Investment Return Expectation

Transcription

1 March 2012 Investment Return Expectation Volume 14 Issue 1 This newsletter is a follow-up to the February Operations Outlook titled The Liability Side of the Pension Equation. As a board member, you employ a process for developing and, in September of every year, certifying the annual state s contribution rate for the upcoming budget year. This September you will vote to certify a specific contribution rate for FY14. That contribution rate (stated as a percent of state payroll) establishes the cost to the taxpayers for FY14 funding of MOSERS. The process used for developing the contribution rate includes you reviewing asset data and various economic and non-economic assumptions that are used to calculate the contribution rate. The state contribution rate relies on assumptions about many future events, such as expectations regarding mortality, age at retirement, the rate of salary growth, and how much the plan s investments will earn, among others. Figure 1. The Actuarial Valuation Process Census Data Furnished by System Staff, Including: Retired Lives Now Receiving Benefits Former Members with Vested Benefits Not Yet Payable Active Members Benefit Provisions Governing Future Payments from the Retirement System Asset Data Asset Smoothing Methodology Assumptions Concerning Future Experiences in Various Risk Areas, Which Assumptions are Established by the Board After Consulting with the Actuary Funding Method for Employer Contributions (Entry-Age Method) Mathematically Combining Assumptions, Funding Method and Data Demographic & Economic Assumptions The Plan s Financial Position (The Percent Funded) A Newsletter for the MOSERS Board of Trustees = Determination of: The Employer Contribution Rate Figure 1 depicts the flow of activity for the entire actuarial valuation process by which actuarial present values and contribution rates are determined. Your responsibility as a board member lies in decisions related to the Asset Data and the Assumptions Concerning Future Experiences. The board has discretion in determining the Asset Smoothing Methodology from information provided by the actuary; discretion in determining Demographic Assumptions also provided by the actuary; and discretion in determining Economic Assumptions from information provided by both the actuary and investment professionals.

2 The actuary, the staff, and the general asset consultant research and analyze various factors which contribute to each of these determinants. The actuary focuses on the demographic assumptions and asset smoothing methodologies. The actuary also reviews expectations for investment returns, pay increases, price and wage inflation, and other financial information in order to make their recommendations on assumptions related to economics. The MOSERS investment staff and the general asset consultant focus on the economic assumptions, specifically capital market expectations and general price inflation impacting investment returns. In the balance of this newsletter we will address the economic (investment return and price inflation) expectations developed by the investment professionals at MOSERS and Summit Strategies. Actual Versus Assumed Investment Returns It is interesting to see how MOSERS historical returns have compared with the current assumed rate of 8.5%. MOSERS total fund investment return exceeded 8.5% in 13 of the last 20 years as shown in figure 2. The most important observation here is that one-year returns have been widely distributed, with both the best and worst one-year outcomes occurring in the last three years. While one-year returns are very volatile, you can see that over time the volatility of results shrinks rather dramatically and has converged toward the assumed return. This pattern is as one would expect, and it simply reinforces the importance of focusing on long-term results. With that said, short-term performance can t be ignored completely because of the human emotion element in investing and all that goes along with it. 2 Figure 2. MOSERS Annual Total Portfolio Returns (Fiscal Years Ending It is for these reasons that a delicate balance of attempting to maximize longterm returns while prudently managing the volatility of the portfolio over shorter time periods is paramount. Why the Investment Return Assumption is Important Policy discussions are rampant surrounding public pension fund investment return assumptions and whether they are unrealistically high given current conditions. Those conditions include (i) very low interest rates, in fact, negative in inflation adjusted (real) terms, (ii) debt levels well above average, which are likely to contribute significantly to below average economic growth for the foreseeable future, and (iii) a world awash in uncertainty following the Great Recession of Figure 3: Revenue Sources MOSERS FUNDING 40% STATE CONTRIBUTIONS 60% INVESTMENT RETURNS The majority of MOSERS funding is not from state taxpayers. Rather, it is from its better than average long-term investment returns. Of all the assumptions that must be established, none has a larger impact on the plan s current contribution rate than the investment return assumption. Over time, it is anticipated that MOSERS earnings from investments will account for approximately 60% of plan revenue (Figure 3). Keep in mind, an investment return assumption that is set too high results in the state not contributing enough, which undercharges current taxpayers and overcharges future taxpayers. On the flip side, a return rate set too low requires contributions that are too high currently, likely resulting in a poor allocation of resources from the state s coffers.

3 One can get an idea of the relative importance of the nominal investment return assumption by contemplating the following simple rules of thumb. Nominal Investment Return Impact on Contribution Rate For every 1% increase/decrease in the nominal investment return assumption ( nominal meaning it is not adjusted for inflation), one should expect the contribution rate to decrease/increase by roughly 5% of payroll. Contribution Rate Converted to Dollars A 1% change in the contribution rate is equal to approximately $18 million, given the current payroll. Holding all other assumptions constant you can use these simple rules of thumb to see that a 1% decrease in the nominal investment return assumption would increase contributions by $90 million (5 x $18 million). Importance of General Price Inflation In addition to the nominal investment return assumption, price inflation, which we measure using the Consumer Price Index for all Urban Consumers (CPI-U), also plays an important role in determining the contribution rate. It does so for a couple of reasons. From an investment perspective the general level, direction, and rate of change in inflation is an important factor in determining expected nominal investment returns. As an example, if inflation expectations increase, interest rates are likely to follow which will negatively impact investment returns on traditional fixed income (bond) investments. In a rising inflation rate regime, it is important to tilt a portfolio s investments toward real return investments and away from those that pay in fixed dollars. Inflation Assumption Impact on Contribution Rate For every 1% decrease in inflation, expect a 1.6% decrease in contribution rate. In addition to price inflation impacting the returns of our investments (assets), both price inflation and wage inflation impact our liabilities for active and retired members. Consider the case of Joe who is 30 years old and in 2011 worked for the state of Missouri for an annual salary of $24,000. Assume Joe works for another 37 years, retiring in Using just the current MOSERS wage inflation rate assumption of 4%, Joe s salary would be $102,400 in Figure 4. Importance of Inflation This very simple example assumes no other factors or changes in Joe s standard of living. The data shown in figure 4 is intended to simply depict the importance of inflation. Note the impact in Joe s salary using slightly different inflation assumptions. Inflation rates are important factors in developing economic assumptions. How Investment Professionals Develop the Investment Return Assumption Summit Strategies and MOSERS investment professionals project future investment returns based on fundamental analysis of various factors, including capital market expectations, interest rates, inflation rates and valuations of the various investments that make up the current investment portfolio. Following that analysis, expected levels of excess return (alpha) above the market returns are also projected. Expected Returns for Stocks We have used a building block methodology for determining the expected returns for stocks since the early 2000s. The methodology is built around four components. The starting dividend yield, expected earnings growth, changes in valuations (defined by changes in the price/earnings ratio) and the expected inflation rate. IN 2011 Joe s Annual Salary = $24,000 IN 2049 Inflation Assumptions Salary 3.0% $71, % $102, % $122,300 3

4 Figure 5 shows a building block model for large-cap stocks. Details of other asset classes are included in the Capital Market Assumptions document from Summit Strategies included in the board packet. Figure 5. Building Block Model for Large-Cap Stocks Dividend Yield The current dividend yield is by far the easiest of the components to determine because it is simply the starting yield for an investor today. Earnings Growth Earnings that are not paid out in dividends are retained by the company and reinvested. These reinvested earnings grow and create more earnings, which grow and create more earnings. Most economic experts share the opinion that earnings cannot grow faster than the economy as a whole over long periods of time. In fact, it is expected that earnings growth will lag economic growth over the long-term due to the fact that new private enterprises produce a portion of the growth in the gross domestic product (GDP) and these companies are not included in the public stock markets. Change in P/E The P/E ratio is the change in the amount investors are willing to pay for a dollar in earnings between the time one buys and when one sells. By far the largest component of the return from stocks during the decade of the 1990 s (the decade that could well go down in history as the best decade for U.S. stocks) was the return investors received due to the willingness to pay more and more for a dollar in earnings. During that 10-year period the price earnings ratio went from 14.7 to Inflation Expected inflation is based on the first quarter of 2012, Philadelphia Fed 10- year estimate. 4 Figure 6. Long-Term Assumptions, 10-Year Forecast (as of January 1, 2012) Public Equities Asset Class Expected Market Return Standard Deviation Domestic 6.75% 18.5% International 7.25% 22.25% Emerging Markets 8.50% 27.00% Public Debt TIPS 2.00% 5.25% Core Fixed Income 2.75% 3.50% High Yield 6.00% 13.00% Market Neutral 6.25% 8.50% Alternative Investments Commodities 4.50% 20.50% Timber 6.00% 8.00% Private Equity 9.50% 21.00% Private Debt 8.50% 15.00% Cash: STIF % Expected Returns for Bonds Estimating the return from bonds is more straight-forward than stocks. The starting yield or interest rate of bonds has historically been a very good predictor of expected returns for bonds. With interest rates at record low levels, expected returns from bonds are also very low. This is contrasted starkly with what an investor in bonds could have expected back at the beginning of the 1980s decade when interest rates were well into double digits. After a similar review of the fundamental factors affecting the other asset classes in which MOSERS invests, we are then able to roll up the analysis into an expected return for the portfolio. Market Expectations for Asset Classes Summit Strategies and MOSERS investment professional s 10-year forecast for the various assets is shown in figure 6.

5 Our expectations for the current policy investment return remains fairly consistent with previous discussions we have had with the board on this subject matter (in the last five years). Based on the collective expectations in Figure 6, the total fund policy portfolio has an expected return of 6.4%. Expectations for Excess Returns While our expectations for the markets are very similar to what we have projected over the last five years, what has changed is our expectation for excess return. Excess return is the amount of investment return that can be attributed to manager selection and strategic allocation decisions. MOSERS realized excess returns have been in the neighborhood of 1.3% per year over the most recent 10-year and 15-year periods. Figure 7 reflects the actual long-term excess returns of the universe of statewide funds and of MOSERS. In reviewing the excess return data in figure 7 you can see that MOSERS excess investment return has been at the very top in comparison to our peers. MOSERS far exceeded, not just the average, but the top 25% (quartile) of all funds. Furthermore, if instead of earning excess returns of 1.3% per year, we had earned.90% per year excess returns, MOSERS excess returns would have still been in the top 10% among our peers.this has been a great result for the system, but what should the expectation be for excess return in the future? Figure 7. Excess Returns Actual Excess Returns 10 years 15 years Average State-wide Fund 0.02% 0.04% Top Quartile State-wide Fund 0.39% 0.34% MOSERS 1.30% 1.31% Our belief is that excess return is likely to decline prospectively. There are several reasons for this. First, MOSERS competition has become more flexible in the way they manage their portfolios. That is to say our peers are managing their portfolios today more like we have been doing for over 10 years. More competition may mean more opportunities for us, but it may also mean that our ability to continue to produce excess returns at such a high relative level will come down. In a addition to more competition, the amount of MOSERS staff time being spent on non-investing issues has grown as a result of This means that some resources are invariably diverted away from creating excess returns and toward other urgent issues. One of these issues is increased financial industry regulation. As an example, most of you have heard about the Dodd-Frank Financial Reform Act that became law as a result of the financial crisis of One of the tennicles of this legislation deals with additional regulation in the area of over the counter derivatives and more specifically derivatives known as swaps. Under the terms of the law, the Commodity Futures Trading Commisssion (CFTC) was given a great deal of latitude in promulgating new rules for swaps. MOSERS has been utilizing swaps for several years and new rules could have a big impact on the way in which we manage the fund. As a result, MOSERS CIO made several trips to Washington DC and was involved in numerous conference calls with other public pension funds and our money managers in drafting comment letters and speaking face to face with CFTC staff members about how their proposed rules would impact our fund. Hundreds of hours have been spent on this issue. Those were hours that could not be spent on generating alpha. The additional time commitments point to lower excess return expectations for the future. In light of all this, we still expect top quartile excess returns, however, with a smaller spread over the competition than we have produced in the past. Based on our assumptions, expected excess return is.85%. MOSERS Total Fund Investment Return Expectations In summary, Summit Strategies and the MOSERS investment staff offer the following expectations for investment return. Policy Return = 6.40% + Excess Return =.85% Total Fund Return = 7.25% 5

6 Conclusion Lowering the expected return on the portfolio will undoubtedly put upward pressure on the contribution rate. We understand that and are exploring ways in which modifications to our portfolio management processes may improve risk adjusted returns for the fund. The investment management processes we are exploring are not new to the industry, however, they are considered leading edge in terms of their application within institutional defined benefit pension plans. We intend to spend a considerable amount of time discussing these ideas with you at the June and July board meetings. Value Added is a collective effort of the investment staff. If you have any questions or comments, please contact us at MOSERS Investment Staff Rick Dahl, CFP Chief Investment Officer Jim Mullen Manager of Public Debt Pat Neylon Manager of Public Equity Tyson Rehfeld, CFA Investment Officer Public Debt Tricia Scrivner, CFA Manager of Hedge Fund Investments Scott Peppard, CFA Manager of Alternatives Chad Myhre Investment Officer Hedge Fund Investments Chris Rackers Manager of Investment Policy & Communications Shannon Davidson, CPA Manager of Investment Risk & Performance Cindy Rehmeier, CFP Manager of Defined Contribution Plans Seth Kelly, CFA Investment Research Strategist Scott Hankins Investment Audit & Operations Analyst Ben Frede Performance/Risk Analyst Casey Fick DC Plans Communications Program Coordinator Karen Holterman Operations Support Specialist 6