1. PSPRS Don’t Stop Thinking About Tomorrow GFOAz Conference August 7, 2014

2. Presentation Outline PSPRS Overview – Jared Smout, Deputy Administrator, PSPRS Rate Components and Funding Levels – Understanding the Actuarial Valuation – Mark Buis, Gabriel Roeder Smith & Co. PSPRS Investment Strategy – Mark Steed, Lead Portfolio Manager/Chief of Staff, PSPRS Town of Paradise Valley’s PD Pension Study – Scott McCarty, Finance Director, Town of Paradise Valley

3. PSPRS Overview

4. The Purpose of PSPRS Arizona Revised Statutes § 38-841 Before the establishment of the public safety personnel retirement system, municipal firemen and policemen, employees of the Arizona highway patrol and other public safety personnel in the state of Arizona were covered under various local, municipal and state retirement programs. These heterogeneous programs provided for wide and significant differentials in employee contribution rates, benefit eligibility provisions, types of benefit protection and benefit formulas….In order to provide a uniform, consistent and equitable statewide program for public safety personnel who are regularly assigned hazardous duty in the employ of the state of Arizona or a political subdivision thereof, this retirement system was created effective as of July 1, 1968.

5. The Local Board System = Local Control Arizona Revised Statutes § 38-847 The administration of the system and responsibility for making the provisions of the system effective for each employer are vested in a local board. The department of public safety, the Arizona game and fish department, the department of emergency and military affairs, the University of Arizona, Arizona State University, Northern Arizona University, each county sheriff's office, each county attorney's office, each county parks department, each municipal fire department, each eligible fire district, each community college district, each municipal police department, the department of law, the department of liquor licenses and control, the Arizona department of agriculture, the Arizona state parks board, each Indian reservation police agency and each Indian reservation fire fighting agency shall have a local board. The Structure of PSPRS

8. PSPRS Annual Aggregate Actuarial Valuation June 30, 2013Employer RateFunded Status Averages32.54%57.1%

13. Do you know where you stand and how you got there?

14. Copyright © 2014 GRS – All rights reserved. Rate Components and Funding Levels Understanding the Actuarial Valuation

15. 15  Present Value of Future Benefits - Present Value of all future benefits payable to current participants (active, retired, terminated vested).  Actuarial Liability - Portion of PV of Future Benefits allocated to prior years.  Normal Cost - Portion of PV of Future Benefits allocated to current year.  Future Normal Costs - Portion of PV of Future Benefits allocated to future years. Actuarial Liability Future Normal Cost Normal Cost Components of the Actuarial Valuation

16. 16 Actuarial Accrued Liability - Actuarial Value of Assets = Unfunded Actuarial Liability Annual Contribution = Normal Cost + Amortization of the Requirement Unfunded Liability Components of the Actuarial Valuation

17. Development of Funded Ratio 17 Funding Ratio will be different for every employer.

18. Development of Employer Contribution Employer contribution rate will be different for every employer. 18

19. Understanding Asset Smoothing Funding value for each employer is determined proportionately based on Market Value. 19

20. Understanding Asset Smoothing and Amortization methods  Year 1 - phase in 1/7 of asset loss  Step 1 – phase in 1/7 of asset loss  Step 2 – amortize UAL over 23 years  Year 2 – Year 1 results PLUS  Step 1 – phase in additional 1/7 of asset loss  Step 2 – amortize UAL over 22 years  …  Year 7 and beyond – Year 1 through 6 PLUS  Step 1 – phase in final 1/7 of asset loss  Step 2 – amortize UAL over remaining years 20

21. Understanding Asset Smoothing and Amortization methods 21 Example of How 30% Loss on Assets Impacts Contribution

22. So Why Have Contribution Rates Been Increasing? 22

23. So Why Has the Contribution Rate Been Increasing?  In most systems, assets losses and gains tend to offset each over time  In PSPRS, asset gains also fund the Permanent Benefit Increases (PBI)  The current return assumption is 7.85%  One-half of excess return over 9% funds the PBI  When markets are volatile, high returns will not completely offset the low returns 23

24. So Why Has the Contribution Rate Been Increasing? 24

25. Comparison of COLA Provisions PSPRS ProvisionsPre SB1609Post SB1609 Investment Return Threshold9%10.5% COLA Maximum4% of Average PSPRS Benefit Prior Year Varies from 2% to 4% Based on Funded Ratio Funded Status ThresholdNone60% Reserve AccumulationYesNo COLA Delay2 Years or age 55Tier 1: 2 Years or Age 55 Tier 2: Age 55 25

26. SB1609 Reversal  Fields case – restores original PBI formula for members who were retired as of June 1, 2011  Hall case – would restore original PBI formula for current active members and reverse changes in the employee contribution rate 26

27. SB1609 Reversal Impact on Employer Contributions 27 Note that contribution requirements for FY2016 are expected to increase due to continued phase-in of assets losses from prior years.

28. SB1609 Reversal Impact on Employer Contributions 28 Example of Impact of Fields Case Reversal

29. Things employers CAN’T control  Investment performance  PSPRS has some control over this  Benefit Provisions  Occasionally modified by statute  Actuarial assumptions and methods  Reviewed every 5 years by actuary 29

30. Things employers CAN control  Managing funding levels  Employers can contribute more than the minimum  Managing workforce  Hiring members with prior PSPRS service  increases cost  Reducing workforce results in costs being spread over lower payroll base  increases cost as percentage of pay  Disability approvals  can increase cost if not managed carefully  Payroll management  allowing pay spiking can increase cost 30

31. PSPRS Investment Strategy Towards a more resilient portfolio

32. Portfolio is managed according to a set of investment beliefs 1.Mandate to achieve assumed earnings rate of at least 7.85% over long-periods of time 2.Markets are difficult to time so diversification offers the best chance to achieve the assumed earnings rate 3.Investment universe should be as wide as possible so as to increase likelihood of accomplishing diversification 4.Risk is defined as the potential for a loss of capital. It can be approximated using statistical conventions but will never be exact 5.The best results come from people who are empowered to make decisions. Human and cognitive diversity are the best tools for solving novel problems in complex systems 6.Making sound decisions requires not only robust quantitative models but sound human judgment. People make models better and models make people better 7.Success depends, in part, on recognizing the role that “randomness”, or chance, plays in any particular market

33. Portfolio returns are derived from a simple equation Total Return = Risk Free Rate (Cash) + Asset Allocation + Active Management Since 1970, traditional portfolios averaged the following: 10.0% = 5.6% (Historical Risk Free Rate) + 4.4% (Asset Allocation) + 0% (Active Management) However, the reduction in the risk-free rate due to monetary stimulus puts the burden of total return on asset allocation and active management 6.1% = 1.7% + 4.4% + 0%

34. This reality leads to two distinct strategic initiatives 1.Improve returns from asset allocation  Passively holding more or less of certain asset classes Problem: The low-rate environment incentivizes investors to purchase riskier assets with higher returns, thus bidding up bond and stock prices and bidding down future returns. Also, markets can behave erratically creating the appearance of randomness. Solution: Focus on a strategic mix of assets that offer the highest probability of success in the aggregate, regardless of the business cycle. Focus on odds. 2.Improve active management decisions  Making relative value decisions within asset classes Problem: This is a zero-sum game, if we win, someone loses. Therefore, opportunities are fleeting because information travels quickly. Solution: Do not assume the rules of the game are fixed. By focusing on the Trust’s competitive advantages (liquidity, time horizon and size), we can make active decisions in opaque markets where informational asymmetry can be exploited

35. Sidebar: What drives outcomes, skill or luck? Strategies should be different depending on what drives the outcome. To what extent does luck or skill determine success for sports teams? What does the dispersion of success look like? How would it be different if the outcome were completely dependent on luck? LeagueContribution of Luck Contribution of Skill Season Ending NBA10%90%2013 Premier League 31%69%2011 MLB34%66%2011 NFL53%47%2012 2013 NBA season calculated by author using “True Score Theory”. All other statistics are for the five seasons ending in the designated year and are taken from Mauboussin, M. The Success Equation. 2012. Harvard Business Review Press.

36. Initiative #1 Total Return = Risk Free Rate (Cash) + Asset Allocation + Active Management There are numerous asset classes but they usually fit in one of four quadrants GrowthInflation RisingEquities Commodities Corporate Credit EM Credit Private Equity IL Bonds Commodities EM Credit Liquid Loans FallingNominal Bonds IL Bonds Direct Lending Equities Nominal Bonds *The key to having a more resilient portfolio is ensuring you hold assets that will perform during any business cycle. Portfolio construction is about balance. **Allocating equal capital to each of the four quadrants will not work (balance will not be achieved) because some assets are more volatile than others. If one asset is twice as volatile as another, it should receive half the capital.

37. With this in mind, the Investment Team has pursued a path that better diversifies the portfolio against macro risks

38. While forecasts and simulations are far from certain we are at least able to say today’s portfolio is better insulated from known macro-economic shocks than has been the case historically. Today’s PortfolioPSPRS Trust Actual Stock Market Crash of 2002-4.5%-21.1% Credit Crunch 2008-8.2%-23.1% Crisis 2009 (Jan – Feb)-4.9%-12.9%

39. Initiative #2 Total Return = Risk Free Rate (Cash) + Asset Allocation + Active Management As markets approach efficiency, returns are driven less by skill and more by luck

40. If you are an underdog, make rules of the game as flexible as possible Nassim Taleb author of Outliers likes to use the example of David and Goliath

41. Over the last five years, the PSPRS Trust has negotiated strategic relationships with key research institutions and asset managers to build a best-in-class information network 57 16 14 26 19 14

42. Results PSPRS maintains one of the most superior risk-adjusted (as measured by the sharpe ratio) portfolios in the nation, placing ahead of 90% of their peers over the last three years. Risk Ratio of PSPRS Risk to 60/35/5 Chart taken from “Modern Pension Fund Diversification”. Figure 4. http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2426593. To be published in the Journal of Asset Management

43. Historical Returns (through 5/31/2014, Gross of Fees) Month EndingFiscal YTDCalendar YTD1 Year3 Years5 Years10 Years PSPRS Trust1.98%12.94%4.86%12.01%7.48%10.94%6.02% Benchmark1.19%12.38%3.57%10.99%8.12%10.90%4.79% Excluding legacy Real Estate 2.08%14.78%5.07%13.35%8.54%12.65%N/A

44. Accolades 2013, Nominee, Innovator Award. Asset International Chief Investment Officers 2011, Recipient, Mid-Size Fund of the Year. Money Management Magazine 2011, Nominee, Small Public Fund of the Year. Institutional Investor Magazine

45. GFOAz Conference August 7, 2014 POLICE PENSION STUDY

46. Contribution Rate~63% Contribution Amount$1.7M Contribution Amount as % of Operating Budget8% Percent Funded30% Unfunded Liability$19.7M Active Employees23 Retirees/DROP Members37 OUR KEY STATISTICS – PD ONLY 46

47. PV PSPRS Average Normal Cost Requirement12.27%12.89% Amortization of Unfunded Liabilities50.17%19.65% Contribution Rate62.44%32.54% “NO ONE IS AVERAGE” 47 The Town’s Unfunded Liability is the Most Significant Factor in Our Contribution Rate

48. Actual Experience Has Not Matched Projections in the Following Areas: 1.Investment Earnings (Can’t Control) 2.Court Rulings (Can’t Control) 3.Retirees Outnumber Actives (CAN INFLUENCE)  Benefits Have Been Earned STUDY RESULTS: UNFUNDED LIABILITY 48

49. PV VS. PSPRS IN FY 12-13 ACTIVES VS. RETIREES 49

50. 1.Relatively Constant Number of Active Positions 2.Only Hire Laterals 3.Large Number of Disability Retirements with Less Than 20 Years of Service 4.DROP Program STUDY RESULTS- WHY OUR RETIREES OUTNUMBER EMPLOYEES 50

51. UNFUNDED LIABILITY GROWS TO A PEAK OF $23M THEN DECLINES 51 Unfunded Liability

52. EMPLOYER CONTRIBUTION STEADILY INCREASES AND GROWS TO 15% OF OPERATING REVENUES 52

53. CONTRIBUTION RATE STEADILY INCREASES TO 80% 53

54. TOTAL CONTRIBUTION: NORMAL COST + UNFUNDED LIABILITY 54 Unfunded Liability $53.5M Total Cost

55. What are We Doing About It? 55

56.  DROP has an Adverse Financial Impact per Actuary Study  FY 14-15 Budget Includes Contributions for All Authorized PSPRS Positions (33)  Added $235k for 4 DROP Members 1. STARTED MAKING DROP MEMBER CONTRIBUTIONS EFFECTIVE JULY 1 ST 56

57.  Expected Results  $90k Additional Interest Income  3 Percentage Point Rate Reduction  Investment Income is Based on the Town’s Average Balance  Average Balance = Beginning Balance + 50% of Annual Changes 2. PREPAID $2M CONTRIBUTIONS ON JULY 1 ST 57

58. What is a Pension Funding Policy?  A Comprehensive Document with the Objective of Ensuring Financial Resources Exist to Fund Pension Obligations 3. DEVELOPING A PENSION FUNDING POLICY 58

59.  Components of the Policy  Defines Funding Levels  Defines Contribution Rates & Amounts  Avoids “Kicking the Can Down the Road”  Defines Actuary Assumptions  Identifies Roles of Responsible Parties 3. DEVELOPING A PENSION FUNDING POLICY (CONCLUDED) 59

60.  Focusing on Addressing $14.3M Unfunded Retiree Liability (Not Total $19.7M Unfunded Liability)  Limited Capacity Under State’s Annual Expenditure Limitation  Reserve is an Interim Option 4. CONSIDERING ADDITIONAL PAYMENTS TO DIRECTLY BUY-DOWN THE LIABILITY 60

61.  Safety Programs  Wellness Programs  Role of Local PSPRS Board  Role of Council 5. IMPLEMENTING BEST PRACTICES 61

62.  League Task Force  Ability to Issue Pension Obligation Bonds 6. EVALUATE LEGISLATIVE OPTIONS 62 Bond Issue Example Status Quo (7.85%)$53.5M Bonds (3.7%)$31.3M Estimated Savings$22.2M

63. 1.Do a Study  What Percent of Your Operating Budget Goes to PSPRS?  We’re Extreme, Are You?  “No One is Average” 2.Create a Pension Funding Policy  Don’t Wait Until It’s Too Late YOUR HOMEWORK 63

64. Questions and Comments 64

65. The following section is a placeholder re. GASB and will be discussed if time permits 65

66. Copyright © 2014 GRS – All rights reserved. New GASB Standards

67. GASB Changes - Overview  New GASB Accounting Standards Statements No. 67 and No. 68 will create accounting results separate from funding results  Funding calculations are not impacted  GASB created a new Net Pension Liability (NPL) and Pension Expense  Statement No. 67 replaces Statement No. 25  Statement No. 68 replaces Statement No. 27 28

68. Summary of Key Changes  Under the GASB’s current standards, there is a close link between the accounting and funding measures. Under the new statements, the two are disconnected: 68

69. GASB Changes – Overview  Key differences for employer accounting  New GASB rules do not allow smoothing of assets  New GASB rules may require lower (or blended) discount rate to value liabilities  Key takeaways  New GASB rules do NOT change the funding contribution rate  New GASB rules do provide a second set of actuarial numbers (may lead to confusion) 69

70. Single Discount Rate  The NPL is similar to the Unfunded Actuarial Accrued Liability (UAAL) that many state and local governments use for funding purposes (based on Market Value of Assets)  However, a key difference is the “Single Discount Rate” which is:  Based on the long-term expected investment return to the extent projected plan fiduciary net position (assets) is sufficient to pay future benefits; and  Based on a tax-exempt municipal bond index rate to the extent projected plan fiduciary net position (assets) is not sufficient to pay future benefits 70

71. Determining the Discount Rate – (GASB) 71

72. GASB Overview  GASB Statement No. 67 is effective for fiscal years beginning after June 15, 2013  PSPRS will receive plan results this fall  GASB Statement No. 68 is effective for fiscal years beginning after June 15, 2014  Employers will receive separate GASB report next spring based on June 30, 2014 measurement date  This will allow auditors to receive information prior to June 30, 2015 fiscal year end 72