all sectors of the liquid, global securities markets. 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32 Appendix B

33 Northern Trust Global Economic Research 50 South LaSalle Chicago, Illinois northerntrust.com Paul L. Kasriel Chief Economist fax Asha Bangalore Economist fax Continued Sluggish Economic Growth Expected Through 2012 July 21, 2011 With this commentary, we unveil our first formal forecast of U.S. economic activity and interest rates for The forecast for real GDP growth is only marginally better in 2012 vs. the forecast for 2011 on a Q4/Q4 basis, 2.45% in 2012 vs. 2.20% in We do expect some forward momentum to build in the second half of 2012 with respect to real GDP growth and for this momentum to intensify in The reason for this building momentum is an expectation of a resumption of Federal Reserve quantitative easing (QE) early in 2012 and/or a pick-up in bank credit creation. Because our forecast is for below-potential real economic growth, our view is that the unemployment rate will creep up from its Q2:2011 average of 9.1%, peaking at 9.5% in Q3:2012. It will not be until 2013, that any sustained meaningful decline in the unemployment rate sets in. With the energy-price spike behind us and with only moderate growth in combined Fed and commercial bank credit in the past couple of years, we expect the growth in the overall CPI to slow toward 2%. Under these real GDP growth/unemployment rate/cpi growth circumstances, the Federal Reserve is unlikely to raise its policy interest rates until early If anything, the Fed will lower the interest rate it pays on bank excess reserves later in At the longer end of the yield curve, below-potential real economic growth and a moderating trend in the growth of the CPI would be expected to keep Treasury bond yields in a narrow range centered on 3%. If, however, a grand bargain could be reached on a 10-year plan to reduce the projected growth in federal debt, then the yield on the Treasury 10-year security could test its October 2010 low of around 2.40%. As an aside, it is our working assumption that some kind of legislation to raise the public debt ceiling will be signed into law before the Treasury has to make decisions on which bills to pay as they come due and which ones to postpone paying. As regular readers of these commentaries know, we believe that a fundamental driver of domestic aggregate demand for goods and services is the combined growth in Federal Reserve and commercial bank credit. With the commercial banking system currently creating only minimal amounts of credit, if any at all, it has been up to the Fed via QE to be the credit creator of last resort. As the chart below shows, QE, which was re-engaged in at the start of November 2010, did result in an acceleration of combined Fed and bank credit through the first week of July Notice also that in the 38 weeks ended July 6, Fed QE was responsible for the entire 6.7% annualized growth in combined Fed and commercial bank credit, with bank credit actually contracting at an annualized rate of 0.8%.