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>> HENRY JONES: We are going to start the, reconvene the workshop. Eric, would you take
it? >> ERIC BAGGESEN: Thank you, Mr. Jones.
The next section in the ALM work that we are going to proceed through is a discussion on
both the liquidity allocation, we have a recommendation related to the actual targeted amount of liquidity
that we have, and that is going to be followed by a discussion on the whole treasury management
function. Ben is going to carry the discussion on liquidity and Cheryl Eason, our CFO will
lead the discussion on the treasury function. Following that, the next session will be related
to the potential on flexible derisking and we will have Alan Milligan and Dave and Jordan
leading those parts of the discussion. I'll turn it over to you, Ben at this point.
>> BEN MENG: Thank you, Eric. I'm senior portfolio manager of asset allocation. Good morning,
committee members. There are four sections to this session of the presentation this morning.
First, we would like to provide you with a overview of the session. And then followed
by our recommendation for strategic asset allocation to liquidity as a asset class.
In the third section we would like to invite our board consultant, Wilshire and PCA to
discuss liquidity allocation by our peer group. Our last session, our chief financial officer,
Cheryl Eason is going to provide a introduction to the function of our treasury management.
There are two objectives of this presentation. First, we recommend a change in the strategic
asset allocation to the liquidity asset class from the current target 4 percent to 2 percent.
The second objective is for our financial office to provide a introduction to treasury
management. Before we get to the strategic asset allocation
for liquidity, it is helpful to provide you with a historical context.
Prior to 2009, there were no official allocation to liquidity. It was during May, 2009 during
the interim asset allocation review we first established a allocation to liquidity.
Back then, we set 2 percent as the target of allocation for liquidity, with a range
between 0 percent to 5 percent. During the last asset and liability management workshop
in 2010, liquidity was formally recognized and established as a asset class with strategic
target of 4 percent allocation, and with a range of between 1 percent and 7 percent.
Mainly due to the age and maturity of our fund as you know that investment cash flow
for our fund went from positive to negative recently. That number is increasingly becoming
more and more negative which highlights the need for us to have a liquidity.
In addition the global financial crisis of 2008 showed us how quickly market liquidity
can dry up during time of market stress. We put this together and highlights the importance
to have you are to manage our liquidity position more proactively going forward.
We made a case of, we have the need to manage our liquidity position much more proactively.
On this slide, we would like to show you that, however, on the flip side of the argument,
having too much liquidity can be costly. What we have done on the slide, we show you
based on 2013 capital market assumptions which shows you the difference in expected returns
between liquidity as a class and three other asset classes from which we could source liquidity
allocation. For example, if we allocate away from the
total fund to liquidity bucket, return difference between liquidity and total funds is 5 percent.
For any 1 percent additional allocation to liquidity, which means roughly $2.7 million
more allocation to liquidity, it represents a opportunity cost per year at $135 million.
The bottom line of this slide is having too much liquidity is costly. But we also know
that not having enough liquidity can be deadly. What is the right amount of liquidity for
us? Yes, Mr. Jelincic. >> JJ JELINCIC: You talk about the opportunity
cost. But there's also an opportunity cost in not
having liquidity, in that one of the things we have done is we have given you a $8 billion
allocation to this special situation fund. And if we don't have $8 billion around you
clearly can't use that. I don't think Joe's got the stomach to make a $8 billion bet in
one fell swoop. I'm not sure he should. But we also, as we reduce the liquidity, we
are actually reducing the ability to take advantage of unique short term market opportunities.
So that really needs to be thought about in terms of the opportunities cost.
>> BEN MENG: Yes, that is a very good point. You are absolutely right. If we reduce the
amount of liquidity too much, we will lose the opportunity, if the market crisis comes,
we don't have the dry powder available to us to deploy. Today's presentation is about
the balance, what is the right balance for us between not having enough liquidity or
having too much liquidity. As I said, not having enough liquidity can
be deadly. Having too much liquidity can be costly. What is the right amount of liquidity?
Before we answer that question, let's take a look at what has changed since 2010, when
we first established the 4 percent liquidity allocation.
I do recall that officially liquidity allocation was in response to the 2008 global financial
crisis. Back then, we had two major concerns of liquidity demand. First is security lending
program, and second is the committed capital to private asset classes.
Since 2008, we have made, we have restructured some of our program areas completely. For
example, for one of the liquidity concerns that we had in 2008 which was security lending
program, the on loan balance has been reduced by more than two thirds from 33.9 bill dollars
in 2008 to roughly $10.8 billion today. Yes. >> JJ JELINCIC: What do you mean by on loan
balances? >> BEN MENG: That is the size of the security
lendings program. The security lending program, we have securities. We can lend other security
and take in cash as collateral, and then in return we manage the cash, the investment,
and during 2008, during the 2008 crisis, we found that our cash investment portfolio was
locked up in dry up of liquidity. But meantime, the collateral, the security we lend out to
other parties, the value was falling. So we had to put up more cash collateral to match
the gap in that. So that was the nature, that was the nature
of the second lending, security lending crisis for 2008.
>> JJ JELINCIC: If they are putting in more cash, why is that our problem?
>> BEN MENG: The cash itself wasn't the problem. The problem, our chief senior investment officer
can chime in, the problem is how we invested the cash back then, back in 2008.
>> Simple example. Stocks worth a hundred dollar, it drops to 80. If it's on loan, we
have to give them back 20 bucks. Right? Because it dropped.
Usually, you do that through redemption of your, whatever you reinvest it in. In the
case of securities lending, there was an asset backs. During that market crisis, asset backs
locked up, could not sell it. Therefore, we needed to get cash from some place else.
Then the fear was, stock market was going to fall even further, right? So we even needed
more cash. So because of the fear of the stock market falling, we built up bigger balances.
Not only immediate needs but future anticipated needs.
This was kinds of the discussion of the shadow banking system and all that stuff, that does
that make sense? >> Yes, thank you.
>> Excuse me. This sounds a little technical. But being squeezed for liquidity in the midst
of a downturn is one of the worst places a pension fund could be.
So that is why the lessons drawn from that are so important, that changes in the management
of the securities lending program and the increase of the liquidity buffer, not to take
away from the presentation that's coming, but we think we understand sources of liquidity
better, and the demand for liquidity is less, and better understood.
That is one of the reasons we are doing this. But let my colleagues make the case in detail.
But I want to underline this. This is one of the key lessons of the global financial
crisis for us, in how we manage the portfolio. >> BEN MENG: Thank you, Joe.
Yes? >> HENRY JONES: I don't want to digress too
much, but Curtis, you mentioned shadow banking. During the last week, I was listening to a
lot of discussions regarding shadow banking. What is shadow banking in the United States?
>> CURTIS ISHII: It's based, the way I define it, it is a way in which lending or the creation
of cash was created outside the banking system. So there was this way for people to get, instead
of getting a loan on margin after a brokerage firm, you can go and get it through the securities
lending, and just, you give collateral, and you got cash. Right? You could do something
with it. So they could lever it up. Traditionally you would do it within the system, the banking
system. This system was getting deregulated, and the
problem with it is, but you couldn't, you didn't know the size of it. You didn't know,
and for us, what Joe, the lesson we learned was, the problem on this was things that we
thought were liquid, so asset backs were liquid, that was a very liquid market going into that.
What happened was, liquid securities can become illiquid. That never happened in my career,
but it is one of those events. So we went back and looked at what was the purpose of
securities lending? And it is said to be driven by the loaned portfolio, and what it was being
driven, was by return. So, went back to basics and said, you know,
this is not something we do. Now, for that, obviously we are making less money, in the
whole, the whole securities lending, because we geared it down.
That is a use of liquidity. But I don't know if I explained it. It is really, any kind
of activity outside the existing banking system. >> I got it. Thanks.
>> You might add to that unregulated outside of the purview of central banks and other
financial institution regulatory authorities. >> HENRY JONES: It is kinds of like we mentioned
during the crisis off balance sheet debt that these big corporations had. No one know how
much because it wasn't on the balance sheet. >> Right.
>> Okay, thanks. >> Was this equivalent to the option rate
prefer, is one example, I guess? >> That was an example of what some people
invested in, yes. >> Right.
>> CURTIS ISHII: That was something that was rolling, and then it came into, suddenly you
couldn't roll it. >> It locked up completely.
>> CURTIS ISHII: Right, so no one could do anything. That was our reinvestment side.
We didn't have a lot of those but we did have some.
>> The brokerage houses were accommodating individual clients, in all, offering alternative
liquidity. But not for industrial clients. Too big a market.
>> CURTIS ISHII: That is exactly the problem. What we did is tested out the market during
the crisis, to see if there really was I wanted to see, everybody was telling me there was
no liquidity so we tested it. We tried to sell a hundred million, which is nothing.
And with ten brokers, got two people to come back, and the person who was the best bid
said, if you sell it to us, we are not going to be there for the rest of this time.
So basically, things dried up, lessons learned is, if you look at the securities and they
will be getting to it in the next slide, is really, the way we got conservative is, we
rely not on the ability to sell, but on the maturities. We changed the whole way it was
going to run. So we make sure, it matures. And that's the
way we look at liquidity now instead of the ability to sell.
>> You are latterring maturities. >> CURTIS ISHII: Correct. Actually it's even
over, 75 percent of the portfolio can mature within 30 days. I think it was, what did you
get? 90 percent? >> Yeah.
>> Okay. Thank you. >> BEN MENG: In addition to completely restructuring
our security lending program, we have also internalized our collateral management process.
So that we can monitor, control and optimize the collateral posting process.
So and also, on top of lease program errors restructuring, we have also made great strides
in investment management process. We established the investment strategy group, which is, consisted
of, comprised of senior investment officers from each asset class to facilitate a timely
discussion of the markets, the economy, and more importantly with an explicit attention
to liquidity management. And the lease represents the collateral management
improve, represent a significant liquidity risk reduction. Yes.
>> The previous page, I think it is worth underscoring the committed but undrawn capital,
in the lessons learned and confessional kind of point, the confessions point of the presentation.
The other squeeze on pension funds across the country and CalPERS in particular in a
financial crisis was the sheer amount of uncommitted capital, particularly related to the private
asset classes. And liquidity management is crucial in that
context when you are looking at committing large amounts of capital to the private asset
classes, or to increase the allocation to private asset classes. What comes with that
are very large commitments to external managers, in the numbers that you see here, which were
again at the very point in time where, actually, you are glad that you have, you hope you have
capital available to take advantage of the market dislocation.
In this case, it was a fear, because the sheer amount of capital that was committed and uncallable,
not able to, we weren't able to cancel it, was another great squeeze on our liquidity
management to see whether we could get through the crisis. I think it is worth underscoring.
>> Yes. >> JJ JELINCIC: Along that line, the reduction
in the use of commingled funds is a significant part of this reduction.
>> It is a portion of it. On the real estate side, the reduction in commingled funds for
sure, and one of the attributes of the real estate separate accounts is that we can cancel
those contributions if need be. But it is not all of it. It doesn't encompass all of
the asset classes and all of the commitments. >> I assume in the private equity some of
that is going on as well. >> So we still do invest in commingled funds,
but the uncalled capital went down from the high 20s to about $12 billion today.
>> JJ JELINCIC: In private equity, aren't we also doing more separate accounts or at
least trying to do? >> More separate accounts, but unlike real
estate we still do invest in commingled funds. >> Thank you.
>> Sorry, Ben, if I can make one comment in relation to this.
this reduction. >> TED ELIOPOULOS: It is a portion of it.
On the real estate side the reduction in commingled funds for sure and one of the attributes of
the real estate separate accounts is that we can cancel those contributions if need
but it doesn't encompass all the asset classes and all the commitments.
>> JJ JELINCIC: And assume in private equity some of that is still going on.
>> We still invest in the commingled funds but the uncalled capital went down from high
20s to about 12 billion dollars today. >> JJ JELINCIC: In private equity are we also
doing more separate accounts. >> We doing more separate accounts but in
real estate we do separate commingled funds. >> ERIC BAGGESEN: If I can make one comment
in relation to this, Mr. JJ Jelincic raised the issue of being able to take advantage
of opportunities that appear in the marketplace and this unfunded committed capital with all
of our external partners is one of the core mechanisms that we use to take advantage of
the opportunities in the marketplace. These are individuals that are highly incented to
identify those opportunities and then they call capital from CalPERS in order to take
advantage of that we need to recognize that we have tons of capital that is available
and also says nothing about the capacity that we have in order to raise capital should we
identify an opportunity that somehow. Don't see and under which try oughts of security
lending program is it has the ability to raise capital and constitutes the equivalent of
a credit line. By putting securities that we already own out as collateral we can take
cash back from intermediaries in the marketplace. The estimates that we have and the securities
lending program right now that we could probably raise anywhere up to $10 billion in a matter
of probably no more than 24 to 48 hours basically if we needed capital to take advantage of
something. And we also have the ability to substitute
exposure. That's one of the attributes of the derivative markets. So in Dan's team and
global equity we have the capacity to substitute the actual ownership of common stock securities
with derivative instruments that free up all kinds of cash underneath that. So that program
currently is rolling derivatives portfolio that is anywhere from 6 to 10 billion dollars
in size and expand that capacity. So that's another source of potential very short term
liquidity but you have to recognize the sources. They constitute borrowings. So we are in essence
borrowing money from the marketplace in order to potentially take advantage of an opportunity
that exists. So I always have to figure out how you are
going to pay back that borrowing if you pursue in that fashion.
>> BILL SLATON: Let's go to 2009 event. And let's go to a market falling now discuss the
alternatives that you just mentioned and the amount of liquidity that we would have?
>> ERIC BAGGESEN: I mean going in to the sort of 2006, 2007 time period we had security
lending balances that approached 50 billion dollars at different time points. The securities
lending people when we went in to this in 2008 that this basically put all kinds of
securities on loan in order to bring cash in to the program to substitute for the cash
that they couldn't sell out of the collateral pools that had been invested in to longer
duration asset backed securities. They had done a terrific job of substituting additional
collateral in the program and puts more assets on loan. Right now we are running a program
you can see the on loan balances is a fraction of what it was in that time period. There
is a tremendous capacity there to put additional securities on loan should that be needed.
And the collateral management is very conservative. So we think that that program right now currently
could create tremendous amounts of liquidity in that area and in the derivative space the
equity segment of the portfolio the liquidity was always there. Albeit you may not have
liked the price too much but if we were substituting derivative exposure for cash security you
are selling in one market at a disadvantageous price and you are buying in another market
at that same disadvantageous price. You are keeping your economic exposure through that
substitution effect. We haven't seen that marketplace cease to be able to function to
be able to raise liquidity should that be necessary but there is it a finite limit of
how much you can do of that. Basically trying to take advantage of opportunities, we have
very much identified a whole array of back stop liquidity functions and features if you
will >> CURTIS ISHII: So simply if you put that
scenario the crash 2008 we would have I think we would have enough liquidity actually to
put money in to the market, right? >> BEN MENG: Now back to the slide, which
mentioned early on there were two major liquidity concerns back in 2008 and when we established
the 4 percent liquidity target the balance is more than two thirds less than in 2008
and committed capital was less than half it was in 2008. So we anticipate large liquidity
from these two sources going forward. And in addition we have made these changes
in our investment management process. So given the restructuring of the programs and changes
and improvements to the investment management process we feel comfortable with liquidity
allocation lower than 4 percent. Now the question becomes how much lower, why is it 2 percent
liquidity allocation is the right number now. Let's turn our attention to the history of
CalPERS cash flow situation. So on these chart the solid blue line represented a month's
end balance of internal short term cash portfolio and some people view these as the checking
account of CalPERS and then the purple bar represents the liquidity need or cash flow
need every month we have since June 2008. First of all, it is important to note that
we as CalPERS have never missed a payment to our members or to our service providers
and on top of that when you compare the solid blue line which is our checking account to
the purple bar which is the monthly cash flow need you can see that we have always maintained
enough cash on hand to meet multiples of month's cash flow needs. In addition as you can see
since July 2011 so last time the asset and liability and management workshop was held
in 2010 and it became effective July 2011, we see the liquidity buffer that's where the
4 percent allocation came about. On top of the solid blue line our checking account,
since July 2011 we have maintained a liquidity buffer. And during the entire period since
July 2011 we have never tapped in to that liquidity buffer. If you look at the dotted
white line that is the combination of the cash account we have now, the solid blue line
plus the liquidity buffer which represents the 4 percent allocation we have today and
then the dotted green line represents our recommendation that we are making for going
forward which is the 2 percent allocation to liquidity. As you can see that's a 2 percent
allocation, which is a dotted green line is sufficient for liquidity management purpose.
Yes, Dr. Diehr. >> GEORGE DIEHR: Something doesn't seem to
add up here. You have got the cash now is about just under 5 billion. The fund is 270.
2 percent on top of that would be another green line is that right?
>> BEN MENG: Yes. You are right when we produce this slide in because of the time constraints
that the data we had the solid blue line, so the short term basically SG 10 account
with investment called SG account that includes not only the cash for the liquidity purpose
also including cash positions from collateral management margin cost. So that's why the
solid blue line when you add it up, your observation absolute lie right. It doesn't seem to add
up on the chart. >> ERIC BAGGESEN: Part of the liquidity buffer
is the CalPERS checking account and the other reason those lines are not flat because, you
know, the value of the fund hasn't changed that radically. There is a range around how
much is allocated in to the liquidity buffer. So the range runs from 1 percent to 7 percent
currently. So we don't maintained a flat lined 4 percent if you will liquidity buffer. We
have taken that up or down marginally depending on what's going on in the portfolio. That's
the reason that the dashed red and green are not just flat lines at the 4 and 2 percent
of CalPERS and the blue is a portion of either of those lines.
>> BEN MENG: Any questions or comments? Ann please.
>> Ann: What's the spike in 2012? >> BEN MENG: December 2012. That's a good
question. >> ERIC BAGGESEN: CalPERS has not had to sell
securities directly ourselves in the past year or two years.
>> CURTIS ISHII: I think that part of it was we were underallocated to liquidity. So the
allocation was made to the 2010. I think the markets had done well and you wanted to take
some risk if I remember right. >> BEN MENG: We can look in to it and get
back to you. >> ERIC BAGGESEN: As this chart is on the
screen, if you look back in the 2008/2009 period you can see the tremendous volatility
was hitting the fund, those purple bars above the thing was basically raising liquidity
and that was the sale of equities. The large purple bar that drops down that was a repurchase
of equity exposure that became evident that we no longer needed that degree of liquidity.
That was an allocation back to the risk markets. >> BEN MENG: Yes, Tara please.
>> TERRY McGUIRE: Just to clarify on this graph, the two dashed lines. I am not going
to refer to colors because I am color blind the but the two dashed lines are just illustrative
of the 2 and 4 percent? There is no other purpose for them other than to illustrate?
>> BEN MENG: Correct. Seeing no further questions we would like to invite our board consultant
to discuss liquidity for our group, Wilshire & Associates.
>> MICHAEL SCHLACHTER: Page 11, all 134 state systems. This is compiled from the CalPERS,
every U.S. state size pension system in the U.S. Very, very top of the page for those
I guess who are not color bind there is that peach or sand colored bar that shows cash.
There are a few I think opportunistic that remain in that area. Cash was very low for
a period of time and then balloon out post crisis. Page 12 we took that one bar and blew
it up. Again average cash and types of other types of liquidity ran from 2 or 3 percent
post crisis that ballooned and as you can see but over the last year or so it has begun
to come back down again because I think that people have began to rationalize how much
cash they need to have on hand. Everyone reacted the same way. The question now is too high
too high or is it a fair level going forward. >> PRIYA MATHUR: Just to be clear you laid
out earlier in this slide deck that you think circumstances have changed to some degree,
not external circumstances so much as our internal circumstances our ability to access
cash more quickly and various other things, so now where was I going with that? The point
I wanted to make we don't want to be in a position where we have to quickly raise cash
expensively if we are hit with a similar situation as we were in 2008 and you are saying we are
in a better position now to raise cash cost effectively because of partly because of what
you said about the using the maturity date for securities as opposed to the ability to
sell and other features, is that in a nutshell what you are saying?
>> ERIC BAGGESEN: Yes, that's exactly correct. We basically changed the structure by which
the organization is managed and the dialogue that happens around the management of liquidity
basically incorporates every asset class now to really understand the view that they have
is to the liquidity they require. And that also allows us to bring evaluation component
to the discussion so we can elect within the portfolio
>> CURTIS ISHII: Prior to this during the crisis liquidity was a lot of it was handled
within fixed income. So any time we needed cash I would just sell part of the portfolio
and just do it. And so that is the silo mentality we had before. I had done it for 20 years.
I just kept doing it. What the change they are talking about since the crisis it is a
discussion. It is brought up and we bring it up every month. So we look at it and so
that's why in we get in to a prolonged situation where, you know, there is going to be draws
then we will have that discussion and then we will figure out how to do it. If you look
at it because the private asset classes have dwindled. That was a huge fear at the time.
I am thinking the stock market is falling like mad and why they aren't they coming in
and they may buy a bunch of corporations and we came to the realization my gosh this book
was too big and the private asset class we have to stop them from putting money to work
but they really weren't as we found out later they needed a fully functioning debt market
and they were closed. It was the fear of all this stuff and that's really why I think you
saw this rise in the liquidity because everyone in the same boat and the you are seeing the
securities lending agency changed after 2008 and it has gotten conservative in what they
allow people to do. >> PRIYA MATHUR: But also for us to be able
to make, you know, special investment if there is opportunities in the market we don't want
to always we don't want to be buying high and selling low. We want it the opposite.
So if there are shocks to the market that we can capitalize on that's where we would
like to be I think. As long as not too expensive to carry the cash, you know, in the other
periods. >> JOE DEAR: I think that's a really important
point and that has been what CalPERS traditionally has done in big downturns is buy. I want to
underscore one other attribute of having sufficient liquidity in a big downturn it gives you the
capacity to ride it out. You lose the diversification advantage and the ability to ride it out helps
you not realize losses and gives you a better shot of returning to the return line that
is the 7 and a half percent expected return that we have currently. So the there are lots
of reasons why liquidity is important and this bow work against a big drawdown is the
most important. It conveys the opportunity to put money to work when everyone else is
afraid or unable. That's a huge advantage. This is at the crux of how to manage the portfolio
over time. >> BEN MENG: Yes.
>> JJ JELINCIC: Putting money in, I was on the desk for the '87 cash we put a billion
dollars in the market that day. We were criticized in the news and if you have a VCR I can show
you the tapes. My question on 12 obviously in '01, '02, '03 and '04 something significant
happened in those years. What happened in 1, 2 and 3 that encouraged people to take
it down to basically 0 and then suddenly pop up in '04 and you may not remember your history
enough to answer the question. >> MICHAEL SCHLACHTER: That was the bottom
of the Nasdaq. Not unlike the credit crisis of 2008 everyone is trying to put things back
to work, opportunities existed in the marketplace. These are the policy targets as stated in
CalPERS. This is simply again the published. So you got to think that much like yourselves
you pick asset allocation target, you then sit with that for the next three years. So
the low cash targets you are seeing in 2001 and 2002 were born of asset allocation work
done two or three years beforehand. The top of the Nasdaq bubble everyone realized that
any cash on a balance sheet is a terrible anchor. Stocks always go up. Stock go to the
moon. Let's take cash to 0 and the Nasdaq bubble obviously collapsed and low and behold
everyone had a cash allocation afterwards and realized it was a mistake. It was simply
recovery to a reasonable level of cash in light of maybe we shouldn't have gotten entirely
out in front of what happened. >> HENRY JONES: Alan.
>> Alan: A couple of issues. The first is in terms of just this term liquidity, you
should be a provider of liquidity. You shouldn't have to pay for liquidity. So just looking
at that from an investor's perspective you want to be on the right side of that trade.
Which means that other people who need cash should be coming to you because you have it
available. I would argue that this isn't on the short term side, isn't really liquidity
management. It is short term asset liability management and in fact, what it is saying
is that you want to make sure that you have a pool of assets that are there without any
market impact to meet your obligations in the timely way. And that is really not liquidity
management of. Those of you remember the savings and loan crisis in the '90s that is about
S and Ls making long term investments and having short term liabilities and that's the
mismatch you want to avoid at all costs. >> GEORGE DIEHR: Just some professor knit
picking, several of us several over what other was. Was this infrastructure or commodities.
Your modified distribution, that one acts as frequency and the other is percent and
the fact that it is monthly data is sort of buried in really small print down at the bottom.
I guess so these things stand by themselves a little more and don't require some explanation
that would be appreciated. >> This is compiled from the 134 state systems.
So the extent that not everyone is diligent in publishing the breakdown. Real estate of
a different type. Hedge funds, private eave quit at this and the other is much like your
ten year >> GEORGE DIEHR: Liquidity stuff.
>> MICHAEL SCHLACHTER: Yes. For the most part it is just cash or you have ten year government
bonds which others might consider a core bond investment you consider it liquidity. We still
lumped your ten year government bonds. >> GEORGE DIEHR: The rest of them because
of focus here is on the cash that would have gotten us over that bump.
>> I think that Mr. McGuire has a comment. >> TERRY McGUIRE: Thank you. The liquidity
is very important. That's this discussion. And I think in December 2010 when we went
from 2 to 4 percent I remember feeling that that was probably an overreaction because
we were about a year passed the crisis. We had already taken significant steps to reduce
risk, liquidity risk in the portfolio. And basically since that time each 1 percent of
liquidity in the asset allocation has caused about 400 million dollars because I like to
measure it on the total return number. I think that's where it is appropriate.
Two important things that were brought up by Eric and Curtis, were the liquidity provided
by the equity portfolio, by futures market and so on. And the securities lending program.
And I think we need to be informed more about that because I think that can impact the discussion
as to whether or not the asset allocation should be 2 percent or 1 percent.
The way it was described it seems like those liquidity provided by those two programs dwarf
in some respects the liquidity target. So why should we have a 2 percent liquidity target.
I sat in an investment committee for the fund across the river on Friday and CE young was
making a presentation and one of their slides presented the asset allocation basically by
policy for that fund's peer group and all other funds. 15 peer group, 184 other funds.
And cash was 1 percent in 2012 by policy. Now of that's different from I talked to Michael
that, you know, that 1 percent is a lot different than the 5 percent presented in the Wilshire
numbers. So liquidity is how you want to classify it. I think we all know that. But we need
to know better what you can classify as liquidity and how much and how available that liquidity
is before I think we can make a decision as to whether or not the 1 percent or 2 percent
might be appropriate. Because each one of these percentages in the asset allocation
is extremely important. It represented a cost over the last three years and potentially
it will represent a cost in the next three years. All right.
>> ERIC BAGGESEN: Mr. McGuire, I think to answer that basically one of the exercises
that we will engage in tomorrow can we can put numbers to some extent behind exactly
of what you just referred to. What is, you know, the opportunity to potentially change
and how that impacts the risk and return profile of the fund if you shift the liquidity target
and threshold. I think the other element in this that's really important one of the aspects
that will come back when we bring a portfolio or a target portfolio asset allocation recommendation
to the board we also be bringing back information around the ranges around which we want to
be able to have discretion to manage the fund because literally the liquidity target is
simply that, it is a target. The staff need and the ability to actually change the amount
of liquidity and the exposure to liquidity that is allocated within the portfolio depending
on market conditions, so as long as the market is operating in a way that basically allows
us to convert assets very flexibly in to cash, then we can have a diminished liquidity target
and the market is certainly operating currently in a way at least in the space of the equity
markets and I think the government bond related markets it is accommodating to reducing those
liquidity targets down to almost nothing. The question becomes one of, you know, how
much do you want to be able to really have reserve for that function. And this is a dialogue
because one of the we have sort of a dichotomy existing right now in that we are talking
about moving to a cash flow negative position and we are talking about reducing liquidity
at the same time. We think that the liquidity allocation is not how we satisfy the cash
flow and the satisfaction of that needs to come out of the normal operating management
profile and this is the sort of insurance policy that we retain to make sure if anything
goes wrong we have the ability to reach in to another asset but I think that it is a
fair comment. Even 2 percent though too much? >> CHERYL EASON: I would add to that Mr. McGuire
because my presentation about treasury management really is about the journey this we need to
take in order to really understand and the work we need to do to better understand is
that 2 percent the right now. We think 4 percent is too high and we think that 2 percent is
better. Is it is it the right one, that's the work I would like to talk about based
on our treasury management, that makes up I think a helps to round out the discussion
on this. >> RICHARD COSTIGAN: I have a question. And
I am trying to understand this. I find this fascinating, I guess where my confusion comes
in a little bit and I appreciate pry ya's comments on the ability to be opportunistic.
We are taking it we are looking at 2 percent reserve as George raised earlier about the
mathematics about the value of the fund but it really isn't across the entire fund because
only a portion of the fund can be liquid at a certain point. Correct? I mean I just want
to make sure I understand this it is not like we can sell a mall tomorrow to raise a cash
and as Ben was talking about I still find it fascinating that we had committed capital
and these folks were waiting on and that is liquid or ill liquid that if it is committed
but not gone and you end up in litigation. The 2 percent reserve is not across the fund
but a portion of the fund. What is liquid within the fund.
>> ERIC BAGGESEN: That's an interesting nuance Mr. Richard Costigan. As part of the risk
reporting that we do attach I think it is in the appendix now in the risk reports we
actually model the profile of liquidity across the assets of the portfolio. So we literally
identify, for example, the public equity portfolio. I mean we can liquidate that virtually at
will. We can raise tens of billions of dollars out of that portfolio but you have to take
the recognition that if you walked in to the marketplace and you took advantage of that
liquidity you are going to start driving the price down. We identify and try to understand
how much do we think we can sell without sustaining too much of an adverse impact. Any way that
kind of modeling is done across all of the assets of the portfolio. So we, for example,
in the case of real estate and private equity we assume those assets are basically locked
up. There is no real capacity for reducing those assets at will and yet private eave
quit at this has been the source of liquidity for CalPERS for the last two years. That has
caused us to not have to turn around and sell a segment of the bond portfolio or the public
equity portfolio. >> RICHARD COSTIGAN: I have opportunistic
dollars and dollars that are liquid and dollars that are locked up and I have risk capital.
Clearly on a much smaller portfolio. But what I am trying to just understand here is we
look at the whole portfolio is it is there is a pot of money and I am getting very simplistic
here, the rest of the portfolio derives from and we have the influx of cash which y'all
haven't really addressed and we keep the 2 percent or 4 percent reserve but we have an
amount of dollars flowing in on a monthly basis. So where does that effect the 2 percent,
4 percent reserve and if we are going to be opportunistic because you are right, the problem
is we sell stock A because of our holdings we have the potential of driving the stock
down and then at the same time as we are moving in to another equity we have the potential
to drive it up because we are buying it. What I am trying to grasp, 2 or 4 percent, all
I care about is I keep three months of reserve in cash. If my firm were to fire me tomorrow
I know I can live for three months and then figure out what too do after that. Is the
2 percent appropriate? Is 1 percent appropriate. Why the folks across the river why do they choose 1 and just last point is
Curtis and I were talking at the break at what point are we so large that we are planning
on margins anyway? >> ERIC BAGGESEN: Yes, I think Ben could you
flip back to the line chart that showed yeah, the basically these little purple bars that
move up or down from the 0 line, are just the net cash flows that are impacting both
inflows from contributions and outflows to benefit payments and expenses and all the
rest of that. So you are absolutely right Mr. Richard Costigan. Those purple bars for
the last couple of years have been noise and no problem in doing that. But what you are
not as one of the things that has kept the blue line, the solid blue line to the size
it has been this return of capital that has come out of the private equity portfolio.
It flowed in and gone back out in terms of benefit payments. So there has been very little
actual investment activity that has been driven by the staff making a conscious allocation
to sell assets and move it in to either the liquidity area or to take money back down
from the liquidity area. This is the ability to manage those purple lines and understand
and anticipate them is everything that the CFO is going to be speaking about in this
treasury management function and the more we can anticipate and understand what is going
to happen then we can drive that liquidity buffer lower and lower. The buffer is a guarantee
fund if you will. If everything goes wrong and we make a mistake in the judgment about
that and we suddenly get a call for a significant amount of money, and that could be a capital
call from one of the external partners, I don't think that ever comes out of benefit
payments or things of that nature because we understand that profile and I think it
is very stable and the expenses of the organization is very stable but it is under that committed
capital number that is the real volatile exists or the market presents you with some kind
of opportunity that you want to take advantage of and it is the ability that fund that that
buffer if you will really constitutes. >> MICHAEL SCHLACHTER: Those purple bars are
monthly. >> ERIC BAGGESEN: Yes.
>> MICHAEL SCHLACHTER: Last month was bigger than that on some days. So beyond the monthly
need to manage cash what is your daily volatility to manage cash and how does that figure in
to this conversation. >> ERIC BAGGESEN: That's a fair comment and
it is an element that gets modeled by the risk team they look at the contingent liabilities.
They look at the amount of money that is embedded within derivative instruments and model out
the volatility that be gendered by currency movement or using equity derivatives the volatility
of the equity market. We do a modeling exercise and then we identify how much capital needs
to be reserved in order to meet those mark to market. As that modeling exercise goes
forward we identify what are those potential contingent sort of liability that exists.
And the fact that it is not creating problem I think is just, you know, a testimonial to
the fact that at least the perspective of looking at that pretty much operates as we
expect it to. Not creating, you know, an untold or an unanticipated need for cash. But we
certainly model and we understand say the accumulated liability that exists on currency
forward as part of the passive hedge. That was one of the dialogues that we had in relation
to the hedge program is the potential of demands that the liquidity creates. And we typically
rolling that stuff mostly on a quarterly basis if I am not mistaken. So we have on a quarterly
basis we have a big potential payment or receipt of cash that can happen due to the movement
of foreign currencies in the structured hedge. So just understanding the calendar as to when
that happens allow us to anticipate that and if we see a liability that's there then we
basically build up the cash Michael to be able to satisfy that liability when it comes
due. >> BILL SLATON: So now I am even more confused.
So help me understand. I am going back to page page 5 of 21, this is back in the history
of liquidity. And in December of 2010 we did a 4 percent target with 1 to 7 page. So help
me understand why with a 1 to 7 page you feel you don't have that you need to adjust your
flexibility. >> ERIC BAGGESEN: Yes, I think the real question
on this is the target for >> BILL SLATON: But does I mean does the target
when you are under the target you are uncomfortable? Maybe I don't understand the different between
target and range. >> ERIC BAGGESEN: We are identifying the targets
that go in to the calculation of the strategic benchmark for CalPERS. So right now we are
carrying a 4 percent target. So that basically is 4 percent that's not allocated to something
else within the structure of the asset allocation. So it has the effect of potentially reducing
the return I think in was Mr. McGuire's comment basically. We suffer an opportunity cost to
the extent that we allocate money to liquidity and then the range around the staff will move
the actual exposure up or done depending on what we anticipate happening and the needs
we can see for liquidity out as far as we can see it. So it is really a question right
now of how much of an in essence a drag do we build in to the asset allocation basically
as a target in that benchmark. The other element that drove this to 4 percent in the sort of
2010 context so there were two aspects of this one was fighting the last war. We continued
to fight that and we obviously are impacted by that to this day, and the other was basically
trying to build a strategic allocation to government bonds that would operate as a diversification
in essence to the equity risk on the portfolio. That was the other reason that 4 percent was
used because the people running asset allocate at the time wanted to build in a more structure
to government bond exposure. To some extent we have far less concerned about the structuring
of the government bond exposure. We are comfortable in taking this target allocation down. In
essence that liquidity allocation was trying to serve two purposes, diversification and
an insurance policy so that anything unexpected could be satisfied.
>> BILL SLATON: What's the recommended range? >> ERIC BAGGESEN: If we reduced it to 2 percent,
honestly I think we move the range from either 0 to 5 percent or retain the existing range
from 1 to 7. I don't think it matters. Either way we can manage that. Other questions? I
think what we will do at this point is move on to the CFO's work to treasury management.
>> CHERYL EASON: Thank you very much. Cheryl EASON, CFO. This discussion tees it up nicely
for me in terms of why treasury management today. Why are we talking about this and as
has been pointed out by a number of people the lessons that we have learned from the
2008 financial crisis the maturing of the fund combines in to this almost perfect storm.
So too creates these opportunities provides the basis for managing risks and assets going
forward. So in September of this year CalPERS investment beliefs were adopted by the board
and that first belief liabilities must influence the asset structure there was also an underlying
subbelief that ensuring the ability to pay promised benefits by maintaining an adequate
funding status what's been touched upon here is that are we managing our cash in a way
that we are able to make sure that we can pay those promised benefits and I can assure
you that today we are doing that. The treasury management is an important process
for this organization because not only does it support that belief but it also will provide
a long term sustainable approach so that we can address these liquidity issues moving
forward. So talking just in terms of the cash shortfall
here you will see the calculation by comparing our projected pension benefit payments and
expenses. So more of our cash management needs with contributions received in investment
income and you can see that we are at a really critical pivotal point where we have our cash
flow being just moving from a net positive position in to a potential shortfall and we
are actually looking at the data that we have within our demographics, looking at the contributions
that as we see our pension plans mature and we are not an outlier in this case, many of
the pension plans are maturing and this demographic change that we are seeing in the increased
number of retiree participants relative to the active participants as that grows our
benefit payments increase at a faster rate and this is what creates this potential shortfall.
>> GEORGE DIEHR: Cheryl, it looks to me like the total contribution investment income isn't
going up fast enough. The fund value should grow and the we have got employer contributions
not only payroll going but the rate contribution rates are going up. It seems the blue line,
seems to be flatter than I would expect it to be over the next about eight years and
I don't what the fund grows on the order of 5 or 6 percent a year, net of payroll 3 percent.
So I mean I think I agree. This is the direction we are going but it just seems to me that
in that amount of time if we are making, hitting our return target and we keep sort of the
cash flow from investments remains about the same proportion of the total fund size that
we shouldn't be in this big of gap. Either the green line would be higher, too, but the
blue line ought to be higher and then also from a perspective standpoint if the fund
value is up 40, 50 percent, then 5 billion isn't as big of a deal.
>> CHERYL EASON: So what we have done working with the actuarial office as well as the investment
office we have looked at the contributions increasing based on the smoothing policy.
We have taken the investment income, we have based that on 7 and a half percent return.
And what we have done is we have looked at the demographics for the benefit payments,
the green line that you pointed out. And that's based on what our current demographic member
data is currently. >> GEORGE DIEHR: Inflation is in here, too.
>> So we had >> HENRY JONES: Excuse me. Excuse me. Eric,
would you continue to call on the members please because I can't see them from the side.
Thank you. >> ERIC BAGGESEN: All right. So first we answer
Mr. Diehr's question about Alan did you have a comment on some of the lines?
>> ALAN MILLIGAN: Yeah, I think that one of the things that some of our cash flows, for
instance, member contributions are relatively stable. And are not growing so much over time.
And so in fact, the increase in employer contributions while it is relatively large it is large relative
to the contributions that are being currently made, we are talking about a lot of money.
And so we do have some of these the member contributions which are relatively inflexible
aren't growing as quickly. So may be part of the why it is not growing as quickly as
you would have expected there. >> ERIC BAGGESEN: Okay. Mr. Jelincic.
>> JJ JELINCIC: On the internal contributions, for the employers we are assuming our current
actuarial assumptions and the (inaudible) keeps telling me we are going to have a 50
percent increase in the employer contribution and that's built in to our blue line or purple
line. >> Yes, it is built in to it.
>> ALAN MILLIGAN: Although as I have repeatedly said it is not quite 50 percent.
>> JJ JELINCIC: They got it wrong. I am shocked. Then I had a question. It was on the next
page. So I will hold off on that one. >> ERIC BAGGESEN: Mr. Bill Slaton.
>> BILL SLATON: So these lines which look very straight which are obviously there seem
to be predictions but on the green line we have had we had an introductory discussion
regarding mortality and we haven't I would suggest or ask the question a change to that
is not in that green line, I presume. >> ALAN MILLIGAN: That is correct. We will
be bringing to the board next month a recommendation about assumption changes. And asking for a
decision in February. And any contribution rate changes as a result of those assumption
changes are not built in to this diagram. >> BILL SLATON: So if we are trying to take
an asset and liability view and we are going to be making a decision, don't we want our
decision time to happen with that included? >> Ann: Thanks. So right now we have scheduled
the decision making arrange the actuarial assumptions for February but we have the decision
making on asset allocation scheduled for December. We have talked about this internally all the
executive staff and one thing that we might able to think about doing if the board warrants
to is move all the decision making in to February. So that you would have all the information
in front of you at the same time and real lay integrate the decision making process
and we have talked to investments. They need to be able to implement the asset allocation
by July 1 but as long as they have their decision by February that seems doable. So we haven't
had a chance to talk with the chairs about how to work it out and which committee it
comes to and all of that. But we think that would be a good idea to take under consideration.
>> HENRY JONES: We will take it in to consideration. >> ERIC BAGGESEN: Any other comments now before
Cheryl continues? >> CHERYL EASON: Okay. Thank you. So why now
and why is it important? Well, it has never been more important to deal with treasury
management because of the lessons that we have been able to learn for years from the
onset of financial crisis and many organizations including CalPERS continue to intensify their
efforts to manage those risks associated with cash flow and liquidity but as has already
been pointed out here, we want to we also want to have the ability to invest for growth which is also important to maintain
adequate funding status while at the same time maintaining an acceptable level of overall
risk for the fund. So we are suggesting today that we need to strengthen our treasury management
function to be able to identify those risks and mitigating strategies early to optimize
our cash flows our timely disbursements of payments and to avoid liquidity risk and minimize
transaction costs and that ability is to be able to achieve our data integration and comprehensive
look through of the portfolio to facilitate that better decision making which we don't
have today. JJ. >> JJ JELINCIC: When we look this treasury
management are we really talking about identifying the cash flows going forward or are we talking
about managing the assets? >> CHERYL EASON: It is about both really.
It is making sure we have managed our cash flow which are the table stakes but also as
we are talking about where we get in to the asset allocation is how much liquidity do
we want to hold in the fund currently which is really what we are what will be part of
the decision making going forward. >> JJ JELINCIC: Okay. Let me try and break
it a little further. What's the role of the CFO versus the CIO in terms of this treasury
management? >> CHERYL EASON: So as the CFO what I am able
to do from a treasury management perspective is to bring really the assurance to the board
that we are accounting for this correctly. It is not to look at the investments. That's
part of the investment management which is the CIO oversees. But it is really the broader
umbrella of the treasury managements that how are are we managing our banking relationships,
are we ensuring that we have cash flow to be able to meet our payments, be they the
benefit payments or expenses which we currently do that today but it is really taking and
it is really working with the CIO, the investment office, and within the within the model of
the asset liability but it is really as from a CFO perspective that broader assurance that
we are managing our liquidity and cash flow. >> JJ JELINCIC: The CFO is about identifying
the cash flows we anticipate needing and observing the portfolio to have some confidence that
the cash will be in the checkbook to write the check as opposed to saying well, you need
to move this asset over to here. It is really about just making sure that the cash flows
are going to be there. >> CHERYL EASON: Assurance around the cash
flows, yes. >> JJ JELINCIC: One thing I would like to
add to Ann's comment I know from my time on staff that even though a decision doesn't
come to the board until February, the work has been done, you know, earlier. And so whether
we actually combine those two or simply told this is the information that is going to be
coming and the things that you need to consider, I think is in some ways a distinction without
a difference as long as the information gets shared.
>> JOE DEAR: You asked a very good question about CFO and Cheryl nailed it really well
from my perspective. I think there is some things that we don't do now that we need to
be doing and likely that's going to be CFO work and some work that the investment office
has done that is probably going to move to the CFO office but we are not going to move
things that are injured to the management of the investment portfolio. Now to get real
clarity about how that works we are going to have to get some help and run a project
and so we will be exploring that with staff and then with you. So we won't be able to
give as precise answers as we might like. We will be able to do that but I thought what
Cheryl did was spot on. And I just think that as we have emphasized with our discussion
this is really important. This is really important work. And we will over time address the details
and spell them out for you. >> JJ JELINCIC: So are we going to see another
rapid results project? >> JOE DEAR: This is going to be this is going
to take more than 100 days. This is a big one. Thank you. And it is going to cost more.
(Laughter). >> Is it starting in December that Cheryl
CFO is going to start bringing to the finance and administration committee a cash management
report? >> CHERYL EASON: Yes, that's right.
>> You will start to see the product. >> CHERYL EASON: There is a lot of work but
we don't have all the answers but there is a lot of work that we need to bring back and
as Joe has mentioned this a long journey. >> JJ JELINCIC: Yes, I wasn't really expecting
answers as much as identifying what the questions were.
>> CHERYL EASON: Okay. Thank you. So this slide just illustrates that this is not done
in isolation. This isn't done in a vacuum. That all of these really work together to
ensure that we have our liquidity risk under control. That it is being managed. That we
have the adequate cash flow to ensure that our commitments are being made and again all
in light of the long term financial health and security or stability sorry of the fund
as part of our fiduciary duty and constitutional authority.
Just the next two slides really talk about what does that mean in terms of an enterprise
function. So as we mention as part of the 2012 to 14 business plan the financial office
had already implemented an initiative to ensure that our cash management process was we were
able to identify what our noninvestment cash flow needs are and we have a dedicated team
that tracks those noninvestment sources and uses of cash and we provide that information
to the investment office to ensure that we have the we are able to meet those cash requirements.
But there is need for further work to be done in the governance area to ensure that we have
accurate accounting around the treasury transactions, we want to make sure that we have all the
proper policies and procedures in place and all that is to ensure that we are managing
our risks carefully both operational and strategic risks as well as ensuring that we look at
liquidity reporting legislative as well as regulatory needs.
As Joe mentioned though that takes some system infrastructure. And part of that infrastructure
is maintaining our relationship with our control agencies the custodians and the banks and
we want to effectively be able to manage the proliferation of the investment data transactions
that we deal with as well as to be able to provide valuable financial reporting to the
board which as Ann mentioned will be looking at doing in December coming back with some
of that cash flow information. But the planning and operations that we need
to do the work that we need to do it really does require some longer term forecasting
on both cash flow and the risk. And that's currently what we are not doing right now.
We are handling the very short term but we don't have the long term forecasts. So we
want to be able to be proactive in the marketplace if need be and we want to be able to ensure
that through that long term forecasting that we are able to do that.
>> JJ JELINCIC: Cheryl, what banks do we deal with? I mean I understand the custodian but
I thought all of our banking was done through the controller's office.
>> CHERYL EASON: Yes. >> JJ JELINCIC: Okay.
>> CHERYL EASON: This is just a we tried to do it as an illustration to just to show how
treasury management plays an important role within the whole asset liability management.
So if you look on the left hand side as moving from left to right, the when we talk about
the recommended change, for example, in the strategic allocation from the 4 percent target
to a 2 percent target, that forms part of the asset allocation mix which in turn contributes
to the investment income. Then added to that you look in turn to the cash management, that
sets out to match and time our contributions our investment income to pay those benefits
and expenses. Ensuring that then we meet those cash flows and as Ben pointed out earlier
we have not missed any of those payments. We do that very well and we are very efficient
around that. Pulling this all together becomes part of the asset liability frame work. The
treasury management piece of that ALM provides an effective approach for managing the cash
flows, managing the liquidity. Hopefully to positively impact the investment performance
and meet those cash requirements and while still increasing our effectiveness around
how we manage risks. >> RICHARD COSTIGAN: I just want to point
out that you mean to reemphasize what Ben said the fact that we never missed a payment.
As the slide shows it is the contributions made by employers that have ensure that we
continue to maintain that obligation. I don't want us to gloss over that fact because you
sort of moving along quickly it is a key component. We have never missed a payment. And the elements
in slide, the contribution of investment income all that integral part.
>> You don't have asset purchases, asset sales net of purchases or where is that?
>> ERIC BAGGESEN: Ultimately, Mr. Diehr, all of these payments get netted together in essence
and that's even trying to think through the treasury model that we need we probably need
to have more distinction. Again in reality for the last couple of decades has been handled
by the fixed income team and they are the people that have been monitoring this stuff
on the day to day basis and as they identify needs and sources of cash moving in to the
fund basically managed exposure of that and brought to the attention of the chief investment
officer either capital that needs to be raised or capital that can be redeployed elsewhere
in the portfolio. It is the creation of this treasury function as we identify the roles
and responsibilities through this exercise it is going to be different in the future
than it is in the past. >> HENRY JONES: But the difference is while
Cheryl will be saying here is what we need, these Curtis and the others will still be
creating the action necessary to generate what we need.
>> ERIC BAGGESEN: Absolutely. To the extent that the money needs to be utilized or needs
to be raised from reducing an investment risk that happens in the body of the investment
strategy group and within the investment office is coordinated by the asset allocation team
basically. So, you know, we have as I said you cannot underestimate the degree of coordination
that is happening now that did not used to happen in the past when we operated in a more
siloed organization. And literally fixed income taking on the responsibility for managing
all that activity. That now happens within the body of the investment strategy group
from the perspective of the investment office but now we need to add in the perspective
of the rest of the organization which is becoming more important as those lines separate and
as we go more cash flow negative we need to understand that and be able to sensitive to
that to a greater degree than we have in the past.
>> BILL SLATON: I think there is a box missing on this chart on the investment side because
you have got the cash yield in asset sales but what you are missing is the negative of
cash calls. Whether it be a private equity deal. There is a minus side as well on cash.
>> ERIC BAGGESEN: Yeah, that's a good catch. >> CHERYL EASON: Uh huh.
>> ERIC BAGGESEN: Any other comments before Cheryl finishes?
>> CHERYL EASON: Okay. So just the next steps and we have already talked about some of this,
but again we do need to further refine how much liquidity is needed and minimize costs
and how to make sure we are managing our risks and we are already identified several things
as Eric mentioned, centrally managing liquidity for the total fund. We have talked about the
liquidity of the PERF and we have other funds that are smaller. They are less resistant
to liquidity risk. We need to make sure that we have an evaluation frame work that's going
to provide some consistent evaluation of all of our assets to better assist with the decision
making on our asset allocation as Mr. McGuire pointed out is that 2 percent number the right
number. That we would do that through an evaluation framework. And then we also need to implement
improved processes to ensure that we have consistent practices to be able to manage
those cash flows and we will be coming back to the board with the progress on that project
as we move forward. >> ERIC BAGGESEN: Mr. McGuire.
>> TERRY McGUIRE: Okay. I wanted to wait until the end of this presentation topic before
just bringing up another related topic on cash management and liquidity and that is
I brought up the topic a couple of times in the last six, nine months of corporate liquidity
facility and I didn't hear the word mentioned it is nowhere in the presentation, and in
some respects I understand that from, you know, the two points that were raised by Eric
and Curtis relative to the liquidity that can be provided through the e quit portfolio
and the liquidity that is available through securities lending. But to the extent we are
not going to count that as real liquidity and count that towards the liquidity consider
what's available through those two sources in relation to the liquidity target that is
adopted, I think we should also be exploring a corporate liquidity facility. When I saw
this presentation I didn't see the words anywhere. So I figured I would kind of look in to it
a little bit myself and the opportunities out there are something that need to be looked
at and considered. For instance, I think this fund could borrow 1 percent, not borrow, just
have a facility in place for 1 percent, about 2.7 billion for an annual fee of somewhere
25 to 35 basis points. Probably at the lower end. And if we ever
had to make a draw what would it cost us. Probably in the range of one month libor plus
125 to 170 basis points. Probably towards the lower end. CalPERS is essentially an AAA
credit. The state has 4 billion of credit facilities in place on various programs but
those are direct pay letters of credit. They are a different animal and they are used for
credit borrowing and supporting financial instruments that the state issues and they
are more expensive and the state's credit rating is in A category. But I think this
organization needs to take that one and that option at least in to consideration because
in some respects we are hearing that liquidity is better. What's the cost of the liquidity?
I would rather have a corporate facility in place. And I like your analysis to at least
consider that going forward. You know, I can understand relative to the equity liquidity
and the securities lending liquidity that may be available but if that doesn't lead
us to reducing that actual target I think we need to consider other options.
>> ERIC BAGGESEN: Yes, again and I think that all of this ends up being a balance basically
between the sources of liquidity and the uses of it. And we believe that as long as the
lending markets operate, in other words, if you extract a corporate credit line, you have
to make sure that that's a credit line that can be paid at the moment that it is needed
and many credit lines were retracted at the moment that they were needed in the sort of
'08 09 crisis. The so the question becomes how much do we continue to fight the old war
that has been fought for the last five years basically. So we tend to view the lending
program as a subtut for that credit line facility. We can take our assets and pledge them and
extract cash from the marketplace on a repo basis and we do not pay a commitment fee for
the ability to do that and that's a unique capability and probably unique to CalPERS
and very few other public pension funds because we internally manage that securities lending
program and the relationship and almost nobody else does that. So that's a capability that
CalPERS has had that we think has made it less necessary to get a corporate line.
>> TERRY McGUIRE: And I agree with that comment totally it needs to be presented to this board
so that we can evaluate that in relation to the liquidity target, the size of it.
>> ERIC BAGGESEN: The real point is take the information that is understood internally
and presenting it to the board so you can have confidence as to the structure of that
and how liquidity is met within the organization and I think that's really the message.
>> BEN MENG: So on that note Mr. McGuire when you first brought up this couple months ago
to us since then we have had a couple of internal discussions about this topic and as Eric pointed
out that's we look at the Ben fit and the cost compared to the internal source and create
this equity exposures to the line of credit and you are right, we have done analysis.
We can bring that information back to the board very easily at a later date.
>> HENRY JONES: Yes. At a later date I think we need to be more specific.
>> BEN MENG: As early as December. >> HENRY JONES: December. Okay. I think we
should do that. >> ERIC BAGGESEN: Sorry Mr. Jones. I think
the real challenge in it is to identify some additional elements. If we are able to satisfy
the issue of liquidity management to the board's construct then maybe move the target down
below 2 percent and if we are not able to do that, maybe needs an optional element somehow
or other in to the information that we collect for the next day so we understand what we
are bringing back. We will probably have to bring back a couple of options, potentially
one with a 1 percent and another one with a 2 percent target and when get to a decision
making perspective we will hopefully have been able to fill in the missing piece of
information that we can't fill in the next 24 hours.
>> JJ JELINCIC: I think it is worth looking at but I also believe that the costs of setting
up that line would be significantly higher than it is being estimated because if I am
the bank that's going to create that line of credit, I am going to assume that CalPERS
is going to draw that line only at the absolute worst possible time. And so I am going to
make sure that I get paid for making it available at the worst possible time, not normal times.
>> HENRY JONES: And that's why we need to have the discussion because conjection right
now about what will happen. Bring the research and we will make a decision going forward.
>> JOE DEAR: I think one of the requests is for us to display that we have considered
that option and to show that so the committee see it is and if additional analysis is needed
we have that available. >> PRIYA MATHUR: Also a page that outlines
what the different capacity is and of different sources of liquidity. Because on page 40 you
outline sort of the reduced demands but nowhere is it really explicitly outlined what's the
new capacity that we have from each of these various approaches.
>> ERIC BAGGESEN: Other observations, questions? Okay. At this point in time we are really
supposed to move in to a section where Alan and his team will be talking about the potential
and flexible to risking. Just kind of looking at the clock. It's 20 minutes to 12. I don't
know how fast you think you can move through your material.
>> HENRY JONES: I don't want to cut it short. Why don't we start around pause for lunch
at an appropriate because think we need to get all this information and dialogue on the
table. >> ERIC BAGGESEN: Perfect.
>> ALAN MILLIGAN: Good morning. Good to be here. Talk about this topic. I will try to
go reasonably promptly through the material without rushing it unduly. In addition to
myself I have David Lameurx our deputy chief actuarial and Jordan. Hopefully if you stump
me with a question I have got backup. I think first thing I want to talk about is
the objective of today. I wanted to educate you a little bit about possible possible derisk
strategy that we are thinking of developing internally. The practicality is this strategy
that we are working on even possible and will it be meaningful and get direction from the
board about whether or not we should continue to develop derisking and some of the options
available, not real so that this is the guidance that we are looking for from the board. I
think this is a first time that we are explicitly asking you for guidance in this workshop and
will not be the last. It is important though to understand that the objectives of today
is not to make the decision about whether or not we should be derisking. That's a much
more elaborate discussion for another day. This is really just do you is there enough
interest in this topic for us to continue to develop this. Obviously if you have no
interest in derisking then there is not much point in us spending the staff time on looking
at this. But if there is that's not the decision you are making today. The decision, there
is no decision today. The guidance I am looking for from you today is really whether or not
this is worth continuing to pursue. So we are going to talk about the concept of derisking
whether or not it can work and some next steps. Various we were looking at derisking and there
is really three possible approaches. We are going to focus on what I have come to call
flexible derisking which is derisk when the markets give us a good opportunity to reduce
risk in a way that will not result in significant immediate increase in employer contributions
or rather not increasing at the employer contributions above what they were already expecting to
have in the way of contribution requirements. We are also going to talk a little bit about
the idea of a systematic derisking and a combination of flexible and systematic derisking. So the
flexible derisking concept that we are looking at right now is really designed to reduce
the funding risk when it is least painful to our stakeholders to do so. Understand that
we cannot truly reduce risk without increasing the expected cost of the program. In order
to derisk it will be necessary to do things that will increase the expected cost to our
stakeholders of our program. But if we do if we derisk after good investment
years, that's a time when as a result of the good investment year the employer contribution
rate would normally we would normally through the actuarial process result in either reduction
in employer contribution rates or at least a smaller increase than was previously scheduled
and presumably built in to employer budgets. That would be a good time to take some risk
off the table because we could do so without presenting employer's with a contribution
increase in excess of what they were already anticipating.
And the flexible part of it is we also don't derisk in years where we have poor investment
returns which could be very difficult and very *** our employers. So how do derisking
be accomplished? After a good investment year we would reduce the discount rate. So this
would be the first step. We would reduce the discount rate in terms of I have talked to
you before this would be added a margin for adverse deviation but we would actually look
at gradually modifying our asset allocation to reduce the volatility and that would in
fact, reduce the expected return over time. Which would mean that our margin for adverse
deviation would go away but the risk level is still significantly reduced. So it is yes,
Mr. JJ Jelincic. >> JJ JELINCIC: One of the things I look at
though is if we have good returns, then one of the things that it does is that increases
our funding status. And as we get more funded we are actually in a better position to take
on more risk. So I mean that's kind of the flipside of this. And so I hope that as we
go along you will address both sides of that equation.
>>ALAN MILLIGAN: Yes. I think that's not going to be really addressed here today. That really
gets more at the question of should we derisk and that is a much more involved discussion
that we are really not prepared to address today. It is something that we need to we
do need to address with the board because that's a very, very significant decision,
something that we really need some serious time, serious thought needs to go in to that
decision. >> JJ JELINCIC: Okay. Thank you.
>> BEN MENG: If I may, early on this morning some of you asked a question when we first
showed the efficient frontier and where we are in the red circle, there was some desire
to see it move up or move down. That is part of the exercise tomorrow morning you will
be able to tell us where you like to go in terms of efficient frontier.
>> ALAN MILLIGAN: The goal of derisking would be to reduce the probability that an investment
shock would threaten the funding of the system. This is the drawdown risk that Joe has been
talking about repeatedly. And this is also in a lot of work that we have done talking
about reducing the funded status below an acceptable level. I have not yet gotten from
the board a decision as to what the acceptable lower level is. But I will continue to pursue
that with you over time. >> HENRY JONES: Alan, I know we have had this
discussion before and I know Priya has cited a number, and I have cited a number. To do
the work on that are you saying you would need a vote by the committee or direction
from the chair? >> ALAN MILLIGAN: At the end of today not
the end of today. At the end of this portion of the workshop, I hope to have a feeling
from the board as to whether or not it is worth continuing to pursue this. Not a not
guidance as to whether or not you think you are actually going to take the step of committing
to derisking policy. So one of the questions, I am going to skip
this one for now because we get to it later. So we are going to have to define at some
point to put a derisking policy in place we have to define a target risk level and we
would like that to be that may be expressed as a desired level of investment volatility.
We would also need to think about a time frame for how quickly do we want to get to this
lower risk level. And I can tell you my expectation is that that will not be one or two years.
That will probably be quite considerably longer. But this is the essence of the discussion
that we will need to have at some point. And we also need to construct a schedule of
derisking event that achieves the target volatility in a specified level of time. So I just realized
I kind of messed up here. This would be a systematic derisking. We still need the first
two we still need a target risk level even for flexible derisking because we need to
know how far we need to go. We will like a time frame of how much we need to do and whether
or not the flexible derisk will accomplish it. We would actually construct a schedule
of derisking events, how quickly do you want to reduce the level of risk if you are above
the if you are not on that schedule, then you would reduce the level of risk. If you
are ahead of schedule for some reason you would not necessarily have to reduce the risk.
That would be a systematic derisking concept. Not a flexible derisking. And in fact, it
is quite possible to combine the two deriskings to have both a flexible derisking where if
you get some good investment returns and you take some risk off the table as well as a
systematic derisking schedule that we have to get at least this far by this point in
time. If we have a combined approach, we could end up with a situation where in fact we never
have to do the systematic derisking because the flexible derisking gets where we need
to go fast enough. On the other hand, if the markets don't get us where we need to, then
the systematic derisking would ensure that we get to the risk level that we want in the
kind of time frame that we are looking for. Yes.
>> PRIYA MATHUR: I see another option which is instead of doing it systematically or instead
of combining them quite this way, having some targets of what we would like to see. We would
like to see us get down this level of risk by the state. We would like to see three derisking
events over this period of time and then check in about it. So really be going with the flexible
derisking path but at least have some parameters to check ourselves against
>> ALAN MILLIGAN: With kind of an ad hoc overlay with further derisking.
>> PRIYA MATHUR: What are our expectations and then we see over time if we are meeting
that and then we can make decisions at that time, some time down the road if it is not
liking we are achieving our goals or we want to reevaluate our goals.
>> ALAN MILLIGAN: That certainly can be a possibility and something that would be very
attractive. >> BILL SLATON: I think one of the overarching
principles of this is the transparency of it if we give employers the ability to see
what can happen, then I think we are meeting part of our objective of creating a system
that employers can live with and plan for and budget for. But if the methodology is
out there I am just I am concerned about ad hoc decisions that we make, you know, year
after year after year after year rather than create a path.
>> ALAN MILLIGAN: You are getting at a point that I will be addressing later on in the
presentation which is the transparency of what's coming up in the way of derisking.
Hopefully I will get there quickly. So I would like it talk a little bit about whether or
not this flexible derisking concept can actually work. One of the first and most critical things
to think about in terms of derisking is how good an investment year would you need in
order to have the opportunity to derisk. So staff have been looking at this and what we
find is that for most of our plans an investment return in the 14 to 18 percent range would
be sufficient to allow us to derisk. And that is not that is something that we have seen
in the past. And it is something that we will likely see in the future. So that kind of
passed the first hurdle. It seems like that is possible. It is not it is not unfortunately
it is not the same level of return for every plan. So one of the difficulties with flexible
derisking is that we would have to set a trigger level to do is derisking and that trigger
level will be good for some employers. Some employers may in fact, actually end up with
a reduction in rate because they could have derisked for them a derisking could have happened
at a lower return without causing their rates to go up above over what was anticipated.
For other employers they would have needed a higher return. If we derisk at that trigger
level you would they would actually still see an increase in the rate above what they
were already anticipating. So that is one of the very difficult things that we would
have to do and unfortunately that will probably have to be just a decision as to what level
what's the trigger level. The higher we set the trigger level the less derisking we get
but the less pain we inflict on employers when we do the derisking.
>> HENRY JONES: If you use the adverse margin and that goes in to the actual rate, that's
the discount rate that you are applying to all the funds. I am not following on. Now
you are looking at individual agencies how you get from this discount rate.
>> ALAN MILLIGAN: Easiest thing to think about Henry would be a plan that has no assets.
So a plan that has no assets if we get a 20 percent investment return their gains are
0 dollars. But if we lower the discount rate that will result in an increase in their contribution
with no offset due to the asset gains. A plan that is 100 percent funded when we get a 20
percent return their gains are like 12 and a half percent of assets relative to the expected
return and so we have a significant opportunity that would result in generally asset gain
that will result in a lower contribution so long as that lower contribution offsets the
increase due to the lower discount rate that employer is actually in a pretty good shape.
So the one of the in our modeling one of the things that we found is the plans that need
the higher return in order to get a derisking event are the plans that have that are at
a lower funded status. Certainly plans that were implemented in the relatively recent
past will due tend to have lower assets. They started at 0 percent funded and they may now
be at 50 percent funded. The typical plan at CalPERS is 70 percent funded. Those plans
will need a higher return in order to offset the increased contribution due to the lower
discount rate. >> HENRY JONES: So you are looking at the
state and looking at schools and then looking at all the other agencies. So they all would
play out differently like the state how many rates do you have for the state?
>> ALAN MILLIGAN: We have 7 rates for the state.
>> HENRY JONES: And for the school district you have one rate.
>> ALAN MILLIGAN: One rate. >> HENRY JONES: And all the other 2,000 counties.
>> ALAN MILLIGAN: About 2,000 rates. >> HENRY JONES: So the school district would
be pretty simple. There is all these other individual agencies that you are referring
to. >> ALAN MILLIGAN: True and the awkward part
of it is because we have one asset allocation and one discount rate assumption for all plans
we don't have the ability to customize the derisking for each of those plans. So we would
have to pretty much come up with here is a trigger level that's kind of a trigger level
that is good for the average plan or maybe is good for 80 or 90 percent of the plans.
But there is still going to be some percentage that the definite risking occurs and their
rates go up beyond what they were expected. That is one of the limitations of this approach.
I think it is a limitation that is not bad. I think it is something that we can kind of
we can come up with a trigger level that works for the vast majority of plans, the ones that
it doesn't work for tend to be relatively poorly funded plans and they are the ones
who probably need the derisking the most. So even though it may cause their rates go
up above what they were expecting that may in fact, be the right thing to do.
>> HENRY JONES: And would that flow through this volatility index of all these cities
and counties? >>ALAN MILLIGAN: Yes, that would flow through
the volatility index to the extent that we get them better funded they will have more
assets and their volatility index will be lie higher which makes a lower risk profile
even more necessary. Yes. >> BILL SLATON: So just an odd ball thought
about this, when you mention about the fact that for most employers it might be okay but
for some a minority of employers it would not, those are the very employers if my math
is right are probably in the most precarious positions and need the most derisking. So
my question is is it possible for this agency to consider more than one pool so that for
those who are meet a certain characteristic that's a pool with a discount rate. And the
state and schools are in another pool. >> ALAN MILLIGAN: So that is the possibility
of multiple investment pools within the PERF with different asset allocations is something
that has come up from time to time. I am having a discussion with one of my colleagues, the
chief investment officer about that idea. It is not something that I think we can implement
in the next year or two. But it is something that we will continue to look at. It is I
think a longer term solution, not a shorter term solution. But there are some aspects
of that that are very attractive to me as the chief actuary. I think there is aspects
that are UN appealing to the chief investment officer. This is something much longer term
that we have to look at. >> JOE DEAR: It is something that could be
done. It is not something that we can do today. A lot of the things that we are working on
with the target model will give us a capability to do that but it is a move towards complexity
and not simplification but it would support those plans and those jurisdictions that have
well funded programs and want to take risk off the table but you can imagine the timing
issues of coming out of a portfolio that has 25 to 30 percent liquid assets. Might know
that the portfolio was undervalued or overvalued and play against that. There is are a lot
of technical and policy issues that stand between us and getting it done. But we did
get that question at the employer conference. So I think our customers are some of them
are interested in that. >> BILL SLATON: I know the agency that I am
on the board of would have be extremely interested in having a portfolio.
>> JOE DEAR: That's a more important statement coming from a board member. We will keep working
on it. I mean that's the best we can do now. And as I said a lot of what we are doing on
the systems and operations are the predicate to being able to do the separate accounting
within the different asset classes. I am at a loss for the right term at the moment. Anyway
the subaccounts you would have to create within each asset class. So it is coming up on the
agenda. >> JJ JELINCIC: That would actually require
us to be able to unitize the investments. >> JOE DEAR: That's the term that was slipping
from me. Unitize the portfolio. It adds a lot of complexity but there are technical
systems to help with that but it is a nontrivial addition to the suite of investment options
that we offer. >> JJ JELINCIC: And it certainly would invite
2000 players to try and time the hell out of us. And to the extent that they were successful
everyone else would hurt big time. >> PRIYA MATHUR: Not to go too far down this
tangent one of our investment beliefs is that we believe there are advantages to being a
long term investor and unitizing our portfolio is a step away from long term. We need to
be mindful of the impacts. >> ALAN MILLIGAN: This is definitely something
that we need to think through that will require time. Technical capabilities as an organization
we are not ready to go there yet. So the second thing on whether or not this will work, is
just how likely is a derisking event. For this particular slide we have using a 18 percent
investment return trigger level which is at the high end of the range. There will still
be plans that would have a contribution rate increase above what was expected even under
this scenario but it would be small group. Good news there is something like unfortunately
I don't have my glasses, 96 percent chance that we would have at least one derisking
event over a 15 year period. So a pretty good chance a very good chance of having at least
one. If you sit your risk reduction level as you want to get to a lower risk state,
in 15 years, there is a very good chance that you can get there. In fact, there is a 70
come on somebody read that one for me. 75 percent chance that we will have two derisking
events. >> I will be the number reader. 40.
>> ALAN MILLIGAN: 40 percent chance of three derisking events.
>> And 13. Lucky number. >> ALAN MILLIGAN: That monitor is little too
far away for me to actually read the numbers. >> (Off microphone).
>> ALAN MILLIGAN: The left axis is the percentage of times. This is the how many simulations
that we got the different numbers of derisking events.
>> JJ JELINCIC: So it is really the probability of 18?
>> ALAN MILLIGAN: Yes. Right. Now one thing to remember is that as you derisk you end
up taking less investment risk and the probability of getting a high investment return is actually
lower. So there is a limit to how much you can do here. But as our simulation shows that
there is actually a pretty good chance and so if you were trying to set up a policy that
said well, we want to reduce the risk by kind of the level that you get for two derisking
events, this 18 percent trigger level is actually a pretty good, you know, there is a pretty
good chance almost three quarters chance that you will get at least two derisking events.
>> PRIYA MATHUR: Wouldn't you want the trigger to decrease over time? So would it need to
be 18 each time or could it be 18, 16, 14, 12 and then we would have a higher probability
of a derisking event? >> ALAN MILLIGAN: I think you are correct.
That that is that's a level of detail that we have not gotten to. I am not really sure
whether we want to build that this to the policy or just to re examine the trigger level
on a my guess is that after the first derisking event there would probably be a good opportunity
at that point to say well, how did this go and did we think the trigger level would be
right and do we think it should be lower and we should probably redo and relook at it as
funded status evolves over time. I don't think this is necessarily a static policy. Need
to be looked at. So what we did here was we took a look at
a 16 percent trigger level. This is we are able to get the derisking event for a significant
number of plans but at a 16 percent trigger level you will have more plans getting contribution
increases as a result of the derisking. But you also have slightly higher probabilities.
You are actually at 62 percent probability of getting three derisking events. This gets
you more derisking sooner but at a cost to employers of some contribution increases.
The other thing to remember is it is not just employers. These derisking events mean essentially
lowering the expected return, lowering the discount rate and that will change the normal
cost. So this would not necessarily be restricted just to the employers.
So I don't want while I have, you know, talked tend to talk about this in terms of impact
on employer rates, in the new pepper world it is not just employer rates but it is also
member rates. So I am about to go in to a fairly lengthy
example. And it is probably going to take me 20 minutes to go through this example.
Question is now the time for a break? >> HENRY JONES: Well, I have already asked
for 12:30 lunch. >> ALAN MILLIGAN: Okay.
>> HENRY JONES: Okay I understand it is ready. So why don't we take a break now and lunch
is ready. And we will reconvene in one hour. We will reconvene we are going to take a lunch
break and we will reconvene in one hour. So that is 50 minutes. 1 o'clock.