The opinions expressed in this presentation are those of the speaker. The International Foundation disclaims responsibility for views expressed and statements made by the program speakers. Asset Allocation in Health and Pension Plans— Your Key Decision Ian W. Jones Director and Senior Consultant The Bogdahn Group Buffalo, New York I02-1
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The opinions expressed in this presentation are those of the speaker. The International Foundationdisclaims responsibility for views expressed and statements made by the program speakers.
Asset Allocation in Health and Pension Plans—Your Key Decision
Ian W. JonesDirector and Senior ConsultantThe Bogdahn GroupBuffalo, New York
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Asset Allocation in Health and Pension Plans—
Your Key Decision• Understanding your demographics and fund projections• Estimating future asset class returns and risk
expectations• ls there an optimal asset allocation model?• What are the different and dominant types of risk
associated with various asset allocation models?• Trade-off of risk and return
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Plan AssetsContributions
+Investment Earnings
Plan LiabilitiesBenefits
+Expenses
=
Plan AssetsPlan Liabilities Funded Ratio=
Benefit Plan Funding Basics
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Benefit Plan Funding Basics
Plan Funding Level:Actuary assesses plan’s demographics and asset allocation structure to determine current and projected funding levels.Factors considered:• Industry: growing or shrinking
– Manufacturing, building/construction, service, etc.
• Age of participant population and how long they live• Ratio of active vs. inactive participants• Contributions, benefits, expenses• Labor/management negotiations• Rate of return potential
Significant factor that will impact the funding level of a defined benefit pension plan is the assumed and actual
rate of return earned on plans assets.
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The ASSET ALLOCATION DECISION is the key determinant of a portfolio’s short and long-
term RETURN and RISK
Asset Allocation Decision
Mix of asset classes• Traditional: Equities and bonds• Alternatives: Real estate, private equity, hedge funds, etc.
Risk management• Understand which strategies will contribute most to total portfolio
risk
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Building an Investment Program
Three Essential Steps1. Define investor’s
– Goals and objectives– Liquidity needs and investment horizon – Risk tolerance
2. Set asset allocation 3. Set manager structure
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Building an Investment Program
Define Investor’sa) Goals and objectives
– To be fully funded • What is investor’s current funded status—Green/Yellow/Red?
– Meet/exceed plan’s actuarial interest rate assumption– Achieving the above with acceptable risk (volatility)– Other?
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Building an Investment Program
Define Investor’sb) Liquidity needs and investment horizon
– Does the plan have net positive or negative cash flow? • If negative, to what extent?
– Will liquidity needs be changing over time?• Industry outlook (growing or shrinking?)• Ratio of active vs. inactive participants• Labor/management negotiations
Liquidity/cash flow needs impact a plan’s time horizonLonger time horizon allows for inclusion of riskier/less liquid
asset classes with higher return potentialTime helps smooth returns
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Employer Contributions – Benefit PaymentsTotal Benefit Plan Assets
= Positive or Negative Cash Flow as a Percentage
$7,000,000 – $10,000,000$100,000,000
= 3% Net NegativeCash Flow
$2,000,000 – $12,000,000$100,000,000
10% Net NegativeCash Flow
VS.
NET CASH FLOW
Benefit Plan #1:
Benefit Plan #2: =
Building an Investment Program
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Building an Investment Program
Define Investor’sc) Risk Tolerance
– Risk/Reward trade off—willingness to take on greater risk in hope of greater return
– Most common risk discussed: Variability of Return • Measured by Standard Deviation
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‐4 ‐3 ‐2 ‐1 0 1 2 3 4
Risk: Variability of return around it’s average.
7.0% +24.0%-10.0%
-27.0% +41.0%
-2σ -1σ +1σ +2σµ-3σ +3σ
Two Standard Deviations - 95.5%
Three Standard Deviations - 99.7%
One Standard Deviation—68.3%
-44.0% 58.0%
Average/Mean
Two Standard Deviations - 95.5%
Three Standard Deviations - 99.7%
One Standard Deviation—68.3%
“Risk” = “Variability” = “Standard Deviation”
Large Cap Equity Average Expected Return of 7.0% with a “RISK” of 17.0%
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Building an Investment Program
Define Investor’sc) Risk Tolerance
Beyond variability/standard deviation, investor must also consider other RISKS:– Investment—manager makes bad investment decisions– Leverage—amplifies losses– Liquidity—evaporates during period of market stress– Operational/business—inability to run a business– Social/political/legislative risk—playing field changes– Valuation—some assets are difficult to price– Headline—manager makes the headlines of the press– Blowup—manager blows up– Systematic/market—correlations go to “1” (like 2008)
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Building an Investment Program
1. Define investor’s– Goals and objectives– Liquidity needs and investment horizon – Risk tolerance
2. Set asset allocation 3. Set manager structure
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Two Types of Asset Allocation ModelsDeterministic Modeling (Mean/Variance Optimization)Forecasts the return and risk potential of portfolios based on a fixed set of inputs (return, risk, and correlation for each asset class) and initial conditions (target return, initial value, and time horizon). The output is fully determinedby the model inputs.
Stochastic Modeling (Monte Carlo Simulation)Forecasts variations in outcomes of portfolios over time based on potential probability distributions of return, risk and other variable inputs. These models possess an inherent randomness in that the same set of parameter inputs will lead to a variety of outcomes to consider.
Building an Investment Program
Perform an Asset Allocation Study
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Must make assumptions for each asset class:1. Returns How will asset classes perform
2. Risk (Standard Deviation) Variability of return around its average
3. Correlation How asset classes move relative to each other
Goal: Generate highest rate of returnwith acceptable level of risk
Building an Investment Program
Perform an Asset Allocation Study
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1. Forward Looking Returns
Perform Asset Allocation Study
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2. Forward Looking Returns and Risk
Perform Asset Allocation Study
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They are a forecast into the future
They are an estimate
They vary from one firm to the next
They will be wrong
But, they provide a framework to make educated decisions
2. Forward Looking Returns and Risk
Perform Asset Allocation Study
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Perform Asset Allocation Study
3. CorrelationsHow asset classes move relative to each other:
Statistical measure between +1 and -1
+1 = assets classes perfectly correlated.
• Both go up and down at the same time.
-1 = asset classes inversely correlated
• One goes up, the other goes down and vice versa.
0 = no distinguishable pattern, more random
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Asset ClassesCurrent Allocation
Option 1 Option 2
U.S. Equities 65% 55% 45%Non U.S. Equities – Developed
15% 15% 15%
Non U.S. Equities – Emerging 5% 5% 5%Total Equities 85% 75% 65%U.S. Fixed Income 15.00% 25.00% 35.00%Total Assets 100.00% 100.00% 100.00%
Current Allocation
Option 1 Option 2
One Year 7.90% 7.50% 7.00%Time Horizon 7.10% 6.80% 6.50%
One Year 13.80% 12.30% 10.80%Time Horizon 4.30% 3.80% 3.40%
One Year 37.30% 33.40% 29.60%Time Horizon 15.80% 14.60% 13.30%
One Year ‐16.60% ‐14.60% ‐12.50%Time Horizon ‐1.10% ‐0.50% 0.10%
One Year 56.00% 55.90% 55.60%Time Horizon 68.30% 67.90% 67.20%
One Year 29.70% 28.20% 26.50%Time Horizon 4.60% 3.40% 2.40%
Probability of Negative Return
Expected Return (Annualized)
Expected Risk (Standard Deviation)
Best Case Return (Annualized)
Worst Case Return (Annualized)
Probability of Target Return
Product of an Asset Allocation Study
Return, Risk and Correlation
Assumptions
Perform Asset Allocation Study
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Perform Asset Allocation Study
Asset Allocation Studies• Is there an optimal model?• Part science, part art.• Output only as good as the inputs.• Inputs vary from one advisor to the next and will be
wrong.• Still a good tool to help understand inter-relationship
of asset classes and that provides a framework to make educated decisions.
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Building an Investment Program
1. Define investor’s– Goals and objectives– Liquidity needs and investment horizon – Risk tolerance
2. Set asset allocation 3. Set manager structure
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Building an Investment Program
Set Manager Structure• Allocation to Core Managers
– Traditional asset classes (equity and fixed income)– Active vs. Passive
• Allocation to Satellite Managers– Both traditional and alternative asset classes– Active, high conviction, opportunistic, value add
• Risk budgeting/risk management– Understanding which strategies will contribute most to total portfolio
risk– Blending non-correlated investment manager strategies to smooth
returns
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Selecting an Optimal Mix
Looking BackwardsOver the past 30 + years what has been the
optimal asset allocation mix?
Options to consider:• Domestic equity • Domestic fixed income• Domestic equity and fixed income• Domestic + international equity and fixed income• Domestic + international equity, fixed income and real estate• Domestic + international equity, fixed income, real estate and
hedge funds
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Asset Allocation Mixes
Looking Backwards
Mix 1 Mix 2 Mix 3 Mix 4 Mix 5 Mix 6
U.S. Equities (S&P 500) 100.0% 60.0% 50.0% 45.0% 45.0%
U.S. Fixed Income (Barclays Aggregate) 100.0% 40.0% 40.0% 35.0% 25.0%
International Equity (MSCI ACW ex US) 10.0% 10.0% 10.0%
Real Estate Equity (NCREIF ODCE) 10.0% 10.0%
Hedge Fund of Funds (HFRI) 10.0%
Since 1/1/78 Since 1/1/78 Since 1/1/78 Since 1/1/78
Mix 4 with Real Estate
allocation made on January 1, 2000
Mix 5 with Hedge Fund
allocation made on January 1, 2006.
Selecting an Optimal Mix
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Looking Backwards—Returns
1 year 2 years 3 years 4 years 5 years 10 years 15 years 20 years 25 years 30 years 35 years Since Inception*
• Domestic equity returns for the last 90+ years have been solid• Last 16 years have been challenging (S&P 500 @ 4.34%) • Consensus is that equity returns for the next 10+ years will
continue to be below their historic average
SOURCE: Horizon Actuarial 2016 Survey of Capital Market Assumptions
Average Expected Return
Average Expected Risk
US Equity - Large Cap 6.6% 16.9%US Equity - Small/Mid Cap 7.0% 21.0%Non-US Equity - Developed 7.1% 19.5%Non-US Equity - Emerging 8.5% 26.3%
Forward Looking Equity Returns
Equi
ties
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Barclays Aggregate Annualized Return
1/1/76-12/31/81 1/1/82-9/30/16 1/1/76-9/30/16
5.04% 8.14% 7.68%
Source: Investment Metrics
‐10.00%
‐5.00%
0.00%
5.00%
10.00%
15.00%
20.00%
25.00%
30.00%
35.00%
1976
1977
1978
1979
1980
1981
1982
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1991
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2011
2012
2013
2014
2015
Calendar Year Price Return Calendar Year Coupon Return Calendar Year Total Return 10 Year Treasury Yield
Barclays Aggregate IndexCalendar Year Returns 1976-2015
Historic Return Perspective: Fixed Income
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*As of 9/30/16
0
2
4
6
8
10
12
14
16
1976
1977
1978
1979
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1981
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2010
2011
2012
2013
2014
2015
Yield
US 10 YR Mid‐Yield Barclays Agg YTW Barclays US Credit YTW Barclays US Mortgage YTW
Since 1976 Barclays Aggregate has
produced an average annual return of 7.68%*
Benchmark Yields: 1976-2016
Barclays Aggregate (09/30/16)
Yield to Maturity: 1.97%Average Maturity: 7.82 Years
Historic Return Perspective: Fixed Income
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Where Will Returns Come From—Fixed Income?
• Domestic fixed income returns for the last 40+ years have been fantastic• Returns for the next 10+ years will not be as robust due to the current low
interest rate environment
Average Expected Return
Average Expected Risk
US Corporate Bonds - Core 3.4% 6.0%US Corporate Bonds - Long Duration 3.8% 10.5%US Corporate Bonds - High Yield 5.9% 11.0%Non-US Debt - Developed 2.4% 7.6%Non-US Debt - Emerging 5.8% 11.6%US Treasuries (Cash Equivalents) 2.1% 2.8%TIPS (Inflation-Protected) 2.8% 6.5%
Forward Looking Fixed Income Returns
Fixe
d In
com
e
SOURCE: Horizon Actuarial 2016 Survey of Capital Market Assumptions