Endowment Fund Investment Board f the o State of Idahodfm.idaho.gov/publications/bb/strategicplans/fy2019/natural-resources/lands...endowed certain lands to be used to generate income

Strategic Plan FY2019 – FY2023

Endowment Fund Investment Board of the

State of Idaho

May 15, 2018 Update

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Background When Idaho became the 43rd state in 1890, the Congress of the United States endowed certain lands to be used to generate income for education and other purposes. At statehood, 3.6 million acres of land were granted to the state by the federal government and 2.4 million acres remain. Certain proceeds from the sale of land and income generated by the land have accumulated in the endowment funds, which totaled $2.0 billion as of June 2017. Per the Idaho Constitution, the State Board of Land Commissioners oversees the state’s endowment assets. The State Board of Land Commissioners is comprised of five elected officials: Idaho’s Governor, Secretary of State, Attorney General, Superintendent of Public Instruction and State Controller. Under the direction of the State Board of Land Commissioners, endowment lands are managed by the Idaho Department of Lands and the endowment funds are managed by the Endowment Fund Investment Board, which consists of nine members appointed by the Governor and confirmed by the Senate.

Mission of the Endowment Fund Investment Board

Provide professional investment management services to its stakeholders consistent with constitutional and statutory mandates.

Goals

For our Clients, we will: • Establish prudent long-term investment policies and strategies that seek to

balance risk and return objectives. • Utilize outstanding investment managers, consultants and other agents

to execute those strategies. • Diligently evaluate investment performance over time. • Act professionally, communicate clearly and strive to be valued

partners.

Endowment Fund Clients:

Fund Clients Land Grant Endowment Funds Board of Land Commissioners State Insurance Fund State Insurance Fund Bunker Hill Water Treatment Endowment Dept. of Environment Quality Southern Idaho Mitigation Endowment Trust Dept. of Fish and Game Craig Mountain Wildlife Mitigation Trust Dept. of Fish and Game Blackfoot Wildlife Mitigation Endowment Dept. of Fish and Game Albani Falls Wildlife Mitigation Endowment Dept. of Fish and Game Trail of the Coeur d’Alene Endowment Dept. of Parks & Recreation Ritter Island Endowment Fund Dept. of Parks & Recreation

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For our Beneficiaries, we will: • Strive to make consistent and sustainable annual distributions. • Strive to maintain reserves sufficient to protect distributions from temporary

income shortfalls and investment volatility. • Strive to grow the permanent corpus at a rate equal to or greater than

inflation and population growth. Endowment Fund Beneficiaries Public Schools Charitable Institutions (Idaho State University, State Juvenile Corrections, State Hospital North, Idaho Veterans Homes and the Schools for the Deaf & Blind) School of Science at the University of Idaho Normal Schools (Idaho State University and Lewis-Clark State College) State Hospital South University of Idaho Penitentiary Agricultural College Capitol Permanent Fund

For the State Board of Land Commissioners and Endowment Fund Board, we will: • Provide resources, information and support to enable engagement as

prudent fiduciaries for our clients and beneficiaries. • Comply with open meeting and public record laws and maintain a website

with current and accurate meeting materials to ensure transparent governance.

• Improve communications and decisions making. State Board of Land Commissioners C.L. “Butch” Otter, Governor Lawerence Denney, Secretary of State Lawrence Wasden, Attorney General Brandon Woolf, State Controller Sherri Ybarra, Superintendent of Public Instruction Endowment Fund Board Dean Buffington, Chair Richelle Sugiyama, Vice Chair Jerry Aldape Representative Neil Anderson Warren Bakes, Chair of Compensation Committee Gavin Gee Irv Littman Gary Mahn, Chair of Audit Committee Senator Chuck Winder

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For our Staff, we will: • Create and maintain an environment that challenges staff to make

meaningful contributions and encourages professional development. • Enhance financial and investment reporting to better communicate

performance to stakeholders. • Improve the use of data analytics to monitor portfolios and investment

managers. • Stay up-to-date on investment research and trends. • Continue to build relationships with other state agencies through knowledge

sharing sessions. • Meet at least annually with clients and beneficiaries to provide investment

updates and foster collaboration. • As a technology customer of the Office of Information Technology Services

(ITS) in the Governor’s, we are using the cybersecurity systems and technical expertise in ITS to fulfill requirements related to Executive Order 2017-02. Staff from ITS briefed the NIST Core Framework, CIS Controls 1-5, and their plan for adoption of the NIST Cybersecurity Framework. We participate in DHR and ITS administered cybersecurity training, as awareness is a critical component of an effective cybersecurity program. As briefed by ITS staff, implementation of the CIS Controls 1-5 will be their responsibility for the systems they operate and, as technology tools applied to the computer systems, largely invisible to us as a customer. ITS is refining the cybersecurity incident response plan in support of our agency.

Endowment Fund Staff Chris Anton, Manager of Investments Chris Halvorson, Investment Officer Michelle Watts, Fiscal Officer Liz Wieneke, Office Manager

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Key performance measures and benchmarks (including the rationale for their adoption)

The efficacy of the Endowment Fund Investment Board can best be measured by: • Stability and growth of distributions to beneficiaries. • Maximization of long-term financial returns at a prudent level of risk. • Growth in permanent corpus to preserve purchasing power for future

generations. Risk/Return Measures & Benchmarks These measures will be calculated annually and over multi-year periods.

• Measure: Return vs. benchmark

o Meet or exceed the Fund’s benchmark, net of fees.

• Measure: Return vs. peers o Exceed median of peer group rankings.

Rationale for establishing these measures/benchmarks There is no single, perfect measure of the performance of an investment portfolio, so multiple performance measurements will be used, customized to the needs of each client and calculated for both annual and multi-year periods. Return vs. benchmark: This is a relative return measure that calculates the value- added of “active” versus “passive” investing. One can invest in many (but not all) major asset classes in the financial markets thru either index funds or via active management. Index funds essentially own a representative portion of the whole market and are therefore referred to as “passive” investments because they do not attempt to predict which specific securities in the class will perform best. “Active” investing attempts to select the assets within a class that will perform better than average. The efficiency of financial markets makes it challenging to earn active returns in excess of the passive index without taking extra risk. Return vs. peers: Since a rising tide lifts all boats, comparison to relevant peers, allows one to measure whether a fund is doing better or worse than similar participants in the financial markets. It measures a fund’s ability to make investment choices better than average, but is difficult to achieve over time because, by definition, half of all funds striving to be above average end up being below average. Also, certain peer group data is only available annually and one can never find a perfectly similar peer group, which limits the value of peer comparison. Land Grant Endowment Growth of Corpus Measures & Benchmarks

• Measure: Percent change in the Permanent Fund o Equal to or greater than inflation and population growth

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Rationale for establishing the measure/benchmark The mission and ultimate purpose of Idaho’s land grant endowments is to provide a perpetual stream of income to the beneficiaries. To balance the needs of current and future beneficiaries, over time the corpus of the endowment funds should grow at a rate equal to or greater than the growth in inflation and population, so that endowment distributions can keep up with the growth in beneficiary funding needs. Land Grant Endowment Distribution Measures & Benchmarks

• Measure: Stability of distributions to beneficiaries o No reductions in total endowment distributions

• Measure: Percent change in distributions to

beneficiaries o Exceed inflation and population growth over a five- year

period

• Measure: Level of Earnings Reserves o 600%-700% of the last year of approved

distributions (depending on endowment)

Rationale for establishing the measure/benchmark The adequacy of the returns of the endowment funds and the efficacy of the Distribution Policy are ultimately measured in terms of the distributions to the beneficiaries, both in absolute dollars and in consistency from year-to-year. While the vision of the state’s land and financial endowment assets is to grow distributions over time at a rate equal to or greater than inflation and population growth, endowment beneficiaries experienced declining distributions for four years straight after FY 2002 due to lower timber revenues than expected, especially in FY 2003 and FY 2005, the significant bear market in equities in 2000-2002, and high levels of distributions in FY 2001 and FY 2002 relative to the size of the reserves. The drop in distributions in FY 2003 was especially traumatic, because it coincided with a significant shortfall in expected General Fund revenues. Since most beneficiary funding supports ongoing personnel costs, maintaining distributions year-over-year is strongly preferred. To allow distributions to continue when there is a shortfall in income, the fund maintains reserves of undistributed income.

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Land Grant Endowment Distributions To Beneficiaries 1995-2019 Actual/Approved/Estimated, Net of General Funds

Nominal and Inflation-Adjusted

(Net of General Fund contributions 1995-2000, 2006; includes special Public School distribution in 2011 of $22M)

100

80

60

40

20

0

Fiscal Year Excludes Capitol Fund

Source: Legislative Services, EFIB records

Earnings Reserve funds for all eight endowments were at target levels at the end of FY 2018. After analyzing the variability of land and fund revenues, the EFIB has determined that having at least six years of distributions for Public Schools and seven years for all other endowments should be sufficient to prevent the need to reduce a beneficiary’s distribution in all but the most extreme disruptions of fund and land revenues. However, if expected land revenues, based on forecasts provided by the Department of Lands, are temporarily much lower than normal, the EFIB may recommend that an endowment temporarily hold additional years of reserves until land revenues recover. At the end of each fiscal year, any reserves in excess of the level that is determined to be adequate and reasonable to secure future distributions thru a market downturn may be transferred to the Permanent Fund. This will allow the Permanent Fund, which is held primarily for the benefit of future beneficiaries, to grow over time at roughly the same rate as the Earnings Reserves, which are primarily for the benefit of current beneficiaries. The policy of setting distributions as a percentage of the Permanent Fund ties growth in distributions to growth in the permanent corpus which further aligning the interests of both current and future beneficiaries.

8 $

Inflation-adjusted (2017$)

$78 $73

$70 $65

$22 $63

$56 $57 $55 $56

$51 $52 $48 $46 $46 $46 $48

$52 $49

$37 $36 $36

$42 $39 M

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f Dol

lars

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The Capitol Permanent Fund has a Maintenance Reserve Fund to accumulate earnings in preparation for major maintenance projects at the Capitol Building in ten years or more. Because it is intended to fund rare, one-time distributions, the Capitol Reserve is less sensitive to temporary disruptions in annual distributions from its Permanent Fund. Other Endowments – Growth of Corpus Measure and Benchmark

• Measure: Percent real change in the fund o Equal to or greater than inflation over a five-year period

Rationale for establishing the measure/benchmark The mission and ultimate purposes of the Bunker Hill Endowment, the Fish and Game Wildlife Mitigation Endowments, the Trail of the Coeur d’Alenes Endowment, and the Ritter Island Endowment Fund are to provide a perpetual stream of income to support certain operations. To balance the needs of current and future beneficiaries, over time the corpus of these endowment funds should grow at a rate equal to or greater than the growth in inflation so that endowment distributions keep up with the growth in beneficiary funding needs.

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External factors that could significantly affect the achievement of our goals and objectives

The major outside factors impacting the EFIB are the returns and volatility of the financial markets and the level of revenue generated from endowment lands. Financial Markets

The portfolios managed by the Endowment Fund Investment Board are subject to the variability in the financial markets. Our investment philosophy values simplicity, transparency, focus and patience. Portfolios are constructed primarily with traditional public equities (domestic equities, international developed market equities, emerging market equities) and fixed income securities (government, mortgage backed securities, inflation protected securities (TIPS) and corporate bonds) and in some cases include private real estate investments. Most of our investments are in securities that are priced daily and can be easily sold to rebalance the portfolio or provide liquidity. The single most important factor in determining the absolute level of investment returns is the long-term asset allocation. We use long-term strategic asset class allocations and rebalance to those allocations within suitable ranges. Rebalancing keeps the portfolio diversified and maintains consistent risk/return characteristics. We periodically conduct asset allocation studies to assess the probability of achieving long-term goals and may make adjustments in asset classes or sub-asset classes. The achievement of long-term investment goals is derived from sound investment decisions and efficient and consistent implementation of the strategy. Tactical asset allocation and frequent manager changes are likely to result in poor outcomes that will impair the long-term performance of the portfolio. Market timing is difficult and ineffective for institutional investors so we remain fully invested in long-term mandates. We utilize long time frames and appropriate benchmarks to evaluate investment managers. Managers will have periods of both under and out-performance relative to indices and can only be evaluated over a full investment cycle. The following table outlines the asset allocation of the two primary portfolios managed by the Endowment Fund Investment Board.

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Asset Allocation of EFIB Portfolios

% Of Assets Invested (Target Mix) Land Grant State

Endowment Insurance Fund Fund

Equities Domestic equity

38% 10% International equity

19% 3% Global equity 9% 0%

Total Equities 66% 13% Fixed Income Treasuries/Agencies 10% 50% TIPS 4% 8% Mortgages (agency) 5% 7% Mortgages (non-agency) 0% 1% Corporates, other 7% 21%

Total Fixed Income 26% 87% Real Estate 8% 0%

Total

100%

100%

Duration/Maturity of

Fixed Income (years) 6.25 4.40 Source: EFIB analysis Note: The duration for the State Insurance Fund matches their liabilities.

For the Land Grant Endowment Fund, gains in the Permanent Fund are recognized as income only when the Fund has a total cumulative gain in excess of inflation. This total real income approach protects the inflation-adjusted corpus or principal in the permanent fund, since gains in any one year will first be applied to offset any past losses in principal. However, this approach will also result in zero revenues flowing to reserves in years in which there are cumulative losses in the securities market. Historically, market losses in a 66% equity, 26% fixed income, and 8% real estate portfolio have occurred in one year out of three. Also, in each twenty-five-year historical period there has been one period where no income would have accrued from the permanent fund to earnings reserve for five consecutive years.

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Land Revenues

For the endowment funds, the performance of the land assets is another major external factor that can significantly affect the achievement of the objective of providing sustainable distributions to beneficiaries. About half of the sensitivity of the return on total endowment assets is driven by the net cash earnings on the lands and about half by the total investment return of the funds. The total cash available for distribution to endowment beneficiaries is highly influenced by variations in net cash earnings of the endowment lands. Over the last fifteen fiscal years, these earnings have averaged $45 million annually, with a range of about plus or minus $10 million (about 20%) except for 2010, when revenues plunged 50% below average and 2014, when revenues jumped almost 40% above average.

By 2019, when the plan to dispose of most commercial properties and cottage sites is complete, at least 85% of the net land revenues of each of the endowments will come from the sale of timber. Therefore, the earnings from land will be even more sensitive to the price and volume of timber harvested.

When financial and land assets are combined, the mix of total endowment assets is approximately 38% equities, 34% timberland, 15% fixed income, 5% U.S. commercial property, and 7% other Idaho land (primarily vacation property ground rents and rangeland).

Fiscal YearNet Cash

Earnings ($M)2003 34.8 2004 49.9 2005 37.8 2006 47.8 2007 54.0 2008 49.8 2009 35.0 2010 21.4 2011 40.9 2012 39.9 2013 48.4 2014 64.1 2015 55.4 2016 52.9 2017 41.4 Ave 44.9

Standard Dev 10.2

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Land assets are valued based on expected cash flow, which excludes the incremental value of land being held for conversion to higher and better use (which appraisals estimate could add over $1 billion to the value).

Land value is based on expected cash income.

Source: EFIB, Callan, IDL (as of June, 2017)

Since over a third of total endowment earnings come from timber, a major external factor outside of our control is the price of timber and the volume of harvest. The following graph reflects the variability of timber prices.

Domestic Equity :: 27% • Commercial Real Estate :: 5%

International Equity :: 12% • Timberland :: 34%

Domestic Fixed Income :: 15% • Other Idaho Land :: 7%

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$/MBF

700

Idaho Endowment Land Log Auction Price Trends Actual and Inflation Adjusted (Six Month Rolling Ave)

1989‐2017

600

500

400

300

200

100

Source: Idaho Department of Lands, EFIB analysis

Like the stock market, timber prices are essentially unpredictable, so this adds significant risk of error to any cash flow forecast the Department of Lands or the EFIB might use to develop recommended distribution levels. As shown in the graph that follows, the volume of total harvest can also vary significantly from year-to-year.

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History shows the potential for significant, temporary drops in harvest volumes. Three different times in the last sixty years,

harvest volume has fallen approx. 50% from one year to the next

Mill

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Idaho Endowment Land Sawlog Harvest Volume By Calendar Year 1951-2014

400

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Calendar Years (Source: Department of Lands)

Because 70% of the endowment timberlands are for the benefit of public schools, the above graph is a fair representation of the variation in harvest levels on school lands. However, since the land bases of the other eight endowments are significantly smaller (see table below), the variations in their harvest levels from year to year are even larger than the graph above implies and therefore more difficult to predict.

Endowment

Total Acres

Forest Land Acres

% of Total

Public School 2,076,829 683,826 70% School of Science 75,497 63,606 7% Charitable Institutions 77,241 63,122 6% Normal School 59,639 43,606 4% University of Idaho 55,094 42,665 4% Penitentiary 28,915 27,125 3% State Hospital South 31,376 26,192 3% Agricultural College 33,526 15,173 2% Capitol 7,283 7,228 1% Total 2,445,400 972,543 100%

Source: Idaho Department of Lands 6/30/2016

Boa

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The variability of land revenues for all of the smaller endowments over the past fifteen years is two to four times greater than the Public School endowment, as shown below.

Volatility Of Land Revenues

Average 17-Year Annual Standard

Revenues Deviation ($ millions) (% of Average)

Public School 40.1 15% Normal School 4.4 30% School of Science 4.1 35% University of Idaho 3.8 40% State Hospital South 4.9 40% Charitable Institutions 4.7 46% Penitentiary 2.2 54% Agricultural College 1.0 64%

65.3 17%

Source: EFIB analysis thru FY 2017. Data is not available for the Capitol Permanent Fund.

Volatility for Normal School and State Hospital South is expected to rise as the current plan to dispose of commercial buildings and cottage sites is completed by 2020.