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: April 2, 24 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 Analysis Action Approve segregation of health care assets for investment purposes and select an asset allocation policy mix for the healthcare fund based on recommendations contained in the attached memo from Ennis Knupp & Associates (EKA). The selected asset allocation will be incorporated in the final Investment Policy document to be presented by staff in May with an implementation schedule. Background At the February and March 24 meetings 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. EKA and staff were directed to provide additional information, which is addressed in the attached memorandum from EKA. Discussion The proposed 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. Staff concurs with EKA s recommended allocation of 5% equity securities of various types and 5% fixed-income securities. 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 May. Implementation 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 three-month time frame. The additional costs for custody and accounting are expected to be in the region of $5, per year. We do not foresee any need for additional internal staffing on account of this change. More specific details on custody costs will be provided in May. The investment staff will develop a strategy to manage the TIPS portfolio internally by the Global Bond department staff. Staff already has experience in investing in TIPS for the internal active bond portfolio. We expect the TIPS portfolio can be implemented within a three-month period. We do not foresee any additions to the Bond staff on account of this portfolio. The REIT allocation of 7% for the Health Care Fund will require additional investments in REITs of about $3 to $4 million. Based on current REIT valuations staff believes it would be prudent to build this portfolio opportunistically over a twelve to eighteen month period. The under allocation to REITs in the Healthcare Fund during this period will be invested in domestic and international equities. Staff is also exploring any legal requirements that may have to be met in the process of segregating the assets, particularly in reference to the valuation of private asset classes (Real Estate and Private Equity). Staff will provide any additional information we have on this topic at the meeting. 2

3 MEMORANDUM To: Investment Committee Ohio Public Employees Retirement System From: Richard M. Ennis, CFA Brady P. O Connell, CFA Date: April 8, 24 Re: Health Care Investment Policy Analysis and Recommendations Summary and Recommendation At the March Investment Committee meeting the trustees requested additional information concerning the proposal to segregate the health care (HC) assets and invest them solely in marketable securities. We furnish that information here with our recommendation for action. The trustees requested a retrospective analysis of the volatility of the HC fund under hypothetical alternative investment polices, which we include here. We also evaluated the possible role of a common hedging strategy employed to provide protection against risk of loss. And finally, we made certain refinements to the portfolio optimization process, as suggested by staff. The more recent analysis confirms our view that the HC assets should indeed be segregated. Investments should be restricted to marketable securities, and the equity allocation should be reduced. We recommend a policy allocation of 5% equity securities of various types and 5% fixed-income securities. Ennis Knupp + Associates vox South Riverside Plaza, Suite 7 fax Chicago, Illinois

4 Review of Prior Work At the February meeting we presented our principal investment policy analysis for the HC assets. The report is reproduced in full as Appendix 1. We summarize here some of the main points of that analysis: Investment Horizon. Figure 1 compares the projected value of the pension and HC funds. The pension fund balance is projected to grow in perpetuity. One implication of this is that each dollar currently in the pension fund has indefinite investment horizon. The projected HC fund balance is a very different picture. That fund is projected to be exhausted in approximately 2 years, in spite of investment earnings and limited future contributions. The stark difference in the funds profiles is the heart of the case for a more conservative investment policy for HC relative to pension. Investment risk tolerance is a direct function of investment horizon. Figure 1 5-Year Projection and Health Care Fund Balances Pension Fund 4 2 Health Care Fund Solvency Preservation Analysis. We developed a Monte Carlo simulation model of the operation of the HC fund, based on projections furnished by GRS. The purpose of the model is to estimate the probability that the HC fund will remain solvent for various time periods under alternative investment policies. The upshot of that analysis is that limiting equities to 5% of total assets enhances the security of the health care plan. Ennis Knupp + Associates 2

5 Risk Feedback. Table 1 illustrates the sensitivity of future HC fund balances to different levels of investment risk. The wide dispersion of outcomes for the 75%-equity policy results from the risk-feedback effect inherent in the HC fund. Table 1 Dispersion of HC Fund Balances Four years Out (Billion $) 1/1/28 Asset Values Percentile All Bonds 75% Equities 95% $1.2 $16.3 9% % % % % % The HC fund balance is subject to investment risk twice, directly and indirectly. If investment returns are negative, the direct effect is a decline in the value of the HC assets. The indirect effect relates to the funding of HC, which is, in effect, a residual of pension funding. If investment returns are negative, contribution requirements for the pension plan increase in order to meet minimum funding requirements. When they increase, HC contributions must be reduced which compounds the effec t of market risk to the HC fund. This is what we mean by the risk-feedback effect. Survey Results. We conducted a survey of the practices of other public funds in managing portfolios of health care assets. The most common practice in managing public health care portfolios is to (1) segregate health care assets from pension assets and (2) invest them predominantly in fixed-income securities. Additional Analysis Requested At the March Investment Committee meeting the trustees requested that additional retrospective analysis be performed to illustrate how pursuing alternative asset allocation policies would have (hypothetically) affected the value of the HC fund and prospective fund solvency. We have also examined and report on the possible application of a hedging strategy to provide protection against a sharp decline in the stock market. Retrospective Analysis. For the each of the 11 hypothetical investment policies (ranging from all bonds to all stocks in ten-percentage point increments), we attempted to re-live the past of the HC fund. We made the following assumptions in conducting the analysis: Ennis Knupp + Associates 3

6 Historical returns are Lehman Aggregate Bond Index for fixed income, Wilshire 5 for U.S. equity, and EAFE for non-us equity. For "risky assets" we assume a mix of 7% U.S. and 3% non-u.s. stocks. For the solvency period calculations, we always assume a forward return expectation of a fixed 8%, as per GRS. This assumption is not affected by the asset allocation parameter. We also assume that actual contributions and benefit payments from 1989 through 23 were known with perfect foresight -- so all the changes here are due to investment performance. For assumed cash flows after 23, we use the same GRS estimates that we have been using -- assuming a change to Package C. In performing the analysis we focus on hypothetical fund asset value and prospective solvency period. The following conclusions may be drawn from the analysis: Fund balances and prospective solvency periods exhibit acute sensitivity to increases in equity allocation as the equity allocation rises above 5% of total assets. Maximum downside protection during the recent bear market is associated with equity allocations in the range of 2% to 6%. The modest (one-year) gain in prospective solvency period that results from a 7%-equity policy is not warranted by the greater degree of volatility. Please refer to Appendix 2 for a detailed presentation of the results of the analysis. In summary, these results strongly reinforce the results of the Monte Carlo simulations in indicating a reduction in the equity allocation of the HC fund. These results are consistent, by the way, with analysis performed by GRS to attribute the sharp decline in the HC fund s solvency period in recent years to various factors. Between 22 and 23 GRS s estimate of the solvency period declined from 51 years to 17 years. GRS attributed the decline in years of solvency as follows: 55% of the decline was due to investment market returns 22% was due to higher anticipated health care inflation in the future 17% was due to reduction in the contribution rate from 5% to 4% 6% was due to higher-than-anticipated health care costs in recent years Ennis Knupp + Associates 4

7 By way of comparison, the 4%-fixed-income-allocation scenario of the current retrospective analysis (Appendix 2) shows the solvency period declining from 51 years to 25 years between 2 and 23. Although the timeframe is slightly different, the order of magnitude of the decline in solvency period is the same. Any way you look at it, solvency period volatility is acutely sensitive to equity allocation. Hedging Strategy. It was suggested by one of the constituency groups that we consider the possibility of OPERS employing a hedging strategy in connection with the HC portfolio. The idea behind this is that it may be possible, using options, to protect the value of the fund from sharp declines in the stock market without having to make a permanent change in the composition of the investment portfolio. The most common technique employed for this purpose is commonly referred to as a costless collar. A costless collar combines two options positions the effective purchase of a put option and the simultaneous effective sale of a call option. In the event of a stock market decline, the put option would increase in value, offsetting some of the loss in the fund s common stocks. With a costless collar, purchase of the put option is financed through the sale of the call option. As a result of selling a call option, the fund would forgo some of the gain on its stocks if the market rises. The put option provides the protection; sale of the call pays for the put. It is in this sense a costless transaction. (The fund would incur not inconsequential transactions costs in connection with a transaction of this type.) In our analysis we assume that a one-year costless collar is applied to the equity portion of the investments and the collar is renewed annually. The collar parameters that we use include: A -1% floor on return, with a -25% re-entry level, i.e., protection is for losses between -1% and -25% (This is the put feature.) A cap on gains to OPERS equal to +1%. (The effect of the call feature.) Table 2 presents simulation results relating to solvency period as originally presented in February, i.e., in the absence of the hedging strategy. Table 3 is the same simulation assuming the existence of a costless collar. Ennis Knupp + Associates 5

8 Table 2 Range of "solvency period" with shortfall probabilities (no collar): Allocation to risky assets % 25% 5% 75% 1% Expected return* 4.6% 5.5% 6.3% 7.% 7.5% Percentile values: 95% % % % % Mean Prob. of period less than X years: 1 % % % 2% 6% 15 35% 31% 29% 29% 29% 2 1% 84% 67% 58% 54% 25 1% 1% 9% 76% 68% * Compound, or geometric average, return using EnnisKnupp assumptions. From Table 3 it is apparent that the hedging strategy lessens downside risk. The 5 th percentile outcome for 75% equities is 11 years compared with 1 years without the hedging strategy. At the same time, however, the hedging strategy forces OPERS to relinquish much of the upside potential in stocks. This can be seen in two ways. The 95 th percentile (most favorable) solvency period drops from 35 years to 21 years when the collar is employed. Also, the mean solvency period for 75% equities declines from years to 15.6 years. Indeed, the distribution of solvency periods for 75% equity with the collar is very similar to the distribution of solvency periods for 25% equity without the collar. Ennis Knupp + Associates 6

9 Table 3 Range of "solvency period" and shortfall probabilities (with collar): Allocation to risky assets % 25% 5% 75% 1% Expected return* 4.6% 4.6% 4.6% 4.6% 4.4% Percentile values: 95% % % % % Mean Prob. of period less than X years: 1 % % % 1% 3% 15 35% 35% 37% 38% 41% 2 1% 99% 94% 87% 81% 25 1% 1% 1% 1% 99% * Compound, or geometric average, return using EnnisKnupp assumptions. In short, there is no advantage in employing a hedging strategy. The downside protection comes at the cost of forgoing market gains. The overall effect is the same as simply lowering the equity allocation. Conclusion and Recommendation All of the work we have done points in the direction of managing the HC fund separately from the pension fund, which has a perpetual investment horizon and, accordingly, operates with approximately 75% in equities and more than 1% in private market investments, by policy. The investment horizon of the HC fund is much shorter, and an equity-oriented investment policy increases the probability of having to make drastic changes in benefit levels or contribution rates. The only possible justification we can see for preserving the status quo is a high degree of conviction that equity markets will be unusually strong in the years ahead. We, like the majority of expert observers of markets currently, do not have such conviction. In the absence of such conviction, staying with the current investment policy strikes us as mere hopefulness, which is not the right basis for investment policy. Ennis Knupp + Associates 7

10 We recommend segregation of the HC assets and adoption of an investment policy similar to Policy B in Table 4. It is an efficiently diversified, moderate risk blend of various types of equities and fixed-income securities. Table 4 Investment Policy Recommendation Portfolios A B C U.S. Equity 23% 28% 33% Non-U.S. Equity REITs Total Equity 4% 5% 6% U.S. Bonds Year Treasuries 25 TIPS Total Fixed Income 6% 5% 4% Our central thesis is that the appropriate degree of equity allocation for HC is directly related to solvency period. While 7% equities may well have been appropriate for OPERS HC assets when the solvency period was in excess of 5 years, we believe that is no longer the case now that the solvency period is closer to 2 years. And if the solvency period continues to shorten one year at a time annually, which will happen in the absence further plan modifications, increased contributions, or a fortuitous investment experience, an ever declining equity allocation is indicated as shown in Figure 2, on the following page. Ennis Knupp + Associates 8

11 Figure 2 Declining Equity Allocation with Lower Solvency Periods % Allocation 1% 9% 8% 7% 6% 5% 4% 3% 2% 1% % Solvency Period Equities Bonds Ennis Knupp + Associates 9

12 APPENDIX 1 MEMORANDUM To: Investment Committee Ohio Public Employees Retirement System From: Richard Ennis, CFA Rowland Davis Brady O Connell, CFA Date: February 17, 24 Re: Investment Policy Recommendations for Health Care This memorandum summarizes our research and analysis of matters bearing on investment of health care (HC) assets and identifies what we believe are the appropriate options for the trustees of OPERS. SUMMARY The forecasted investment horizon for HC assets is materially shorter than that of the pension assets. Whereas moneys currently comprising the pension fund are expected to remain there indefinitely, HC assets are expec ted to be spent within about 2 years. To achieve the stated goal of a solvency period of years, the trustees will almost certainly need to make further changes in the HC plan, the level of its funding, or both in the years to come. Our financial analysis indicates two changes in investment policy for the HC assets. One is to phase out nonmarketable securities, and the second is to reduce moderately the equity allocation of HC assets. Either of these changes requires segregation of the HC portfolio for investment purposes. While survey results concerning the practices of other state funds are sketchy, they reinforce these conclusions. Recognizing the significance of such a shift and the improbability of reversing it, an option for the trustees is not to act now to implement these changes, but, rather, to monitor the situation for a period of time, with a view to revisiting the decision a year from now. Ennis Knupp + Associates vox South Riverside Plaza, Suite 7 fax Chicago, Illinois

13 FINANCIAL ANALYSIS With the assistance of GRS, we have conducted extensive financial analysis and modeling of the OPERS HC fund. One key premise underlying this work is adoption of Package C of the Health Care Preservation Plan (HCCP) with a phase-in beginning in 26. The value of HC assets at 1/1/4 is $1.75 billion, which is the starting point of the study. Under GRS s assumption of a net return of 8% per year, the solvency period is estimated to be 22 years. We have assumed that contributions to HC will be equal to 4% of payroll unless an adverse investment experience in the pension fund results in an increase in contributions required there to meet minimum funding requirements for pensions. The primary analysis does not reflect any further revision to the HC plan itself or any additional funding. Figure 1 is a 5-year projection of the fund balances for pension and HC for an initial investment amount of $1,. It shows that $1, of pension assets is expected to increase over the next 5 years to more than $11,. The ending balance reflects the effect of projected contributions and benefit disbursements. The fund balance grows by over 4% a year during the course of the projection. From this we conclude that the investment horizon of the existing pension assets is essentially perpetual, meaning the dollars that make up the fund today are projected to never be required to make benefit disbursements. Figure 1 5-Year Projection of Pension and Health Care Fund Balances Pension Fund 4 2 Health Care Fund Ennis Knupp + Associates 11

14 The projected HC fund balance is a very different picture. That fund is exhausted in approximately 2 years, in spite of investment earnings and projected contributions. The HC projection resembles what might be the anticipated retirement fund balance of an individual retiring at age 6 with a life expectancy of 2 years. We employed a simulation model to estimate the likelihood of preserving HC solvency for various periods of time under alternative investment policies. The idea behind this is seeking to ensure a minimum solvency period for HC in order to provide the board with a reasonable timeframe to continue to educate plan participants, modify the plan of benefits, as necessary, and to seek additional sources of funding. Table 1 contains our estimate of the probability that HC remains solvent for various time periods under alternative investment policies, ranging from all bonds to all equities. Limiting equities to 5% of total assets offers virtual certainty that HC remains solvent for at least 1 years, whereas an allocation of 75% equities indicates a 2% probability of insolvency within 1 years and an all-equity policy a probability of 6%. Table 1 Probability of Sustaining Solvency for Various Time Periods Allocation to Risky Assets % 25% 5% 75% 1% Expected Return 1 4.6% 5.5% 6.3% 7.% 7.5% Probability of Solvency of at Least X Years: 1 99+% 99+% 99+% 98% 94% Table 2 shows the distribution of possible solvency periods for alternative investment policies. Under the fixed income policy, the range is narrow, with only six years separating the 5 th and 95 th percentiles. The median period is 15 years. As the equity allocation increases, the median solvency period lengthens by four years, reflecting the higher expected investment return for an all-equity policy. The range of outcomes also increases fairly dramatically from 6 to 36 years. Table 2 illustrates that extending the expected solvency period through assuming greater equity exposure comes at the risk of shortening it. (Note: the median solvency periods shown are less than the 22-year figure mentioned at the outset. The 22-year figure is based on the assumption that HC assets earn 8% year, net of expenses, each and every year. The solvency period estimates in Table 2 reflect (1) a lower expected return than 8%, even for an all-equity policy, and (2) the effect of a variable pattern of returns.) 1 Compound, or geometric average, return using EnnisKnupp assumptions. Ennis Knupp + Associates 12

15 Table 2 Distribution of Solvency Periods (4% Contribution Rate) Allocation to Risky Assets % 25% 5% 75% 1% Expected Return 2 4.6% 5.5% 6.3% 7.% 7.5% Percentile Values (years): 95% % % % % Table 3 is a forecast of the range of possible asset values four years hence (1/1/8) under two investment alternatives, all bonds and 75% equities. It exhibits a wide range of fund balance outcomes for the 75%-equity policy. This is relevant in liquidity planning. If the fund includes illiquid assets such as real estate and private equity and experiences a significant decline in value, those illiquid investments have the potential to become a much larger fraction of fund value. This is an undesirable outcome, especially for a fund subject to significant liquidity requirements. Table 3 Dispersion of HC Fund Balances Four Years Out (Billion $) 1/1/28 Asset Values Percentile All Bonds 75% Equities 95% $1.2 $16.3 9% % % % % % There is an additional factor at play that contributes to the wide dispersion of possible future fund balances shown in Table 3 for the 75%-equity policy. This is what we have referred to previously as the risk-feedback effect. The HC fund balance is subjected to investment risk twice, directly and indirectly. If investment returns are negative, the direct effect is a decline in the value of HC assets. The indirect effect relates to the funding of HC, 2 Compound, or geometric average, return using EnnisKnupp assumptions. Ennis Knupp + Associates 13

16 which is, in effect, a residual of pension funding. If investment returns are negative, contribution requirements for the pension plan increase in order to meet minimum funding requirements. When they increase, HC contributions must be reduced, which compounds investment risk to the HC fund. If a 75%-equity exposure were maintained with the HC assets and the fund experienced another period of falling stock prices, as it did in 2-22, such that its value declined from $1.8 billion to, say, $7 or $8 billion, prudence might dictate reducing the equity exposure to ensure a certain level of solvency going forward. While prudence might dictate such an adjustment, it might prove to be a particularly disadvantageous time to be liquidating common stocks. Generally speaking, it is desirable to adopt an asset allocation that can be maintained in bad times as well as good. Collectively, this analysis leads us to two conclusions. The first is that it may be prudent to reduce the potential volatility of the fund. This would be accomplished primarily by reducing the equity exposure. An equity percentage of 5% to 6% virtually assures solvency for 1 years. Shortening the bond duration somewhat would further stabilize the fund balance, perhaps without sacrificing significant interest income. One way to accomplish this would be to place 2% to 25% of the portfolio (or half the bonds) in instruments with maturities in the one- to three-year range. This would also tend to lessen the prospect of having to sell stocks and longer-term bonds during a market downturn. The second conclusion is that the liquidity requirements of the HC fund are such that it should consist solely of marketable securities. This would permit flexibility in restructuring the fund s asset allocation as circumstances change. SURVEY RESULTS In mid-december of last year we contacted 2 statewide funds with some form of health care provision to learn what we could of their circumstances, plans, and investment policies. We received some information from 9 of them. Separately, we present the results of the survey. The inferences we are able to draw from the survey are these: Approximately half the respondents have a health care portfolio and half do not. Only one respondent of the nine commingles health care and pension investments. The other eight maintain a separate funding vehicle for HC. The most common approach to the investment of health care assets, when done separately from pension assets, is to invest them predominantly in fixed-income securities. Ennis Knupp + Associates 14

17 The survey results are, frankly, sketchy at best. We believe this outcome results in part from the fact that most systems have not as yet taken or are just beginning to take steps to ensure long-term viability of their health care plans. The limited information available reinforces the investment policy conclusions for OPERS HC assets that result from the primary financial analysis already discussed. OTHER CONSIDERATIONS The study does not reflect any further measures to sustain the HC plan. These might include further revisions to the plan of benefits or supplemental funding. Thus, it might be argued that the projections present an unnecessarily pessimistic outlook for HC solvency. For example, if the solvency period declines over time, as this analysis indicates it will, it might be expected that further modifications will be made to preserve some form of HC benefit for retirees. Likewise, the analysis does not reflect any increase in contribution rates for employees or employers, even though seeking such an increase is currently being contemplated. Anticipating benefit modifications after 26 is beyond the scope of this study. We did, however, do some testing to determine the impact of increasing contribution rates. Table 4 is the same as Table 2, except for the assumption concerning contribution rates. For the purpose of Table 4 contribution rates are assumed to be 5% of payroll. The increase in contribution rates extends the median solvency period for all investment policies by three years, and improves the worst-case scenarios by about one year. But the higher contribution rate, which could not be implemented overnight, does not alter the fundamental outlook for the solvency of the HC plan. Table 4 Distribution of Solvency Periods (5% Contribution Rate) Allocation to Risky Assets % 25% 5% 75% 1% Expected Return 3 4.6% 5.5% 6.3% 7.% 7.5% Percentile Values (years): 95% % % % % Compound, or geometric average, return using EnnisKnupp assumptions. Ennis Knupp + Associates 15

18 Nevertheless, owing to (1) the inevitability of further modifications to the plan of HC benefits, (2) the possibility of moderately greater funding through an increase in employer and/or employee contribution rates, and (3) the possibility that we might continue to enjoy favorable investment returns in the years ahead, it might eventuate that curtailing the equity exposure at this juncture proves unnecessary and, in retrospect, disadvantageous. For this reason, and in view of the fact that once done, separation of HC and pension investing would likely be a permanent change, the board may wish postpone any action for now. CONCLUSION The financial analysis of the probable solvency of the HC fund indicates to us that an equity allocation of 5-6% 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. The survey results, sketchy as they are, confirm the indications of the financial analysis. Most other funds invest health care assets primarily in fixed income securities. Two options suggest themselves for the board s consideration. One is to implement the type of changes indicated now. The alternative is to wait for up to a year before modifying the way HC assets are managed in order to increase our confidence that change is truly warranted. Under the postponement option, however, a significant decline in the stock market during 24 would likely lead to an even greater abatement of the equity percentage when the reckoning were actually made, and the timing of that adjustment could prove to be unfavorable. Ennis Knupp + Associates 16

19 APPENDIX Sensitivity of Solvency Period to Assumptions Wage Inflation Return Contr. Rate Solvency Period Baseline Assumptions 4% 8% 4% 21 Change Wage Inflation 3% 8% 4% 22 5% 8% 4% 2 Change Return Assumption 4% 1% 4% 27 4% 6% 4% 18 4% 4% 4% 15 Change Contribution Rate 4% 8% 5% 26 4% 8% 3% 18 Ennis Knupp + Associates 17

20 APPENDIX 2 Theoretical Historical Asset Values and Solvency Periods 1% Fixed Income Allocation OPERS Healthcare Fund Theoretical Solvency Period (years) OPERS Healthcare Fund Theoretical Fund Value ($ billions) Ennis Knupp + Associates 18

21 9% Fixed Income Allocation OPERS Healthcare Fund Theoretical Solvency Period (years) OPERS Healthcare Fund Theoretical Fund Value ($ billions) Ennis Knupp + Associates 19

22 8% Fixed Income Allocation OPERS Healthcare Fund Theoretical Solvency Period (years) OPERS Healthcare Fund Theoretical Fund Value ($ billions) Ennis Knupp + Associates 2

23 7% Fixed Income Allocation OPERS Healthcare Fund Theoretical Solvency Period (years) OPERS Healthcare Fund Theoretical Fund Value ($ billions) Ennis Knupp + Associates 21

24 6% Fixed Income Allocation OPERS Healthcare Fund Theoretical Solvency Period (years) OPERS Healthcare Fund Theoretical Fund Value ($ billions) Ennis Knupp + Associates 22

25 5% Fixed Income Allocation OPERS Healthcare Fund Theoretical Solvency Period (years) OPERS Healthcare Fund Theoretical Fund Value ($ billions) Ennis Knupp + Associates 23

26 4% Fixed Income Allocation OPERS Healthcare Fund Theoretical Solvency Period (years) OPERS Healthcare Fund Theoretical Fund Value ($ billions) Ennis Knupp + Associates 24

27 3% Fixed Income Allocation OPERS Healthcare Fund Theoretical Solvency Period (years) OPERS Healthcare Fund Theoretical Fund Value ($ billions) Ennis Knupp + Associates 25

28 2% Fixed Income OPERS Healthcare Fund Theoretical Solvency Period (years) OPERS Healthcare Fund Theoretical Fund Value ($ billions) Ennis Knupp + Associates 26

29 1% Fixed Income Allocation OPERS Healthcare Fund Theoretical Solvency Period (years) OPERS Healthcare Fund Theoretical Fund Value ($ billions) Ennis Knupp + Associates 27

30 % Fixed Income Allocation OPERS Healthcare Fund Theoretical Solvency Period (years) OPERS Healthcare Fund Theoretical Fund Value ($ billions) G:\April 24\I.A. Health Care & Investments-EKA.doc Ennis Knupp + Associates 28

31 DRAFT Ohio Public Employees Retirement System Statement of Investment Objectives and Policies Health Care Fund 24

32 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

33 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 41(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

34 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

35 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

36 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

37 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

38 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 1% 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

39 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