1. Fundamentals of Pension Fund Investing
Certified Trustee Program
Bob Thompson
Paul Snyder
Senior Managing Director
Senior Portfolio Manager
Institutional Trust Services
Institutional Investments

2. Agenda Terminology Outline Plan Administration Prudent Investor Rule
Investment Policy Outline - (Order is important)
Asset Allocation
Risk & Return and related measures
Parameters & Constraints
Portfolio Construction
Conclusion

3. Post Retirement Benefits - Two Types
Defined Contribution Plan
Defined Benefit Plan
Employer promises to provide participants with certain contributions or “matching” contributions each period.
Employer promises to provide participants with a certain pension amount at retirement.
Economic Risk
falls on Employee
401k, 403b
Economic Risk
falls on Employer

4. Plan Administration Terminology
Source: Investopedia.com

5. Plan Investment Terminology
Definition
Source: Investopedia.com

6. Prudent Investor Rule
Uniform Prudent Investor Act (UPIA) An updated trust investment law that reflects the changes that have occurred in investment practice since the late 1960s, specifically with regard to modern portfolio theory.
The Uniform Prudent Investor Act (UPIA) made five fundamental changes to the previous Prudent Investor Act standard. The most important change was that the standard of prudence would henceforth be applied to any investment in the context of the total portfolio, rather than to individual investments. Another key change was the extension of permission to the trustee to delegate investment management functions, subject to appropriate safeguards; such delegation was expressly forbidden by the former trust law.
By taking the total portfolio approach and eliminating category restrictions on different types of investments, the UPIA fostered a greater degree of diversification in investment portfolios. It also made it possible for trustees to include in their investments more non-traditional asset classes such as derivatives, commodities and futures. While these investments individually have a relatively higher degree of risk, they could potentially reduce overall portfolio risk and boost returns when considered in a total portfolio context.
Per Illinois Statute, there are restrictions on non-traditional asset class investing.
Diversification Asset Allocation Lower Volatility Higher Return Potential
Source: Investopedia.com

7. Investment Policy Statement (IPS)
What is it?
A formal document that governs the investment decision making, taking into account objectives and constraints of the plan.
Must be readily implemented by current or future investment manager.
Must promote long term discipline for portfolio related decisions.
Must help protect against short term shifts in strategy when either market environments or portfolio performance cause panic or overconfidence.

8. IPS – Statement of Purpose (1)
What is it?
Brief but concise description of the plan, plan participants, plan beneficiaries and administrative personnel.
Should provide enough background information so that any competent investment manager can gain a common understanding of the overall state of affairs.
Should include key factual data and identify any unique parameters and constraints.
No one size fits all
No formal template or boiler plate

9. IPS – Statement of Responsibility (2)
What is it?
Identify all related parties with their respective duties and responsibilities. (investment manager, custodian, trustees)
Identify any regulatory or statutory mandates that must be followed.
Determine the means by which all parties are to be measured/monitored.

10. IPS – Investment Objectives & Goals (3)
What is it?
Objectives should focus on risk and return considerations.
Risk objectives are associated with the plan beneficiaries’ ability and willingness to take on certain risks.
Examples:
Required near term funding needs (liquidity)
Existing financial strength (under funded??)
Time Horizon
Stated risk tolerances (volatility of no more than 25% in any given year)

11. IPS – Investment Objectives & Goals contd (3)
Return objectives should be realistic, flexible and commensurate with normal market conditions.
Should be consistent with Risk Objectives.
Differentiating between nominal and “real” returns
Should be viewed from a “Total Return” perspective

12. IPS – Investment Objectives & Goals contd (3)
What is it?
Goals should be used to achieve a balance that satisfies both nearer term and longer term beneficiaries.
Benchmark indices should be identified
Quantifiable measures against such indices should be identified. (compare apples to apples)

13. IPS – Investment Guidelines (4)
What is it?
Identification of asset classes that are to be used or forbidden in constructing a portfolio:
Fixed Income: US Government Bills, Notes, Bonds, Agencies, Municipals, Corporates, TIPS, CD’s ……..what is the lowest acceptable credit quality???
Equities: Domestic and International Large Caps, Mid Caps, Small Caps
Alternatives: Real Estate, Commodities
Benchmark indices should be identified for above
Quantifiable measures against such indices should be identified. (compare apples to apples)

14. IPS – Investment Performance Review & Evaluation (5)
What is it?
Goal is to obtain information from investment manager(s) to identify actual performance (Gross & Net of Fees)
Determine if performance was derived within the boundaries of the Investment Guidelines
Ascertain capital market expectations
Rebalance (if necessary) to targets given market fluctuations.
Discussion of any proposed changes in the future.

15. The Importance of Asset Allocation
Goal is to develop an investment strategy that attempts to balance risk versus reward by adjusting the percentage of each asset class according to the unique needs of the pension fund.
In general, adding asset classes that offer returns that are NOT perfectly correlated can reduce the overall risk in terms of the variability of returns.

16. Risk & Return: The Basics
Inherent trade off between return and risk.

17. Determining Asset Allocation Policy
Income Oriented
Growth Oriented

18. Identifying Acceptable Asset Classes
Expected Rate of Return
Based on historical data
Risk Free Rate: The theoretical rate of return of an investment with zero risk.
Ex: Short term Treasury Bills
Risk Premium: The return in excess of the risk free rate that an investment is “expected” to yield. This is a form of compensation for investors who are willing to tolerate extra risk.
Think of this as “hazard” pay (Haz Mat, SWAT etc..)

19. Identifying Acceptable Asset Classes
Expected Rate of Return
If Treasury bill rate = 2%
If the Risk Premium = 5.5%
Then the expected rate of return is as follows:
ER = RF + RP
?? =
.075 or 7.5% “Expected” return

20. Identifying Acceptable Asset Classes
Risk or Volatility
Measured in terms of Standard Deviation
Defined as a measure of the dispersion of a set of data from its average or mean. The more spread apart the data, the higher the deviation. Standard deviation is calculated as the square root of variance.

21. Identifying Acceptable Asset Classes
Which asset class has more risk in terms of volatility?

22. Identifying Acceptable Asset Classes
Risk or Volatility contd (Beta)
A quantifiable number describing the relation of an assets returns with those of the respective benchmark.
Beta is a useful measure used to describe the “relationship” of returns over time.
A Beta of 1 is typically used as the respective benchmark return.
If the benchmark index has market volatility of 10%, a fund with a beta of 1 should have the same 10% volatility.
If the benchmark index has market volatility of 10%, and your fund moved 15%, the Beta of this fund would be 1.5.
If the benchmark index has market volatility of 10%, and your fund moved 8%, the Beta of this fund could would be 0.8.

23. Identifying Acceptable Asset Classes
Risk or Volatility contd (Beta)
Ex: The S&P 500 returned +12% in the past year. ABC fund has historically had a Beta of 1.3.
Should the return of ABC fund be <12%, =12%, >12%?
If ABC fund had a Beta of 1.3 relative to the S&P 500 in the above example what should you expect the return to be?
S&P 500 return = 12% Fund Beta = 1.3
ABC fund Beta = (12%*1.3) =15.6%
In dollar terms: $1000 invested in S&P 500 would return $1120 in one year. $1000 invested in ABC fund would return $1156.

24. Relationship of Investment Risk & Return (Correlation)
In a perfect world

25. Relationship of Investment Risk & Return (Correlation)
Trend is upward sloping
The real world
Trend is downward sloping
The real world

26. Determining Asset Allocation Policy (Weighting Constraints)
A brief (very brief) summary of Illinois Pension Code (40 ILCS 5/1‑113)
If pension fund assets <$2.5 million, then equity must not exceed 10%. (separate/mutual funds)
If pension fund assets >$2.5 million, then equity must not exceed 45%. (separate/mutual funds)
If pension fund assets >$5 million, then equity must not exceed 45%. (separate/mutual funds individual equities via investment manager)
If pension fund assets >$10 million, then equity must not exceed 50%. ***Changes in 2011 & 2012***
What about Fixed Income (bonds)???

27. Determining Asset Allocation Policy (Time Constraints)
Plan participants are the ultimate beneficiaries of the plan assets…..NO MATTER WHAT!!!
Time horizons are typically perpetual for pension funds
Working with the actuaries can provide some guidance to your specific plan.

28. Determining Asset Allocation Policy (Investment Goals or Target Returns)
Realistic Expectations based on recent market history and a similar interest rate environment.

29. Ibbotson® SBBI® Stocks, Bonds, Bills, and Inflation 1926–2010
$16,055
$10,000
$2,982
Compound annual return
• Small stocks
12.1 %
1,000
• Large stocks
9.9
• Government bonds
5.5
• Treasury bills
3.6
• Inflation
3.0
$93
100
$21
$12 10
Ibbotson® SBBI® 1926–2010
An 85-year examination of past capital market returns provides historical insight into the performance characteristics of various asset classes. This graph illustrates the hypothetical growth of inflation and a $1 investment in four traditional asset classes over the time period January 1, 1926, through December 31, 2010.
Large and small stocks have provided the highest returns and largest increase in wealth over the past 85 years. As illustrated in the image, fixed-income investments provided only a fraction of the growth provided by stocks. However, the higher returns achieved by stocks are associated with much greater risk, which can be identified by the volatility or fluctuation of the graph lines.
Government bonds and Treasury bills are guaranteed by the full faith and credit of the U.S. government as to the timely payment of principal and interest, while stocks are not guaranteed and have been more volatile than the other asset classes. Furthermore, small stocks are more volatile than large stocks, are subject to significant price fluctuations and business risks, and are thinly traded.
About the data
Small stocks in this example are represented by the fifth capitalization quintile of stocks on the NYSE for 1926–1981 and the performance of the Dimensional Fund Advisors, Inc. (DFA) U.S. Micro Cap Portfolio thereafter. Large stocks are represented by the Standard & Poor’s 500®, which is an unmanaged group of securities and considered to be representative of the stock market in general. Government bonds are represented by the 20-year U.S. government bond, Treasury bills by the 30-day U.S. Treasury bill, and inflation by the Consumer Price Index. Underlying data is from the Stocks, Bonds, Bills, and Inflation® (SBBI®) Yearbook, by Roger G. Ibbotson and Rex Sinquefield, updated annually. An investment cannot be made directly in an index. 1
0.10
1926
1936
1946
1956
1966
1976
1986
1996
2006
Past performance is no guarantee of future results. Hypothetical value of $1 invested at the beginning of Assumes reinvestment of income and no transaction costs or taxes. This is for illustrative purposes only and not indicative of any investment. An investment cannot be made directly in an index. © 2011 Morningstar. All Rights Reserved. 3/1/2011

30. Ibbotson® SBBI® Stocks, Bonds, Bills, and Inflation 1991–2010
$20
Compound annual return
• Small stocks
13.5%
$12.57
• Large stocks
9.1
• Government bonds
8.4 10
• Treasury bills
3.5
• Inflation
2.5
$5.75
$5.05
$1.97
$1.64
Ibbotson® SBBI® 1991–2010
Examining the past 20 years of capital market returns can provide historical insight into the performance characteristics of various asset classes. This image illustrates the hypothetical growth of a $1 investment in four traditional asset classes, as well as inflation, over the time period January 1, 1991 through December 31, 2010.
As illustrated in this image, stocks produced greater returns and higher ending wealth values than fixed-income investments. Small stocks performed better than all the other asset classes. However, stocks are associated with much greater risk, which can be identified by the volatility or fluctuation of the graph lines.
Government bonds and Treasury bills are guaranteed by the full faith and credit of the United States government as to the timely payment of principal and interest, while stocks are not guaranteed and have been more volatile than the other asset classes. Furthermore, small stocks are more volatile than large stocks and are subject to significant price fluctuations, business risks, and are thinly traded.
About the data
Small stocks in this example are represented by the performance of the Dimensional Fund Advisors, Inc. (DFA) U.S. Micro Cap Portfolio. Large stocks are represented by the Standard & Poor’s 500®, which is an unmanaged group of securities and considered to be representative of the stock market in general. Government bonds are represented by the 20-year U.S. government bond, Treasury bills by the 30-day U.S. Treasury bill, and inflation by the Consumer Price Index. Underlying data is from the Stocks, Bonds, Bills, and Inflation® (SBBI®) Yearbook, by Roger G. Ibbotson and Rex Sinquefield, updated annually. An investment cannot be made directly in an index. 1
0.60
1991
1996
2001
2006
Past performance is no guarantee of future results. Hypothetical value of $1 invested at the beginning of Assumes reinvestment of income and no transaction costs or taxes. This is for illustrative purposes only and not indicative of any investment. An investment cannot be made directly in an index. © 2011 Morningstar. All Rights Reserved. 3/1/2011

31. Stocks, Commodities, REITs, and Gold 1980–2010
$100
Compound annual return
• REITs
12.3%
• U.S. stocks
11.4
• International stocks
10.1
$36.02
• Commodities
7.5
• Gold
$28.08
3.2
$19.98
$9.35 10
$2.68
Stocks, Commodities, REITs, and Gold
International stocks, real estate investment trusts (REITs), commodities, and gold have traditionally served to lower the overall risk of a domestic portfolio.
This image illustrates the hypothetical growth of a $1 investment in domestic stocks, international stocks, commodities, REITs, and gold over the time period January 1, 1980 to December 31, REITs were the best-performing asset class over this time period, with $1 growing to approximately $ U.S. stocks came in second, with $1 growing to $28.08.
International stocks, commodities, real estate, and gold are often overlooked in an investor’s asset allocation decision. These assets can be excellent vehicles for diversification purposes, because their returns have demonstrated low or even negative correlation with more traditional assets. In other words, when traditional assets have done poorly, these alternative assets may have done well, thereby reducing the overall volatility (risk) of your portfolio. Commodities, real estate, and gold can also be an effective hedge against rising inflation rates.
Diversification does not eliminate the risk of experiencing investment losses. Returns and principal invested in stocks, REITs and commodities are not guaranteed. International investments involve special risks such as fluctuations in currency, foreign taxation, economic and political risks, liquidity risks, and differences in accounting and financial standards. Transactions in commodities carry a high degree of risk, and a substantial potential for loss. In light of the risks, you should undertake commodities transactions only if you understand the nature of the contracts (and contractual relationships) into which you are entering and the extent of your exposure to risk. Trading in commodities is not suitable for many members of the public. You should carefully consider whether this type of trading is appropriate for you in light of your experience, objectives, financial resources and other relevant circumstances. Gold, like any other coin or bullion, is subject to investment risks like perceived scarcity of coin, its quality, current demand, market sentiment, and economic factors.
About the data
U.S. stocks in this example are represented by the Standard & Poor’s 500®, which is an unmanaged group of securities and considered to be representative of the stock market in general. International stocks are represented by the Morgan Stanley Capital International Europe, Australasia, and Far East (EAFE®) Index, commodities by the Morningstar Long-Only Commodity Index, REITs by the FTSE NAREIT Equity REIT Index® , and gold by the Federal Reserve (2nd London fix) from 1980–1987 and Wall Street Journal London P.M. closing price thereafter. An investment cannot be made directly in an index. 1
0.50
1980
1985
1995
2000
2005
1990
2010
Past performance is no guarantee of future results. Hypothetical value of $1 invested at the beginning of Assumes reinvestment of income and no transaction costs or taxes. This is for illustrative purposes only and not indicative of any investment. An investment cannot be made directly in an index. © 2011 Morningstar. All Rights Reserved. 3/1/2011

32. Conclusion
Questions & Answers
Quiz