Rising to the Risk Challenge

Contents Pensions with Purpose Rising to the Risk Challenge EXECUTIVE SUMMARY SECTION 1: The risk-return equation at the heart of the industry s challenge SECTION 2: Making bold strides into alternatives SECTION 3: Varied strategies to risk exposure SECTION 4: A deeper understanding of risk types SECTION 5: Enhancing in-house risk capabilities SECTION 6: Enhanced governance underpins risk strategy CLICK THE LINK WHEREVER YOU SEE THIS SYMBOL SECTION 7: Deepening board-level expertise CONCLUSION: Enhancing risk management capabilities is mission-critical IMPORTANT DISCLOSURES GLOSSARY RESEARCH AT A GLANCE. This report is based on a survey of 400 senior executives in the pension fund industry in 2015 find out more

Executive Summary See main research report PENSIONS WITH PURPOSE Pension funds are battling to balance risk versus return to achieve better member outcomes Our research 1 shows that the majority of respondents are seeking to reduce overall investment risk a group we have called Risk Cutters. By contrast, Return Hunters say their funding situation dictates that they pursue a higher risk, higher return approach. Both groups are united by a need to master risk like never before even those who want to add risk are looking to do so with minimum impact on the overall risk budget. Which best describes your institution? We are actively looking for ways to de-risk our portfolio Our funding situation dictates that we seek higher risk, higher returns strategies We plan to make no significant changes to our risk profile 19 % 45 % Risk Cutters 36 % Return Hunters 1. State Street 2015 Asset Owners Survey conducted by Longitude Research in October and November 2015. See p.19 for full details. Both groups will need to adapt their governance frameworks Boards must empower the investment function to hunt for higher returns and to act quickly on new opportunities. Governance processes must be enhanced to ensure objectives both investment returns and improved member outcomes are achieved within the fund s risk threshold. Improving risk capabilities is a top priority for both groups Our survey indicates that in-house risk teams will be enhanced with experts in investment and liquidity risk across diverse asset classes. Gaps in board knowledge will be addressed. Leading pensions will invest in sophisticated risk management tools to obtain a 360-degree view of exposure. 02 PENSIONS WITH PURPOSE - RISING TO THE RISK CHALLENGE / EXECUTIVE SUMMARY

Section 1 The risk-return equation at the heart of the industry s challenge True diversification means investing in things that are unfamiliar and perhaps make you feel uncomfortable that s not easy to do But to gain what can be significant risk reduction without giving up returns, some delegation might be required. DAVID ALEPPO Head, DB Investment Advisory Services (UK), Willis Towers Watson CLICK TO READ THE FULL Q&A Diversification does not ensure a profit or guarantee against loss 03 PENSIONS WITH PURPOSE - RISING TO THE RISK CHALLENGE / SECTION 1. THE RISK-RETURN EQUATION AT THE HEART OF THE INDUSTRY S CHALLENGE

The risk-return equation at the heart of the industry s challenge Pension funds may need a deeper, more precise understanding of investment risk to achieve the strong returns they require while keeping risk exposure to a minimum. Balancing this equation will require new expertise and tools. 4% Superannuation fund 8% Superannuation fund In our survey, it s clear both Risk Cutters and Return Hunters view alternatives as an important source of higher returns. Expertise in portfolio diversification will be important to keep risk levels to a minimum as pension funds increase their exposure to alternatives. In addition, our research shows that more private pensions are taking risk off the table, while public sector pension funds are more likely to be increasing investment risk in search of higher returns. 17% Public pension or retirement system 79% Private pension or retirement system State Street Asset Owners Survey 2015 Risk Cutters Return Hunters 30% Public pension or retirement system 63% Private pension or retirement system Diversification does not ensure a profit or guarantee against loss 04 PENSIONS WITH PURPOSE - RISING TO THE RISK CHALLENGE / SECTION 1. THE RISK-RETURN EQUATION AT THE HEART OF THE INDUSTRY S CHALLENGE

Section 2 Making bold strides into alternatives Over the past few years we ve ramped up private equity, and to some extent hedge funds, and we ve been doing a lot more private real estate. WILLIAM LEE Chief Investment Officer Kaiser Permanente CLICK TO READ THE FULL Q&A 05 PENSIONS WITH PURPOSE - RISING TO THE RISK CHALLENGE / SECTION 2. MAKING BOLD STRIDES INTO ALTERNATIVES

Return Hunters are making bold strides into alternative asset classes The majority of Return Hunters plan to boost exposure to funds of hedge funds (62 percent) and real estate (57 percent) over the next three years. Half of this group will increase their allocation to private equity. According to our survey, Return Hunters also have a higher level of interest in environmental, social and governance (ESG) investments than Risk Cutters. These investments may provide sustainable returns that match pension funds long-term liabilities. Alternative asset classes in which pension funds plan to increase exposure over the next 3 years 62 % 46 % 57 % 48 % 50 % 44 % 45 % 28 % 43 % 43 % 37 % 35 % 62 % of Return Hunters plan to boost exposure to funds of hedge funds 57 % of Return Hunters plan to boost exposure to real estate Fund of hedge funds Real Estate Private Equity Hedge funds (single manager) Infrastructure Direct loans State Street Asset Owners Survey 2015 Return Hunters Risk Cutters 06 PENSIONS WITH PURPOSE - RISING TO THE RISK CHALLENGE / SECTION 2. MAKING BOLD STRIDES INTO ALTERNATIVES

Section 3 Varied strategies to risk exposure There are many options pensions could look at [to reduce risk], such as dynamic risk management tools, option strategies and volatility management. However, take-up rates by UK private pension schemes is relatively low, instead they tend to focus more on diversification of assets. IAIN COWELL Interim Head of Investment Affairs, Pension and Lifetime Savings Association, UK CLICK TO READ THE FULL Q&A Diversification does not ensure a profit or guarantee against loss 07 PENSIONS WITH PURPOSE - RISING TO THE RISK CHALLENGE / SECTION 3. VARIED STRATEGIES TO RISK EXPOSURE

Risk Cutters will employ varied strategies to help reduce their overall risk exposure Risk Cutters are also deepening their exposure to alternatives, although they are making a less pronounced shift than Return Hunters. Across hedge funds, real estate, private equity and direct loans, Risk Cutters appetite for increased exposure is lower than that of Return Hunters. Pension funds plans to introduce a DC scheme or hybrid DB/DC scheme* However, both groups share the same appetite for increasing their exposure to infrastructure, with 43 percent of each planning to do this over the next three years. This might reflect a perception that returns from infrastructure investment are likely to be more stable though potentially lower than other alternative asset classes. DC 3 % 13 % 56 % 28 % Hybrid (DB/DC) 6 % 22 % 47 % 25 % As a potential way to manage their longevity risk exposure and reduce future liabilities, 73 percent of those Risk Cutters that are defined benefit (DB)-only institutions plan to introduce a defined contribution (DC) scheme, or a hybrid model with features of both DB and DC, within the next three years, compared to just 48 percent of Return Hunters. Don t know Yes - over the longer term Yes - within three years No (more than three years) *The base is all respondents whose funds are defined benefit (DB)-only. State Street Asset Owners Survey 2015 73 % of DB-only Risk Cutters plan to introduce a DC scheme 43 % of both Risk Cutters and Return Hunters plan to increase exposure to infrastructure 08 PENSIONS WITH PURPOSE - RISING TO THE RISK CHALLENGE / SECTION 3. VARIED STRATEGIES TO CUT RISK EXPOSURE

Section 4 A deeper understanding of risk types We ve been honing our techniques for assessing risk as carefully as we can to make sure that future generations enjoy the same level of benefits that the current generation does. BARBARA CREED Chair, Church Pension Fund Board of Trustees CLICK TO READ THE FULL Q&A 09 PENSIONS WITH PURPOSE - RISING TO THE RISK CHALLENGE / SECTION 4. A DEEPER UNDERSTANDING OF RISK TYPES

Both groups require a deeper understanding of risk exposures to make their philosophies pay-off While increased allocations to alternative assets may impact portfolio liquidity, pension funds may be well-positioned given their long-term liabilities to take greater advantage of opportunities in illiquid assets than other market participants. The key is to be able to evaluate each opportunity of this kind and to understand its liquidity impact, ensuring that it will add value to the fund without creating additional risk. Percentage agreeing with statements on risk transparency and regulatory limits on exposure 49 % 49 % 36 % 54 % A deeper shift into alternatives will also require specialist knowledge to fully comprehend the associated investment risks and interplay of assets within the portfolio. Return Hunters and Risk Cutters alike are in need of greater transparency about the risks of investing in alternative assets. We have not yet achieved real transparency on risks stemming from alternative assets It is getting harder to ensure we don t breach local regulatory limits on exposure to a specific asset class State Street Asset Owners Survey 2015 Return Hunters Risk Cutters 10 PENSIONS WITH PURPOSE - RISING TO THE RISK CHALLENGE / SECTION 4. A DEEPER UNDERSTANDING OF RISK TYPES

Only a handful of pension funds have a 360-degree view across risk types We examined pension funds capabilities across four distinct types of risk: investment, liquidity, longevity and operational risk. For each of these areas, only one-fifth of funds at most consider their risk management to be very effective. How effective respondents believe their institutions are at managing each type of risk* According to our survey, large funds appear to manage the different types of risks more effectively than do small funds. Public sector funds seem to manage them better than private pensions. 81 % 80 % 80 % Key types of risk 73 % Increased life expectancy is heightening longevity risk for pension funds 21 % Longevity 6 % 15 % Liquidity * High effectiveness = self-assessed scores of 9 or 10 on a 1-10 scale; low effectiveness = self-assessed scores of 1 or 2. State Street Asset Owners Survey 2015 4 % 14 % 6 % Investment 20 % 0.3 % Operational High Medium Low A low-yield environment has increased investment risk as returns are more likely to fall short of expectations Shifts into alternative assets may reduce liquidity and increase liquidity risk Operational risk is increased when systems, processes or people fail to perform as needed 11 PENSIONS WITH PURPOSE - RISING TO THE RISK CHALLENGE / SECTION 4. A DEEPER UNDERSTANDING OF RISK TYPES

Section 5 Enhancing in-house risk capabilities If they want to go further, they need the ability to monitor counter-party risk, liquidity risk and market risk, among others. It will therefore require a significant cultural change within Italian pension funds, as some large funds only have a few specialized professionals dedicated to this activity today. MARCO DI LIBERTI Consultant CLICK TO READ THE FULL Q&A 12 PENSIONS WITH PURPOSE - RISING TO THE RISK CHALLENGE / SECTION 5. ENHANCING IN-HOUSE RISK CAPABILITIES

All funds especially Return Hunters are enhancing in-house risk capabilities Actions in regard to the internal risk team that institutions are planning to take in the next 3 years Pension funds will need to develop their in-house risk expertise to assert greater control over increasing risk exposures. Return Hunters are moving especially strongly in this direction. Even as pension funds develop more sophisticated risk management capabilities, the support required from external partners is unlikely to diminish. More than one-quarter (27 percent) of respondents plan to increase the number of external consultants they use over the next three years. This support will be particularly important in areas where funds lack specialist expertise, or cannot afford to implement the required risk tools in-house. Return Hunters Decrease headcount 22% No change 20% Increase headcount 58% Risk Cutters Decrease headcount 28% No change 28% Increase headcount 44% Smarter risk tools are already being deployed to achieve the deeper insights required. Risk-factor analysis is increasingly being used to complement the individual view of risks with a holistic one that assesses risk across the entire portfolio. 27 % More than one-quarter of respondents plan to increase the number of external consultants they use over the next three years. State Street Asset Owners Survey 2015 13 PENSIONS WITH PURPOSE - RISING TO THE RISK CHALLENGE / SECTION 5. ENHANCING IN-HOUSE RISK CAPABILITIES

Section 6 Enhanced governance underpins risk strategy If you ve got a clear mission and clear investment beliefs that underpin it, you can react more quickly to unexpected events or new opportunities. DAVID ALEPPO Head, DB Investment Advisory Services (UK), Willis Towers Watson CLICK TO READ THE FULL Q&A 14 PENSIONS WITH PURPOSE - RISING TO THE RISK CHALLENGE / SECTION 6. ENHANCED GOVERNANCE UNDERPINS RISK STRATEGY

Enhanced governance must underpin the risk strategy whether reducing or increasing risk Pension funds governance frameworks need to be fit for purpose, enabling both investment agility and strong oversight of risks. Percentage planning to take the following actions over the next 3 years 54 % 53 % 52 % 49 % More Return Hunters than Risk Cutters will increase the autonomy of the investment function over the next three years (54 percent versus 39 percent). 39 % 36 % 38 % 36 % A larger number of Return Hunters than Risk Cutters also plan to increase the detail Increase the Change the process Increase transparency Increase the detail and/or frequency of reporting autonomy of the for recruiting new to members about the or frequency of to the board. Over the next investment function board members governance and investment reporting to the board three years, pension funds performance of the fund will provide a higher level of transparency to board members. State Street Asset Owners Survey 2015 Return Hunters Risk Cutters 15 PENSIONS WITH PURPOSE - RISING TO THE RISK CHALLENGE / SECTION 6. ENHANCED GOVERNANCE UNDERPINS RISK STRATEGY

Section 7 Deepening board-level expertise We re embarking on further education that will involve bringing in outside experts for informal gatherings with our trustees to talk about cutting edge issues in investments, in pension plan design, and so on. BARBARA CREED Chair, Church Pension Fund Board of Trustees CLICK TO READ THE FULL Q&A 16 PENSIONS WITH PURPOSE - RISING TO THE RISK CHALLENGE / SECTION 7. DEEPENING BOARD-LEVEL EXPERTISE

Return Hunters are seeking to deepen board-level investment expertise Greater expertise around both investments and risk is needed at board level for those funds that plan to take on higher levels of risk. Over half (53 percent) of Return Hunters plan to change the process for recruiting new board members in the next three years, compared to 36 percent of Risk Cutters. Percentage saying their boards have a high level of understanding of risks facing the retirement fund* Return Hunters Risk Cutters Percentage saying they plan to change the process for recruiting new board members in the next three years Return Hunters Risk Cutters In addition, a higher proportion of Return Hunters say their boards have very strong investment literacy than Risk Cutters. They also have a better understanding of the 43 % 29 % 53 % 36 % overall risks facing the fund. *High level of understanding = self-assessed scores of 9 or 10 on a 1-10 scale. State Street Asset Owners Survey 2015 17 PENSIONS WITH PURPOSE - RISING TO THE RISK CHALLENGE / SECTION 7. DEEPENING BOARD-LEVEL EXPERTISE

CONCLUSION: Enhancing risk management capabilities is mission-critical whatever strategies are adopted Other Resources: Pensions with Purpose Meeting the Retirement Challenge (Full report) Pension Industry Experts Q&A Library The pension industry is united by the need to master risk. Pension funds will be able to grasp the opportunities for transforming their organization and driving returns by accessing the tools and techniques to manage the different exposures they face. The steps they should consider include: Using predictive modeling to obtain a clearer picture of long-term liabilities, and developing new risk Deploying systems that aggregate global data from a diverse range of traditional and alternative asset Recruiting specialists who can master the risk management and analytics tools, while diverse Doing more to take advantage of their long-term liability profile by seizing more investment opportunities in Partnering with external providers to access expertise around less familiar risk exposures, and to gain and performance classes to deliver investment illiquid assets. specialist support metrics that fit a detailed view strategies are in moving toward new or adjusted of their potential pursued. a 360-degree strategies. risks and returns to view of the risks senior managers. facing the fund. 18 PENSIONS WITH PURPOSE - RISING TO THE RISK CHALLENGE / SECTION 8. STRENGTHENING RISK MANAGEMENT IS MISSION-CRITICAL

Research at a Glance This report is based on a State Street survey of 400 senior executives in the pension fund industry conducted by Longitude Research in October and November 2015. Respondents to the global survey included representatives of public and private pension or retirement systems, and superannuation funds across 20 countries. The quantitative research was supplemented by in-depth interviews with 43 pension industry experts from 13 countries. Please note all sources are based on the above State Street survey unless otherwise indicated. Respondents by Region Predominantly board and C-level respondents 29 percent Defined Benefit (DB)-only, 20 percent Defined Contribution (DC)-only, 51 percent have both DB and DC schemes 45% 23% 25% 7% Insights from pension fund board members, in-house and external investment managers, private and public funds, consultants, academics, and State Street experts see our Executive Q&A Library North America Source: Institution Type Latin America & Caribbean Europe Asia Pacific State Street Asset Owners Survey 2015 Range of Total Assets Overseen Private pension or retirement system $10 billion or more 68 22% % Public pension or retirement system 25% $5 billion-$9.9 billion Superannuation fund 7% $1 billion-$4.9 billion 28% 42% $500 million-$999 million 6% Less than $500 million 2% 19 PENSIONS WITH PURPOSE - RISING TO THE RISK CHALLENGE / RESEARCH AT A GLANCE CONTENTS

Glossary of Terms Alternatives: An alternative asset is any type of non-traditional asset that would not be found in a standard investment portfolio. Examples include hedge funds, infrastructure and real estate. Counter-party risk: Counter-party risk is the risk to each party of a contract that the other party will fail to meet their contractual obligations. Dynamic risk management tools: Sophisticated software tools that help investors to identify, analyze and decide how to mitigate one or more risks across a portfolio on a continuous basis, as exposures change over time. Liquidity risk: The risk stemming from the lack of marketability of an investment that cannot be bought or sold quickly enough to prevent or minimize a loss. Market risk: Market risk is the possibility for an investor to experience losses due to factors that affect the overall performance of the financial markets. Market risk cannot be eliminated through diversification, though it can be hedged against. Option strategies: An investor may undertake simultaneous buying and/or selling of stock options to achieve preferable pricing on specific securities. Private pension or retirement system: A private sector fund which pays pensions to its members, accumulated from contributions made by employers, employees, or both. Public pension or retirement system: A public sector fund which pays pensions to its members, accumulated from contributions made by employers, employees, or both. Superannuation fund: An organizational pension program created by a public or private sector employer for the benefit of its employees. Volatility management: Managing the effects on an investment portfolio of the relative rate of price changes of a security. Rapid price movements, up or down, over the short term, means high volatility. If the price of the security hardly changes, it has low volatility. 20 PENSIONS WITH PURPOSE - RISING TO THE RISK CHALLENGE / GLOSSARY OF TERMS CONTENTS

Important Disclosures Investing involves risk including the risk of loss of principal. Equity securities are volatile and can decline significantly in response to broad market and economic conditions. Asset Allocation is a method of diversification which positions assets among major investment categories. Asset Allocation may be used in an effort to manage risk and enhance returns. It does not, however, guarantee a profit or protect against loss. The whole or any part of this work may not be reproduced, copied or transmitted or any of its contents disclosed to third parties without State Street s express written consent. 2016 State Street Corporation All Rights Reserved. Web: www.statestreet.com Tracking Number: CORP-1891 Expiration Date: 04/30/2017 21 PENSIONS WITH PURPOSE - RISING TO THE RISK CHALLENGE / IMPORTANT DISCLOSURES CONTENTS