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

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 The Structure of PSPRS 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.

8. PSPRS Annual AggregateActuarial Valuation

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

14. Rate Components and Funding Levels Understanding the Actuarial Valuation

15. Components of the Actuarial Valuation • 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. Future Normal Cost Actuarial Liability Normal Cost

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

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

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

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

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

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

22. So Why Have Contribution Rates Been Increasing?

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

24. So Why Has the Contribution Rate Been Increasing?

25. Comparison of COLA Provisions

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

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

28. SB1609 ReversalImpact on Employer Contributions 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

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

31. PSPRS Investment Strategy Towards a more resilient portfolio

32. Portfolio is managed according to a set of investment beliefs • Mandate to achieve assumed earnings rate of at least 7.85% over long-periods of time • Markets are difficult to time so diversification offers the best chance to achieve the assumed earnings rate • Investment universe should be as wide as possible so as to increase likelihood of accomplishing diversification • Risk is defined as the potential for a loss of capital. It can be approximated using statistical conventions but will never be exact • 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 • Making sound decisions requires not only robust quantitative models but sound human judgment. People make models better and models make people better • 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 • 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. • 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? 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 ManagementThere are numerous asset classes but they usually fit in one of four quadrants *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.

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 26 19 14 16 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. Ratio of PSPRS Risk to 60/35/5 Risk 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)

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. police pension study GFOAz Conference August 7, 2014

46. Our key statistics – PD only

47. “no one is average” The Town’s Unfunded Liability is the Most Significant Factor in Our Contribution Rate

48. Study results: unfunded liability Actual Experience Has Not Matched Projections in the Following Areas: • Investment Earnings (Can’t Control) • Court Rulings (Can’t Control) • Retirees Outnumber Actives (CAN INFLUENCE) • Benefits Have Been Earned

49. PV vs. PSPRS in FY 12-13actives vs. retirees

50. Study results- Why our retirees outnumber employees • Relatively Constant Number of Active Positions • Only Hire Laterals • Large Number of Disability Retirements with Less Than 20 Years of Service • DROP Program