May 2, 2006 Review of Treasurer s Office Annual Incentive Plan (AIP) Recommended Changes for FY 2006-07 Committee on Investments Terry A. Dennison Los Angeles
Background Incentive plan for Office of the Treasurer established by the Regents in March 2002 Goals: Attract and retain quality staff; encourage limited risk taking to provide positive incremental return Designed by: Mercer HR Consulting, Mercer Investment Consulting, the Regents investment consultant, UC Office of the President HR, and the Treasurer Periodic changes recommended by Treasurer and Mercer / UCOP Mercer Investment Consulting 2
Background Investment objectives set by Regents; changes recommended by Mercer and approved by Regents Baseline for all awards are the investment benchmarks set by Regents for each asset class and total fund Awards are earned if investment returns exceed the benchmark by a given increment Awards paid out over three year period Awards are capped over a certain point to discourage excessive risk taking Negative value added results in a negative award Mercer Investment Consulting 3
Overview of Recommendations Asset class performance standards: Develop standards for new investment mandates Modify existing standard Develop standards for combined mandates (equity and fixed income) Entity performance standard: Gradual increase in target return due to changed scope of active management Recommendations are summarized on page 15 Proposal requires approval of President / Chairs of Regents, Finance, Investment Committees Recommendations effective for FY 2006-2007 Mercer Investment Consulting 4
High Yield Debt Sector not part of original plan Performance objective (benchmark): Merrill Lynch High Yield Cash Pay Index Recommend: Floor=(106), Threshold=12, Target=65, Maximum=130 bp Consistent with opportunities to add value over investment grade bonds Mercer Investment Consulting 5
Emerging Market Debt Sector not part of original plan Performance objective (benchmark): J.P. Morgan Emerging Market Bond Index Plus Recommend: Floor=(200), Threshold=25, Target=125, Maximum=250 bp Consistent with opportunities to add value over investment grade bonds Mercer Investment Consulting 6
Global Equity Sector not part of original plan Performance objective (benchmark): MSCI World Tobacco Free Index Net Recommend: Floor=(140), Threshold=15, Target=85, Maximum=170 bp Consistent with opportunities to add value over passive developed market equities Mercer Investment Consulting 7
Emerging Market Equity Recommend change in existing target Performance objective (benchmark): MSCI Emerging Market Index Net Recommend reduction of target by 25 bp due to reduced opportunities in asset class: Floor=(200), Threshold=25, Target=125, Maximum=250 bp Mercer Investment Consulting 8
Combined Mandates Develop more appropriate metric for those responsible for multiple asset classes (Managing Directors) Performance objective based on objectives of underlying assets, combined at policy weights Similar to entity performance calculation; returns and benchmarks combined at actual weights Mercer Investment Consulting 9
Combined Mandates: Equity Combined US equity, Non US equity (developed), Emerging market equity, Global equity Recommend: Floor=(140), Threshold=15, Target=80, Maximum=170 bp Mercer Investment Consulting 10
Combined Mandates: Fixed Income Combined US core fixed (LPF / Agg), High yield, Non-USD (developed), Emerging market debt, Income funds (Savings fund and STIP) Recommend: Floor=(70), Threshold=5, Target=40, Maximum=80 bp Mercer Investment Consulting 11
Change Entity performance standards to reflect changed scope of active management Targets for entity performance based on these factors: Mix of asset classes within total fund Desired asset class performance and risk Amount of assets actively managed Entity targets to be reviewed annually for changes in any of these factors Mercer Investment Consulting 12
Change Entity performance standards: All three factors changed during past FY Recommend increasing targets to be consistent with original standards for risk-return trade-off Floor=(60), Threshold=5, Target=30, Maximum=70 bp Currently: Floor=(50), Threshold=5, Target=25, Maximum=60 Recommendation for modified Entity targets is for FY 2006-2007 only Mercer Investment Consulting 13
Performance Objectives CURRENT, APPROVED AUGUST 2005 Excess Performance Over Benchmark (1) Entity (UC Treasurer's Office) Benchmark Floor Threshold Target Maximum GEP, UCRP, UCRSP, STIP & HIP Asset Weighted Policy Benchmark -50 bp 5 bp 25 bp 60 bp Asset Class (2) Benchmark Floor Threshold Target Maximum US Equity Russell 3000 Tobacco-Free Index -120 bp 15 bp 75 bp 150 bp Developed Non US Equity MSCI World ex US Net Tobacco Free Index -164 bp 18 bp 100 bp 200 bp Emerging Markets Equity MSCI Emerging Markets Free Net Index -200 bp 27 bp 150 bp 300 bp Private Equity - Entity Roll Up Russell 3000 Tobacco-Free Index -300 bp 300 bp 600 bp 900 bp Private Equity - Asset Class Venture Economics Vintage Year Indices -100 bp 50 bp 100 bp 200 bp Bonds [UCRP + GEP] Salomon Brothers Long Pension Fund -90 bp 5 bp 50 bp 100 bp 403(b) Bonds Lehman Brothers Aggregate -50 bp 5 bp 30 bp 60 bp Real Estate Custom RE Benchmark (Wilshire REIT & NCREIF Property -110 bp 10 bp 65 bp 130 bp Absolute Return US 1-month Treasury Notes + 450 bps -110 bp 10 bp 65 bp 130 bp Group/Sector Benchmark Floor Threshold Target Maximum Government Sponsored (Salomon LPF) Government Sponsored Sector from Salomon LPF -90 bp 5 bp 50 bp 100 bp Government Sponsored (LB Agg. Index) Government Sponsored Sector from LB Agg. Index -50 bp 5 bp 30 bp 60 bp Credit (Salomon LPF) Credit (Salomon LPF) Sector from Salomon LPF -90 bp 5 bp 50 bp 100 bp Credit (LB Agg. Index) Credit (LB Agg. Index) Sector from LB Agg. Index -50 bp 5 bp 30 bp 60 bp Collateral (Mortgage) - Salomon LPF Collateral (Mortgage) Sector from Salomon LPF -50 bp 5 bp 30 bp 60 bp Collateral (Mortgage)- LB Agg. Index Collateral (Mortgage) Sector from LB Agg. Index -40 bp 5 bp 25 bp 50 bp Treasury Inflation Protected Securities Tracking Error of Monthly Returns (annualized) 45 bp 35 bp 25 bp 15 bp Short Term Investment Pool (STIP) US 2-year Treasury Notes Income Return -50 bp 5 bp 30 bp 60 bp Savings Fund US 2-year Treasury Notes Income Return -50 bp 5 bp 30 bp 60 bp ICC Fund US 5-year Treasury Notes Income Return -50 bp 5 bp 30 bp 60 bp (1) All floor, threshold, target & maximum performance objectives are based on total return. (2) Equity Asset Class includes GEP and UCRP equity. Mercer Investment Consulting 14
Performance Objectives PROPOSED, TO BE EFFECTIVE FY 2006-07 Excess Performance Over Benchmark (1) Entity (UC Treasurer's Office) Benchmark Floor Threshold Target Maximum GEP, UCRP, UCRSP, STIP & HIP Asset Weighted Policy Benchmark -60 bp 5 bp 30 bp 70 bp Asset Class (2) Benchmark Floor Threshold Target Maximum US Equity Russell 3000 Tobacco-Free Index -120 bp 15 bp 75 bp 150 bp Developed Non US Equity MSCI World ex US Net Tobacco Free Index -164 bp 18 bp 100 bp 200 bp Global Equity MSCI World Tobacco Free Index Net -140 bp 15 bp 85 bp 170 bp Emerging Markets Equity MSCI Emerging Markets Index Net -200 bp 25 bp 125 bp 250 bp Private Equity - Asset Class Venture Economics Vintage Year Indices -100 bp 50 bp 100 bp 200 bp Bonds - UCRP Citigroup Long Pension Fund Index -90 bp 5 bp 50 bp 100 bp Bonds - GEP and 403(b) Bond Fund Lehman Brothers Aggregate -50 bp 5 bp 30 bp 60 bp High Yield Bonds Merrill Lynch High Yield Cash Pay Index -106 bp 12 bp 65 bp 130 bp Emerging Market Debt JP Morgan Emerging Market Bond Index Plus -200 bp 25 bp 125 bp 250 bp Real Estate Custom RE Benchmark (Wilshire REIT & NCREIF Property -110 bp 10 bp 65 bp 130 bp Absolute Return US 1-month Treasury Notes + 450 bps -110 bp 10 bp 65 bp 130 bp Group/Sector Benchmark Floor Threshold Target Maximum Government Sponsored (Citigroup LPF) Government Sponsored Sector from Citigroup LPF -90 bp 5 bp 50 bp 100 bp Government Sponsored (LB Agg. Index) Government Sponsored Sector from LB Agg. Index -50 bp 5 bp 30 bp 60 bp Credit ((Citigroup LPF) Credit Sector from Citigroup LPF -90 bp 5 bp 50 bp 100 bp Credit (LB Agg. Index) Credit Sector from LB Agg. Index -50 bp 5 bp 30 bp 60 bp Collateral (Mortgage) - (Citigroup LPF Collateral (Mortgage) Sector from Citigroup LPF -50 bp 5 bp 30 bp 60 bp Collateral (Mortgage)- LB Agg. Index Collateral (Mortgage) Sector from LB Agg. Index -40 bp 5 bp 25 bp 50 bp Treasury Inflation Protected Securities Tracking Error of Monthly Returns (annualized) 45 bp 35 bp 25 bp 15 bp Short Term Investment Pool (STIP) US 2-year Treasury Notes Income Return -50 bp 5 bp 30 bp 60 bp 403(b) Savings Fund US 2-year Treasury Notes Income Return -50 bp 5 bp 30 bp 60 bp 403 (b) ICC Fund US 5-year Treasury Notes Income Return -50 bp 5 bp 30 bp 60 bp Combined Equity Asset Weighted Policy Benchmark (Equity) -140 bp 15 bp 80 bp 170 bp Combined Fixed Income Asset Weighted Policy Benchmark (Fixed Income) -70 bp 5 bp 40 bp 80 bp (1) All floor, threshold, target & maximum performance objectives are based on total return, net of fees (2) Equity Asset Class includes GEP and UCRP equity. Note: references to "Salomon Brothers" replaced by "Citigroup" CHANGES HIGHLIGHTED Mercer Investment Consulting 15