COMMONWEALTH OF PENNSYLVANIA PUBLIC SCHOOL EMPLOYEES RETIREMENT SYSTEM. Frequently Asked Questions About PSERS Investments

COMMONWEALTH OF PENNSYLVANIA PUBLIC SCHOOL EMPLOYEES RETIREMENT SYSTEM Frequently Asked Questions About PSERS Investments Updated: August 2016

Table of Contents What are PSERS Investment Objectives? How Does PSERS Achieve its Return Objectives? PSERS Success Blending Passive and Active Strategies How Does PSERS Evaluate its Investment Manager Fees? PSERS Investments are a Profit Center Why Does PSERS Invest in Hedge Funds, Private Equity and Private Real Estate? Has PSERS Achieved its Investment Objectives? How Have PSERS Investments Benefitted the Commonwealth? 1

What are PSERS Investment Objectives? RETURN: to meet or exceed the actuarial rate (currently 7.25%) over the long-term. RISK: to minimize the risk of losses through diversification. CONSTRAINTS: To maintain adequate liquidity to meet required benefit payments; and To act solely in the interests of the members of the System and for the exclusive benefit of the System s members, and their beneficiaries. 2

What are PSERS Investment Objectives? RETURN OBJECTIVE: The overall return objective is to realize a return sufficient to achieve funding adequacy on an inflation-adjusted basis. The System has a return objective of meeting or exceeding the actuarial rate (currently 7.25%) over the long-term. In addition, the Board has the following broad objectives: The assets of the System shall be invested to maximize the returns for the level of risk taken; and, The System shall strive to achieve a return that exceeds PSERS Policy Index. 3

What are PSERS Investment Objectives? RISK OBJECTIVES: The assets of the System shall be diversified to minimize the risk of losses within any one asset class, investment type, industry or sector exposure, maturity date, or geographic location. Failure to do so could seriously impair the System s ability to achieve its funding and long-term investment goals and objectives; and, The System s assets shall invested so that the probability of investment losses (as measured by the Policy Index) in excess of 15% in any one year is no greater than 2.5% (or two standard deviations below the expected return). 4

What are PSERS Investment Objectives? CONSTRAINTS: Downside Risk, or the risk of loss of capital The Commonwealth and school districts already face significant fiscal challenges. Large investment losses could result in even larger requirement for employer contributions. Risk-averse investment strategies that limit the probability of losses are most appropriate in this environment. Liquidity Risk PSERS currently pays out over $6 billion in member benefits annually. Member benefit payments exceeded employee and employer contributions by over $3.1 billion in FY 2008, and have modestly shrunk to $2.6 billion for FY 2015. Maintaining adequate short term liquidity is an expense to the taxpayer because it limits PSERS ability to achieve long term return objectives. 5

What are PSERS Investment Objectives? CONSTRAINTS (con t) Fiduciary Standard: Commonwealth law requires PSERS investments to be made solely for the benefit of the members. Prudent Person Standard: Commonwealth law requires PSERS Board exercise that degree of judgment, skill and care under the circumstances then prevailing which persons of prudence, discretion and intelligence who are familiar with such matters exercise in the management of their own affairs. 6

Table of Contents What are PSERS Investment Objectives? How Does PSERS Achieve its Return Objectives? PSERS Success Blending Passive and Active Strategies How Does PSERS Evaluate its Investment Manager Fees? PSERS Investments are a Profit Center Why Does PSERS Invest in Hedge Funds, Private Equity and Private Real Estate? Has PSERS Achieved its Investments Objectives? How Have PSERS Investments Benefitted the Commonwealth? 7

How Does PSERS Achieve its Return Objectives? ASSET ALLOCATION POLICY The mix of stocks, bonds, and other classes of investment assets targeted by the fund. The Asset Allocation Policy is typically responsible for 80% to 90% of investment performance. MANAGER SELECTION AND ALLOCATION TILTS Mix of Active/Passive and other investment strategies within and between asset classes. Typically responsible for about 10% to 20% of investment performance. 8

How Does PSERS Achieve its Return Objectives? Asset Allocation Considerations: PSERS investment time horizon; Capital market assumptions (e.g., expected return, risk, correlations); Return targets; Demographics of plan participants and beneficiaries, and actuarial analysis; Cash flow requirements; PSERS funded status; The Commonwealth s and School Districts financial strength; and The Board s willingness and ability to take on risk. PSERS asset allocation plan is designed to meet the unique needs of a defined benefit system that is currently underfunded and had been receiving employer contributions below the actuarial required contribution for over 10 years. 9

How Does PSERS Achieve its Return Objectives? Manager Selection Criteria: Have a unique insight or process; Have the ability to add consistent excess returns above passive alternatives, net of fees; Process is sustainable and timeless; Have adequate capacity to execute the strategy; Add diversification to our existing investment structure; Do not exhibit style drift; and Exhibit a high level of ethical behavior. 10

How Does PSERS Achieve its Return Objectives? Passive and active strategies each play important roles Passive Strategies Active Strategies Investment Goal Endeavor to achieve the return of the targeted market over extended periods Endeavor to exceed the return of the targeted market over extended periods Costs Generally lower (less management need) Generally higher (more management required) Investment Risks Availability in Public Markets Availability in Private Markets Generally exhibit volatility similar to the index replicated Nearly all public markets; effectiveness is usually good in deep, developed markets but less effective in smaller and emerging markets Rarely available in private markets Varies greatly depending on strategy details All public markets; effectiveness often struggles in deep, developed markets but is often more effective in smaller and emerging markets Well-developed market for institutional investors 11

Table of Contents What are PSERS Investment Objectives? How Does PSERS Achieve its Return Objectives? PSERS Success Blending Passive and Active Strategies How Does PSERS Evaluate its Investment Manager Fees? PSERS Investments are a Profit Center Why Does PSERS Invest in Hedge Funds, Private Equity and Private Real Estate? Has PSERS Achieved its Investments Objectives? How Have PSERS Investments Benefitted the Commonwealth? 12

PSERS Success Blending Passive and Active Strategies When passive strategies are appropriate, PSERS staff have outperformed outsourced alternatives. Comparison of Net of Fees Performance of Vanguard S&P 500 Index versus PSERS S&P 500 Index For Years Ending December 31, 2015 Vanguard S&P 500 PSERS S&P 500 PSERS Outperformance 1 Year 1.25% 1.43% 0.18% 5 Year 12.40% 12.65% 0.25% 10 Year 7.18% 7.61% 0.43% 13

PSERS Success Blending Passive and Active Strategies PSERS has better returns than passive alternatives, even with fees and expenses taken into account, at lower levels of risk. Comparison of Net of Fee Annualized Performance of PSERS Total Fund versus Policy Benchmark For Years Ending December 31, 2015 1 3 5 10 Performance PSERS -1.80% 5.08% 6.15% 5.01% Policy Benchmark -2.49% 3.24% 4.14% 3.72% Value Added as Percentage over Pure Index 0.69% 1.84% 2.01% 1.29% Value Added in $ Billions over Pure Index $0.32 $0.86 $0.94 $0.60 Sharpe Ratio Standard Deviation 1 3 5 10 PSERS -0.31 1.02 1.2 0.42 Policy Benchmark -0.45 0.71 0.83 0.32 PSERS 5.54% 4.95% 5.08% 10.39% Policy Benchmark 5.37% 4.63% 4.97% 9.15% 14

Table of Contents What are PSERS Investment Objectives? How Does PSERS Achieve its Return Objectives? PSERS Success Blending Passive and Active Strategies How Does PSERS Evaluate its Investment Manager Fees? PSERS Investments are a Profit Center Why Does PSERS Invest in Hedge Funds, Private Equity and Private Real Estate? Has PSERS Achieved its Investment Objectives? How Have PSERS Investments Benefitted the Commonwealth? 15

How Does PSERS Evaluate its Investment Manager Fees? Integrated with asset allocation & investment manager selection processes. PSERS contracts require lowest fees offered ( Most Favored Nation ). Business Case: For the fees to be paid, how likely is it that the investments will be profitable? 16

Table of Contents What are PSERS Investment Objectives? How Does PSERS Achieve its Return Objectives? PSERS Success Blending Passive and Active Strategies How Does PSERS Evaluate its Investment Manager Fees? PSERS Investments are a Profit Center Why Does PSERS Invest in Hedge Funds, Private Equity and Private Real Estate? Has PSERS Achieved its Investment Objectives? How Have PSERS Investments Benefitted the Commonwealth? 17

PSERS Investments are a Profit Center The success of PSERS investment activities should be evaluated as any business by asking: ARE PSERS INVESTMENTS PROFITABLE TO THE COMMONWEALTH? 18

PSERS Investments are a Profit Center Fiscal Year Ended June 30 Actual Investment Return above Policy Benchmark Return, Before Fees ("REVENUES") Fees ("COSTS") Actual Investment Return above Policy Benchmark Return, After Fees ("PROFIT") 2015 $ 952 $ 455 $ 497 2014 $ 2,001 $ 482 $ 1,519 2013 $ 1,801 $ 558 $ 1,243 2012 $ 1,381 $ 481 $ 900 2011 $ 2,088 $ 515 $ 1,573 2010 $ 2,276 $ 522 $ 1,754 2009 $ (2,653) $ 478 $ (3,131) 2008 $ (219) $ 399 $ (618) 2007 $ 2,674 $ 314 $ 2,360 2006 $ 1,846 $ 211 $ 1,635 $ 12,148 $ 4,415 $ 7,733 Dollar amounts in millions. Fees are actual total investment expenses, and include investment management fees, service provider fees (e.g., custodian), consultant fees, and overhead (personnel, technology, etc.) 19

PSERS Investments are a Profit Center Over the last 10 fiscal years, PSERS earned $12.1 billion OVER indexed market returns, incurred $4.4 billion in investment expenses, and earned a profit of $7.7 billion. Actual Investment Return above Policy Benchmark, Before Fees ("REVENUES") 2006-2015 Total $ 12,148 Fees ("COSTS") $ 4,415 Actual Investment Return above Policy Benchmark, After Fees ("PROFIT") $ 7,733 Dollar amounts in millions. 20

Table of Contents What are PSERS Investment Objectives? How Does PSERS Achieve its Return Objectives? PSERS Success Blending Passive and Active Strategies How Does PSERS Evaluate its Investment Manager Fees? PSERS Investments are a Profit Center Why Does PSERS Invest in Hedge Funds, Private Equity and Private Real Estate? Has PSERS Achieved its Investment Objectives? How Have PSERS Investments Benefitted the Commonwealth? 21

Why Does PSERS Invest in Hedge Funds, Private Equity, and Private Real Estate? Hedge Funds, Private Equity, and Private Real Estate are expensive asset classes: In isolation, fees paid to managers in these asset classes are higher than fees paid in other asset classes. Reasons why fees are higher can include: Larger management teams. Greater infrastructure needs. Limited capacity (not scalable like an index). Supply vs. demand leads to higher costs. Unique strategies are difficult to replicate. Intellectual capabilities. Proprietary insights. 22

Why Does PSERS Invest in Hedge Funds? To generate returns that are uncorrelated to equity, fixed income, and commodity markets: Improves diversification, reduces investment risks. Proprietary strategies take advantage of market inefficiencies. Access to top-quartile investment managers to implement these strategies. 23

Why Does PSERS Invest in Private Equity? Attractive excess returns can be achieved over public equity: Market inefficiencies in private markets. Illiquidity premium expected for committing capital for periods in excess of 5 years. Access to top-quartile managers and excellent consulting relationships to exploit these inefficiencies. Greater diversification using both public and private equities reduces investment risks. 24

Why Does PSERS Invest in Private Equity? PSERS Private Equity investments have outperformed publicly traded stocks, net of all investment management fees $12 PSERS Private Equity through September 2015 Actual NAV versus if Invested in VITSX ($ amounts in billions) $10 $8 $6 $7.79 $4 $2 $0 $2.08 1998 Dec 1999 Jun 1999 Dec 2000 Jun 2000 Dec 2001 Jun 2001 Dec 2002 Jun 2002 Dec 2003 Jun 2003 Dec 2004 Jun 2004 Dec 2005 Jun 2005 Dec 2006 Jun 2006 Dec 2007 Jun 2007 Dec 2008 Jun 2008 Dec 2009 Jun 2009 Dec 2010 Jun 2010 Dec 2011 Jun 2011 Dec 2012 Jun 2012 Dec 2013 Jun 2013 Dec 2014 Jun 2014 Dec 2015 Jun PSERS Private Equity Vanguard Total Stock Market Index Fund (VITSX) 25

Table of Contents What are PSERS Investment Objectives? How Does PSERS Achieve its Return Objectives? PSERS Success Blending Passive and Active Strategies How Does PSERS Evaluate its Investment Manager Fees? PSERS Investments are a Profit Center Why Does PSERS Invest in Hedge Funds, Private Equity and Private Real Estate? Has PSERS Achieved its Investment Objectives? How Have PSERS Investments Benefitted the Commonwealth? 26

Has PSERS Achieved its Investment Objectives? PSERS has better returns than its targeted policy benchmark, even when all fees and expenses are taken into account: Annualized Net of Fee Performance for Years Ending December 31, 2015 1 3 5 10 PSERS -1.80% 5.08% 6.15% 5.01% Policy Benchmark -2.49% 3.24% 4.14% 3.72% Value-added % 0.69% 1.84% 2.01% 1.29% 27

Table of Contents What are PSERS Investment Objectives? How Does PSERS Achieve its Return Objectives? PSERS Success Blending Passive and Active Strategies How Does PSERS Evaluate its Investment Manager Fees? PSERS Investments are a Profit Center Why Does PSERS Invest in Hedge Funds, Private Equity and Private Real Estate? Has PSERS Achieved its Investment Objectives? How Have PSERS Investments Benefitted the Commonwealth? 28

How Have PSERS Investments Benefitted the Commonwealth? Pennsylvania-based investment managers or partnerships were managing 34.7% of PSERS assets, or $16.2 billion, as of December 31, 2015. This includes portfolios managed by staff and 39 Pennsylvania-based investment managers or partnerships. 29

How Have PSERS Investments Benefitted the Commonwealth? Summary of Investments in Pennsylvania as of December 31, 2015 Asset Class ($'s in millions) Total PA Market Total PA Market Value (PSERS' Value (Total Portion) Invested) # of People Employed Payroll U.S. Equities $ 175.7 $ 175.7 * * Fixed Income $ 61.5 $ 61.5 * * Private Real Estate $ 79.8 $ 2,327.4 290 $ 6.8 Private Markets: Venture Capital $ 121.4 $ 408.9 3,419 $ 77.9 Private Equity $ 1,073.1 $ 13,512.5 22,492 $ 535.7 Private Debt $ 201.7 $ 1,689.7 8,426 $ 207.6 Total $ 1,713.2 $ 18,176.0 34,627 $ 828.0 *Statistics for publicly traded companies not included due to the difficulty in obtaining the information. 30

How Have PSERS Investments Benefitted the Commonwealth? More Investment Earnings = Lower Employer Contributions from both School Districts and the Commonwealth. Investments in PA Businesses = PA Employment + PA Corporate and Real Estate Tax Revenue. 31

COMMONWEALTH OF PENNSYLVANIA PUBLIC SCHOOL EMPLOYEES RETIREMENT SYSTEM Frequently Asked Questions About PSERS Investments Updated: August 2016