Mitigating Drawdowns

June 17, 2019Yu (Ben) Meng, Ph.D.Chief Investment Officer, CalPERS

1

Building Blocks for Determining Capital Market Assumptions (CMAs)

2

Inflation

Real Risk-Free RateFoundations common to all asset class assumptions

Risk Premium Risk premiums vary by each asset class due to its unique attributes and risks

Agenda Item 9a, Attachment 1, Page 2 of 14

CalPERS CMA’s Are Within Industry Ranges

3

Expected Return %

1 - 10 Years, 6.1% Expected Return11 - 60 Years, 8.3% Expected Return1 - 60 Years, 7% Expected Return (net of expenses)

2017 CalPERS ALM 1-10 Year Estimates2018 Horizon Survey 10-Year Estimates

*Data Source:• Horizon Survey of Capital Market Assumptions• CalPERS 2017 Asset Liability Management Capital Market Assumptions.

Agenda Item 9a, Attachment 1, Page 3 of 14

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A Wide Distribution of Potential Outcomes

17.5%-5.3%−𝟏𝟏𝟏𝟏 𝟏𝟏𝟏𝟏

68%

28.9%−𝟐𝟐𝟏𝟏 𝟐𝟐𝟏𝟏

95%

-16.7%

Left Tail (Drawdown)

Lower (Expected Return) Higher

6.1%×

40.3%-28.1%−𝟑𝟑𝟏𝟏 𝟑𝟑𝟏𝟏

99%

Agenda Item 9a, Attachment 1, Page 4 of 14

High Current Valuations Do Not Bode Well for Future Returns

Min= -0.8% Max=8.2%U.S. Treasury Real Rates

U.S Equity Real Yields

Min

=2.6

%M

ax=8

.8%

Today

Global Financial Crisis

1981 Recession

Nominal Expected Return 14.7% Discount Rate 8.5%

Nominal Expected Return 4.3%Discount Rate 7%

5

Agenda Item 9a, Attachment 1, Page 5 of 14

What Is a Drawdown?“Putting it plainly, a drawdown is the “pain” period experienced by an investor between a peak (new highs) and subsequent valley (a low point before moving higher).”

- Wikipedia

-50%

-45%

-40%

-35%

-30%

-25%

-20%

-15%

-10%

-5%

0%

Cumulative Drawdown %

1987 Crash Dot-Com Bubble Global Financial Crisis

S&P 500 composite declines from all-time highs since 1987

20% Market Decline

RecessionPeriods

6

Agenda Item 9a, Attachment 1, Page 6 of 14

Why Do We Care About Drawdowns?

Under Funded Status

High Assumed Rate of Return

Riskier Portfolio

Potential for Larger

Drawdown

Timing of Market

Drawdown is unpredictable

Before the Drawdown

Establish a Plan

During the Drawdown

Stick to the Plan

7

Agenda Item 9a, Attachment 1, Page 7 of 14

What “Pain” Does a Drawdown Inflict?S&P 500 Total Returns versus Liabilities from 2007 - 2012

Total Accrued Liabilities

6.5%

8

Over 4 Years to Recover

-50%+100%

October 2007 March 2012

Agenda Item 9a, Attachment 1, Page 8 of 14

What is the Likelihood of a Drawdown?

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• Unconditional probability of a drawdown is ~15%

• If we believe that we are in late cycle, the conditional probability is higher

• Estimates are based on history and are backward looking

Agenda Item 9a, Attachment 1, Page 9 of 14

What has Already Been Done to Prepare for a Drawdown?

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Steps already taken to make us less vulnerable to a drawdown

Lower Discount Rate New Asset

Allocation Capital injection from the State Shorter

Amortization

Agenda Item 9a, Attachment 1, Page 10 of 14

Effects of a Drawdown

MITIGATE IMPACT (NOT ELIMINATE

IMPACT):

Pro-active, Contingent Liquidity Action Plan

MITIGATE IMPACT (NOT ELIMINATE

IMPACT):

Strong Policy and Guidelines

1

2

3

4

Run Out of Money

Miss the Opportunity to take advantage of market dislocations

Panic and Sell Assets that Crystalize Loss

Cannot Maintain the Risk Profile

11

Agenda Item 9a, Attachment 1, Page 11 of 14

What Else Can We Do?

Our Preparation Develop an Action Plan of What To Do and Not To Do

Implement centralized Liquidity and Leverage Management

Implement more real-time monitoring and scenario

analysis

Update investment policies to allow for faster response

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Work together to forge solutionsBe part of the plan

Support the plan during the drawdown

=Planning + Partnership = A Strong Defense Against a Drawdown

Your Partnership

Agenda Item 9a, Attachment 1, Page 12 of 14

Developing an Action PlanWhat do we do during a drawdown?

1. Meet all of our required cash flowobligations

2. Assess and understand impacts ofdrawdown across the portfolio

3. Maintain our desired risk exposures

4. Opportunistically seek to deploycapital / dry powder

What do we NOT do during a drawdown?

1. Succumb to common investmentbehavioral biases

2. Allow deviation from pre-determinedplan without a strong justification

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Agenda Item 9a, Attachment 1, Page 13 of 14

When the Drawdown Arrives, Remember to ….

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Agenda Item 9a, Attachment 1, Page 14 of 14