SELECTING A STRATEGIC ASSET ALLOCATION. San Diego County Employees Retirement Association. March 2014

Transcription

1 SELECTING A STRATEGIC ASSET ALLOCATION San Diego County Employees Retirement Association March 2014 SEATTLE LOS ANGELES

2 TABLE OF CONTENTS SESSION OBJECTIVES Page REVISITING RISK Page ASSESSING ENTERPRISE RISK TOLERANCE Page EVALUATING ALTERNATIVE PORTFOLIOS Page 2

3 SESSION OBJECTIVES Develop a general and intuitive understanding of the Board s willingness and Plan s ability to assume investment risk Select a strategic asset allocation 3

4 REVISITING RISK 4

5 THE CRITICAL IMPORTANCE OF RISK Risk is not the result of returns; it is the driver of returns You take the risk, then you get the return Risk comes first! General Rule of Thumb: Geometric Return ~ = Arithmetic Return x ½ Variance Portfolio A Arithmetic Return: 8% Standard Deviation: 0% Geometric Return: 8.0% Portfolio B Arithmetic Return: 8% Standard Deviation: 10% Geometric Return: 7.5% Portfolio C Arithmetic Return: 8% Standard Deviation: 20% Geometric Return: 6.0% $1 Billion Invested for 20 Years: $4.7 Billion $4.2 Billion $3.2 Billion 5

6 DRAWDOWNS HAPPEN MORE OFTEN THAN YOU THINK 0% 10 Year Monthly Rolling Observations 10% 20% Maximum Drawdown 30% 40% 50% 60% Example: in the ten year period ending June 2003, a representative pension fund* suffered a 32% maximum drawdown. 70% 80% Period Ending at Ten Years Rolling Maximum Drawdown 30% Average Max Drawdown in a Ten Year Period 23% Probability of Suffering a Drawdown of 30% in Any Ten Year Period 45% *Typical pension fund risk equivalent asset allocation portfolio with ~14% ex-ante volatility. 6

7 COMPOUNDING NEGATIVE NUMBERS IS DEVASTATING Compound Return 10 Years at 10% return produces an annualized return of 10%. What would be the annualized return if on the 10 th year the portfolio experiences a -30% return? The Importance of Limiting Drawdowns 9 years at 10% return plus a one year return of -30% produces an annualized return of 5.14%. 7

8 ASSESSING ENTERPRISE RISK TOLERANCE Enterprise Risk Tolerance is determined by measuring investor willingness and ability to assume risk Willingness Resolve Inconsistency Low Risk Moderate to High Risk Low to Moderate Risk Ability 8

9 ABILITY Participant Demographics Cash Flow Contributions Funded Status Flexibility Economic vitality Borrowing Capacity Note: Assumes all modeling assumptions are realized. 9

10 AGE OF POPULATION There are currently 37,711 members, 44.8% are Active with an average age of 45. As of June 30, 2013, there were 14,341 retired members and 1,477 beneficiaries receiving about $530 million in annual benefits. The inactive member population is expected to grow relative to the active member base for the next 20 years before beginning to recede. Number of Members 18,000 16,000 14,000 12,000 10,000 8,000 6,000 4,000 2, ,891 Active Members by Status 12,706 Service Retired 1,635 Disabilty Retired 5,000 Inactive Vested 1,477 Beneficiary Average Age Active Members 45.3 Service Retired 69.0 Disability Retired 62.5 Inactive Vested 46.7 Number of Members 30,000 25,000 20,000 15,000 10,000 5,000 Active vs. Inactive Members Beneficiary Year Number Active Number Inactive Source: Segal, Wurts 10

11 CASH FLOW $4,000 Contributions and Benefit Payments $3,000 $2,000 Millions $1,000 $ $(1,000) $(2,000) $(3,000) Benefit Payments Total Contributions Net Cash Flow

12 CONTRIBUTIONS $1,200 40% $1,000 35% Contributions ($Millions) $800 $600 $400 $200 30% 25% 20% 15% 10% 5% Contributions as % of Pay $ 0% Employee Cont. ($) Employer Cont. ($) Employee Cont. (%) Employer Cont. (%) Note: Assumes all modeling assumptions are realized. 12

13 FUNDED STATUS 110% 105% 100% 95% 90% 85% 80% 75% 70% Funded Ratio SDCERA achieves fully funded status in year Funded status is projected to increase from 79% to virtually 100% in 19 years. 1 Since the model assumes the Plan earns the assumed rate of return each year and maintains the Plan as fully funded, the UAAL is virtually fully amortized by After this, the contributions mainly consist of the normal cost component. Millions $1,200 $1,000 $800 $600 $400 $200 $ Normal Cost and UAAL Cost Unfunded actuarial accrued liability is nearly paid off Normal cost increases with inflation and wage growth. Total Normal Cost UAAL Cost 1 The actuarial assumptions have small losses built in each year. This keeps the model slightly under 100% funded, but the difference is negligible in a forecasting exercise, and the Plan should be viewed as fully funded as of

14 SOLVENCY & DRAWDOWNS* We can say with a reasonable degree of confidence that SDCERA is likely to experience another large drawdown with the current allocation. But when? Assuming the employers can meet all future recommended contributions, the Plan can still achieve fully funded status, albeit 10 to 20 years later than under the Baseline scenario. Employer contributions could reach levels between 50% and 60% of payroll if the Plan experiences a 20% drawdown within the next 10 years. 110% 100% 90% 80% 70% 60% 50% 40% Funded Ratio Baseline Drawdown 2017 Drawdown 2022 Drawdown 2027 $1,200 $1,000 Annual Employer Contributions 60% 50% Annual Employer Contributions (as % of Pay) Millions $800 $600 $400 $200 $ Baseline Drawdown 2017 Drawdown 2022 Drawdown % 30% 20% 10% 0% Baseline Drawdown 2017 Drawdown 2022 Drawdown 2027 *Graphs assume actuarial rate of return for all years except for one 20% drawdown event. 14

15 ECONOMIC VITALITY Agency Publication Date Fitch Ratings June 2013 Moody s February 2013 Assessment San Diego County is the nation's fifth most populous county, with more than three million residents and 18 incorporated cities. The core industries of its diverse economy include manufacturing, the military and related defense industries and tourism. Employment levels have risen at a steady pace since 2010, with 35 consecutive months of year over year growth. Unemployment rates remain elevated at 7.7% as of March 2013 but have continued to decline and compare favorably to the state rate of 9.4%. Wealth and income indicators for the county remain above average. STRENGTHS Very large economy that is slowly improving Strong fiscal position that should remain stable Consistent and solid fiscal management CHALLENGES Still weak recovery from the economic downturn Unemployment remains higher than national level Standard & Poor s November 2013 Strong economy, bolstered by a sizable, deep, and diverse economy with a favorable location that exhibits relatively stable assessed valuation (AV), coupled with strong wealth; Very strong budgetary flexibility with 2012 available reserves equal to 23.9% of expenditures, including reserves for emergency contingencies; Strong budgetary performance, with the general fund posting at least slight surpluses for the past three years; Very strong liquidity providing very strong cash levels to cover both debt service and expenditures and extremely strong market access; Very strong management conditions with strong financial policies; and Strong debt and contingent liabilities position. 15

16 LONG TERM OBLIGATIONS The County currently holds about $1.17 billion in long term debt obligations. About 66% of that debt is Pension Obligation Bonds. POBs issued in October of 2002 have about $52 million in principal outstanding and will be paid down in the next few years. Interest rates of the Pension Obligation Bonds range from 4.72% to 6.03%. The most recent issues from Series 2008 have rates ranging from 5.18% to 6.03%. $400, 34% Debt Outstanding ($ Millions) Total Pension Obligation Bonds $771, 66% Total Certificates of Participation & Lease Revenue Bonds Pension Obligation Bonds: Payments Remaining as of June 30, 2013 Source:

17 CREDIT RATINGS Source: 17

18 ABILITY - EXERCISE Participant Demographics Lo Med Hi Cash Flow Contributions Funded Status Flexibility Economic vitality Borrowing Capacity Note: Assumes all modeling assumptions are realized. 18

19 BOARD SURVEY CLUES TO WILLINGNESS General consensus across several survey topics: Goals Protecting existing benefits is primary concern Reducing volatility of contributions also important Objectives Achieving actuarial rate is paramount Beating peers in the near term is low priority Implementation Asset allocation is key Risk Risk centric, rather than returns centric perspective Some inconsistency in risk tolerance Preference for diversification across economic regimes Long term focus Other Willingness to take advantage of illiquidity premium Focus on value for fees (rather than just fees themselves) Willingness to move away from the herd Holistic, integrated perspective on portfolio construction Willingness to delegate implementation and focus on policy 19

20 ASSESSING ENTERPRISE RISK TOLERANCE -EXERCISE Enterprise Risk Tolerance is determined by measuring investor willingness and ability to assume risk Willingness Resolve Inconsistency Low Risk Moderate to High Risk Low to Moderate Risk Ability 20

21 ALTERNATIVE PORTFOLIOS 21

22 ALTERNATIVE PORTFOLIOS 22

23 DIVERSIFICATION OF RISKS SDCERA s Policy Targets SDCERA s Risk Decomposition Liquid Alts/HFoF, 20% Private Equity/VC, 15% Large Cap US Equity, 10% International Large, 10% Emerging Markets, 5% High Yield Fixed Income, 5% 120% 100% 80% Real Estate, 10% Emerging Market Debt, 10% TIPS, 5% 60% 40% 66% Commodities, 5% 20% T Bills, 40% Asset-diversified, but 0% Policy Rates Credit Equity Inflation Currency Hedge Fund/Other Risk diversified? Because many assets are inextricably tied to the risks embedded in global equity markets and that risk is greater than other types of risk, an MVO-constructed portfolio derives the majority of its risk from equities. Source: BarraOne Risk Analytics 23

24 SDCERA POLICY VS. ALTERNATIVE PORTFOLIOS SDCERA Policy Average Pension Risk Parity Permanent Portfolio Salient Option 1 Salient Option 2 CMA's (10 Yr) Large Cap US Equity Small/Mid Cap US Equity 5.1 Total Domestic Equity International Developed International Small 7.7 Emerging Markets Total Int'l Equity Total Equity US Core Fixed Income High Yield Fixed Income Emerging Market Debt TIPS US Treasuries Total Fixed Income Commodities Gold Real Estate Total Real Assets Liquid Alts/HFoF Private Equity/VC Private Credit Total Non-Public Investments Cash Risk Parity (10 Vol) Risk Parity (15 Vol) Total Allocation Forecasted Return 7.3% 6.4% 7.1% 5.3% 7.5% 7.9% Standard Deviation Sharpe Ratio Sharpe Ratio assumes a Cash Return of 2.1% Natural Resources has been modeled as 50% Commodities and 50% Private Equity The Risk Parity component of the Salient Mixes utilizes a 15 Vol Risk Parity sleeve 24

25 RISK FACTOR DECOMPOSITION Risk Contribution by Risk Factor 120% 100% 80% 60% 25% 40% 66% 86% 84% 63% 61% 20% 0% 20% Policy Average Pension Permanent Portfolio Risk Parity Salient Opt 1 Salient Opt. 2 Rates Credit Equity Inflation Currency Hedge Fund/Other 25

26 DIVERSIFICATION OF ECONOMIC SENSITIVITY Low Growth Low Inflation Low Growth High Inflation High Growth Low Inflation High Growth High Inflation SDCERA Policy Average Pension Permanent Portfolio Risk Parity Salient Option 1 Salient Option 2 26

27 TAIL-RISK ANALYSIS & STRESS TESTS Tail Risk Scenario Analysis Tail Risk Stress Tests July January Subprime Mortgage Meltdown (Oct. to Feb.) 2001 Dot com Slowdown Policy Average Pension Permanent Portfolio Risk Parity Salient Option 1 Salient Option 2 Commodity 20% USD +20% Oil Price Rise Oil Price Decline Global Equity 20% 1994 US Rate Hike Policy Average Pension Permanent Portfolio Risk Parity Salient Option 1 Salient Option European Currency Crisis Nikkei Stock Price Correction Global Credit Spreads +100 bps 1987 Market Crash (Oct. 14 to Oct. 19) Global Interest Rate +200bps Oil Crisis (Dec. to Sep.) 40% 30% 20% 10% 0% 10% 20% 30% 40% 12% 10% 8% 6% 4% 2% 0% Analysis performed using BarraOne Risk Analytics. 27

28 STOCHASTIC MODELING: EMPLOYER CONTRIBUTIONS $1, Year Projections Employer Contributions Employer Contributions (Millions) $1,200 $1,000 $800 $600 $400 $200 $ Policy Average Pension Risk Parity Permanent Portfolio Salient Option 1 Salient Option 2 10 Year Projection Employer Contributions Policy Average Pension Risk Parity Permanent Portfolio Salient Option 1 Salient Option 2 Worst Case Scenario $1,110,090,785 $1,088,950,590 $1,169,981,080 $1,131,486,004 $1,123,042,671 $1,128,407,450 Median $485,049,508 $563,057,162 $463,698,505 $641,812,500 $473,997,141 $443,191,194 Best Case Scenario* Normal Cost Normal Cost Normal Cost Normal Cost Normal Cost Normal Cost *SDCERA policy requires a minimum employer contribution equal to normal cost. For modeling purposes, we assumed Employee Contributions may go to $0. 28

29 STOCHASTIC MODELING: FUNDED RATIO Year Projection Funded Ratio 200 Funded Ratio (%) Policy Average Pension Risk Parity Permanent Portfolio Salient Option 1 Salient Option 2 10 Year Projection Funded Ratio (%) Policy Average Pension Risk Parity Permanent Portfolio Salient Option 1 Salient Option 2 Best Case Scenario Median Worst Case Scenario

30 RECOMMENDATION & NEXT STEPS Recommendation We recommend Salient Mix 2 for the following primary reasons: Our perception of the Plan s risk tolerance Favorable economic and risk diversification (which should mitigate tail risk and drawdown severity) Modestly favorable expected outcomes in key metrics (contributions and funded ratio) Next Steps Should the Board accept this recommendation, next steps would include: Selecting an implementation framework Revising the IPS Updating the Risk Dashboard Migrating the portfolio to the approved allocation 30