Pension Funds DIY: A Hands-On Future for Asset Owners

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Pension Funds DIY:

A Hands-On Future for Asset Owners

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ASSET OWNERS

Executive Summary

• This executive briefing explores how pension funds are adapting to the challenges of a new

investment environment

• The research presented in this report is based on an international State Street survey, conducted by

the Economist Intelligence Unit in August 2014, of 134 senior executives in the pension fund industry

Five Trends Are

Reshaping the Industry

• RISK

3 out of 4 pension will ramp up their risk appetite as the search for

returns intensifies in a tough investment climate

• INVESTMENT

Private equity will be biggest winner from a surge in alternatives

investment by pension funds

• INSOURCING

Insourcing changes the game as 4 out of 5 pension funds plan to take

control of their destiny and manage more of their assets in-house

• PERFORMANCE

Pension funds set a new threshold for performance from their

asset managers

• GOVERNANCE

Half of pension funds will prioritize improvements to governance as

regulatory scrutiny intensifies

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ASSET OWNERS

In what region are you located?

Americas 42%

APAC 22%

EMEA 36%

3%

20%

77%

We are a regional institution,operating in more than one

country across a single region

We are a global institution,operating in more than one

region

We are an institution thatoperates in only one country

Which best describes

your institution?

The research presented in this report is based on an international State Street survey of 134 senior

executives in the pension fund industry. The survey was conducted by the Economist Intelligence Unit in

August 2014. Respondents from 15 countries participated in the survey, with the majority being drawn

from the US, UK, Australia and Canada.

State Street 2014 Survey of Pension Funds – Geographic Focus

Source: State Street 2014 Asset Owner Survey, conducted by the Economist Intelligence Unit. Pension fund respondents.

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ASSET OWNERS

17%

31%

52%

Superannuation fund

Private sector pension orretirement system

Public sector pension orretirement system

Please select your institution type

Both DB and DC

62%

Defined benefit (DB) 20%

Defined contribution

(DC) 18%

Which best describes your institution?

Just over half of respondents came from public sector pension funds, nearly a third from private sector

pension systems, and 16 percent from superannuation funds. Most respondents came from

organizations that oversee both defined benefit (DB) and defined contribution (DC) funds.

State Street 2014 Survey of Pension Funds – Institution Types


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Three-quarters of pension funds surveyed will ramp up their risk appetite as the search for

returns intensifies in a tough investment climate

Trend 1:

Getting Hands-On With Investment Risk


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Q8. Do you expect your institution's investment risk appetite to:

3%

20%

55%

57%

41%

19%

2%

2%

2%

Over the nextyear

Over the nextthree years

Increase significantly Increase slightly Stay the same

Decrease slightly Decrease significantly

Survey Insights

• More than three

quarters of

respondents in

(77 percent)

expect their

institutions'

investment risk

appetite to

increase over the

next three years

• Nearly 60% see

such increased

appetite for risk

even in the next

12 months

Pension Funds Ramp Up Their Risk Appetite


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Pension funds face a dilemma. Many say they would like to derisk their portfolios, but the current

environment requires them to weight their investments towards higher growth/higher risk strategies.

Success therefore requires them to strike a new balance on risk and return.

Interview Quotes – The Risk-Return Dilemma

Pension funds are stuck between an equity market that's been on a good run for many years and

a bond market that still looks expensive. Then on top of that you have all the Central Bank

interventions pressing rates down. Funds want to maximize their returns and at the same time try

to minimize risk. We are in territory we haven't been in before.

Robin Diamonte, Chief Investment Officer, United Technologies Corporation

The low interest rate environment has definitely been a real challenge for many investors,

including CalPERS. Right now, our required rate of return is 7.5 percent. To achieve this in the

current climate, we have followed a fairly growth oriented portfolio strategy. If you add up all our

equity and growth oriented assets, our private equity and public equity positions, it comprises

almost 62 percent of the plan’s total assets. It’s a relatively high allocation to growth assets for a

mature plan.

Wylie Tollette, Chief Operating Investment Officer, CalPERS

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Based on the survey results, private equity will be the biggest winner from a surge in

alternatives investment by pension funds. Emerging market investments are also

becoming more important.

Trend 2:

Big Bets on Alternatives


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ASSET OWNERS

Q4. Please indicate whether your institution plans to make any

changes to its relative allocations. Survey Insights

• 60% of

respondents see

an increased

allocation to

private equity

• Direct loans are

the second-most

desirable

alternative asset,

with 54% of

respondents

expecting to

increase direct

loan allocations

• One quarter of

respondents are

making first time

investments into

hedge funds

60%

54%

45%

39%

29%

20%

2%

6%

2%

2%

3%

3%

5%

7%

3%

9%

25%

27%

28%

28%

45%

50%

22%

29%

6%

5%

5%

1%

21%

20%

Private Equity

Direct Loans

Real Estate

Infrastructure

Hedge funds (singlemanager)

Fund of hedge funds

Will increase existing allocation

Will decrease existing allocation

Will invest for the first time

Will make no change to existing allocation

N/A (no allocation and no plans to invest)

Pension Funds’ Alternative Asset Allocations


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Q2. Where do you see investment opportunity for your

institution increasing or decreasing? Survey Insights

• Vast majority

(81%) of

respondents see

investment

opportunity in

developed

markets

increasing

• Nearly two-thirds

(62%) are bullish

on emerging

markets

opportunities

19%

11%

5%

62%

52%

21%

16%

35%

65%

3%

7%

1%

1%

1%

1%

Developed Markets

Emerging Markets

Frontier Markets

Strongly increasing Slightly increasing

No change Slightly decreasing

Strongly decreasing N/A

Momentum of Regional Investment Opportunities

Source: State Street 2014 Asset Owner Survey, conducted by the Economist Intelligence Unit.

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Insourcing changes the game as the vast majority of pension funds surveyed plan to

manage more of their assets in-house

Trend 3:

DIY on Asset Management


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ASSET OWNERS

Q6. Over the next three years, do you plan to:

Survey Insights

• The great majority

(81%) of pension

funds expect to

increase the

internally

managed

proportion of their

portfolio

• The right

insourcing

strategy can

deliver substantial

cost savings

• Insourcing also

enables pension

funds to get

closer to their

assets and to

reduce agency

risk

19%

81%

Make no change to the proportionof your portfolio that is managed in-

house

Increase the proportion of yourportfolio that is managed in-house

Insourcing: Asset Owners Become Asset Managers


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ASSET OWNERS

Pension funds are facing a choice to either continue to purchase asset management services or to build

the capabilities in-house.

Interview Quotes – The Build-or-Buy Dilemma

Can we insource some components of the process and outsource other components?

Traditionally we’ve bought the whole car. Maybe we need to buy the engine or buy the brakes or

buy the engineering capability and just build the car ourselves.

Richard Brandweiner, CIO, First State Super


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ASSET OWNERS

Q11. Will your institution seek to make any of the following

changes within the next three years? Survey Insights

• A greater number

of funds and

investment

schemes is the

most widely

expected change

(76%). This

points to greater

complexity.

• 53% of

respondents see

increased

deployment of

lower-cost

investment

strategies

Evolution of Pension Funds’ Investment Tools and Strategies

76%

53%

43%

14%

2%

2%

6%

18%

22%

45%

51%

68%

Number of funds/schemes

Usage of lower-cost strategies toachieve desired investment outcomes

Number of technologyplatforms/software solutions

Number of external consultants for yourinvestment portfolio

Will seek to increase Will seek to decrease Will make no change


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Pension funds set a new threshold for performance from their asset managers

Trend 4:

The Relationship With Asset Managers Evolves


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Q5. Have you experienced any of the following over the past

year with respect to your external managers? Survey Insights

• Understanding

the risk-adjusted

performance of

external

managers is the

most common

challenge for

pension finds –

58% struggle with

that

• Aligning interests

and incentives in

the second-most

common

challenge (52%)

• Justifying the cost

of external

mangers is a less

common issue

(29%)

Pension Funds’ Relationship With External Managers

18%

16%

10%

8%

6%

40%

36%

28%

28%

23%

Gaining a complete picture of risk-adjustedperformance

Ensuring their interests are aligned with ours

Conducting due diligence post-hire to ensuremanagers are meeting our expectations

Conducting due diligence when hiring newmanagers

Justifying the fees

Major challenge Minor challenge

Source: State Street 2014 Asset Owner Survey, conducted by the Economist Intelligence Unit.

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ASSET OWNERS

Pension funds need asset managers who can help them develop investment strategies that are

compatible with their broader investment philosophy. For their part, asset managers must master the

transition from product providers to becoming fully-fledged “solution builders.”

Interview Quotes – Managers as Solutions Providers

“Instead of saying here’s a product for you to invest, they (asset managers) are collaborating to

develop investment solutions that are more appropriate for your particular needs.”

Richard Brandweiner, CIO, First State Super


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ASSET OWNERS

Half of pension funds surveyed will prioritize improvements to governance as regulatory

scrutiny intensifies

Trend 5:

Fortifying Governance


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ASSET OWNERS

Q12. What level of priority will your institution place on

strengthening the following areas over the next three years? Survey Insights

• Regulatory

compliance is top

of mind for

pension funds –

61% see it as

high priority and

another 35% as

medium priority

• Strengthening

governance is

high on the list for

over half of

pension funds

• Data

management is

another high

priority for 55% of

respondents

61%

55%

51%

24%

10%

35%

39%

41%

43%

46%

4%

6%

8%

33%

44%

Regulatory compliance

Data management

Overall governance

Cybersecurity

Contingency planning (ie, disasterrecovery, business continuity)

High Priority Medium Priority Low Priority

Pension Funds’ Top Priorities for Improvement


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ASSET OWNERS

Pensions will increasingly need an approach that emphasizes oversight, transparency and disclosure.

Regulation is certainly a factor in this trend. The increased use of complex alternatives may also require

pension funds to bring in more professional trustees or specialist advisors.

Governance With Expertise

Pensions funds have had a lot of discussions with the regulator about the expertise of board

members… The pension funds agreed that they should have more specialists with asset and risk

management skills on the board.

Peter Borgdorff, Director, Pensioenfonds Zorg en Welzijn (PFZW)

25% of respondents say that the increasing complexity of portfolios

will require them to make changes to the composition of their trustees.


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ASSET OWNERS

Focus for the Future

To succeed in today’s complex investment environment, pension funds will need to develop strategies

in each of the following five areas:

Manage the Risk Budget Across the Portfolio

Invest in specialist tools and capabilities to improve analysis across multi-asset portfolios. 1

Master the New Investment Mix

Learn how to blend alternative investments with low cost strategies to strike a new balance on risk

and return.

2

Think Strategically on Insourcing

Understand where your in-house talent can add more value. Create the operating model to

optimize in-house asset management.

3

Develop Strategic Partnerships With Key Managers

Many pension funds are concentrating on developing fewer but deeper relationships with their

asset managers.

4

Professionalize Governance

Ensure professional oversight on risk and governance. Make better use of expert trustees and/or

specialist advisors.

5


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Appendix

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ASSET OWNERS

Q4. Please indicate whether your institution plans to make any changes to its relative allocations.

58%

50%

50%

44%

44%

38%

12%

15%

8%

16%

8%

21%

Direct loans

Hedge funds(single manager)

Real estate

Infrastructure

Private equity

Fund of hedgefunds

A Shift in Allocations – Top Three Countries

50%

43%

29%

29%

25%

14%

4%

7%

21%

7%

18%

25%

Private equity

Direct loans

Infrastructure

Real estate


Fund of hedgefunds

Will increase existing allocation

Will invest for the first time

75%

54%

46%

39%

11%

7%

7%

7%

4%

36%

36%

Private equity

Direct loans

Real estate

Infrastructure

Fund of hedgefunds


Australia UK US


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ASSET OWNERS

Q5. Have you experienced any of the following over the past

year with respect to your external managers? – Ensuring their

interests are aligned with ours Survey Insights

• Ensuring external

managers’

interests are

aligned with those

of pension funds

is a particularly

strong concern

among Australian

respondents

• This is also

perceived as a

challenge by

pension funds in

the UK

Concerns About Alignment of Interest with External Managers

27%

14%

7%

31%

39%

29%

Australia

UK

US

Major challenge Minor challenge


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ASSET OWNERS


strengthening the following areas over the next three years? –

Overall governance

Survey Insights

• Governance is a

much higher

priority among US

pension funds

• Its importance

among pension

institutions in

Australia and the

UK is lower,

though still on

their top-three list

Prioritizing Governance – Top Three Countries

73%

41%

40%

23%

56%

48%

4%

4%

12%

US

UK

Australia

High priority Medium priority Low priority


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ASSET OWNERS


strengthening the following areas over the next three years? –

Regulatory compliance

Survey Insights

• Regulatory

compliance is a

higher priority

among US

pension funds

• At the same time,

it is very high on

the agenda

among UK

institutions – no

UK respondents

considered it a

low priority

Prioritizing Regulatory Compliance – Top Three Countries

73%

62%

48%

23%

38%

48%

4%

4%

US

UK

Australia

High priority Medium priority Low priority


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ASSET OWNERS

Survey Methodology

The international State Street survey was conducted by the Economist Intelligence Unit in August 2014.

The information presented is based on the survey results of 134 senior executives in the pension fund

industry. Respondents are from 15 countries, with the majority being drawn from the US, UK, Australia

and Canada.

Just over half (52 percent) of respondents came from public sector pension funds, 31 percent from

private sector pension systems, and 16 percent from superannuation funds. Most respondents (62

percent) came from organizations that oversee both defined benefit (DB) and defined contribution (DC)

funds.

This survey sought to explore how pension funds are adapting to the challenges of a new investment

environment. The survey was conducted online and consisted of ten multiple-choice questions.

CORP-1133

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Disclaimer

Investing involves risk including the risk of loss of principal.

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has been obtained from sources believed to be reliable. There is no representation or warranty as to the accuracy of the information and State Street shall have no liability for

decisions based on such information

The views expressed in this material are based on interviews that took place in September 2014. They are subject to change based on market and other conditions. This document

contains certain statements that may be deemed forward-looking statements. Please note that any such statements are not guarantees of any future performance and actual results or

developments may differ materially from those projected.

Risk associated with equity investing include stock values which may fluctuate in response to the activities of individual companies and general market and economic conditions.

Bonds generally present less short-term risk and volatility than stocks, but contain interest rate risk (as interest rates rise bond values and yields usually fall); issuer default risk; issuer

credit risk; liquidity risk; and inflation risk. These effects are usually pronounced for longer-term securities. Any fixed income security sold or redeemed prior to maturity may be subject

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Investing in foreign domiciled securities may involve risk of capital loss from unfavorable fluctuation in currency values, withholding taxes, from differences in generally accepted

accounting principles or from economic or political instability in other nations.

Investments in emerging or developing markets may be more volatile and less liquid than investing in developed markets and may involve exposure to economic structures that are

generally less diverse and mature and to political systems which have less stability than those of more developed countries.

Investing in REITs involves certain distinct risks in addition to those risks associated with investing in the real estate industry in general. Equity REITs may be affected by changes in

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default by borrowers and self-liquidation. REITs, especially mortgage REITs, are also subject to interest rate risk (i.e., as interest rates rise, the value of the REIT may decline).

There are risks associated with investing in Real Assets and the Real Assets sector, including real estate, precious metals and natural resources. Investments can be significantly

affected by events relating to these industries.

Hedge funds are typically unregulated private investment pools made available to only sophisticated investors who are able to bear the risk of the loss of their entire investment. An

investment in a hedge fund should be viewed as illiquid and interests in hedge funds are generally not readily marketable and are generally not transferable. Investors should be

prepared to bear the financial risks of an investment in a hedge fund for an indefinite period of time. An investment in a hedge fund is not intended to be a complete investment

program, but rather is intended for investment as part of a diversified investment portfolio

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Expiration date: 11/30/2015

Economy & Finance

Pension Funds DIY: A Hands-On Future for Asset Owners