San Jose Pension Plans 20171220 - SIEPR · Analysis of San Jose Retirement Investment Portfolios 3...

Joe Nation, Ph.D.

Olympia Nguyen Tulloch

Clive Lipshitz

November 20, 2017

Working Paper No. 17-039

Analysis of City of San Jose Retirement Plans

Investment Portfolios

AnalysisofCityofSanJoseRetirementPlansInvestmentPortfoliosCityofSanJosePoliceandFireDepartmentRetirementPlanSanJoseFederatedCityEmployees’RetirementSystem

JoeNation,Ph.D.*OlympiaNguyenTulloch

CliveLipshitzNovember20,2017

*NationistheProjectDirectorforPensionTracker;NguyenisthePensionTrackerProjectManager;LipshitzservedasaconsultantforthisWorkingPaper.SydneyMaplesandNicolasPenaBrownservedasResearchAssistantsforthisPaper.GregRosstonreviewedthisWorkingPaper.

AnalysisofSanJoseRetirementInvestmentPortfolios

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IntroductionSanJosevotersapproveda2016taxincreaseinpartonanassertionthatincrementalrevenueswerenecessarytofundmaintenanceofessentialinfrastructureandenhanceemergencyservices.Inpractice,however,muchoftheincrementalrevenuesisbeingdirectedtotheCity’sunderfundedpublicpensionplans.1ThisWorkingPaperanalyzesSanJose’stwopublicpensionplans:theCityofSanJosePoliceandFireDepartmentRetirementPlan(referredtohereinas“Police&Fire”),andtheCityofSanJoseFederatedEmployees’RetirementSystem(referredtohereinas“Federated”).Themethodologyweuseisafinancialstatement-basedevaluation.Weexaminenumerousfactors,includingfundedstatusandtheimpactofdiscountrateassumptions,assetallocation,investmentperformance,theimpactofdemographicsandemployment,theimpactof(andon)stakeholders(employees,retirees,andtaxpayers),andtheefficiencyofinvestmentofficemanagement.Toprovidecontext,weevaluatetheSanJoseplanswithinapeergroupofpublicpensionsystemswithsimilarlevelsofplanassets.ThisincludespublicplanssponsoredbyvariousSanFranciscoBayAreacountiesandbycitiesinotherpartsofthecountry.OuractuarialanalysisisbasedondataasoftheendofthemostrecentFiscalYear(FY),asspecifiedinTable1.PerformancedatareflectthecalendaryearendingDecember31,2016unlessotherwisenoted.

1Giwargis,Ramon,“WillSanJose’spensioncostsconsumerevenuefromnewtaxes?”SanJoseMercuryNews,February20,2017,http://www.mercurynews.com/2017/02/20/will-san-joses-pension-costs-consume-revenue-from-new-taxes/.Conversationswithcitystaffconfirmthatalargeshareofnewrevenuesarefundingpensioncosts.


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Table1–PeerGroup,SelectMetrics Pension

LiabilityPlan

AssetsFundedRatio

Members AsofDate

MunicipalPopulation

$mm $mm mmCityofSanJosePoliceandFireDepartmentRetirementPlan(Police&Fire)

4,220 3,044 72.1% 3,731 Jun-16 1.03

CityofSanJoseFederatedCityEmployeesRetirementSystem(Federated)

3,692 1,859 50.4% 7,300 Jun-16 1.03

SeattleEmployeesRetirementSystem(SCERS)

3,793 2,489 65.6% 15,533 Dec-16 0.70

ContraCostaCountyEmployees’RetirementAssociation(CCCERA)

8,839 7,439 84.2% 18,948 Dec-16 1.14

AlamedaCountyEmployees’RetirementAssociation(ACERA)

8,411 6,168 73.3% 19,132 Dec-16 1.65

FresnoCountyEmployees’RetirementAssociation(FCERA)

5,542 4,009 72.3% 13,446 Jun-16 0.98

SanDiegoCityEmployees’RetirementSystem(SDCERS)

9,609 6,808 70.8% 16,425 Jun-16 1.41

DallasPoliceandFirePensionSystem(DPFP)

8,491 2,168 25.5% 9,560 Dec-16 1.32

Employees’RetirementFundoftheCityofDallas(DallasERF)

4,292 3,352 78.1% 15,730 Dec-16 1.32

DistrictofColumbiaPoliceOfficersandFireFighters’RetirementFund(DCPolice&Fire)

4,676 4,954 106.0% 8,362 Sep-16 0.68

Source:PensionplandatafromComprehensiveAnnualFinancialReports.PopulationdatafromUnitedStatesCensusBureau,estimateasofJuly1,2016.Here,andelsewhere,wesimplifyanalysesthatmakeuseofmembercountbyincludingonlyannuitants(retiredmembersearningbenefits)andactivemembers(thosepayingcontributionsandnotyetreceivingbenefits);weexcludeinactivemembersnotreceivingbenefits.

DeteriorationinFundedStatusThefundedstatusofapensionplanistheratioofnetplanassetstoactuariallycalculatedliabilities.Figure1illustratesthedeteriorationinthefundedstatusofthePolice&Fireplanfromalmost118%in2006to72%in2016andoftheFederatedplanfrom90%to49%overthatperiod.


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Figure1–FundedStatusofSanJosePlans(2006,2011,2016)

Source:ComprehensiveAnnualFinancialReports.ThistrendisnotuniquetotheSanJoseplans;ithasbeenwelldocumentedacrosstheU.S.publicpensionsystems.Figure2illustratesthefundedstatusofthepeergroupovertheprecedingfouryears.

2006

20062011

20112016

2016

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Figure2–FundedRatiosofPeerGroup(2013-2016)

Source:ComprehensiveAnnualFinancialReports.FrameworkforAnalysisThisdeclineinfundedstatusisdrivenbymarketperformanceanddemographicfactors.Itishelpfultoanalyzetheimpactofthesefactorsthroughevaluationofplanfinancialstatements,specificallybylookingat:

• Thediversifiedportfolioofinvestmentsheldintrustforbeneficiaries,commonlyreferredtoasnetplanposition,orsimply,planassets;

• Planliabilities,calculatedasthepresentvalueoffuturebenefitpaymentsestimatedbyplanactuaries,discountedbyanactuarially-determinedratewhich,perGovernmentalAccountingStandardsBoard(GASB)rules,aregenerallybasedontheexpectedportfolioreturnsonportfolioofplanassets;and

• Changesinnetplanposition,whichcanbethoughtofasacashflowstatement(althoughitisreportedonanaccrualbasis)thatreflectsthenetimpactonplanassetsofinflowsfromannualcontributionsbyplanmembersandtheiremployingagencies,outflowsfrombenefitpaymentstoannuitants,planadministrationexpenses,andthenetcontributionfromplaninvestments.

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2013 2014 2015 2016Police&Fire Federated SCERS CCCERAACERA FCERA SDCERS DPFPDallasERF DCPolice&Fire


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Pensionplanswithagrowingfundinggaphavethreetoolsattheirdisposal:benefitreform,contributionpolicy,andportfoliomanagement.Ouranalysisfocusesonthethirdofthese.AssetAllocationandPlanLiabilitiesTheinvestmentprogramofapensionplanisguidedbyanInvestmentPolicyStatementapprovedbytheplan’sfiduciary(aboardcomprisedofsomecombinationofrepresentativesofthebeneficiarypopulationandofthesponsoringmunicipality,whichmayincludepublicsectororotherpoliticalappointeesand/ortrusteeswithinvestmentexperience).Generallyguidedbyinvestmentconsultants,thefiduciarydeterminesalong-termtargetassetallocation,fromwhichcanbedeterminedaweighted-averagebenchmarkreturn.Investmentstaff,typicallyledbyaChiefInvestmentOfficeroverseenbythefiduciaryoraninvestmentcommitteeappointedbythefiduciary,managestheinvestmentprogramtoattempttoearnatleastthereturnsofthisbenchmark.Variousfactorsgointotheformulationoftheinvestmentpolicy,includingthestructureanddurationofplanliabilitiesaswellasliquidityneeds.Investmentstaffmanagetheportfoliotoachievetheinvestmentgoalsbyconstructingadiversifiedportfolioofassetsthatoptimizesreturnsforareasonablelevelofrisk.Table2illustratestheinvestmentobjectiveandtargetallocationofeachassetclassintheSanJoseplans’portfolios.Werestrictourportfolioevaluationtothelevelofassetclassallocationsanddonotexploretheunderlyingfundcommitmentsanddirectinvestmentsmadebytheplans.


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Table2–AssetAllocationsofSanJosePlans(Current) TargetAllocations

Assetclass Objective FederatedPolice&Fire

Globalequity Passiveandactivestrategiesonaglobalbasis. 28% 31%

Privateequity

Outperformancerelativetopublicequities.Focusonleadingmanagers.Primaryfundexposures(upto80%),co-investmentsandsecondaries(upto40%).NorthAmerica(40-55%),Europe(35-45%),restofworld(upto15%).Diversifiedacrossvintageyears.Primaryfundcommitments:buyouts(upto80%),specialsituations(upto30%),venturecapital(upto20%). 9% 8%

Globalfixedincome

Enhancingreturnsthroughlowcorrelationwithequitymarkets,totalreturnsacrossallmarketenvironments,andcurrentincome.Globalcore(25-100%),non-investmentgrade(upto50%),emergingmarketdebt(upto50%). 19% 16%

Privatedebt

TargetS&PGlobalLeveragedLoanIndex+2%.Seniorloans/directlending(25-100%),mezzanine/subordinateddebt(upto25%),distresseddebt(upto25%),nichestrategies(upto75%). 5% 11%

Absolutereturn

Target3-monthLibor+5%withrealizedvolatilityof4-8%,andabetatoMSCIWorldIndexoflessthan-.2.Relativevalue(25-50%),macro/directional(35-75%),equitylong-short(upto10%),eventdriven(upto10%). 11% 6%

GTAA/opportunistic

Multi-assetactively-managedstrategies,includes"opportunistic"componentexpressedthroughtacticalshort-to-mediumterminvestmentsona"bestideas"basis. 5% 10%

RealAssets

Diversification(lowcorrelation),inflationprotection.Public,private,active,andpassivemanagersonadirectandfund-of-fundsbasis,throughseveralsub-assetclasses 23% 17%

RealEstate

Corepublicandprivate(open-endandclosedend),value-add,opportunistic,anddebtfunds,onaprimaryfundandfund-of-fundsbasis,aswellasdirectpropertyholdingsandlistedsecurities. 7% 7%

CommoditiesAgriculture,energy,livestock,industrialmetals,andpreciousmetals. 6% 7%

Infrastructure

Core,value-add,andopportunisticstrategiesonaprimaryfundandfund-of-fundsbasis,aswellasinlistedsecurities,mayincludedebtinvestmentsaswellassingleassetinvestments. 5% 3%

NaturalResourcesDiversification,inflationprotection(crudeoil,copper,timber,agriculturalproducts). 5% 0%

Cash 0% 1%

Sources:InvestmentPolicyStatementsofthePoliceandFirePlan(1/5/17)andtheFederatedPlan(1/19/17).


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Overthepastdecade,portfoliosacrossthepublicpensionplansystemhaveevolved.Theuniverseofpotentialinvestmentinstrumentshasbecomemoresophisticated,andinvestmentofficershavebecomeincreasinglyconfidentwithallocationstomoreesotericinvestmentstrategies.Thishasledtoincreaseddiversificationandallocationstoalternativeinvestments2,includinglessliquidassets.Figure3illustrateshowthetargetallocationsoftheSanJoseplansevolvedbetween2006and2016.Byallocatingmoretoassetclassessuchasprivateequity,realestate,andinfrastructure,investmentprogramsaccessreturnstreamsbeyondthoseavailableinthepublicmarkets.Additionally,theseilliquidassetclassesprovideinvestmentprogramswiththebenefitsofilliquiditypremia3andarearguablywell-suitedtomatchthelonger-durationofpensionplanliabilities.Ithasbecomeevidentthatcertainalternativeassetclasses,suchascommoditiesandabsolutereturnstrategieshavenotgeneratedconsistentafter-feereturnsrequiredtomeetpensionsystems’targetreturns.Figure3–TargetAssetAllocationsofSanJosePlans(2006and2016)

Source:ComprehensiveAnnualFinancialReports.2Thereisdebatewhatconstitutesanalternativeinvestment.Ingeneral,alternativeinvestmentassetsarenotstocks,bondsorcash.3Whiletheacademicliteratureisequivocalabouttheexistenceofanilliquiditypremiumovertheverylongterm;thereisresearcharguingforapremiumoverthemediumterm.Seeforexample–Staub,Renato,“ModelingIlliquidityPremiumsforAlternativeInvestments,”CFAInstituteConferenceProceedingsQuarterly,June2010:40.

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Mar-06 Mar-17 Mar-06 Mar-17

Cash

NaturalResources

Infrastructure

Commodities

RealEstate

GTAA/opportunistic

Absolutereturn

Privatedebt

Globalfixedincome

Privateequity

Globalequity

Police&Fire Federated


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Targetallocationsaregenerallyexpressedintermsofranges;actualallocationsregularlydriftslightlyfromthesetargets.Reasonsforthesedeviationsincludetacticaldecisionstoover-orunderweightaparticularassetclassforafiniteperiodoftime,theneedtorotateintooroutofassetclasseswhenallocationtargetschange,andthelatencyinherentindrawdownofcapitalcommitmentsorreinvestmentofproceedsfromrealizedgains.Table3illustratesthevariancebetweentargetandactualallocationsasatDecember31,2016forthetwoSanJoseplans.Table3–TargetandActualAllocationsofSanJosePlans(December31,2016) Police&Fire Federated Target Actual Variance Target Actual VarianceGlobalequity 31.0% 30.5% -0.5% 28.0% 30.6% 2.6%Privateequity 8.0% 7.8% -0.2% 9.0% 3.0% -6.0%Globalfixedincome 16.0% 16.0% 0.0% 19.0% 19.7% 0.7%Privatedebt 11.0% 7.4% -3.6% 5.0% 4.2% -0.8%Absolutereturn 6.0% 8.4% 2.4% 11.0% 13.8% 2.8%GTAA/opportunistic 10.0% 9.1% -0.9% 5.0% 0.0% -5.0%RealEstate 7.0% 7.2% 0.2% 7.0% 5.7% -1.3%Commodities 7.0% 6.4% -0.6% 6.0% 6.4% 0.4%Infrastructure 3.0% 2.4% -0.6% 5.0% 5.1% 0.1%NaturalResources 0.0% 0.0% 0.0% 5.0% 5.6% 0.6%Cash 1.0% 4.8% 3.8% 0.0% 5.9% 5.9%

Source:TargetAssetallocationsasperInvestmentPolicyStatementsofthePoliceandFirePlan(1/5/17)andtheFederatedPlan(1/19/17).Actualassetallocationasperinvestmentconsultantreport,datedMarch31,2017.AsseeninTable3,bothplansholdmeaningfullymorecashrelativethanisbudgetedintheirbenchmarkallocations.Additionally,thePolice&Fireplanhasunder-allocatedtoprivatedebtandover-allocatedtoabsolutereturn,whiletheFederatedplanhasunder-allocatedtobothprivateequityandglobaltacticalassetallocationstrategies(GTAA)andover-allocatedtoglobalequityandabsolutereturn.Asapointofreference,Figure4comparestheactualassetallocationsofthepeergroupaverage.


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Figure4–ActualAssetAllocationsofPeerGroup(December31,2016)

Source:Consultantreportsorinvestmentreports,asofDecember31,2016.Peergroupaverageisthearithmeticmean.Wherenecessary,wehaveconsolidatedassetclassestoensureconsistency.Observationsfromthiscomparisoninclude:

• TheSanJoseplanshaveallocatedapproximately17%lesstopublicequitiesthanthepeergroupaverage.Oneplan(DPFP)hasallocatedonly7.7%toequities(whileanother,DallasERF,hasallocatedasmuchas60%totheassetclass).

• TheSanJoseplanshaveallocatedconsiderablymoretoabsolutereturnstrategiesthanhasthepeergroup(7%moreinthecaseofthePolice&Fireplanand11%moreinthecaseoftheFederatedplan).4ThePolice&Fireplanhasallocated9%totheGTAAstrategy,whichisnotreportedasadistinctallocationamongotherplans.

• TheSanJoseplanshavesignificantlylargercashholdingsthantheotherplans.DPFPheld13.7%incashatDecember31,2016(likelybecauseoftheneedtofundsubstantialwithdrawalsbyretirees).5Itisalsotheweakestperformeramongtheseplansforallreportingperiods.

4ItshouldbenotedthatcertainfundsheldintheSanJoseplans’PublicEquityandFixedIncomeallocationsaresponsoredbyhedgefundmanagersandmaybeconsideredhedgefundstrategies.5RetireeconcernsaboutthesustainabilityoftheDPFPledtosubstantialredemptionswhichledtoaDecember2016suspensionofredemptions.SeeHallman,T.,“DallasPoliceandFirePensionBoardendsrunonthebank,stops$154mminwithdrawals,”Dallas

0% 5%

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Police&Fire Federated Peergroupaverage


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Theactualinvestmentprogramshouldearnreturnsatleastequaltheactuariallydetermineddiscountrate(whichitselfisbasedonexpectedreturnsonplanassets).Figure5illustratesthediscountrateforeachplaninthepeergroupoverthelastfouryears.Figure5–DiscountRatesAssumedinCalculationofPensionLiabilities(2013-2016)

Source:ComprehensiveAnnualFinancialReports.WhatisimmediatelyevidentfromFigure5isthedownwardtrendindiscountratesacrossallplansexceptforDCPolice&Fire.TheSanJoseplansbothuseadiscountrateof7%asofFY2016.Thisleadstothequestionofwhethertheactualportfoliosselectedbyinvestmentstaffwillgeneratefuturereturnsequaltothesediscountrates.Table4illustratesportfolioreturnsfortheyearendedMarch31,2017aswellashypotheticalreturnsforthatperiodundervariousscenarios:

• Hypotheticalactualassetclassreturnsweightedforthetargetassetallocation;

MorningNews,December8,2016,https://www.dallasnews.com/news/dallas-city-hall/2016/12/08/dallas-police-fire-pension-board-ends-run-bank-stops-154m-withdrawals.

6.0%

6.5%

7.0%

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8.0%

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2013 2014 2015 2016Police&Fire Federated SCERS CCCERAACERA FCERA SDCERS DPFPDallasERF DCPolice&Fire


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• Hypotheticalbenchmarkreturnsweightedfortheactualassetclassallocation(notethatcertainofthebenchmarksarebasedonindicesthatarenotinvestable);

• Hypotheticalbenchmarkreturnsweightedforthetargetassetallocation;and• Projectedportfolioreturns6usingindependentprojectionsforeachasset

class.InthecaseofthePolice&Fireplan,theportfoliounderperformedthebenchmarkby30basispointsduetoassetclassweighting–8.5%to8.8%.InthecaseoftheFederatedplan,theportfoliolaggedthebenchmarkby170basispointsduetodivergencefromboththeassetallocationandsecurityselection(i.e.activemanagementcomparedwithindexallocations)–7.3%to9.0%.

6ProjectedreturnsarebasedonoutlookperBlackRockInvestmentInstitute(https://www.blackrock.com/institutions/en-us/insights/portfolio-design/capital-market-assumptions)andlong-termequilibriumreturnsbasedonageometricmean(time-weighted)calculation,asofNovember13,2017.


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Table4–SanJosePlans–ReturnsUnderVariousScenarios(YEMarch31,2017) Allocations Returns

Police&Fire Federated Police&Fire Federated Outlook

Assetclass Benchmark Target Actual Target Actual Benchmark Actual Benchmark Actual

Globalequity MSCIACWIIMI,Net

31% 31% 28% 31% 15.4% 14.7% 15.4% 12.7% 6.0%

Privateequity CambridgeAssociatedPEIndexLaggedone-quarter(andotherbenchmarks,includingMSCIAWCIIMIPublicMarketEquivalent+300bps)

8% 8% 9% 3% 9.7% 11.1% 10.4% 3.6% 6.8%

Globalfixedincome

Diversifiedindex 16% 16% 19% 20% 0.2% 7.1% 0.3% 2.6% 3.5%

Privatedebt S&PGlobalLeveragedLoans+2%

11% 7% 5% 4% 9.3% 7.4% 10.8% 2.1% 5.3%

Absolutereturn

HFRIAllMacroIndex

6% 8% 11% 14% -0.5% 0.7% -0.6% 1.3% 3.4%

GTAA/opportunistic

60%MSCIWorld/40%CitiWGBI

10% 9% 5% 0% 7.1% 7.3% 8.2% 0.0% 3.4%

RealEstate NCREIFPropertyIndex

7% 7% 7% 6% 8.1% 7.3% 7.3% 11.0% 4.1%

Commodities BloombergCommoditiesIndex

7% 6% 6% 6% 9.1% 2.1% 8.7% 2.8% 3.2%

Infrastructure DJBrookfieldGlobalInfrastructureIndex

3% 2% 5% 5% 11.9% 0.0% 11.9% 11.5% 7.0%

NaturalResources

S&PGlobalNaturalResourcesIndex

0% 0% 5% 6% N/A N/A 24.6% 23.1% 3.2%

Cash 91-dayTBills 1% 5% 0% 6% 0.4% 0.4% 0.0% 0.0% 2.0%

Actualportfolioreturns 8.5% 7.3%

Hypotheticalreturns(targetallocations,actualportfolio) 8.8% 7.3%

Hypotheticalreturns(actualallocations,benchmarkportfolio) 7.2% 8.4%

Hypotheticalreturns(targetallocations,benchmarkportfolio) 7.6% 9.0%

Projectedreturns 4.8% 4.8%Sources:TargetassetallocationsasperInvestmentPolicyStatementsofthePoliceandFirePlan(1/5/17)andtheFederatedPlan(1/19/17).Actualassetallocationsandbenchmarkreturnsasprovidedbyinvestmentconsultant,asofMarch31,2017.OutlookisbasedonprojectedreturnsasperBlackRockInvestmentInstitute(https://www.blackrock.com/institutions/en-us/insights/portfolio-design/capital-market-assumptions),long-termequilibriumreturnsbasedonageometricmean(i.e.time-weighted)calculation,asofNovember13,2017(publicequities,fixedincome,creditaggregatedfromsub-assetclassprojections,realestatedataisforcore,naturalresourcesbasedoncommodities).Figure6illustratestheassetclassreturnsfortheSanJoseplansrelativetotheperformanceofthepeergroupwithineachassetclass.TheFederatedplanunderperformedthepeergroupinallassetclassesexceptforrealestate,infrastructure,andnaturalresourcesduringcalendar2016.ThePolice&Fireplan


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underperformedinallassetclassesexceptforfixedincome,privateequityandrealestate7.Figure6–AssetClassReturnsofSanJosePlansComparedwithPeerGroup

Source:InvestmentconsultantreportsandinvestmentreportsforyearendedDecember31,2016.Note:thiscomparisonmustbeevaluatedwithanumberofcaveats,notably(i)certainassetclasseswereconsolidatedorreclassifiedtoensureconsistencyacrossplans,(ii)certainplansreporthighyielddistinctlyfromfixedincome,(iii)onlytwootherplans(FCERAandACERA)haveallocationstocommodities,(iv)onlyoneotherplan(DPFP)hasanallocationtoGTAA.SensitivityAnalysisonFundedStatusReturningtoTable4,weobservethatprojectedreturnsforthetwoplansareeachapproximately4.8%,basedontheprojectedreturns8forthevariousconstituentassetclassesandtargetassetallocation.9Thisismeaningfullybelowthe7%discountrateillustratedinFigure5.ThetrendofdecreasingdiscountratesillustratedinFigure5isattributabletopensionplansadjustingtheirprojectedreturnsdownwards.Thepotentialimpact

7AlthoughtheFederatedplanoutperformedthepeergroupinrealestate,itshouldbenotedthatitsallocationwaslower.Similarly,thePolice&Fireplanoutperformeditspeersinfixedincome,privateequity,andrealestatebutwasunderweightedrelativetopeers.Theoutperformancemayhavebeendrivenbyallocation,selectionortiming.8Actualandbenchmarkprojectedreturnsareweightedbyactualandtargetallocations.9PleaseseetheassumptionsunderlyingprojectedreturnsinthesourcenotestoTable4.

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onfundedstatusfromalowerdiscountrateissignificant.Table5illustratestheimpactontheSanJoseplansofa100basispointdecreaseinthediscountrate,i.e.to6%.AsatJune30,2016,thiswouldincreasetheaggregatenetpresentvalueoffuturepensionliabilitiesofthetwoplansby$1.15billion.Table5–SensitivityofPlanNetPositiontoDiscountRate Police&Fire FederatedDiscountrateassumption 6% 7% 6% 7% $mm $mm $mm $mmTotalpensionliability 4,849 4,220 4,213 3,693Fiduciarynetposition 3,044 3,044 1,859 1,859Netpensionliability 1,805 1,176 2,354 1,834Fundedstatus 62.8% 72.1% 44.1% 50.3% Source:ComprehensiveAnnualFinancialReportsoftheplans.ChangesinNetPlanAssetsandtheImpactofDemographicsWenowturntotheannualcontributionsbymembersandtheiremployers,andbenefitspaidtoretireesandtheirbeneficiaries.Thedemographicsofthemembershipoftheplans,specifically–theratiobetweenannuitants(whodrawcashoutofaplan)andactivemembers(whofundcashintoaplan)haveasignificantimpactoncashflows.10LikemostU.S.publicplans,althoughtoagreaterdegreethanthepeergroup,theSanJoseplansaremature,withgrowthinannuitantsexceedinggrowthinnewmembers.Figure7illustratestheratioofannuitantstoactivemembersofthepeergroup.ThispointisfurtherhighlightedinFigure8,whichshowsthecumulativechangeinthenumberofannuitantsandactivemembersofplansinthepeergroupfrom2006-2016.

10Thisissimilartothedependencyratiothatiscommonlycitedineconomicandsociologicalstudies.


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Figure7–RatioofAnnuitantstoActiveMembersofPeerGroup(2013-2016)

Source:ComprehensiveAnnualFinancialReports.Figure8–ChangeinAnnuitantsandActiveMembersofPeerGroup(2006-2016)

Source:ComprehensiveAnnualFinancialReports.

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2013 2014 2015 2016Police&Fire Federated SCERSCCCERA ACERA FCERASDCERS DPFP DallasERF

-25% -15% -5% 5%

15% 25% 35% 45% 55% 65% 75%

Annuitants ActiveMembers


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TheSanJoseplansareagainoutliersinthattheyhaveamongthehighestincreaseinretireesandthelargestdecreaseinthenumberofmembersactivelymakingcontributions.11Overtime,theinvestmentprogramshouldearnsufficientcashflowsfromyield(interestincomeanddividends)andrealizedgainsoninvestmentstofundtheexcessofbenefitpaymentsovercontributions;otherwise,itwouldhavetofundsuchexcesspaymentsfromcashholdings.12Figures9,10,and11illustratecontributionsandbenefitpaymentsfortheSanJoseplansandthepercentageofbenefitsthatiscoveredbycontributions,atleastintheshortterm.Figure11showsemployerandemployeecontributionsandannualshortfallofcontributionsrelativetobenefitspaid.Asnotedabove,thisshortfallmustbemadeupforbyrealizedinvestmentgains,yield,orcashholdingsinthenearterm.13Figure9–BenefitPaymentsandContributions($mm)–Police&Fire(2007-2016)

Source:ComprehensiveAnnualFinancialReports. 11Thedecreaseinactivememberswaslikelyrelatedtotheoveralleconomiccrisisin2008-2010,aswellasgeneralcitybudgetchallenges.12Thisobservationignoreslesssignificantlineitems,includingexpenses,deathbenefits,andrefunds.13Asnotedearlier,highDPFPplanoutlayswerelikelycausedbysubstantialwithdrawalsbyretirees.

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Figure10–BenefitPaymentsandContributions($mm)–Federated(2007-2016)

Source:ComprehensiveAnnualFinancialReports.Figure11–ContributionsandShortfallasPercentageofBenefits(2016)


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EvaluatingInvestmentPerformanceNext,weconsiderportfoliorelativeperformance.AsisevidentinTable6,theSanJoseplansareamongtheweakestperformingofthepeergroup.Table6–PortfolioPerformanceofPeerGroup(throughDecember31,2016)

1-year 3-years 5-years 10-years

DallasERF 9.17% CCCERA 5.50% ACERA 9.32% ACERA 5.50%

SCERS 8.45% SDCERS 4.90% CCCERA 9.10% CCCERA 5.40%

SDCERS 8.30% SCERS 4.56% SDCERS 9.00% SDCERS 5.40%

DCPolice&Fire 7.50% DallasERF 4.55% DallasERF 8.84% FCERA 4.90%

ACERA 7.44% ACERA 4.13% SCERS 8.21% DCPolice&Fire 4.00%

CCCERA 6.90% DCPolice&Fire 3.10% FCERA 7.20% Police&Fire 3.30%

FCERA 6.60% Police&Fire 2.50% DCPolice&Fire 7.00% Federated 3.30%

Federated 6.30% FCERA 2.50% Police&Fire 5.80% DPFP 1.40%

Police&Fire 6.20% Federated 2.40% Federated 5.00%

DPFP 3.20% DPFP -2.10% DPFP 1.60%

Source:InvestmentconsultantreportsofinvestmentreportsoftheplansasofDecember31,2016.Note:trailing10-yearreturnsforSeattleandDallasEmployeesnotavailable.

Table7showstheplans’investmentrankrelativetoauniverseoflarge($1bn+)publicplans.14Onthisbasis,theplansareamongtheweakestperformersinthislargerpeergroupatthefifthpercentileorlower.Table7–PortfolioPerformanceofSanJosePlans(throughMarch31,2017) 1-yr 3-yrs 5-yrs 10-yrsMedianforplanswith$1bn+ofnetassets 11.6% 5.0% 7.4% 4.9% Police&Fire Actual 8.5% 2.9% 5.2% 3.4%Policybenchmark 8.7% 2.9% 5.2% 3.8%Percentile 3% 3% 5% 4% Federated Actual 7.3% 2.5% 4.2% 3.4%Policybenchmark 8.3% 2.3% 5.1% 4.0%Percentile 1% 1% 2% 4%

Source:Investmentconsultantreports,March31,2017.Note:PercentilereflectstherankingintheuniverseofpensionplansintheInvestorForcePublicDefinedBenefitplandatabaseforplanswithmorethan$1bninnetplanassets.14Investmentconsultantreports,March31,2017.NotethatthisanalysisisfortheperiodendingMarch31,2017,i.e.onequarterlaterthanthatillustratedinTable6.


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Table8providessomeinsightintoportfolioperformancerelativetotargetreturns.Thistableillustratesactualperformanceofeachassetclassforeachofthetwoplansforthe1-,3-,5-,and10-yearperiodsendingMarch31,2017.Italsoreportstheperformanceoftheparticularindex(orgroupofindices)selectedasthebenchmarkfortheseassetclassesoverthesameperiods.Asanillustration,theFederatedplan’sprivateequityportfoliogeneratedactualannualizedreturns,netoffees,of7.2%overtheten-yearperiodendingMarch31,2017.Overthatsame,theplan’sbenchmark(theCambridgeAssociatesGlobalPrivateEquityIndex)reportedannualizedgainsof8.5%,implyinganannualizedunderperformancefortheFederatedplanof130basispointsofactualallocationsrelativetobenchmark.Thevariancebetweenactualandbenchmarkreturnsreflects,tosomedegree,theimpactofactiveportfoliomanagement.Investableindicesexistforcertainoftheassetclasses(forexample,equities),inthecaseofotherassetclasses,thebenchmarkindicesarenotreadilyinvestable,i.e.itisnotpossibletomimicthereturnstreamoftheunderlyingbenchmark.


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Table8–PerformanceRelativetoBenchmarksofSanJosePlans(throughMarch31,2017) Police&Fire Federated 1-yr 3-yrs 5-yrs 10-yrs 1-yr 3-yrs 5-yrs 10-yrs Equity 14.7% 5.2% 8.3% 12.7% 4.5% 8.2% Custombenchmark 15.4% 5.1% 8.6% 15.4% 5.1% 8.5% Excessreturn -0.7% 0.1% -0.3% -2.7% -0.6% -0.3% Privateequity 11.1% 9.1% 11.8% 9.8% 3.6% 7.7% 10.3% 7.2%Custombenchmark 9.7% 7.2% 10.4% 7.6% 10.4% 8.5%Excessreturn 1.4% 1.9% -6.8% 0.1% -0.1% -1.3%Fixedincome 7.1% 2.7% 4.5% 6.0% 2.6% 1.3% 2.2% Custombenchmark 0.2% 0.5% 2.3% 5.0% 0.3% 0.5% 0.9% Excessreturn 6.9% 2.2% 2.2% 1.0% 2.3% 0.8% 1.3% Privatedebt 7.4% 2.1% 4.3% 6.5% Custombenchmark 9.3% 10.8% 4.3% 6.3% Excessreturn -1.9% -8.7% 0.0% 0.2% Realestate 7.3% 9.2% 10.0% 6.5% 11.0% 16.0% 14.1% 4.9%Custombenchmark 8.1% 7.6% 7.3% 10.6% 10.7% 6.7%Excessreturn -0.8% 1.6% 3.7% 5.4% 3.4% -1.8%Infrastructure 11.5% 5.1% Custombenchmark 11.9% 4.7% Excessreturn -0.4% 0.4% Commodities 2.1% -9.8% -7.3% 2.8% -12.3% -8.8% Custombenchmark 9.1% -9.5% -6.3% 8.7% -13.9% -9.5% Excessreturn -7.0% -0.3% -1.0% -5.9% 1.6% 0.7% Absolutereturn 0.7% 1.8% 1.3% 2.8% Custombenchmark -0.5% 0.9% -0.6% 1.8% Excessreturn 1.2% 0.9% 1.9% 1.0% GTAA 7.3% 1.2% 0.0% Custombenchmark 7.1% 2.9% 8.2% Excessreturn 0.2% -1.7% -8.2% Naturalresources 23.1% -4.4% Custombenchmark 24.6% -2.2% Excessreturn -1.5% -2.2% Source:Investmentconsultantreports,March31,2017


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Risk-AdjustedReturnsWenowevaluatetheperformanceoftheSanJoseplansonarisk-adjustedbasisversusthatofthepeergroup.Inthecontextofportfoliomanagement,themostbasicmetrictomeasureriskisvolatility,calculatedasstandarddeviationofreturns.AcommonlyusedmetricthatcombinesriskandreturninasinglestatisticistheSharpeRatio,whichiscalculatedastheratioofexcessreturnsabovearisk-freerate,tovolatilityinreturns,asmeasuredbystandarddeviation.15Figure12showstheSharpeRatioforeachoftheplansinthepeergroup.Perunitofrisk,theSanJoseplansareinthemiddleoftherangerelativetothepeergroup.Theirreturnsarebelowthoseoftheotherplansandtheirriskisalsosomewhatbelowthoseofthemeanofthepeergroup.Figure12–SharpeRatiosofPeerGroup(periodendingFY2016)

Source:InvestmentperformancefromComprehensiveAnnualFinancialReportfortheperiod2006-2016.Calculationusesannualobservations.Risk-freerateisthe1-yearTreasury,whichwas1.3%atthetimeofwriting.Thisdataacrossplansisnotdirectlycomparableastheplanshavedifferentfiscalyearsandhencedifferentreportingperiods.

15Accordingly,ahighertheSharpeRatiomeansbetterqualityreturns.AfewcaveatstotheuseoftheSharpeRatioareworthnoting.Itdoesnotdistinguishbetweenupsideanddownsidevolatility.TheSortinoRatioseekstoaddressthisbyonlypenalizingdownsidevolatility;itislessprevalentandhencewehaveusedtheSharpeRatiointhisdocument.Additionally,theSharpeRatioassumesanormaldistributionofreturns,whichisnotnecessarilyobservedinreturndataoveralltimeseries.

-

0.05

0.10

0.15

0.20

0.25

0.30

0.35

0.40

0.45

0.50


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InvestmentExpensesOnefinalfactorthatimpactsnetplanpositionandreturnsistheexpenseloadformanagingportfolios.Thisincludesinternalcosts(primarily,investmentstaffcompensationandrelatedexpenses)andexternalcosts(feespaidtoexternalinvestmentmanagersandadministrativeexpenses).Beforeweexploretheimpactoffees,wenotethatahighexpenseloadisnotnecessarilyanegativeindication.After-feereturnsaremuchmoreimportantthantheexpenseofachievingthosereturns.Figures13and14showthattotalinvestmentexpensesoftheSanJoseplanshaveincreasedoverthepastthreeyearsonbothanabsolutebasisandasapercentageofnetplanassets.Thisispartlyattributabletoachangeintheassetallocationtowardsmorealternativeinvestmentproducts,whichincurhigherfees(includingperformancefees)thanequityandfixedincomestrategies.Interestingly,bothSanJoseplansunderperformedthepeergroupintheabsolutereturnsassetclass(Figure6),oneinwhichtheyhadhigherrelativeallocations(Figure4).Figure13–Police&FirePlan-InvestmentExpenses($mm,2006-2016)

Source:ComprehensiveAnnualFinancialReports.Note:TERreferstotheTotalExpenseRatio,theratioofexpensestomarketvalueofassets.

0.2%

0.3%

0.4%

0.5%

0.6%

0.7%

0.8%

-

5

10

15

20

25

2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016

OtherInvestmentexpenses Managementfees TER


23

Figure14–FederatedPlan-InvestmentExpenses(($mm,2006-2016)

Source:ComprehensiveAnnualFinancialReports.Note:TERreferstothetotalexpenseratio,theratioofexpensestomarketvalueofassets.Onarelativebasis,theSanJoseplansareamongthemoreexpensivelymanagedofthepeergroup,ascanbeseeninTable9andFigure15.Asindicated,theTERin2016fortheSanJoseplansexceededallotherplansexceptACERA.In2015,SanJoseTERsexceededthoseinfiveoftheeightpeergroupplans.

0.2%

0.3%

0.4%

0.5%

0.6%

0.7%

-

2

4

6

8

10

12

14

2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016

OtherInvestmentexpenses Managementfees TER


24

Table9–ManagementFeeandTotalExpenseRatioofPeerGroup YearEnd Market

ValueofAssets

MgmtFee

ExpenseRatio

TotalExpenses

TotalExpense

Ratio $mm $mm $mm Police&Fire Jun-16 3,044 19.65 0.65% 21.52 0.71%Federated Jun-16 1,859 10.52 0.57% 11.86 0.64%SCERS Dec-15 2,313 9.10 0.39% 9.75 0.42%CCCERA Dec-16 7,439 43.66 0.59% 45.03 0.61%ACERA Dec-16 6,133 40.90 0.67% 47.36 0.77%FCERA Jun-16 4,009 16.91 0.42% 18.07 0.45%SDCERS Jun-16 6,388 29.51 0.46% 32.36 0.51%DPFP Dec-16 2,680 6.95 0.26% 11.78 0.44%DallasERF Dec-16 3,328 14.93 0.45% 18.19 0.55%DCPolice&Fire Sep-16 4,954 11.81 0.24% 14.15 0.29% Source:ComprehensiveAnnualFinancialReports.Note:Seattlehadnotpublishedits2016CAFRasofthedateofwriting,assuchfiscal2015dataisusedforthatplan.Figure15–TotalExpenseRatiosofPeerGroup(2015and2016)


0.0%

0.1%

0.2%

0.3%

0.4%

0.5%

0.6%

0.7%

0.8%

0.9%

1.0%

2015 2016


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Withrespecttointernalexpensesandstaffcount,theSanJoseplansarealsooutliers,withtotalinvestmentstaffoften.Mostotherplansreportinvestmentstaffofoneortwo(SCERSreportsfourstaff).16ConclusionsUsingafinancialstatementapproach,lookingatassets,liabilities,andcashflows,wehaveillustratedchallengesfacingtheSanJosepublicpensionplans.Wehavenotedthattheseplanshavesufferedfromadeteriorationintheirfundedstatus(seeFigure1)attributableto(i)demographicfactorssuchasamaturingandshrinkingworkforce(seeFigure7),(ii)relativelyweakinvestmentperformancecomparedwithapeergroup(seeTable6forancross-sectionalview,Table7forarankingagainstalllargeplans,andFigure6foranassetclassview),and(iii)relativelyhighinvestmentexpenses(seeTable9andFigure16)thatactasadragonperformance.LikemanyU.S.publicpensionplans,theSanJoseplansfaceashortfallofcontributionsrelativetobenefitpayments(seeFigures9-10foratimeseriesviewandFigure11foracross-sectionalview),makingthemparticularlysensitivetoweakerinvestmentperformanceand,especially,tothecurrentincome(yield)componentoftheinvestmentprogramwhichisnecessarytopayexcessbenefitpayments.TheSanJoseplanshavecorrectlyincreasedtheirallocationstolonger-durationinvestmentstomatchthelongdurationoftheirliabilities(seeFigure3).Thatsaid,itisquestionablewhethertheallocationstoalternativeassetclasseshavebeendoneinthemostoptimalway.Thisistruefromtheperspectiveofassetallocationandportfoliocomposition(Figure6providesacross-sectionalillustrationofassetclass-levelperformanceforthepeergroup).Theobservationregardingrecentinvestmentperformance,netofinvestmentexpenses,isimportantbecausesubparperformanceaffectspensionplansintwoways:itreducesthepotentialgrowthinassetsand,ifitisexpectedtoreduceprojectedperformance,couldrequireadownwardadjustmenttothediscountrateashasbeenoccurringinrecentyears(seeFigure5),whichhasadirectimpactonliabilities(seeTable5).Reducedgrowthinnetplanassetsandincreasedpresentvalueofliabilitiesbothexpandthefundinggap,andassuch,theinvestmentstrategyandmanagementshouldbeaparticularfocusoftheplanfiduciaries.

16Thisstaffingdatareferstopositionsontheorganizationchartsineachplan’sCAFR;itdoesnotnecessarilyimplythateachpositioniscurrentlyfilled.Itisnotpossibletoquantifythecostofthisstaff,astheplansdonotreportaggregatecompensationdata.

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