State Board of Administration FRS Pension Plan Risk Management and Asset Allocation

1. State Board of AdministrationFRS Pension Plan Risk Management and Asset Allocation FGFOA Meeting May 8, 2012 INVESTING FOR FLORIDA’S FUTURE

2. Presentation Outline • SBA Overview • SBA Enterprise Risk Management • FRS Pension Plan Case Study • Pension Finance • Asset Liability Modeling • Asset Allocation • Implementation and Business Model • Other Management Considerations

4. SBA Funds Under Management April 23, 2012 Estimates

5. SBA’s Strategic Risks • Investment Management Risk • Governance/Management Risk • Communication/Public Affairs/Reputational Risk • Legislative/Political Risk • Compliance Risk • Fraud/ Misconduct/ Internal Controls Risk • Service Provider Risk • Client Relationship Risk • Operational Risk • Human Capital Risk • Security Risk • Business Continuity/Infrastructure Risk • Legal Risk

7. SBA Investment Risk Components • Policy Risk • Policy Design Risk • Investment Objective Risk • Capital Market Assumption Risk • Liability Risk • Implementation Risk • Strategy Risk • Portfolio Under Performance Risk • Trading Risk • Asset Transition Risk • Model Risk • Due Diligence Risk • Leverage Risk • Aggregate Issuer/Counterparty Credit Risk • Inherent Risk • Market/Systematic Risk • Idiosyncratic/Unsystematic Risk

8. FRS Pension Plan Case Study • Pension Finance • Asset Liability Modeling • Asset Allocation • Implementation and Business Model

9. Pension Obligations – Future Benefit Cash Flows D Millions of 2011 $ C2 B C1 A A = benefits for current retirees B = benefits already accrued/earned for current employees C1+C2 = benefits yet to be earned for current employees (C1 = portion allocated by actuarial method for past service) D = benefits for future employees

10. FRS Pension Plan Investment Policy Objective • … provide investment returns sufficient for the plan to be maintained in a manner that ensures the timely payment of promised benefits to current and future participants and keeps the plan cost at a reasonable level. • To achieve this, a long-term real return approximating 5% per annum (compounded and net of investment expenses) should be attained, consistent with the actuarial investment return assumption of 7.75%. • As additional considerations, the Board seeks to avoid excessive risk in long-term cost trends. • To manage these risks, the volatility of annual returns should be reasonably controlled.

11. Economic Simulation Interest Rates Asset Returns Inflation Actuarial Assump. Asset Growth Liability Growth Asset Smoothing Actuarial Methods Plan Cost & Funded Status Structure Of Asset-Liability Model

12. U.S. Equity Return • For the 2012 asset liability update we used an equity risk premium assumption equal to 4.36%, the average of the assumptions used by the four SBA investment consultants. The resulting expected average compounded return for U.S. equities is equal to 7.4% (the U.S. bond expected return of 3.0% plus the equity risk premium of 4.4%): All returns are 15-year geometric average expected returns.

13. FRS Pension Plan Return & Risk Assumptions Risk Assets Fixed Income

14. Range of Possible 15-Year Compound Returns -- Nominal Percentile: 95th 7.75% actuarial assump. ( 50% probability ) 75th 50% confidence range: from 4.7% to 10.5% 50th %-tile = 7.8% (median value) 90% confidence range: from -0.1% to 13.8% 50th Best estimate = 7.4% (mean value) 25th 5th

15. Range of Funded Ratios –Current Asset Allocation Policy Trend line Dark shaded area indicates the 50% probability zone, and light shaded area indicates the 90% probability zone.

16. Range of Employer Contribution Rates (DB Plan Only) – Current Asset Allocation Policy Trend line Dark shaded area indicates the 50% probability zone, and light shaded area indicates the 90% probability zone.

17. Risk / Reward AnalysisBased On Long-Term Economic Cost Current Mix Lower cost Less risk More risk Diagonal line = 3-to-1 risk/reward benchmark Avg. Cost Savings ($MM) (All 500 scenarios) Higher cost Avg. Risk Increase ($MM) (Worst 100 scenarios) Change in cost relative to values using current mix

18. 2011 Asset Liability Update: Diversification Impact Diversification changes can improve the results. The Recommended policy offers long-term cost savings of $2.3 billion, with no material change in risk profile Recommended Policy (with diversification) Increased diversification shifts curve in favorable direction Avg. Cost Savings ($MM) (All 1,000 scenarios) June 2010 Policy (before diversification) Avg. Risk Increase ($MM) (Worst 200 scenarios)

19. Investment Policy Themes: Enhancing diversification and taking risk more efficiently • Maintain or reduce the overall level of investment risk in the fund • Reduction in the fund’s overall exposure to global stock markets • Decrease in the fund’s use of active management in the public stock and bond markets • Further increase diversification of investments • Greater global diversification within the publicly traded stock investments • Greater diversification into a broader array of investment types (i.e. alternative investments) that do not necessarily fluctuate with stock markets • Increase flexibility to take investment risks more efficiently • Downside protection from volatile markets through bond investments • Participate in worldwide economic growth through stock investments • Generate above market returns, with strong risk controls, through skillful opportunistic investing

20. FRS Pension Plan Asset Allocation Policies *Prior to July 2010, Global Equity was composed of two asset classes, Domestic Equities and Foreign Equities, with target allocations of 38% and 20%, respectively. ** Global Equity asset class includes existing Domestic Equity, Foreign Equity and Global Equity mandates; Strategic Investments includes existing High Yield allocation. *** In recognition of the dynamic nature of this asset class, there is no specific expected weight. Its actual allocation will vary within the policy range depending on the mix of included strategies at any given time. When the actual allocation of Strategic Investments is greater than zero, all other asset class target allocations shall be reduced pro-rata.

21. Strategic Investments Detail • Allocations reflect current expectations for future allocations in Strategic Investments for modeling purposes. Actual allocations, including possible investments in commodities and timberland, will vary dependent on identification of attractive opportunities.

23. FRS Pension Plan Net Managed and Target Returns As of March 31, 2012

24. FRS Results Relative to TUCS Top Ten Defined Benefit PlansPeriods Ending 12/31/2011 Total FRS (Gross) Top Ten Median Defined Benefit Plan Fund (Gross) 15.0 11.2 11.0 10.0 5.5 5.4 4.5 5.0 3.9 2.8 2.2 2.0 0.0 -0.3 Rate of Return (%) -5.0 -10.0 -15.0 Quarter 1-Year 3-Year 5-Year 10-Year Note: The TUCS Top Ten Universe includes $1.1 trillion in total assets. The median fund size was $112.5 billion and the average fund size was $109.7 billion. 24

25. Comparison of Asset AllocationAs of 12/31/2011 Strategic Investments Cash Cash 4.1% 0.7% 2.1% Private Equity 4.9% Alternatives 17.6% Real Estate 7.4% Global Equity** Global Equity* 56.9% Real Estate 46.8% 6.3% Fixed Income 26.0% Fixed Income 27.3% FRS Pension Plan vs. Top Ten Defined Benefit Plans FRS TOTAL FUND TUCS Top Ten **Global Equity Allocation: 28.9% Domestic Equities; 17.9% Foreign Equities. *Global Equity Allocation: 25.5% Domestic Equities; 28.7% Foreign Equities; 2.8% Global Equities. Percentages are of the Total FRS Fund. Note: The TUCS Top Ten Universe includes $1.1 trillion in total assets. The median fund size was $112.5 billion and the average fund size was $109.7 billion. 25

26. Hedge Fund Return and Risk Attributes Outperformance Lower Risk Growth of a Dollar Jan 1994 – Dec 2010 Annualized Volatility Jan 1994- Dec 2010

27. FRS Pension Plan Cost Comparison to CEM Peer Group Cost Effectiveness Measurement (“CEM”) maintains a global database of detailed cost information provided by public and corporate pension plans. The SBA’s 2010 CEM Peer Group included 16 U.S. plan sponsors with assets from $22.5 billion to $225.6 billion. 27

28. High Level Investment Guidelines Public market asset classes shall be well diversified with respect to their benchmarks and have a reliance on low cost passive strategies scaled according to the degree of efficiency in underlying securities markets, capacity in effective active strategies, and ongoing total fund liquidity requirements. Private Equity, Real Estate and Strategic Investments asset classes shall utilize a prudent process to maximize long-term access to attractive risk-adjusted investment opportunities through use of business partners with appropriate: Financial, operational and investment expertise and resources; Alignment of interests; Transparency and repeatability of investment process; and Controls on leverage.

29. FRS Pension Plan Asset Class Allocations February 2012

33. Looking Forward: 2012 FRS Pension Plan Asset Liability Update • Supports continuation of the current multi-year implementation of increased allocations to real estate, private equity, and strategic investments, but identifies changes to be considered • Conflicting indicators on best portfolio risk target – some supporting an increase in risk and some supporting a decrease in risk • Growing importance of liquidity management over intermediate-term • Re-emphasizes the value of diversification • The funding policy has a direct impact on some of the investment policy risk-reward analysis • Deferring actuarially recommended contributions (“UAL”) • Treatment of 2011 benefit changes • Actuarial assumptions • Amortization and other actuarial cost methods