3. 2,62. to Seattle City Employees? Retirement System Investment Advisory Committee CHY Annual Report for Fiscal Year 2016 vLuul ?L?ii\ To the Seattle City Employees? Retirement System (SCERS) Board of Administration: The Investment Advisory Committee (IAC) of the Seattle City Employees? Retirement System (SCERS) met with Board members and SCERS staff (Staff) four times during 2016. Additional discussions and communications to discuss pertinent issues for the Investment Committee also occurred throughout the year. Fotlowing is the report for calendar year 2016. I. Statement of Purpose According to RCW 35.39.0910, the investment Advisory Committee (IAC) shall have the following duties: 1. Make recommendations on general investment policies, practices and procedures to the Board. 2. Review the investment transactions of the Board annually. I 3. Prepare a written report of its activities during each fiscal year. ll. IAC Membership investment Advisory Committee members serve three-year terms or until the Board acts to extend or end that member's appointment. Dr. Cathy Cao and Steven Hill were appointed to the Investment Advisory Committee during 2016. IAC members and their terms are: 0 Joseph Boateng (Chair), Chief investment Officer, Casey Family Programs (term: January 2016 December 2018) - Dr. Cathy Cao, Assistant Professor of Finance, Seattle University (term: July 2016 June 2019) 0 Dr. Alan Hess, Professor Emeritus of Finance and Business Economics, University of Washington (term: January 2016 December 2018) - Steven Hill, former SeniorVice President of Human Resources, Weyerhaeuser; former Director, Washington State Department of Retirement Systems (term: July 2016 June 2019) - Dwight McRae, former Managing Director, Metzler Real Estate (term: January 2016 -- December 2018) Major Developments for SCERS in 2016 Specific 2016 investment initiatives included: - SCERS continued to make progress with its positive action strategy regarding environmental, social and governance (ESG) issues that includes corporate engagement, integrating climate change risk into investment process and considering sustainability investments. - NEPC investment consultant) performed a comprehensive analysis of the fees that SCERS pays its investment managers. NEPC concluded that overail fees are generally lower than those of other NEPC clients, but are likely to increase over time as more alternative strategies are implemented. - Staff and NEPC conducted annual reviews for each of asset classes to educate and update the Investment Committee on the portfolio role, composition and developments in each asset class. - The Washington State Legislature passed an exemption from the Public Records Act for city retirement systems related to their investments in private funds. SCERS and the City of Seattle led the effort, which also included the cities of Spokane and Tacoma. This law provides the ability to access top-tier private funds and receive greater information to appropriately and effectively monitor private fund investments. - Public Equity: Dimensional Fund Advisors was selected to manage SCERS's US small cap equity ailocation following the termination of Fisher Investments in 2015. Parametric?s covered call mandate was changed from US to global to benefit from additional diversification. Private Eguity: Adams Street Partners committed $86 million in 2016 (through November 2016) to 13 primary funds and 20 secondaries. - Fixed Income: SCERS restructured its Broad Fixed Income allocation from four managers that generally pursued a core plus strategy to two managers that pursue a core strategy. The restructuring is intended to aiign the Broad Fixed Income allocation with its intended portfolio role of diversification and capital preservation. Correspondingly. the target allocation to Broad Fixed Income was reduced from 18% to 16% and the target allocation to Credit Fixed income was increased from 5% to SCERS also selected Ares to manage its corporate high yield and bank loan investments within the Credit Fixed Income asset class. - Real Assets: SCERS committed $12 million to Brookfield Infrastructure Fund Ill and $12 million to Global Infrastructure Partners These commitments are consistent with the pacing plan that SCERS adopted in 2015 to guide future investment activity and achieve the 3% target weight to Infrastructure over time. Diversifyinq Strategies: SCERS terminated a fund of hedge funds strategy managed by BiackRock due to senior management turnover. AQR was selected to manage a $50 million long/short style mandate that invests in two AQR strategies. SCERS also reduced the minimum lower bound for Diversifying Strategies to 0% from Workout and legacy Private Equity: SCERS received $2.8 million and $6.6 million in distributions from the Workout and legacy Private Equity allocations, respectively. in addition to these investment initiatives, SCERS prepared operationally to implement the second tier that the City of Seattle has adopted for employees hired after January 1, 2017. The second tier will require reduced contributions from the City and is therefore expected to improve long?term financial strength. The Actuarial Required Contribution for the first tier is 25.32% and the comparable figure for the second tier is 21.42%. IV. Performance as of September 30, 2016 10v gFund - 10.81% "9.26%i 9.39% 4.54% 7.24% 9.90% iPoiicyind?x 7.92% 9.71% MedianFund?t 9.72% 6.19% - 9.47% 5.77% 6.94% 9.95%; Note: Performance is gross of fees *Peer group consists of public plans in the lnvestorForce Public DB Universe. each with assets in excess of $1 billion ?The Fund experienced positive performance (10.81% gross of fees, 10.65% net of fees) for the one-year period ending September 30, 2016, as did the Policy Index and median fund. The Fund outperformed the Policy Index by 72bps and outperformed the median fund by 109bps over this time period. As compared to the median fund, SCERS has a higher allocation to Public Equity and Real Estate and a lower allocation to Private Equity. Below is the asset allocation of Total Fund as of September 30, 2016. Target 5? 9/30/16 2016 gPublic Equity 48.0% 57.5%. .. 56.0% I 1.5% [Private Equity 9.0% 3" 0.7% Broad Fixed Income 1 18.0% 22.0% I 20.0% 2.0% CreditFixedIncome - 5.0% 5.2% I .. 5.0% I 0.2% I ReaiEstate I ?12.0% I 11.1%? I 10.0% I infrastructure 3.0% 0.3%7 "71.0% 7-0.7% I Diversifying Strategies I I 5.0% I 0.0% I. I. 5.0% I Cashmere '7 7 i 0.0% I. 0.0% 0.0% ?rWorkout' 7 I 7 0.2% 0.0% 0.2% The Fund has experienced weak relative performance versus the Policy index and median fund over longer time periods that include the 2008 Global Financial Crisis (GFC), such as the last 10 years. Fund performance has improved over more recent time periods. The long-term underperformance was due in part to poor realized performance in select investments during and immediately following the 2008 GFC, structural differences in asset allocation between the Fund and Policy Index and misaligned asset class benchmarks included in the Policy index. The Fund continues to exhibit modestly higher risk than the Policy Index. The estimated funding ratio as of November 30, 2016 was 65.8% on a mark-to-market basis. This compares to a funding ratio of 65.2% as of November 2015. The funding ratio was generally unchanged in 2016. as investment performance was in line with the assumed rate of return. 2016 Activities Investment Committee Meetings In February, the IAC met with the investment Committee to review annual report on E86 matters and updated recommendation against fossil fuet divestment. Dr. Alan Hess provided his perspective that markets are efficient and therefore divestment is not a suitable approach for SCERS. The IAC also participated in the review of Q4 2015 performance and contributed to the decisions to commit capital to Brookfieid Infrastructure Fund and redeem from BlackRock?s fund of hedge funds strategy. In May, the met with the Investment Committee to review the composition of the Public Equity asset class and review SCERS's Of 2016 performance. Dimensional Fund Advisors was selected to manage US small cap equity allocation. IAC members provided comments on strategy for Public Equity and questioned the cause of SCERS's long?term underperformance (described further in Section N). VI. in August, the IAC met with the Investment Committee to review 02 2016 performance and discuss NEPC's fee analysis and cost effectiveness study related to SCERS's investment managers. members participated in the discussion and asked questions related to expected asset class returns. in November, the met with the investment Committee to review the composition of the Real Assets asset class and participate in a discussion led by JP Morgan on the real estate market environment. members emphasized the importance of assessing real estate over a long horizon. The IAC also participated in the review of Q3 2016 performance. Ad Hoc Invoivement The investment Advisory Committee charter acknowledges explicitly that engagement of members, collectively or individually, outside of the regularly scheduled meetings provides a great benefit to SCERS. For example, Staff consulted several times with Joseph Boateng to obtain his opinion on restructuring the Broad Fixed Income asset class, as well as investment managers in Credit Fixed Income and Real Estate. Staff also consulted with Dr. Alan Hess on the academic justification for tong/short style investing. SCERS indicated that it very much appreciated their advice on these matters. 2017 Recommendations The recommendations for 2017 are as follows: 1. SCERS should continue to evaluate the impact of achieving a return that is likely to be less than the assumed rate of return (currently 7.5% annualized) given the low return environment that is being experienced globally. Ifthe realized return is less than the assumed rate of return, the underfunded status of the plan will increase and the monies that the City currently has available and anticipates having available to pay for current and future retiree benefits will be insufficient. In addition to making sufficient contributions, the IAC urges the City to continue to discuss the unfunded iiability and develop strategies/policies to address it. In addition, whereas assumed rate of return falls within the range of its peer group, the beiieves the assumed return is quite optimistic and inconsistent with the reality of a low return environment. We encourage SCERS to continually validate the basis of the required rate of return for reasonableness. 2. SCERS should adopt and implement a comprehensive approach for assessing and managing Total Fund Risk. It is noted that Total Fund has consistently exhibited more risk, as measured by standard deviation, than the policy benchmark. in addition, SCERS should seek transparency in private market investments to enhance staff?s ability to evaluate value creation and assist with the judicious allocation of assets to achieve superior risk adjusted returns in the long run. 3. SCERS shouid continue to monitor payments to vendors and compensation of plan fiduciaries for efficiencies especially in a low return environment. This is particularly important as SCERS increases its exposure to private market investments. In addition, SCERS shouid continue to explore ways in which SCERS can extract more value from the services offered by consultants and other vendors. 4. SCERS should continue with 2016 actions of elevating its positive action strategy regarding ESG issues including corporate engagement, integrating climate change risk into SCERS's investment process and pursuing, as appropriate, investments that are expected to produce investment results consistent with fiduciary duty to its members and, if possible, also positively address climate change and other environmentai and governance issues. The IAC advises that the Board?s fiduciary obligation is to the members of the system, so ESG issues must be subordinated to the goal of achieving the assumed rate of return at minimum risk. 5. SCERS should continue to assess the effectiveness of alternative beta and diversifying strategies in the achievement of fund's return objectives.