Agenda Item No.9: Discussion of Real Return Portfolio Structure; and Possible Action (January 25, 2012, Special Retirement Board Meeting)

CITY OF LOS ANGELES DEPARTMENT OF WATER AND POWER INTERDEPARTMENTAL CORRESPONDENCE

Date: January 17, 2012

To: Retirement Board Members

From{tJ Sangeeta Bhatia, Retirement Plan Manager

Subject: Board Agenda Item No.9: Discussion of Real Return Portfolio Structure; and Possible Action (January 25, 2012, Special Retirement Board Meeting)

At the Regular Board meeting held on January 16, 2008, the Retirement Board adopted an asset allocation plan that included the Real Return asset class with a weighting of 7% (Resolution No. 8-49). The purpose of the Real Return asset class is to diversify equity risk, provide a hedge against inflation, and produce relatively stable returns with principal protection for the Plan's overall portfolio. The performance objective of the Real Return portfolio is to generate a total return, net of fees, that exceeds the Consumer Price Index (CPI) + 4%.

As a matter of background, when the Plan's Real Return asset class was established, it included two hedge fund-of-funds managers: Aetos Alternatives Management, LLC, (Aetos), and Pacific Alternative Asset Management Company, LLC (PAAMCO). Global Inflation Linked Securities manager, Western Asset Management Company (WAMCO) was added to the class in 2010; PAAMCO was terminated in October 2010 (Resolution No. 11-33).

Currently, the Real Return asset class in the Retirement Fund (RF) includes Aetos and WAMCO, which were hired in 2007 and 2010, respectively. Aetos was initially funded with $33.0 million, and WAIVICO was initially funded with $125.0 million. As of December 31, 2011, the market value of the Aetos portfolio was $35.2 million, and the market value of the WAMCO portfolio was $334 million (which includes additional funding of $137.35 million in October 2010, $34.08 million in January 2011, and $3.4 million in May 2011 ).

In the Retiree Health Benefits Fund (RHBF), Aetos was funded in September 2010 with $7.5 million and WAMCO was initially funded in April 2010 with $16.0 million. As of December 31, 2011, the market value for the Aetos portfolio was $7.7 million, and the market value of the WAMCO portfolio was $68 million (which includes additional funding of $7.2 million in January 2011, $0.7 million in May 2011, and $40.0 million in June 2011 ).

At the Regular Board meeting on June 8, 2011, representatives from Pension Consulting Alliance (PCA) proposed a revised asset allocation structure to the Plan's portfolio to include a 5% allocation to the new Covered Calls asset class. As a result of

9.1 the new allocation to Covered Calls, the revised asset allocation structure also included reducing the Real Return's allocation from 7% to 6% (Resolution No. 11-96) to partially cover the allocation to Covered Calls.

At the Regular Board meeting on December 14, 2011, representatives from PCA proposed the following restructuring options for the Real Return asset class:

Option 1 Keep existing structure and managers Option 2 a) Increase exposure to existing Absolute Return allocation b) Add new Commodities mandate c) Add new Timber mandate Option 3 a) Increase exposure to and restructure Absolute Return allocation b) Add new Commodities mandate c) Add new Timber mandate Option 4 a) Increase exposure to and restructure Absolute Return allocation b) Add a new complementary Absolute Return strategy c) Add new Commodities mandate d) Add new Timber mandate

PCA recommends restructuring the Plan's real return asset class in accordance with Option 4, which will require the following actions: 1) restructure Aetos; 2) add complementary Absolute Return strategy; and 3) add new Commodities and Timber managers to further diversify strategic class. PCA also recommends lowering the Real Return benchmark from CPI+4% to CPI + 3%.

Furthermore, PCA is proposing two possible Real Return asset allocation options should the Retirement Board adopt Option 4 as described above. The attached memo from PCA contains additional details.

The following documents are attached: • Resolution No. 12-53 • Correspondence from PCA • Resolution No. 8-49 (approved 1-16-2008) • Resolution No. 11-33 (approved 10-27-2010) • Resolution No. 11-96 (approved 6-22-2011)

e Wolfson ief Investment Officer

SB:JW:SV:AL

9.2 RESOLUTION NO. 12-53

RESOLUTION TO ADOPT THE RESTRUCTURING PLAN FOR THE REAL RETURN ASSET CLASS

WHEREAS, at the Regular Board meeting held on June 16,2008, the Retirement Board adopted a new asset allocation that included a Real Return asset class with a weighting (of 7% (Resolution No. 8-49); and

WHEREAS, the Retirement Plan's (Plan) Real Return asset class initially included two hedge fund-of-funds managers: Aetos Alternatives Management, LLC (Aetos) and Pacific Alternative Asset Management Company, LLC (PAAMCO), and later added one global inflation linked securities manager, Western Asset Management Company (WAMCO); and

WHEREAS, PAAMCO was terminated in October 2010 (Resolution No. 11-33); and

WHEREAS, as of December 31, 2011, the Plan's Real Return asset class includes Aetos and WAMCO; and

WHEREAS, as of December 31, 2011, the market value of the entire real return portfolio, 'including both the Retirement Fund and Retiree Health Benefits Fund portfolios, was $445 million; and

WHEREAS, at the Regular Board meeting on June 22, 2011, Pension Consulting Alliance (PCA) proposed, and the Retirement Board approved, a revised asset allocation structure reducing the Real Return's allocation from 7% to 6% (Resolution No. 11-96); and '

WHEREAS, at the Regular Board meeting on December 14, 2011, PCA proposed the following restructuring options for the Real Return asset class:

WHEREAS, PCA recommends restructuring the Plan's Real Return asset class in accordance with Option 4; and

9.3 WHEREAS, should the Retirement Board adopt Option 4, PCA is also proposing two possible Real Return asset allocation options:

StrateQY Option A Option B Global TIPS 40% 40% Core Absolute Return MQr 20% 15% New Absolute Return MQr 10% 15% New Commodities Mandate 20% 20% New Timber Mandate 10% 10% Total 100% 100%

NOW, THEREFORE, BE IT RESOLVED, the Retirement Plan Manager is hereby authorized to restructure the Plan's Real Return asset class in accordance with Structural Option __ and Asset Allocation Option as outlined above.

I HEREBY CERTIFY, the foregoing is a full, true, and correct copy of a Resolution adopted by the Retirement Board of Administration [created by Section 1102 (b) of the Los Angeles City Charter] at its special meeting held on January 25, 2012.

Sangeeta Bhatia Retirement Plan Manager

9.4 DATE: January 13, 2012

TO: The Board of the Water & Power Employees' Retirement Plan (WPERP)

FROM: Pension Consulting Alliance, Inc. (PCA) cc: Jeremy Wolfson - cia Sangeeta Bhatia Neil Rue - PCA David Sancewich - PCA Kay Ceserani - PCA

RE: Summary of Real Return Structure Review

Summary & Recommendations

At the December 14th Board meeting, PCA presented its findings and recommendations from the 2011 Real Return Structural Review. Following this review, the Board requested PCA write a formal memo which outlines the recommended actions to consider. This memo summarizes the results of the Real Return Review and discusses the impact of the recommended changes. In light of the discussion and review, PCA recommended that the Board adopt the proposed Option #4 from the Real Return Review, which the Board approved. Option 4 specifically increases exposure to and restructures the Absolute Return Segment, adds a new complementary absolute return strategy, and adds new Commodities and Timber mandates, while changing the asset class benchmark to CPI+3% from CPI+4%.

Discussion

As of 12/31/2011 the combined WPERP and Health Plan (Aggregate Plan) Real Return portfolio totaled roughly $369.1 million. This class amounts to over 5% of WPERP's total investment assets. During the first quarter of 2011, the Board approved a revised strategic policy allocation for the Aggregate Plan's total investment portfolio. This new policy calls for the Real Return class to be slightly increased over time, from the current 1 policy level of 5% up to 6% by 2014 •

1 PCA's 2011 Asset Allocation Recap memo.

9.5 ·~------WPERP Real Return Portfolio period ending September 30, 2011, Net of Fees

• WPERP Real Retum .CPI +4%

111

110

109

108

107

106 8 ;;;105 '0 ~104 Cl 103

102

101 ...... 100 ~~:::::::;r;;;;;;;;;olf------

99 -I----.------.------.----~------~ Apr-10 Jun-10 Sep-10 Dec-10 Mar-11 Jun-11 Sep-11

As shown in the chart above, the Real Return portfolio has produced lower returns than the current CPI+4% policy benchmark. Given the current overweight to TIPS, outperformance versus the current policy benchmark becomes difficult as TIPS are designed to match, not exceed inflation. The inclusion of Commodities and Timber in the Real Return class should help enhance risk-adjusted returns over various market cycles. To the extent that WPERP is reasonably confident that current equity market volatility will continue through future investment cycles, the Board approved making several changes within the Real Return portfolio.

Summary and Review of Recommended Portfolio Changes

As the 2011 Real Return Review highlights, there are several key factors influencing PCA's recommendation to increase exposure and restructure the Absolute Return segment, add a new complementary Absolute Return strategy, and add new Commodities and Timber mandates. First, the current fund of hedge funds manager, Aetos, has failed to add value over the since inception period, relative to its current benchmark target, TBills+3%. In light of this result and the different market conditions versus 2007 when this product was funded, PCA believes restructuring the Aetos portfolio to a separate account should benefit the Absolute Return segment. The addition of a second fund of hedge funds manager will be established to further diversify the Absolute Return segment. Second, the addition of Commodities and Timber to the Real Return class should provide two return streams that have the potential to help the Real Return class improve its risk-adjusted return. Finally, the Board approved changing the policy benchmark from CPI+4% to CPI+3% to reflect a lower level of risk.

9.6 .------ Examination of Aetos' Role and including a new Absolute Return manager

As discussed during the December 14th meeting, the current Aetos portfolio is structured using the manager's three commingled fund vehicles. While providing WPERP with diversification, the current structure does not allow customization of client guidelines, specifically the ability to reduce the current equity risk premium inherit in the portfolio. For an enhanced Absolute Return segment, PCA recommends that WPERP develop specific investment guidelines for use under a separate account format. A separate account format allows for significant customization, which is critical within Absolute Return. PCA also recommends that WPERP conduct an informal RFI process to determine if Aetos' current role and fee structure is industry standard and appropriate for WPERP's purposes. This information will also be used to examine potential new managers to complement the Aetos portfolio. As PCA reviewed the available options in this segment of the portfolio, the ability to lower the equity risk premium, lower fees, and further diversify the absolute return segment, led to our recommendation of the changes mentioned above.

Additions of Commodities and Timber

PCA reviewed the current WPERP Real Return portfolio to that of its policy benchmark, the CPI+4%, and noted a significant overweight of the TIPS assets, currently 91 % of the overall portfolio. Given that TI PS are designed to match inflation and not exceed it, the current portfolio warrants further diversification. A prudently structured Real Return portfolio should diversify equity risk and provide inflation hedging and structured such that it can produce relatively stable returns with principal protection. PCA recommends the addition of new active Commodities and Timber mandates to the Real Return asset class as the addition of these two segments can help accomplish the above objectives.

WPERP Current Real New Real Return Return Portfolio Structure

_Global Tips

• Global TIps • Absolute Return

• Absolute Return • Commodities

-Aetos' current fee structure consists of an ongoing management fee plus profit participation. On average, current SMA structures do not include the profit component.

9.7 .------ Changing the policy benchmark

Currently the WPERP investment policy benchmark for Real Return is CPI+4%. This target was established pre-200B and does not currently reflect the long-term market return assumptions for the asset class. PCA is recommending lowering the Real Return policy target to CPI+3%. Such a move helps better position the asset class to meet its policy objective, while taking into account current long-term market return expectations.

In summary, if, over an investment cycle, the new and current managers meet investment performance expectations, PCA's recommendation should help improve the risk-adjusted performance of the WPERP Real Return portfolio.

Summary of Proposed Real Return Recommendations Strategy Option A Option B

WAMCO, GlobalTips 40% 40%

Core Absolute Return 20% 15% Position (currently Aetas)

New Absolute Return 10% 15% Manager

New Commodities 20% 20% Mandate

New Timber Mandate 10% 10%

Total 100% 100%

Source: peA WPERP 2011 Real Return Structural Review

9.8 RESOLUTION NO. 08-49

RESOLUTION TO RATIFY THE BOARD'S ACTION IN CONNECTION WITH THE ADOPTION OF ANEW ASSET ALLOCATION STRUCTURE

WHEREAS, the Water and Power Employees Retirement Plan's (WPERP) Statement of Investment Objectives Goals and Guidelines indicate that the Plan's asset allocation policy may be subject to periodic review and revisions as fund conditions change and as investment conditions warrant; and

WHEREAS, WPERP's current strategic asset allocation policy was adopted by the Board on September 18, 2002 in accordance with Board Resolution 03-09; and

WHEREAS, at the regular Board meeting held on April 18, 2007. the Board approved the one-time asset/liability study project proposed by Pension Consulting Alliance (PCA) and EFI Actuaries, Inc. (EFI), for the Retirement Fund and the Retiree Health Benefit Fund (RHBF) (Board Resolution 07-67); and

WHEREAS, PCAIEFI conducted the asset/liability study to determine the Retirement Board's risk tolerance by allowing the Board to vote on a set of 5 risk factors which resulted in new asset class allocation targets for both the Retirement Fund and the RHBF; and

WHEREAS, PCA recommends that the Board adopt the same strategic investment policy for both the Retirement Fund and the RHBF because the expected returns and risk make the optimal allocations to these Funds virtually equivalent; and

WHEREAS, optimal investment targets in each asset class for both the Retirement Fund and the RHBF were identified as follows; and

Ass CIcIS' Selected Current

WHEREAS, considering the significant changes to the asset allocation targets, PCAIEFI proposed a 4-year window of implementing these newly adopted targets as follows; and

~~~ef¢.!ass'f!C~ .,.':~;:~ ~ .:~~ ~:,~~.' 9/~Olioo~V1 O(1~j~ooi:1r:~:7Tf?2oo81r :?!1~qO:91[;f0~'~~ L~_~~,"~~~_Jl~...~~~E~':!.2!Jt~~Q£~OO!:jL~!~gL~5'j~ ;"6/~q ~EQ.,~~ Cash 1 1 1 1 1 Fixed Income 32 30 28 26 24 Real Return 1 3 4 6 7 Real Estate 1 2 3 4 5 Domestic Equity 45 39 38 35 34 International Equity 20 24 24 24 24 Private Eauitv 0 1 2 4 5 "Real Retum allocation IS WPERP's current Hedge Fund segment allocation "*To align with fiscal year reporting FiLE COpy

9.9 RESOLUTION NO. 08-49

WHEREAS, at its regular meeting of December 19, 2007, the Board moved to adopt,the PCAIEFI recommendations of the completed WPERP Asset Liability Study;

NOW, THEREFORE, BE IT RESOLVED, the Retirement Plan Manager is authorized to proceed with the implementatioh of the new asset allocation structure in accordance ,with the implementation schedule recommended by PCAIEFI.

I HEREBY CERTIFY, the foregoing is a full, true, and correct copy of a Resolution adopted by the Board of Administration (Retirement Board), created by Section 1102 (b) of the City Charter of the City of Los Angeles, at its regular meeting held January 16, 2008.

Secretary

F\lE COpy

9.10 RESOLUTION NO. 11-33

RESOLUTION TO TERMINATE THE CONTRACT WITH PACIFIC ALTERNATIVE ASSET MANAGEMENT COMPANY, A HEDGE FUND OF FUNDS MANAGER

WHEREAS, the Board of Administration (Board) of the Water and Power Employees' Retirement Plan (Plan) hired Pacific Altemative Asset Management Company, LLC (PAAMCO) to manage a hedge fund of funds mandate for the Retirement Fund (RF) in February 2007 and for the Retiree Health Benefits Fund (RHBF) in August 2010. with an initial funding of $33.0 million and $7.5 million, respectively; and

WHEREAS, the market value of the PAAMCO account in the RF was $35.6 million, and $7.51 million in the RHBF, as of September 30,2010; and .

WHEREAS, at the Regular Board meeting held on October 13, 2010, Staff notified the Board of an organizational change involving the ownership structure of PAAMCO Founders, LLC (Founders); and

WHEREAS, the new ownership structure of Founders entitled Donald Sussman, a passive investor in the company, to convert his loan to PAAMCO into a 40% equity ownership in Founders; and

WHEREAS, at the Regular Board meeting held on October 13, 2010, the Board voted to place PAAMCO on organizational watch status for a period of six to twelve months due to the aforementioned organizational change; and

WHEREAS, PAAMCO, on September 30, 2010,' notified Staff of a special redemption period allowing the Plan an opportunity to redeem all or part of its investments with PAAMCO, as of December 31, 2010, provided PAAMCO is notified by October 27, 2010; and

WHEREAS, Pension Consulting Alliance (PCA) believes the new ownership structure may impact PAAMCO's ability to attract and retain talented employees or partners; and

WHEREAS, PCA recommends terminating the contract with PAAMCO and fully redeeming the Plan's investments with PAAMCO in the RF and RHBF accounts and to begin the Request for Proposal process for a new hedge fund of funds manager to replace PAAMCO.

NOW, THEREFORE, BE IT RESOLVED, the Retirement Plan Manager is hereby authorized to terminate the Plan's contract with PAAMCO, to fully redeem the Plan's funds with PAAMCO in the RF and RHBF, and to begin a Request for Proposal process for a new hedge fund of funds manager.

RATIFICATION OF THE BOARD'S ACTION REGARDING THE OVERALL ASSET ALLOCATION STRUCTURE FOR THE RETIREMENT FUND AND THE RETIREE HEALTH BENEFITS FUND

WHEREAS, at the Regular Board meeting held on June 8, 2011, Pension Consulting Alliance (PCA) proposed the following revised Asset Allocation Structure, which includes the new Covered Calls asset class, for the Retirement Fund and the Retiree Health Benefits Fund (RHBF); and

New Retirement Fund and RHBF Investment Allocation Targets

Previous Target Previous Target New Target Allocation for the Allocation for the ' Allocation for RF RF RHBF & RHBF Il~ (December 2007) (December 2007) Cash 1 1 1 Fixed Income 24 24 24 Real Return 7 7 6 Real Estate 5 5 5 Domestic Equity 34 34 33 International Equity 24 24 21 Covered Calls 0 0 5 Private Equity 5 5 5

WHEREAS, at the RegUlar meeting on June 8, 2011, the Board, after considerable discussion, adopted the proposed new Asset Allocation StnJcture as noted above.

NOW THEREFORE, BE IT RESOLVED, the Board hereby ratifies the action taken on June 8, 2011, to adopt the proposed new Asset Allocation Structure and authorizes the Retirement Plan Manager to implement the new Asset Allocation Targets for the Retirement Fund and the Retiree Health Benefits Fund.

~~ ~atia riLE COpy Retirement Plan Manager

9.12