State Board of AdministrationFRS Pension Plan Risk Management

and Asset AllocationFGFOA Meeting

May 8, 2012

INVESTING FOR FLORIDA’S FUTURE

Presentation Outline

• SBA Overview

• SBA Enterprise Risk Management

• FRS Pension Plan Case Study

– Pension Finance

– Asset Liability Modeling

– Asset Allocation

– Implementation and Business Model

• Other Management Considerations

2

3

4

SBA Funds Under ManagementApril 23, 2012 Estimates

5

SBA’s Strategic Risks

1. Investment Management Risk

2. Governance/Management Risk

3. Communication/Public Affairs/Reputational Risk

4. Legislative/Political Risk

5. Compliance Risk

6. Fraud/ Misconduct/ Internal Controls Risk

7. Service Provider Risk

8. Client Relationship Risk

9. Operational Risk

10. Human Capital Risk

11. Security Risk

12. Business Continuity/Infrastructure Risk

13. Legal Risk

SBA Risk Management and ComplianceResidual Risk Assessment - Aggregated Strategic Risk Level As of 6/30/11

1. Investment Management Risk 2. Governance/ Management Risk 3. Communication/ Public Affairs/ Reputational Risk 4. Legislative/ Political Risk 5. Compliance Risk6. Fraud/ Misconduct/ Internal Controls Risk 7. Service Provider Risk 8. Client Relationship Risk 9. Operational Risk10. Human Capital Risk

10 4 11. Security Risk3 12. Business Continuity/ Infrastructure Risk

1 2 13. Legal Risk

13

79 5 11

8 12

6

4 - Highly Likely

1 - Minor

1 - Highly Unlikely

2 - Unlikely

2 - Moderate 3 - Major

3 - Likely

6

7

SBA Investment Risk Components

– Policy Risk • Policy Design Risk

• Investment Objective Risk

• Capital Market Assumption Risk

• Liability Risk

– Implementation Risk • Strategy Risk

• Portfolio Under Performance Risk

• Trading Risk

• Asset Transition Risk

• Model Risk

• Due Diligence Risk

• Leverage Risk

• Aggregate Issuer/Counterparty Credit Risk

– Inherent Risk • Market/Systematic Risk

• Idiosyncratic/Unsystematic Risk

FRS Pension Plan Case Study

• Pension Finance

• Asset Liability Modeling

• Asset Allocation

• Implementation and Business Model

8

Pension Obligations – Future Benefit Cash Flows

A

B C1

C2

D

Mil

lion

s of

201

1 $

A = benefits for current retireesB = benefits already accrued/earned for current employeesC1+C2 = benefits yet to be earned for current employees (C1 = portion allocated by actuarial method for past service)D = benefits for future employees

9

10

FRS Pension Plan Investment Policy Objective

– … provide investment returns sufficient for the plan to be maintained in a manner that ensures the timely payment of promised benefits to current and future participants and keeps the plan cost at a reasonable level.

– To achieve this, a long-term real return approximating 5% per annum (compounded and net of investment expenses) should be attained, consistent with the actuarial investment return assumption of 7.75%.

– As additional considerations, the Board seeks to avoid excessive risk in long-term cost trends.

– To manage these risks, the volatility of annual returns should be reasonably controlled.

Structure Of Asset-Liability Model

AssetReturns

InterestRates

Inflation

Economic Simulation

AssetGrowth

LiabilityGrowth

Plan Cost &Funded Status

AssetSmoothing

ActuarialMethods

ActuarialAssump.

11

• For the 2012 asset liability update we used an equity risk premium assumption equal to 4.36%, the average of the assumptions used by the four SBA investment consultants. The resulting expected average compounded return for U.S. equities is equal to 7.4% (the U.S. bond expected return of 3.0% plus the equity risk premium of 4.4%):

U.S. Equity Return

2010 2011 2012AL Study AL Update AL Update

Price inflation 2.40% 2.15% 2.10%US bond returns 4.60% 4.20% 3.00%Risk premium for US equities

HEK 2.40% 3.60% 4.50%Callan 4.00% 4.25% 4.50%Wilshire 3.25% 3.50% 4.65%Mercer 3.80% 3.80% 3.80%Average 3.36% 3.79% 4.36%

US equity returns 7.96% 7.99% 7.36%

All returns are 15-year geometric average expected returns.

12

FRS Pension Plan Return & Risk Assumptions

Risk Assets

Fixed Income

--- Expected Average Return ---Current Policy

Targets* Compounded Single Year Standard Deviation

Global Equity 52% 8.5% 10.6% 20.8%

Private Equity 5% 9.2% 13.2% 28.3%

Real Estate 7% 7.1% 8.4% 16.3%

Strategic

Debt-oriented 3% 9.5% 10.1% 10.5%

HF - Absolute Return 2% 5.8% 6.3% 9.3%

HF - Equity Long/Short 2% 7.7% 8.4% 11.5%

HF - Open Mandate 2% 7.3% 7.8% 10.6%

Infrastructure 2% 8.5% 10.2% 18.3%

US Bonds 24% 3.0% 3.1% 3.5%

Cash 1% 2.2% 2.2% 1.3%

Inflation 2.1%

Total Portfolio

Gross 7.5% 8.4%

Expenses 0.14% 0.14%

Net - Nominal Return 7.4% 8.3% 13.0%Net - Real Return 5.3%

* Allocation targets based on "Expanded Authority" policy, with typical diversification within the "Strategic" class13

Range of Possible 15-Year Compound Returns -- Nominal

Percentile:

95th

75th

50th

25th

5th

Best estimate = 7.4%(mean value)

7.75% actuarial assump. ( 50% probability )

50% confidence range: from 4.7% to 10.5% 90% confidence range:

from -0.1% to 13.8%

50th %-tile = 7.8%(median value)

14

%-tile values:

5% 87% 84% 70% 61% 53% 44% 40% 38% 37% 33% 32% 30% 27% 25% 25% 24%25% 87% 85% 84% 82% 80% 76% 72% 69% 67% 66% 63% 61% 59% 58% 56% 54%50% 87% 86% 86% 86% 87% 86% 86% 86% 86% 87% 87% 87% 87% 86% 88% 87%75% 87% 87% 87% 89% 91% 92% 95% 99% 101% 104% 107% 110% 116% 119% 122% 127%95% 87% 87% 90% 94% 100% 104% 111% 121% 132% 142% 153% 161% 172% 183% 196% 212%

87%94%

153%

212%

86% 87% 87%

61%

32%24%

0%

20%

40%

60%

80%

100%

120%

140%

160%

180%

200%

220%

FY12 FY13 FY14 FY15 FY16 FY17 FY18 FY19 FY20 FY21 FY22 FY23 FY24 FY25 FY26 FY27

Range of Funded Ratios –Current Asset Allocation Policy

Trend line

Dark shaded area indicates the 50% probability zone, and light shaded area indicates the 90% probability zone.

15

%-tile values:

5% 4.1% 8.7% 8.6% 7.9% 6.9% 4.7% 4.7% 1.3% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0%25% 4.1% 8.7% 9.0% 8.8% 8.6% 7.6% 7.5% 6.6% 5.6% 4.7% 4.7% 3.8% 2.5% 0.0% 0.0% 0.0%50% 4.1% 8.7% 9.2% 9.3% 9.7% 9.3% 9.8% 9.7% 9.9% 10.0% 9.9% 9.8% 9.9% 10.0% 10.5% 10.3%75% 4.1% 8.7% 9.4% 9.9% 11.0% 11.5% 13.1% 14.3% 15.7% 16.4% 16.8% 17.7% 18.6% 19.3% 19.6% 20.2%95% 4.1% 8.7% 9.9% 14.6% 18.5% 21.2% 23.8% 25.6% 26.5% 27.1% 28.0% 28.8% 29.9% 30.2% 30.7% 30.9%

4.1%

14.6%

28.0%

30.9%

9.3% 9.9% 10.3%

7.9%

0.0% 0.0%0%

5%

10%

15%

20%

25%

30%

35%

FY12 FY13 FY14 FY15 FY16 FY17 FY18 FY19 FY20 FY21 FY22 FY23 FY24 FY25 FY26 FY27

Range of Employer Contribution Rates (DB Plan Only) – Current Asset Allocation Policy

Trend line

Dark shaded area indicates the 50% probability zone, and light shaded area indicates the 90% probability zone.16

-$20,000

-$15,000

-$10,000

-$5,000

$0

$5,000

-$60,000 -$45,000 -$30,000 -$15,000 $0 $15,000

More risk

Low

er c

ost

Hig

her

cos

t

Current Mix

Change in cost relative to values using current mix

Less risk

Avg. Risk Increase ($MM)(Worst 100 scenarios)

Avg

. Cos

t Sav

ings

($M

M)

(All

500

sce

nar

ios)

Risk / Reward AnalysisBased On Long-Term Economic Cost

Diagonal line = 3-to-1 risk/reward benchmark

17

2011 Asset Liability Update: Diversification Impact

Diversification changes can improve the results.

The Recommended policy offers long-term cost savings of $2.3 billion, with no material change in risk profile

Avg. Risk Increase ($MM)(Worst 200 scenarios)

Av

g.

Co

st

Sa

vin

gs

($

MM

)(A

ll 1

,00

0 s

ce

na

rio

s)

June 2010 Policy(before diversification)

Recommended Policy(with diversification)

Increased diversification shifts curve in favorable direction

18

Investment Policy Themes: Enhancing diversification and taking risk more efficiently

• Maintain or reduce the overall level of investment risk in the fund– Reduction in the fund’s overall exposure to global stock markets– Decrease in the fund’s use of active management in the public stock and bond

markets

• Further increase diversification of investments– Greater global diversification within the publicly traded stock investments– Greater diversification into a broader array of investment types (i.e. alternative

investments) that do not necessarily fluctuate with stock markets

• Increase flexibility to take investment risks more efficiently– Downside protection from volatile markets through bond investments– Participate in worldwide economic growth through stock investments– Generate above market returns, with strong risk controls, through skillful

opportunistic investing

19

FRS Pension Plan Asset Allocation Policies

*Prior to July 2010, Global Equity was composed of two asset classes, Domestic Equities and Foreign Equities, with target allocations of 38% and 20%, respectively.

** Global Equity asset class includes existing Domestic Equity, Foreign Equity and Global Equity mandates; Strategic Investments includes existing High Yield allocation.

*** In recognition of the dynamic nature of this asset class, there is no specific expected weight. Its actual allocation will vary within the policy range depending on the mix of included strategies at any given time. When the actual allocation of Strategic Investments is greater than zero, all other asset class target allocations shall be reduced pro-rata.

Asset Class

Pre-July 2010Policy

CurrentPolicy

Expanded Authority Policy

Global Equity 58% 56% 52%

Fixed Income 28 26 24

High Yield Fixed Income 2 – –

Real Estate 7 7 7

Private Equity 4 4 5

Strategic Investments – 6 11

Cash 1 1 1

Total 100% 100% 100%

20

Strategic Investments Detail

Asset Category

Recommended(% of Total Fund)

Debt-Oriented Funds 3.0%

Infrastructure 2.0

Absolute Return Hedge Funds 2.0

Long/Short Equity Hedge Funds 2.0

Open Mandate Hedge Funds 2.0

Commodities --

Timberland --

Total Strategic Investments 11.0%

Allocations reflect current expectations for future allocations in Strategic Investments for modeling purposes. Actual allocations, including possible investments in commodities and timberland, will vary dependent on identification of attractive opportunities.

21

22

0%

500%

1000%

1500%

2000%

76 77 78 79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11

Fiscal Year Ending J une 30

Cumulative Performance HistoryFiscal Years 1976 Through 2011

Cumulative Net Return on FRS Pension Plan Assets

Actuarial Return Assumption (currently 7.75%)

Returns are net of investment manager fees for periods after December 1984.

FRS Pension Plan

23

FRS Pension Plan Net Managed and Target ReturnsAs of March 31, 2012

FRS Results Relative to TUCS Top Ten Defined Benefit PlansPeriods Ending 12/31/2011

Total FRS (Gross) Top Ten Median Defined Benefit Plan Fund (Gross)

Note: The TUCS Top Ten Universe includes $1.1 trillion in total assets. The median fund size was $112.5 billionand the average fund size was $109.7 billion.

Rat

e o

f R

etu

rn (

%)

4.5

-0.3

11.2

2.0

5.43.9

11.0

5.5

2.22.8

-15.0

-10.0

-5.0

0.0

5.0

10.0

15.0

Quarter 1-Year 3-Year 5-Year 10-Year

24

Comparison of Asset AllocationAs of 12/31/2011

FRS Pension Plan vs. Top Ten Defined Benefit Plans

**Global Equity Allocation: 28.9% Domestic Equities; 17.9% Foreign Equities.

Note: The TUCS Top Ten Universe includes $1.1 trillion in total assets. The median fund size was $112.5 billionand the average fund size was $109.7 billion.

*Global Equity Allocation: 25.5% Domestic Equities; 28.7% Foreign Equities; 2.8% Global Equities. Percentages are of the Total FRS Fund.

FRS TOTAL FUND

Fixed Income

26.0%

Private Equity

4.9%

Strategic Investments

4.1%Cash

0.7%

Real Estate

7.4%

Global Equity*

56.9%

TUCS Top Ten

Cash

Global Equity**

46.8%

Fixed Income27.3%

Real Estate 6.3%

Alternatives17.6%

2.1%

25

Outperformance Lower RiskGrowth of a DollarJan 1994 – Dec 2010

Annualized VolatilityJan 1994- Dec 2010

Hedge Fund Return and Risk Attributes

0%

5%

10%

15%

20%

25%

DJ/CSHedge Fund

Index

HFR FundWeighted

Index

Dow JonesU.S Total

Stock MarketIndex

S&P 500Index

MSCI AllCountry

World Index

BarclaysAggregateBond Index

GoldmanSachs

CommodityIndex

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

4.5

5.0

Dec

-93

Dec

-94

Dec

-95

Dec

-96

Dec

-97

Dec

-98

Dec

-99

Dec

-00

Dec

-01

Dec

-02

Dec

-03

Dec

-04

Dec

-05

Dec

-06

Dec

-07

Dec

-08

Dec

-09

Dec

-10

HFR Fund Weighted Composite S&P 500 Index Tbill

26

FRS Pension Plan Cost Comparison to CEM Peer Group

27

Cost Effectiveness Measurement (“CEM”) maintains a global database of detailed cost information provided by public and corporate pension plans. The SBA’s 2010 CEM Peer Group included 16 U.S. plan sponsors with assets from $22.5 billion to $225.6 billion.

0.0

10.0

20.0

30.0

40.0

50.0

60.0

2005 2006 2007 2008 2009 2010

SBA Total CostsPeer Group Median Total Costs

Cost

in B

asis

Poi

nts

Calendar Year

27

28

High Level Investment Guidelines

• Public market asset classes shall be well diversified with respect to their benchmarks and have a reliance on low cost passive strategies scaled according to the degree of efficiency in underlying securities markets, capacity in effective active strategies, and ongoing total fund liquidity requirements.

• Private Equity, Real Estate and Strategic Investments asset classes shall utilize a prudent process to maximize long-term access to attractive risk-adjusted investment opportunities through use of business partners with appropriate:– Financial, operational and investment expertise and resources;– Alignment of interests;– Transparency and repeatability of investment process; and– Controls on leverage.

29

FRS Pension Plan Asset Class AllocationsFebruary 2012

30

FRS Pension Plan Active Risk Budget Monitoring Standards

  Active RiskActive Share

TAA/ Asset ClassMonitoring Standard

Current Market Standard

 

Tactical Asset Allocation 0.20% 0.40% --

Global Equity 1.00% 1.50% [40%, 60%]*

Fixed Income 0.75% 1.25% [25%, 75%]

Real Estate 5.00% 8.00% --

Private Equity (secondary benchmark) 6.00% 10.00% --

Strategic Investments 4.00% 6.00% --

Cash 0.10% 0.20% --

   

Total Fund 1.00% 1.50%  

31

32

Looking Forward: 2012 FRS Pension Plan Asset Liability Update

• Supports continuation of the current multi-year implementation of increased allocations to real estate, private equity, and strategic investments, but identifies changes to be considered– Conflicting indicators on best portfolio risk target – some supporting an

increase in risk and some supporting a decrease in risk– Growing importance of liquidity management over intermediate-term– Re-emphasizes the value of diversification

• The funding policy has a direct impact on some of the investment policy risk-reward analysis– Deferring actuarially recommended contributions (“UAL”)– Treatment of 2011 benefit changes– Actuarial assumptions– Amortization and other actuarial cost methods

33