2017 Investment Review - Board of Pensions

What is Real? A Rabbit, a Creek, an Orchard and the Boss

The 2017 Investment Review The Board of Pensions Balanced Investment Portfolio returned 17.0%

As we review what was real in markets and investment performance, we will try to see, hear and value the events and markets of 2017 from multiple perspectives and provide forward looking commentary. A Rabbit – What is Real? “What is REAL”, asked the Rabbit. “Real isn’t how you are made. It’s a thing that happens to you,” said the Skin Horse. When you are real you don’t mind being hurt. It doesn’t happen at once. It takes a long time. That’s why it doesn’t happen to people who break easily, or who have sharp corners. Generally by the time you are Real, most of your hair has been loved off, and your eyes drop out, and you get loose in your joints and very shabby. But these things don’t matter at all, because once you are Real, you can’t be ugly, except to people who don’t understand. Margery Williams Bianco, The Velveteen Rabbit (Apologies for use of Freyer Family cement rabbit/ ceramic horse) A Creek – What Do We See? The secret of seeing is, then, the pearl of great price. If I thought he could teach me to find it and keep it forever I would stagger barefoot over a hundred deserts after any lunatic at all. But although the pearl may be found, it may not be sought. Annie Dillard, Pilgrim at Tinker Creek. An Orchard – What Do We Hear? A distant sound is heard coming from the sky as it were, the sound of a snapping string mournfully dying away. All is still again, and nothing is heard but the strokes of the ax against a tree far away in the orchard. Anton Chekhov, The Cherry Orchard The Boss – What Do We Value? I’ve been knockin’ at the door that holds the throne I’ve been lookin’ for the map that leads me home I’ve been stumblin’ on good hearts turned to stone The road of good intentions has gone dry as a bone We take care of our own, We take care of our own Wherever this flag’s flown, We take care of our own Bruce Springsteen, We Take Care Of Our Own 1

Throughout the difficult times we faced in 2017 as investors and citizens of a global planet, it was hard to know what was real and keep things in perspective and at the forefront of our daily lives. We had to prioritize what we saw and what we heard in order to close out the cacophony of sounds and data from multiple sources, whether CNN, Fox, Twitter, MSNBC, or too many emails and apps. Turning down the volume could be as simple as recalling the story of a favorite rabbit who became real; recalling insights into what we can see but do not want to see; hearing the noises of change; and understanding what we value as humans. 2017 Investment Outlook versus 2017 Actual Results Good investment performance is as simple as getting more things right than wrong in asset allocation and manager selection. 2017 was a year when we were right, partly right and wrong in our major asset allocation decisions. While our managers outperformed in major asset classes, we were also fortunate to be right in our major asset allocation decisions. We will compare our January 2017 outlook with actual results. Our 2017 Outlook comments are from the 2016 Investment Review. 

Our 2017 Outlook: Global investors in equity and debt markets will face challenges in 2017. As we enter 2017, there are few clearly attractive undervalued asset classes. Once again it should be a year for managers gifted in security selection. We believe we have retained those managers as we have noted in our list of relationships we can be proud of. 2017 Actual: Partly right. Our U.S. equity component exceeded the passive benchmark due to superior stock selection by our active managers. Despite strong stock selection by active developed market managers, the international equity component lagged the benchmark due to disappointing performance from emerging market equity managers.

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Our 2017 Outlook: We believe stocks are likely to outperform bonds in 2017, yet it is unclear which regions are most likely to outperform. The U.S. economy is clearly the strongest in the developed world yet U.S. stocks are also expensive relative to peers, and the Federal Reserve has begun a course of increasing interest rates while other global central banks may continue to ease. 2017 Actual: Right. While U.S. stocks underperformed international stocks in 2017, U.S. growth company stocks outperformed most international managers. Maintaining the U.S. equity allocation and realizing gains was a successful strategy to raise cash for benefits payments.

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Our 2017 Outlook: International developed markets will face challenges in 2017. The potentially negative impact of new regulations on European banks has been deferred, but there will be increased regulatory and market issues in the telecommunications and technology sectors and many governments will continue to grapple with large debt levels. The U.K will wrestle with the impact of BREXIT, the decision to leave the EU. We believe our managers will select the best companies, but at this time do not plan to increase the allocation to international developed markets. 2017 Actual: Despite our January 2107 outlook, we increased the allocation to developed international stocks in early 2017. With strong international equity performance in 2017, this was the right decision.

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Our 2017 Outlook: After being totally wrong since 2014, we still expect longer duration fixed income assets to be less attractive in 2017 as the Federal Reserve continues to increase rates. Spreads on high yield and investment grade corporate bonds narrowed in 2016 but we still see opportunities for high yield in 2017. 2017 Actual: Right. Our core managers added value over a passive bond index fund, with durations below that of the benchmark. High yield outperformed core, but the best performance was from international and emerging market bonds.

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Our 2017 Outlook: Emerging market stocks and bonds should provide superior long-term investment performance. We feel comfortable with the current allocations in 2017. 2017 Actual: Right. Despite our January 2107 outlook, we increased the allocation to emerging market stocks and bonds in early 2017. With strong emerging markets performance in 2017, this was the right decision.

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Our 2017 Outlook: We do not expect inflation will be a problem in 2017. The Investment Committee and the Investment Team will continue to evaluate inflation and real return strategies that could benefit the Balanced Investment Portfolio in periods of inflation. 2017 Actual: Right. No additional inflation protection strategies were added in 2017 and existing strategies were not increased. In 2017, with no increase in inflation, these strategies were a drag on total performance.

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Our 2017 Outlook: In the U.S., a new administration is hurling depth charges that could blow up global trade pacts, re-design healthcare in the U.S. and destroy long-term alliances with friends and neighbors. On the positive side the administration could reduce tax rates to repatriate monies now held offshore to avoid U.S. tax rates and could launch a major program rebuilding roads, bridges and other parts of our aging infrastructure. 2017 Actual: Right. While not an action item for Balanced Investment Portfolio asset allocation, the action/inaction in Washington can impact the direction of markets. With legislative gridlock, less was achieved on the domestic front than could have been expected, which may have benefited the stock market. The hope of a tax re-design kept investors optimistic and markets edging upward in 2017. The tax reduction for U.S. corporations should be beneficial for U.S. companies and the stock market in 2018. Infrastructure fell off the agenda.

2017 Major Asset Allocation Decisions 

Retain global equity manager to invest in fossil fuel free portfolio and focus on resource efficiency and optimization. The portfolio invests in companies around the world that are developing innovative solutions to resource challenges across energy, water, waste and sustainable food and agricultural markets.

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Use U.S. equity manager outperformance as a source of funds for benefits payments and funding of global equity manager.

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Increase allocation to international and emerging markets managers.

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Decrease total allocation to interest rate sensitive strategies in the fixed income component. Increase allocation to global and emerging markets debt managers.

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Introduction The Board of Pensions Balanced Investment Portfolio returns net of fees and the asset allocation on December 31, 2017 were as follows: 2017

Asset Allocation

Long-Term Strategic Asset

Return

$ Millions

Percent

U.S. Equity International Equity

23.6% 26.9

$3,429 2,234

35.7 23.2

30-50% 10-25

Fixed Income Private Partnerships

5.0 14.2 7.8

2,634 816 503

27.4 8.5 5.2

25-45

$9,616

100.0%

Marketable Diversifying Investments Total

17.0%

Allocation Ranges

1-20

The Board of Pensions Balanced Investment Portfolio began 2017 with total assets of $8.586 billion. With an investment return of 17.0% in 2017, the market value of the Portfolio increased to $9.616 billion by December 31, 2017, after paying out $407 million in net benefits payments to Plan members and their surviving spouses. Performance of the Board of Pensions Balanced Investment Portfolio is compared to the absolute return benchmark of the 6.0% long-term investment return assumption for the Pension Plan. Performance is also compared to a relative Asset Mix Policy Benchmark, the return the portfolio could achieve using passively managed index funds and no asset allocation decisions. The return of each component of the Balanced Investment Portfolio is compared to the relevant asset class benchmark.

The Absolute Return Benchmark: The Long-Term Investment Return Assumption In October 2016, a comprehensive review of future long-term capital market assumptions and their impact on the Balanced Investment Portfolio was presented in a joint meeting of the Investment and Pension Committees. As global economic and market conditions and historically low global interest rates have dampened expectations for long-term investment returns for almost all asset classes, the Investment Committee recommended, and the Board of Directors approved, a reduction in the expected long-term investment return assumption for the portfolio, from 7 percent to 6 percent. By moving to a more conservative assumption for financial planning, the Board took a step to ensure the long-term solvency of the Pension Plan, whose assets make up 89 percent of the portfolio. The Board believed that it would not be acting in the best interest of plan members if it continued to rely on a long-term investment assumption of 7 percent when all indicators are that the Balanced Investment Portfolio could not achieve that return without restructuring the portfolio into asset classes that have higher risk and less liquidity than the current long-term asset allocation. 4

The Relative Benchmark: The Asset Mix Policy Benchmark of Investable Market Indices The relative benchmark, or asset mix policy benchmark, is used to compare the performance of the Board of Pensions Balanced Investment Portfolio to that of investable market indices. The asset mix policy benchmark is the return the Portfolio would have achieved by investing in each asset class using a passively managed index fund at the midpoint of the long-term strategic allocation range for each asset class. Alternatives are not included in the benchmark since there are no investable market indices for alternative investments.

The Value of Long-Term Outperformance: The Board of Pensions Balanced Investment Performance Versus Asset Mix Policy Benchmark Performance As seen on the graph that follows, the actual investment performance of the Balanced Investment Portfolio compared to that of the asset mix policy benchmark through December 31, 2017 provided an additional $1.1 billion in portfolio value since December 1990. The green line is the return of the Balanced Investment Portfolio. The red line is the return of the passive asset mix policy benchmark. The graph shows the sharp recovery in portfolio value from the cumulative market decline of 2000-2002 and the depths of the financial crisis of 2008. Balanced Investment Portfolio outperformance has come from strong long-term performance from active investment managers and asset allocation decisions by the Investment Team and the Investment Committee.

Balanced Investment Portfolio Market Value and Cash Payments: 1988 - 2017 The Balanced Investment Portfolio had $2.1 billion in assets in 1988, paid out $5.6 billion in benefits to plan members and surviving spouses from 1988 through 2017, and closed the year with assets of $9.6 billion on December 31, 2017. 5

Benefits paid have exceeded dues received since 1988. This is not a problem and is part of the plan design. In 1988, when the Balanced Investment Portfolio was valued at $2.1 billion, the cash payment from the portfolio, in addition to 1988 dues received, was $15 million. Cash from the Balanced Investment Portfolio for benefits payments totaled $132 million for the five years from 1987 to 1991. In 2017 additional cash for benefits payments totaled $407 million. Cash payments for benefits were $1.7 billion for the five years from 2013 to 2017.

An Overview of Economic and Market Events That Impacted 2017 Investment Performance When we assess what is real, we will note whether the impact of real or unreal is potentially positive, negative or neutral.

What is Real? The Global Economy Global economic expansion: Real - Positive In early 2017, The Economist published the latest one year change in GDP of 1.7% in the U.S., 1.7% in the Euro area, 1.1% in Japan and 6.7% in China. There was limited belief that there would be synchronized global growth in 2017. By the third quarter of 2017, actual GDP data was better than anticipated, with 2.3% for the U.S., 2.8% for the Euro area, 2.1% for Japan and 6.8% for China. With improved GDP data for the U.S, Euro area and Japan synchronized growth, economic expansion had picked up in major countries. As shown in the graph below, a rating above 50% in the PMI (Purchasing Managers Index) is expansionary, while below 50% reflects a weak economy.

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Source: J.P. Morgan Asset Management

Pickup in Global Growth: Real - Positive The graph that follows shows the pickup in global growth for the companies in the MSCI All World Equity Index, as measured by the year-over-year change in earnings per share. After years of flat to negative EPS growth, 2017 was a year when year-to-year EPS change exceeded 20%.


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Shift in ACWI Country Allocations: Real - Positive (expanded investment opportunities) It is not surprising that the U.S. stock market allocation in the ACWI Index increased from 46.5% in 1999 to 52.2% in 2017, given the strength of U.S. markets over the last decade. For the 10 years ended December 31, 2017, the Russell 3000 had a compound annual return of 8.6% compared to 1.9% return of the EAFE Index of developed international stock markets, and a 1.7% return for the MSCI Emerging Markets Index. Despite underperforming the U.S. over the past decade, the growth in emerging markets since 1999 has resulted in a more than doubling of the ACWI allocation to emerging markets, from 5.1% to 11.8%. Stocks of companies in Japan, the UK and Europe ex UK all had a reduced role in the ACWI Index on December 31, 2017. Changes in the allocation of benchmark indices are important for active managers as well as index funds.

Changes in the Global Bond Market: Real - Positive (expanded investment opportunities) Investors in fixed income securities know that global bond markets have experienced significant changes since 1990. On December 31, 1989, the opportunity set for an investor in bonds was 61.3% in U.S. bonds, 37.8% in developed non U.S. bonds and 1.0% in emerging market bonds. The global bond market was about $11 trillion in market value. While in 1988 there were dedicated managers in international bonds, including emerging market bonds, there were few core managers with more than a 5% allocation to international bonds. The use of international developed and emerging market bonds as part of a total bond portfolio strategy began to increase in 2005-2006. Following the global financial crisis in 2008, as more countries issued bonds in local currencies as well as U.S. dollars, and U.S. interest rates remained at decade low, yield-seeking investors began to more aggressively explore less traditional bonds. In June 2017, U.S. bonds were 37.4% of the $104 trillion global bond market. Emerging bonds increased in value to $21 trillion, or 20.1% of the global bond market.

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Corporate Debt Levels in China: Real/Unreal – Potentially negative impact for long-term growth Debt levels in China are difficult to measure based upon what may not be full disclosure of data. This leads to a mixed rating of Real/Unreal, so investors should question the validity of data. Given the large number of Chinese companies that are SOEs or State Owned Entities, it is important to monitor the level of non-financial corporate debt as these are the public market companies that offer shares as well as bonds to investors. In 1990, all debt was less than 150% of GDP. By the second quarter of 2017, it was over 250% of GDP, with the largest growth in non-financial corporate debt. At the same quarter in 2017, non-financial corporate debt was 163.4% of the Chinese GDP when U.S. non-financial corporate debt was 98.0% of the U.S. GDP.


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China’s Long-Term Vision and Global Strategy: Real – Significant implications for global politics and economics as China asserts leadership role The One Belt One Road Initiative was proposed by China in 2013 to focus on connectivity and cooperation among countries. The One Belt One Road Initiative is expected to bridge the global infrastructure gap with an estimated cost outside of China of $900 billion a year for the next 10 years. The yellow line, the Silk Road Economic Belt, includes the countries on the original Silk Road through Central Asia, West Asia, the Middle East and Europe. The initiative calls for the integration of the regions into a cohesive economic area through building infrastructure, increasing cultural exchanges and broadening trade. The north road would go from China, through Central Asia to Moscow and Rotterdam. The southern road goes from Beijing through Central Asia to Tehran, Istanbul and Europe. The blue line is the Maritime Silk Road, a complementary initiative to encourage development in Asia and Africa. In order to better align relationships in Africa, China is building a railway line in Kenya from Mombasa to Nairobi.

Source – Quest47 Intelligence

Global Infrastructure Needs: Real - A global investment concern in developed and emerging economies but a significant U.S. problem after decades of neglect The table that follows focuses on the global infrastructure needs to support global growth from 2017 to 2035. Long-range planning and investment resources need to be dedicated in 2018 to begin to commit the estimated $3.7 trillion needed annually to support the new and updated global infrastructure. This may be a low estimate given an estimated cost outside of China of $900 billion a year for the next 10 years for the One Belt One Road Initiative.

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What is Real? The U.S. Economy Drivers of U.S. GDP Growth and 4% GDP: Unreal – Expectations of 4% cannot be achieved without significant changes in key drivers of growth in the number of workers and worker productivity President Trump made growth a key plank in his platform. What are the chances we will attain 4% growth in GDP? The graph that follows shows the drivers of U.S. GDP growth by decade for the past 60 years. With a 4.2% growth in real GDP, the only decade with 4.0% or greater growth was 1957-1966. Labor productivity or the growth in real output per worker contributed 2.8% with a 1.4% growth in workers. We hit 3.3% GDP growth in 1977-1986, with 1.2% productivity and a 2.1% growth in workers as baby boomers and women entered the work force. The most recent decade had the lowest growth in real output per worker at 0.9%, combined with a 0.4% growth in workers. A target of 4% GDP growth will be a high hurdle.

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Growth in Working Age Population: Real – Changes in immigration policies may contribute to the growth in working age population A key component of GDP growth is growth in the working age population. The graph that follows shows that from 2017-2026, the net growth in U.S. workers will be at the lowest level in decades, with a growth in native born workers of 0.04%. At the same time, increasing numbers of baby boomers will retire from the workforce and the percent increase in immigrants is at a level last seen in the decade 1977-1986.

Source – J.P. Morgan Asset Management

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Decline in Labor Force Participation: Real - Impact on Social Security benefits could be an economic issue We have experienced a decline in labor force participation from pre-recession in 2006 of 66.0% to 62.7% in November 2017. Some of the decline is due to the normal aging of the U.S. population and the retirement of baby boomers but some is also due to the changing job skill requirements for a service economy that requires technical skills many do not possess. In 1970 the ratio of active workers to pensioners on Social Security was 3.7X. In 2010 the ratio w a s 2.9X. A declining ratio of active workers to retired will mean reduced Social Security benefits or a significant increase in Federal debt or taxes.


Declining Unemployment and Stagnant Wage Growth: Real – Impact on wage rates and inflation Civilian unemployment following the Global Financial Crisis of 2008 peaked at 10.0% in October 2009. It began a steady decline to close at 4.1% in November 2017, below the 50-year average of 6.2% unemployment. Wage growth has averaged 4.2% over the same period. After reaching 4.2% in 2007-2008, the wage growth rate declined to below 2.0% and is now 2.3%, well below the 50-year average. As unemployment reaches levels not experienced since 2000, it will put pressure on employers to increase wages or increase the use of machines to replace scarce workers.


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Slow and Steady Federal Reserve Balance Sheet Expansion/Contraction: Real – The contraction back to 2007 levels may take 20 years The Federal Reserve balance sheet was below $1 trillion in early 2008, expanding to over $2 trillion with the introduction of quantitative easing (QE1) in December 2008. By October 2014, and the end of QE3, the balance sheet had exploded to $4.5 trillion. Contracting the balance sheet without damaging the bond market will require time, as shown on the right side of the graph noted as forecasted reduction. While the balance sheet expansion took six years, it may take even more than six years to return to the $2 trillion level of late 2008 and the $1 trillion level of early 2008. The forecast shows the balance sheet at about $3 trillion in 2022, eight years after the end of QE2.


Total Assets of Major Central Banks $14.3 Trillion: Real - The BOJ and ECB have more balance sheet debt than the Fed As shown on the graph that follows, on December 31, 2017, the balance sheet assets of other Central Banks exceed those of the U.S. Bank of Japan (BOJ) had a $4.6 trillion balance sheet and the European Central Bank (ECB) had a $5.3 trillion balance sheet on December 31, 2017.

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What is Real? U.S. Inflation U.S. Inflation Not a Near Term Issue: Real – While not current an issue, wage pressures could lead to inflationary pressure Headline CPI, which includes food and energy, peaked in the 1980s at almost 15%. It dropped into negative territory in 2009-2010 and again in 2015. It was 2.1% in December 2016, well below the 50 year average of 4.1%. Core CPI is less volatile since it excludes food and energy. While it has not dipped into recessionary territory in the last 50 years, the current rate is 2.2% compared to the 50 year average of 4.1%.


Oil Prices, Supplies and Consumption: Real - Implications for U.S. as an Oil Power Oil Prices: Real – Positive for Producers Projecting the price of oil from one year to the next has never been for the faint-hearted. As shown on the graph that follows, prices fell from $40 in September 1990 to $11 in November 1998, a 72% decline over eight years. Following a steady climb to $140 in June 2008, prices declined 70% in seven months to $42. After bottoming at $42 in January of 2009, prices increased by 150%, to $105 a barrel in June 2014. Just six months later, on December 31, 2014, the price was $53, a 50% decrease. In 2015 it closed the year at $37 a barrel. Price volatility has made it challenging to project the economic viability of oil exploration and production projects as well as alternative energy, such as wind and solar projects. The most recent period has provided a measure of price stability. Oil was $54 at the start of 2017, closing the year at $60, a 12% increase.

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The U.S. Leads the Way: Real - Increased production and decreased demand has reduced U.S. long-term historic dependency on OPEC Oil production in millions of barrels a day has increased in each year since 2014, with U.S. production experiencing 18.3% growth since 2014. This is higher than the global average of 6.6% and OPEC production growth of 7.5%. Consumption has also increased annually; however, the US. had a 6.1% growth in consumption since 2014, compared to 16.5% for China and 6.8% for the average global increase in consumption.


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What is Real? U.S. Markets Global Reduced Stock and Bond Market Volatility: Unreal – Current levels of stock market volatility will not continue In the graph that follows, the volatility of stocks and bonds is measured by the annualized standard deviation of the last three years of monthly investment performance. Historically, investors used a balanced portfolio approach to dampen portfolio volatility, including bonds, with lower volatility, as shown in 1965 when bonds had a 1% standard deviation of return, and stocks with a standard deviation of returns as high as 23%. The standard deviations of stocks and bonds have converged, such as in 1983, with bond volatility exceeding that of stocks. The current 10% standard deviation for both stocks and bonds is unusual and may be a short term anomaly based on the strong upward trajectory of U.S. stocks in 2017.

Source: KKR

Macro Market or Stock Pickers Market: Real – Trend favorable for active managers The graph that follows provides the correlation of U.S. stocks to each other from 1986-2017. Correlations are calculated for each stock in the S&P 500 against each of the remaining stocks in the index. This analysis shows how stocks in the index move relative to one another. High correlations above the red line are periods when stocks move in tandem based upon macroeconomic factors. When below the red line, stocks will move based on company specific factors and these periods are generally favorable for managers to use independent company research for bottom up stock selection. In December 2017, at a 23-year low of correlation of 8.8%, 2018 should be a stock picker’s market. As we report in the U.S. equity component of the Balanced Investment Portfolio, 2017 was a very good year for our active managers, with 8 out of 9 exceeding the return of their benchmark.

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Source: KKR

Financial and Real Economy Prices 2009 – 2017: Unreal – Investors should expect a reversion to mean pricing The graph that follows shows the growth of financial assets compared to the growth in real economy prices since January 2009. In January 2009, global stock and credit markets had not met 2009 lows and housing prices in the U.S. continued to decline. By the close of 2017, the S&P 500 had increased more than 250%, with an increase of more than 200% for European high yield bonds. Those gains were closely followed by the total return performance of U.S. high yield bonds and the MSCI World Index. Real economy prices lagged in U.S. wages, European wages, and U.S. housing prices. While it is not forecasted that 2018 will be the catch-up year for real economy prices, investors should understand that the wide dispersion between financial asset prices/returns and real economy prices will at some point experience a reversion to the mean.

Source: KKR

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What is Real? Forecasting 2018 and Beyond S&P 500 2018 Estimated EPS: Real? - Highly concentrated growth contribution The graph that follows provides earnings per share estimates for the S&P 500 and sector components. Two sectors, telecommunications companies or telcos, and utilities have a 1.7% combined contribution to the 11.9% S&P 500 EPS growth. Growth forecasts for financials and information technology are more robust and contribute 50.2% of the estimated S&P 500 EPS growth. Investors should be aware of the highly concentrated sources of growth in the S&P 500 for 2018 that rely primarily on two sectors subject to regulation, tax legislation and merger and acquisition activity.

Source: KKR

Earnings Estimates for Emerging Markets by Region: Real? – An overweight to emerging markets in Asia may be warranted The graph the follows provides emerging market consensus earnings by region. Emerging markets Asia has the highest earnings per share estimates, significantly outpacing the forecast EPS for EMEA or emerging markets in the companies in Asia representing 73.2% of the MS Emerging Markets Index.

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Change in Employment Patterns: Real - Workers will need to develop new skills to remain employed throughout their working lifetime U.S. employment has been changing from routine jobs to non-routine jobs. As we can see from the graph that follows, the top blue line represents the significant increase in non-routine cognitive (or thinking) jobs. Also increasing as shown in the bottom turquoise line is the growth in non-routine manual labor. Those workers in the middle with routine cognitive and routine manual jobs will experience a decline in employment opportunities. In the near-term future, the successful employees will be out-of-the-box thinkers in non-routine jobs. The U.S. economy of the future will be increasingly made up of creative people, computers and robots.

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Source – Economist.com

Job Survival: Possibly Real - Workers will need to develop new skills to remain employed throughout their working lifetime The table that follows provides information on the probability of computerization (think robots as well) of certain jobs. While investment managers are not on the list, the biggest losers to computerization and robots include telemarketers, accountants and auditors, retail salespeople and technical writers. Top jobs with a low probability of computerization include recreational therapists, dentists, athletic trainers and clergy.

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Source – Economist.com

U.S. Markets in 2017 – Surprise! Surprise! Surprises in Interest Rates and the Strength of the Stock Market The annual overview of economic and market events that impacted investment performance usually concludes with a timeline to help us remember just how our U.S. stock and bond markets were impacted by domestic and international events. In 2017, the timeline is of less use since the U.S. stock and bond markets seemed to shrug off any external events and remain on a pre-destined course of lower interest rates and higher stock market levels. Markets ignored a lack of action by the U.S. Congress on any issues of substance other than taxes; tweets by President Trump on any topic; threats of nuclear war from North Korea; continuing investigation into Russian involvement in the 2016 U.S. Presidential election; and worries over the economic impact of a potential shut down of the government due to lack of agreement on immigration issues. Basically, investors ignored any negative news that might impact U.S. stock and bond markets. When in the USA First Bubble, concerns over BREXIT; the formation of a German government; political instability in the Middle East; the continuing war in Afghanistan; and the rise of China as an economic and political super power did not impact interest rates or the trajectory of U.S. markets. In the graph that follows, the green line (right axis) is the value of the Standard & Poor’s 500 Index. The red line (left axis) is the interest rate on a 10-year U.S. Treasury bond. The interest rate on a 10-year U.S. Treasury was 2.45% on December 31, 2016. It closed on December 31, 2017 at 2.41%, a decrease of 4 basis points in a volatile year. Bond investors were pleasantly surprised when the 10-year Treasury declined from 2.45 to 2.04% in August of 2017, a decline of 41 basis points. They were less excited to have the 2.04% yield increase by 37 basis points to close the year at 2.41%. The S&P 500 began the year at 2239 and began a continuous increase throughout 2017, closing 2017 at 2674, or a gain of 19.4% excluding dividend payments. 22

Review of the Board of Pensions Balanced Investment Portfolio We begin the detailed review of the Board of Pensions Balanced Investment Portfolio with an overview of global markets in 2017 and a comparison of the 2017 Balanced Investment Portfolio return of 17.0% to the returns available from public market indices. As shown on the graph that follows, the best strategy for those with nerves of steel in 2017 would have been to invest only in emerging market stocks for a return of 38%. (black line). Stocks from companies in developed international markets (blue line) gained 25%, closely followed by a 22% return from U.S. markets (red line). Investors could have had less volatile returns from Treasury Bonds (green line) with a 9% return and high yield bonds (brown line) with a 7% return, The 6% return from a basket of commodities (pink line) masked the volatility of commodities in 2017, with the index down more than 15% before a rebound to close the year at 6%.

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In all years, the impact of currency can be either benign, positive or negative. As shown on the graph that follows, in 2017 the U.S. dollar depreciated against major developed market currencies. The decline in the value of the U.S. dollar improved the investment return for dollar-based investors. It was a strong year for investors in international developed and emerging markets. In 2017, the three major currencies strengthened against the dollar, with the euro appreciating 14%, the British pound, 9% and the Japanese yen, 4%.

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As a diversified portfolio, the Board of Pensions Balanced Investment Portfolio return of 17.0% is made up of the returns provided by multiple asset classes. The 2017 Investment Review will provide a detailed commentary, analysis and performance review of all components of the Balanced Investment Portfolio, to include U.S. equity, international equity, fixed income, private partnerships and marketable diversifying strategies. As shown on the graph that follows, it was a good year for virtually all asset classes. We could have increased our return by investing in more small company stocks, the Russell 2000 Index, and holding fewer developed market stocks, the EAFE (Europe, Australasia and the Far East) Index. Returns of Market Indices and Board of Pensions Balanced Investment Portfolio December 31, 2017

MSCI EM

37.3

MSCI EAFE

27.8

MSCI ACWI ex US

27.2

Russell 3000

21.1

BOARD OF PENSIONS

17.0

JPM GBI EM Gl Diversified Unhedged

15.2

Russell 2000

14.6

CG High Yield Cash Pay

7.0

S&P US REIT

4.3

Barclays Govt/Credit

4.0

0

5

10

15

20

25

30

35

40

% Return

Sources: BNY Mellon, MSCI (net)

What is the Structure of the Board of Pensions Balanced Investment Portfolio? The Board of Pensions Balanced Investment Portfolio uses external investment management firms for the day-to-day investment of $9.6 billion in assets. The Portfolio is unitized on a monthly basis and is the investment portfolio for the Pension Plan as well as other plans and programs administered by the Board of Pensions. The U.S. equity component of the Portfolio has ten active investment managers and two index funds. The international equity component has nine active managers, including two managers focused solely on emerging markets, and two index funds. The fixed income component has seven active managers, including dedicated assignments to managers for high yield or below investment grade securities, global bonds, emerging markets debt and short duration securities. Private partnership investments include commitments to 69 limited partnerships investing in distressed debt, private equity, venture capital and real estate. Marketable diversifying strategies include absolute return and inflation protection strategies. Portfolio diversification is a function of the long-term expected return for each asset class, but also must include risk assessments based on investment styles, liquidity and the potential firm risk for each investment manager retained by the Investment Committee. One manager was excused in 2017 and two new managers were retained. Three new commitments were approved to limited partnerships in international private equity, distressed debt and secondary investments. Each year separate account managers for the Balanced Investment Portfolio are provided lists of those companies on the current Prohibited Securities lists. The lists have historically included companies on the General Assembly Divestment List for involvement in military and tobacco, as well as those global companies whose primary businesses are in the alcohol and gaming industries. The military list includes those corporations that manufacture hand guns and assault weapons. 25

In recent years, the General Assembly of the Presbyterian Church (U.S.A.) voted to add to the General Assembly Divestment List companies that operate for-profit prisons and three U.S. companies whose products and services were deemed to detract from the peace process in Israel and Palestine. The Board of Pensions policy does not require the sale of companies newly added to the lists. Instead the policy prohibits the future purchase of the securities and enables managers to retain securities until managers sell them in accounts with the same investment objective and strategy.

BOARD OF PENSIONS BALANCED INVESTMENT PORTFOLIO PERIODS ENDED DECEMBER 31, 2017 Annualized Rate of Return (%) 1 Year 2 Years 3 Years 5 Years 10 Years 15 Years 20 Years BOP U.S. EQUITY Russell 3000 Index

23.6 21.1

17.8 16.9

11.8 11.1

16.3 15.6

9.2 8.6

11.2 10.3

8.3 7.4

BOP INTERNATIONAL EQUITY MSCI All Country World Index ex US (gross)

26.9 27.8

15.9 15.8

9.3 8.3

8.5 7.3

3.6 2.3

9.7 9.2

7.0 6.1

5.0 4.0

5.8 3.5

3.3 2.4

2.7 2.1

4.8 4.1

5.0 4.2

5.4 5.0

14.2

11.8

8.7

10.6

8.3

13.0

--

BOP MARKETABLE DIVERSIFYING STRATEGIES

7.8

8.4

2.4

1.3

2.2

--

--

BOP BALANCED PORTFOLIO

17.0

12.9

8.0

9.3

6.2

8.6

7.1

BOP RELATIVE BENCHMARK Asset Mix Policy Benchmark*

16.0

12.0

7.7

9.4

6.3

8.3

6.7

6.0

6.0

6.0

6.0

6.0

6.0

6.0

BOP FIXED INCOME Bloomberg Barclays Gov/Credit Index BOP PRIVATE PARTNERSHIPS

LONG-TERM INVESTMENT RETURN Pension Plan Actuarial Assumption

.

Notes: Returns are net of management fees. *Effective 1/1/2005, the Asset Mix Policy Benchmark is calculated using each asset class midpoint multiplied by its index. The policy benchmark is: U.S. Equity = 47.5% * Russell 3000 Index International Equity = 17.5% * MSCI All Country World Index ex US (ACWI) Fixed Income = 35% * Bloomberg Barclays Capital Gov/Credit Bond Index Alternative Investments = 0

26

Review of the Board of Pensions Balanced Investment Portfolio Performance Performance of the Board of Pensions Balanced Investment Portfolio is measured against both a relative benchmark and the 6.0% long-term investment return assumption for the Pension Plan. The Relative Benchmark: The Asset Mix Policy Benchmark of Investable Market Indices The relative benchmark, or asset mix policy benchmark, is used to compare the performance of the Board of Pensions Balanced Investment Portfolio to that of investable market indices. The asset mix policy benchmark is the return the Portfolio would have achieved by investing in each asset class using a passively managed index fund at the midpoint of the long-term strategic allocation range for each asset class. Alternatives are not included in the benchmark since there are no investable market indices for private partnership investments. Years such as 2017 with above benchmark performance reflect the contribution, both positive and negative, of active investment management strategies and asset allocation decisions, including allocations to high yield bonds, emerging market stocks and bonds, distressed debt, private equity and other non-benchmark investments. The following graph for the Balanced Investment Portfolio shows returns compared to the asset mix policy benchmark. Columns above the line are those years when the difference between the actual return and the asset mix policy benchmark is positive. Columns below the line are years when the actual return was lower than the policy benchmark. The green bar for 2017 is the 17.0% actual return less the 16.0% asset mix policy benchmark return, or positive increase of 1.0%. While it is difficult to consistently add value over a passively managed index portfolio, the Balanced Investment Portfolio has been able to do so in 20 out of the last 31 years, or 65% of the time, as well as over the one, two, three, fifteen and twenty year periods ended December 31, 2017.

Investment Performance vs. Asset Mix Policy Benchmark Actual Investment Performance net Asset Mix Policy Benchmark

5 4 2 1 0 -1 -2 -3 -4 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017

% Return

3

Actual Inv Perf net Asset Mix Policy Benchmark

27

10 Year Trend

The Long-Term Investment Return: The 6.0% Pension Plan Actuarial Assumption In calculating the health and solvency of the pension plan, the actuary uses certain assumptions about plan demographics and financial metrics. These assumptions are reevaluated regularly to ensure that they are reasonable and current. One of the critical assumptions is the investment return of pension plan assets. To measure the health of the pension plan, the actuary assumes that the return on the Balanced Investment Portfolio will, over the long-term, meet or exceed 6.0%. It is important to remember that this is a long-term goal and will not be met in every calendar year. For the long-term health and stability of the pension plan, it is imperative that the actual long term return on assets meet or exceed the plan investment return assumption. The 17.0% return in 2017 exceeded the 6.0% long-term assumption. The Balanced Investment Portfolio returns exceeded the 6.0% assumption for the one, two, three, five, ten, fifteen and twenty years ended December 31, 2017.

Performance Attribution Performance attribution compares actual investment performance with Asset Mix Policy Benchmark performance. The Asset Mix Policy Benchmark does not include alternative investments since there are no investable market indices for alternative investments. The table that follows shows the average allocation in 2017 for each asset class compared to the allocation used in the Asset Mix Policy Benchmark. 2017 AVERAGE ASSET ALLOCATION vs. ASSET MIX POLICY BENCHMARK 2017 Actual Asset Mix Over/ Average Policy Benchmark Underweight Asset Allocation Asset Allocation U.S. Equity 36.5% 47.5% (11.0%) International Equity 21.4 17.5 +3.9 Fixed Income 28.2 35.0 (6.8) Private Partnerships 8.6 0.0 +8.6 Marketable Diversifying 5.3 0.0 +5.3 Strategies Total 100.0% 100.0%

2017 PERFORMANCE ATTRIBUTION BOARD OF PENSIONS BALANCED INVESTMENT PORTFOLIO vs. ASSET MIX POLICY BENCHMARK Asset Mix Policy Benchmark Return U.S. Equity International Equity Fixed Income Private Partnerships Marketable Diversifying Strategies

16.00% +0.188 +0.225 +1.204 (0.154) (0.471)

Net Impact on Portfolio Performance Board of Pensions Balanced Investment Portfolio Return 28

+1.00

17.00%

When reviewing the performance of the Board of Pensions Balanced Investment Portfolio return of 17.0% in 2017 compared to the 16.0% return of the Asset Mix Policy Benchmark, asset allocation differences between the actual portfolio and the benchmark should be noted. The most significant difference is the asset mix policy benchmark does not contain an allocation to alternative investments, an average allocation of 13.9% in the actual portfolio. As noted above, this is because there are no index funds to replicate private limited partnership investments. The actual commitments to private partnerships and marketable diversifying strategies were made over the last fifteen years by reducing the allocations to both U.S. equity and fixed income. The U.S. equity allocation in 2017 averaged 11.0% below the benchmark while the fixed income allocation averaged 6.8% below. Part of the long-term reduction in U.S. equity was reallocated to international equity. 2017 Performance Attribution: Contributors and Detractors +1.204% Fixed Income - Contributor The fixed income component added to performance due to strong performance by out of benchmark strategies such as high yield, non-U.S. bonds, and emerging market debt. Since the fixed income component return of 5% was lower than the 16% return of the Asset Mix Policy Benchmark and the component was underweight, with an average asset allocation of 28.2% compared to the 35.0% allocation in the Asset Mix Policy Benchmark, fixed income contributed to performance in 2017. +0.225% International Equity - Contributor International equity managers lagged the benchmark of the ACWI ex U.S. Index. However, the international equity component had a higher return than the Asset Mix Policy Benchmark and the component was overweight, with an average asset allocation of 21.4% compared to the 17.5% allocation in the Asset Mix Policy Benchmark, and contributed to performance in 2017. +0.188% U.S. Equity - Contributor U.S. equity managers outperformed the benchmark of the Russell 3000 Index. Despite being underweight an asset class that outperformed, the benefit of strong stock selection among active managers contributed to performance in 2017. (0.154)% Private Partnerships – Detractor The 14.2% return from illiquid partnerships detracted from the return of the Balanced Investment Portfolio. An average asset allocation of 8.6% compared to the 0% allocation in the Asset Mix Policy Benchmark detracted from performance in 2017. (0.471)% Marketable Diversifying Strategies - Detractor The 7.8% return from the marketable diversifying strategies exceeded the 7.1% return of the benchmark of the Consumer Price Index plus 5% annually, but the asset class underperformed the Asset Mix Policy Benchmark. An average allocation of 5.3% compared to the 0% allocation in the Asset Mix Policy Benchmark detracted from performance in 2017.

29

Asset Allocation The Balanced Investment Portfolio is invested for the long term. The strong performance in 2017 was based on asset allocation decisions and manager selections made in the past 24 months or longer. While it appears as if the asset allocation was relatively static from one year to the next, $407 million was raised during 2017 to provide benefits to plan members and active asset allocation decisions were made to increase or decrease asset classes based upon expectations for outperformance in the next 12-24 months. The Investment Team meets on a monthly basis to review global economic and market conditions and expectations, investment performance and upcoming capital commitments and cash flow requirements for benefits. Asset allocation shifts between year-end 2016 and 2017 reflect market movement but also the rebalancing from asset classes and managers with the greatest outperformance in 2017 to those with the best expected returns in 2018 and beyond. COMPARATIVE ASSET ALLOCATION BOARD OF PENSIONS BALANCED INVESTMENT PORTFOLIO December 31, 2017 December 31, 2016 $Millions

Percent

$Millions

Percent

Equity U.S. Equity International Equity

5,663 3,429 2,234

58.9 35.7 23.2

4,877 3,194 1,683

56.8 37.2 19.6

Fixed Income

2,634

27.4

2,484

28.9

Alternative Investments Private Partnerships Marketable Diversifying Strategies

1,319 816

13.7 8.5

1,225 758

14.3 8.8

503

5.2

467

5.4

Total

9,616

100.0%

8,586

100.0%

U.S. Equity Component of the Balanced Investment Portfolio 35.7% of the Balanced Investment Portfolio on December 31, 2017 The U.S. equity component of the Board of Pensions Balanced Investment Portfolio had a return of 23.6% in 2017, exceeding the 21.1% return of the benchmark Russell 3000 Index. The U.S. equity component exceeded the return of the Russell 3000 Index for the one, two, three, five, ten, fifteen and twenty years ended December 31, 2017. The U.S. equity component at the close of 2017 had an allocation of 69% to managers investing in large company stocks, 21% to managers investing in the stocks of small and mid-sized companies and 10% to a manager who can invest in the stock of companies of any market capitalization. Long-term outperformance is a function of retaining superior active investment managers. The U.S. equity component has two managers with tenure of less than two years. It has eight managers with an average relationship of 14 years, with a range of 8 years to almost 30 years. Regular reviews include performance evaluation as well as a review of investment strategy, portfolio composition, changes in assets under management, risk management and compliance, staffing and succession management. The evaluation of investment performance is based upon data and statistics as well as the art of evaluating people, processes and philosophy. The appropriate blend of science and art is required for long-term investment success. 30

The large capitalization component of the portfolio returned 24.5%, exceeding the 21.8% return of the S&P 500. Both of the two core managers exceeded the return of the benchmark S&P 500 Index. Both of the two value managers exceeded the 13.7% return of the Russell 1000 Value Index. Both of the two growth stock managers exceeded the 30.2% return of the benchmark Russell 1000 Growth Index. The small and mid-capitalization component of the Portfolio returned 23.8%, exceeding the 18.1% return of the Dow Jones Completion Index. The active small capitalization growth manager returned 24.8% compared to the 22.2% return of the Russell 2000 Growth Index. The active small capitalization core manager returned 22.3%, exceeding the 14.6% return of the Russell 2000 Index.

U.S. Equity Index Returns Year to Date December 31, 2017

Russell 1000 Growth

30.2

Board of Pensions U.S. Equity

23.6

Russell 2000 Growth

22.2

S&P 500

21.8

Russell 3000

21.1

Russell 1000 Value

13.7 7.8

Russell 2000 Value S&P US REIT

4.3 0

5

10

15

20

25

30

35

% Return Source: BNY Mellon

* Preliminary June 30, 2008 data

U.S. Equity Market Historical Performance The Russell 3000 Index includes stocks of large and small companies and is a broader measure of the U.S. equity market than the S&P 500. However, the Russell 3000 originated in 1979, so it does not have the extensive history that is valuable for long-term investment perspective. For purposes of the following graph, U.S. equity market returns are represented by the S&P 500 Index beginning in 1970 and the Russell 3000 Index in 1979. The Russell 3000 Index had a 21.1% return in 2017. The 21.1% return is above both the 8.6% average return of the last ten years, as reflected in the 10-year trend line, and the long-term 48year average return of 10.4% since 1970. The U.S. equity market had negative returns in nine out of those 47 years, four of the last 18 years, and one of the last ten years.

31

U.S. Equity Returns in Historical Perspective January 1, 1970 – December 31, 2017

60 50

40

37.1

32.3

36.8

28.3

32.1

30 20

21.1 48-Year Average 10.4%

10

8.6%

0 -10

-5.1

-5.1

-7.4

-20 -21.5

-30

-26.5

-37.3

-40 1970

1975

1980

1985

1990

1995

2000

2005

2010

2015

Includes reinvestment of dividends S&P 500/Russell 3000 Blended

10 Year Trend

Note: S&P 500 through 1978; Russell 3000 effective 1979

Market Capitalization and Style Investors know that the size of the companies they invest in, or company market capitalization, can significantly impact portfolio success. Market capitalization, the price per share of the company stock, times the number of shares outstanding, can vary as the share price of a company increases or decreases over time. As shown on the table below, large company stocks in the Russell 1000 Index returned 8.6% annually for the ten years ended December 31, 2017, virtually the same as the 8.7% return of small company stocks in the Russell 2000 Index for the same time period. Investment styles also affect performance. Stocks in the Russell 1000 Growth Index returned 10.0% annually for the ten years ended December 31, 2017, exceeding the 7.1% return of the Russell 1000 Value Index. Small growth stocks also outperformed small value stocks over the ten year period. However, value outperformed growth for the long-term, as measured over the twenty years ended December 31, 2017. Large value had a 0.5% annual advantage over large growth. Small value had an even larger long term advantage over small growth, with an extra 1.9% annually credited to value investors. LARGE/SMALL AND VALUE/GROWTH PERFORMANCE FOR PERIODS ENDED DECEMBER 31, 2017 Short Term 1 Year

Medium Term 10 years

Long Term 20 years

(annualized)

(annualized)

Russell 1000 (Large) Russell 2000 (Small)

21.7% 14.6

8.6% 8.7

Russell 1000 Value Russell 1000 Growth

13.7 30.2

7.1 10.0

7.4 6.9

Russell 2000 Value Russell 2000 Growth

7.8 22.2

8.2 9.2

8.6 6.7

Source: Russell Investments

32

7.4% 7.9

As shown in the table that follows, getting both style and market capitalization right was important in 2017. Getting style right was more important for investors in 2017 than size. Growth exceeded value in large, mid and small capitalization companies. The stocks of large capitalization companies in the Russell 1000 Growth Index outperformed stocks in the Russell 1000 Value Index by 16.5%. The stocks of small companies in the Russell 2000 Growth Index exceeded the return of large companies in the Russell 1000 Index by 14.4%. 2017 U.S. STOCK MARKET PERFORMANCE BY MARKET CAPITALIZATION AND STYLE Russell 3000 – Total Market

21.10%

Russell 1000 Index (Large Capitalization) Russell Mid Cap Index (Mid Capitalization) Russell 2000 Index (Small Capitalization)

21.7 18.5 14.6

Russell 1000 Growth Index Russell 1000 Value Index

30.2 13.7

16.5% advantage to growth

Russell Midcap Growth Index Russell Midcap Value Index

25.3 13.3


Russell 2000 Growth Index Russell 2000 Value Index

22.2 7.8


7.1% advantage to large vs.small

Source: Russell Investments

Sector Performance As noted above, the broad U.S. stock market, as represented by the Russell 3000 Index, had a return of 21.1% in 2017. All sectors with the exception of telecom and energy, the best sectors in 2016, had positive returns in 2017. Performance ranged from 37.0% for stocks in the information technology sector to (2.0)% for stocks in the energy sector. As it often happens, 2017 saw reversals of winners and losers. Energy, which was the worst sector in 2015, with a return of (23.2)%, was the best performing sector, +26.9%, in 2016 and the worst sector in 2017 with a return of (2.0)%. The best sectors in 2015, healthcare, consumer discretionary and consumer staples, were the worst performing sectors in 2016, with healthcare one of the top three sectors in 2017 with a return of 23.2%

33

It is important to remember that sector weights are not constant and will vary over time, as shown in the graph that follows. There are three major sectors in the S&P 500, the large capitalization passive index frequently used by investors as the U.S. stock market. Technology was 33.6% of the index when tech stocks were high fliers in the late 1990s. The weight of technology stocks as a sector was at a low of 12.2% after the collapse of the tech bubble. With strong performance for information technology stocks in 2017, the sector was 23.8% of the index at the close of 2017.

34

The Balanced Investment Portfolio had broad sector diversification in 2017. The top ten stocks held on December 31, 2017 were Alphabet (Google), Microsoft, JP Morgan, Southwest Airlines, Wells Fargo, Amazon, Eli Lilly, Biogen, Charles Schwab and Visa. Some of these stocks were not the top ten holdings of the Balanced Investment Portfolio for the entire year. Eight of the companies were in the top ten holdings on December 31, 2016. These top ten U.S. stock holdings were 13.3% of the U.S. equity component of the portfolio and include companies in the health care, industrials, information technology and financials sectors.

Structure of the U.S. Equity Component of the Balanced Investment Portfolio Stock Selection in the U.S. Equity Component Active portfolio managers select individual stocks based upon valuations and expectations for future growth. Many of the best managers call themselves “benchmark agnostic”, meaning they don’t select stocks or sectors based upon the weighting in a benchmark. It is important to remember that the composition of most indices is backward looking, reflecting the performance of prior periods. The weighting of an individual stock and its sector in most indices is based upon its market capitalization, so strong past performance leads to a higher weighting in the index. When you buy an index fund, you are buying more of the recent winners, and fewer of the recent losers. Since active managers try to anticipate the next winners, the stocks and sectors in their portfolios often differ significantly from an index. Sector Allocation in the U.S. Equity Component When the stocks selected by our U.S. equity managers are aggregated by sector, the U.S. equity component has over and underweights in certain sectors. Employing active portfolio managers who select companies with the greatest potential for stock price appreciation should result in a portfolio that does not look like an index fund. Since these are decisions made at the level of individual companies and not sectors, the U.S. equity component has over and underweights when compared to the sector weights of the Russell 3000 Index. As shown in the graph that follows, U.S. equity managers’ favorable outlook for information technology, healthcare and consumer discretionary stocks resulted in overweights in these three sectors, three of the four best performing sectors in the Russell 3000 Index. Unfavorable earnings expectations for stocks in the real estate, telecom and energy sectors led managers to underweight these stocks in the three worst performing sectors. When the U.S. economy is strong and there is limited chance for a recession, consumers buy more products of consumer discretionary or consumer cyclical companies. Products are nice to have but not necessities (to some consumers), including apparel, entertainment, leisure goods and services and autos. Consumer durables or staples are products that most would consider to be essential regardless of economic conditions. This would include products such as food, beverages and basic household items. At this point time in the U.S. economic cycle, investment managers favored consumer discretionary companies over consumer staples. The green bars show the U.S. equity component sector allocation compared to that of the Russell 3000. The bottom up stock selection of superior companies in the technology, healthcare and consumer discretionary sectors contributed to the U.S. equity component return of 23.6% compared to the 21.1% of the Russell 3000.

35

International Equity Component of the Balanced Investment Portfolio 26.9% of the Balanced Investment Portfolio on December 31, 2017 The international equity component of the Board of Pensions Balanced Investment Portfolio had a return of 26.9% in 2017, lagging the 27.8% return of the benchmark MSCI All Country World Index ex U.S., or ACWI ex U.S Gross1. The index is designed to measure the equity market performance of both developed and emerging markets, including the country indices of 23 developed and 21 emerging market countries. The international equity component of the Balanced Investment Portfolio exceeded the return of the ACWI ex U.S. Index for the two, three, five, ten, fifteen and twenty years ended December 31, 2017.

1

The International Equity component of the Balanced Investment Portfolio is benchmarked against the ACWI ex U.S. benchmark gross of taxes on dividends, because it has a longer history; it returned 27.8% in 2017. Several charts in this review show the benchmark net of taxes on dividends, which returned 27.2% in 2017.

36

International Equity Index Returns Year to Date December 31, 2017

MSCI EM Asia

42.8 37.3

MSCI EM MSCI ACWI ex U.S.

27.2

Board of Pensions International Equity

26.9 25.5

MSCI Europe

25.0

MSCI EAFE MSCI Japan

24.0

MSCI EM Latin America

23.7 22.3

MSCI United Kingdom MSCI EM Europe

20.5 0

10

20

30

40

50

% Return Sources: BNY Mellon, MSCI (net)

Emerging markets stocks in Asia as represented in the MSCI EM Asia Index, were the best performers, with a 42.8% return. Currency was a significant component of the return to U.S. dollar investors. Virtually all currencies appreciated against the U.S. dollar, providing higher returns to U.S. dollar investors like the Board of Pensions. The EM Asia Index return for U.S. dollar investors was 42.8%, with a 35.9% return to investors in local market currencies. For the second year in a row, the MSCI Emerging Markets Index (net) return of 37.3% exceeded the 25.0% return from developed market companies, represented by the MSCI EAFE Index. In a volatile year, the returns for the countries known as the BRICS had a significant divergence in performance. Countries whose currencies appreciated against the dollar had better performance than countries whose currencies were flat or declined against the dollar. With weaker local currencies, Brazil and China had slightly lower returns for U.S. Dollar investors of 24.1% for Brazil and 54.1% for China. Russia, India and South Africa, countries where the local currency declined against the dollar, resulted in a 5.2% return for Russia, 38.8% return for India and 36.1% for South Africa. Local investors, due to the strength of the local currency and weakness of the U.S. dollar, received lower investment returns in their own currencies. Since managers in the international equity component of the Balanced Investment Portfolio build portfolios on a stock by stock basis, stock selection was the primary reason for below benchmark performance. The international equity component of the Balanced Investment Portfolio has managers with a value bias. This detracted from performance in 2017 when information technology growth stocks provided a return of 51.1%. Four out of six developed market international equity managers in the international equity component of the Balanced Investment Portfolio outperformed respective benchmarks in 2017. These managers had allocations of 24-29% in Japan, significantly higher than the MSCI All Country World Index ex U.S. weight of 16.5% on December 31, 2017. Japanese stocks returned 19.8% to local investors and with the strengthening of the yen against the dollar, returned 24.0% to U.S. dollar investors in Japanese stocks. Investment performance in Europe was stronger than expected as a result of improved economic conditions and the decline in the value of the dollar. MSCI Europe Index was 43.6% of the ACWI ex US Index in 2017, with a return of 25.5%. International equity manager above benchmark allocations to companies in Europe generally detracted from performance. Four of the six developed market manager had allocations to countries in Europe that ranged from 51.0% of their portfolio to 70.6%, significantly higher than the 43.6% allocation to the benchmark index. 37

In a year when the U.S. dollar declined in value against virtually all currencies, only one of the six developed markets managers hedged currency in 2017. The portfolio returned 19.2%, exceeding the hedged benchmark of 16.8%. The international equity component total allocation to emerging markets stocks was 24.6%, virtually the same as the 24.8% allocation to emerging market stocks in the ACWI ex U.S. Index. Emerging markets stocks are selected for the international equity component of the portfolio by the six core international equity managers and two dedicated emerging markets managers. Four of these core managers found compelling investment opportunities in emerging markets but had less than the index weight of 24.8% in emerging markets. Both emerging markets managers underperformed their benchmark, with one manager returning 32.2% and the other, 28.0% versus the index return of 37.3%. Underperformance was primarily due to stock selection that led to an overweight of companies in Russia and underweight growth companies in Asia, including China and Taiwan. The Emerging Market Index had a 29.7% allocation to companies in China on December 31, 2017. The two dedicated emerging market managers had allocations of 9.6% and 13.5% to China, resulting in reduced exposure to the 54.1% return from Chinese companies. The underweight to Asia is more significant when Taiwan is added for a 41.0% allocation in the Emerging Markets Index compared to 13.8% and 18.7% allocations by emerging markets managers in the international equity component of the Balanced Investment Portfolio.

International Equity Market Historical Performance We have created a graph of historical long-term international equity returns showing developed international equity markets, as represented by the MSCI Europe, Australasia and the Far East (EAFE) Index from 1970 through 2000 and developed and emerging markets represented by the MSCI All Country World Index ex U.S. beginning in 2001, the inception date of the ACWI ex U.S. Index. As shown in the graph that follows, the 2017 net return of 27.2% is above the 10year trend line return of 1.8% and the long-term 48-year average return of 9.7% for the blended indices since 1970. Following the pattern of the U.S. equity market, international equity had negative returns in 14 out of 48 years and in seven of the last 18 years.

International Equity Returns in Historical Perspective January 1, 1970 – December 31, 2017 80

69.9 56.7

60 40

41.5

40.8

37.6

32.9

27.2

48-Year Average 9.7%

15.3

20

1.8

0 -5.7

-20

-13.7 -22.2

-21.4

-23.2

-40 -45.5

-60 1970

1975

1980

1985

1990

1995

MSCI EAFE/ACWI exUS blended

Note: MSCI EAFE until 2000; MSCI ACWI ex US effective 2001

38

2000

2005

10 Year Trend

2010

2015

As shown in the graph that follows, international stocks outperformed U.S. stocks in 2017. However, the pattern of U.S. versus international outperformance is not predictable, with long periods of over and underperformance for developed markets international stocks versus U.S. stocks. Stocks in the S&P 500 Index had a ten year compound annual return of 8.5% for the period ending December 31, 2017, significantly outperforming the return of 1.9% from international stocks in the developed markets EAFE Index.

Developed Markets Performance International equity performance in 2017 depended on both stock and country selection while, as shown in the graph that follows, currency had a significant impact. A weak dollar contributed to superior returns for U.S. dollar investors in virtually all developed markets. A weak dollar makes imported goods and vacations abroad more expensive for Americans, but it helps our export industries and increases investment returns since international stocks are worth more in weak U.S. dollars than in local currencies. As shown on the graph that follows, U.S. investors in the twelve EMU countries that use the euro as their currency had a return of 28.1% compared to the 12.6% return to local investors. However, the 28.1% return from an index of stocks based on the twelve countries and translated back to U.S. dollars masks the variability of returns U.S. investors would have received from the indices of each country, from the 18.1% return for companies in Ireland to a 58.3% return for companies in Austria. The returns of the 21 country indices in the EAFE Index was 25.0% for U.S. dollar investors and 15.2% for local currency investors. Returns varied widely by country, from the 58.3% return for companies in Austria to the 2.1% return for companies based in Israel. Despite incomplete BREXIT negotiations, the index of UK companies returned 22.3% for U.S. investors and 11.7% for pound-based investors.

39

International Sector Performance Despite the linkages of a global economy, it cannot be assumed that the best performing sector in one region will also be the best sector in another. However, as shown in the graph that follows, international sector performance was similar to that in the U.S. in 2017. Information technology companies were the best performing sector in the international equity component and the U.S. equity component, with returns of 51.1% for international and 37.0% for U.S. energy, the worst performing sector in the Russell 3000 Index, returning (2.0)% in 2017 while energy returned 16.5% in the ACWI ex U.S. Index, the second worst sector performance.

40

As investors review portfolio performance in 2017, it is important to appreciate the difference in composition between the Russell 3000 Index of U.S. companies and the ACWI ex U.S. of international companies. Active portfolio management results in different sector allocations than the index and provides portfolio diversification that is different from that of the Russell 3000 Index of U.S. companies. Financials are the largest sector in the ACWI ex U.S., with a 23.2% weighting, yet financials represented only 15.1% of the Russell 3000 Index. Information technology, the largest sector in the Russell 3000 Index, had a weight of 22.8% on December 31, 2017. With fewer and smaller technology companies based in non-U.S. markets, information technology had only a 9.2% weighting in the ACWI ex U.S. Index in 2016; however a return of 51.1% in 2017 resulted in an information technology allocation of 11.4% in the Index on December 31, 2017. Sector Allocation in the International Equity Component When the stocks selected by our international equity managers are aggregated by sector, the international equity component has over and underweights in certain sectors. If we explore the structure and composition of the international equity component of the Board of Pensions Balanced Investment Portfolio compared to the sectors of the ACWI ex U.S. Index, as shown in the graph that follows, we can see that the portfolio’s international equity component, based upon sector allocations, does not look like the ACWI ex U.S. Index. Employing active portfolio managers who select companies with the greatest potential for stock price appreciation should, and did, result in a portfolio that does not look like an index fund. Since these are decisions made at the level of individual companies and not sectors, the resulting portfolio has over and underweights when compared to the sector weights of the ACWI ex U.S. Index. The overweight to information technology, the best performing sector, contributed to performance, as did an underweight to energy companies, one of the worst performing sectors.

As shown on the graph that follows, active stock selection also results in country allocations that differ from the ACWI ex U.S. Index. The international equity component had an underweight in EM Asia, the best performing regional index in 2017. A slight underweight to Pacific ex Japan detracted from performance as did an overweight in Europe ex EMU.

41

Emerging Markets Performance In 2017, the MSCI Emerging Markets Index (net) returned 37.3%. In many years, currency in emerging markets has had limited impact on investment performance, but in periods of rising inflation and central bank management of reserves and interest rates, the relationship of a country’s currency to the U.S. dollar can add to or detract from performance for U.S. dollar- based investors. Brazil experienced improved economic political stability in 2017. The stock market returned 26.5% to local investors, As the Brazilian real appreciated slightly against the dollar, U.S. investors had a return of 24.1%. The Russian economy experienced volatile oil prices and a depreciation of the ruble. Russian stocks returned 0.3% to local investors and a 5.2% return to U.S. dollar-based investors. Despite the continuation of political turmoil in Turkey, the Turkish lira appreciated against the U.S. dollar, lowering the return of 49.1% that local investors experienced to a 38.4% return for U.S. dollar denominated investors like the Board of Pensions.

42

As shown on the graph that follows, emerging markets outperformed developed markets in 2017, with a return of 37.3% compared to the 25.0% return from EAFE developed markets. The MSCI Emerging Markets Index had a ten year compound annual return of 1.7%, slightly underperforming the return 1.9% return from stocks in the developed markets EAFE Index for the ten year period ending December 31, 2017. The Russell 3000 had a return of 8.6% for the same period.

43

Fixed Income Component of the Balanced Investment Portfolio 27.4% of the Balanced Investment Portfolio on December 31, 2017 The fixed income component of the Balanced Investment Portfolio is the most structurally complex part of the portfolio. To provide superior investment returns, the portfolio structure must successfully anticipate the direction of U.S. interest rates, spreads of investment grade, high yield and emerging market bonds, as well as credit quality and the impact of currencies. In 2017 the fixed income component of the Portfolio had a return of 5.0% compared to the benchmark return of 4.0% provided by the Bloomberg Barclays U.S. Government/Credit Index. The fixed income component exceeded the return of the Barclays Government/Credit Index for the one, two, three, five, ten, fifteen and twenty years ended December 31, 2017. As shown on the graph that follows, investing in fixed income outside the U.S. was important for portfolio success in 2017. The best 2017 fixed income index performance was the 15.2% return from the JPM GBI-EM Global Diversified Unhedged Bond Index, an index of unhedged emerging market debt denominated in local currencies. The Citigroup World Government Bond Index Unhedged, an index of global developed bonds, had a return of 10.3%. The JPM Emerging Markets Bond Global Diversified Index, an emerging market debt index based in U.S. dollars, also had a return of 10.3% in 2017. Core fixed income strategies benchmarked to the Bloomberg Barclays Government/ Credit Index returned 4.0%.

Fixed Income Index Returns Year to Date December 31, 2017 JPM GBI-EM Global Diversified Unhedged

15.2

CG Non-US WGBI Unhedged

10.3

JPM Emg Mkts Bond - Global Diversified

10.3

CG High Yield Cash Pay

7.0

6.0

Board of Pensions Fixed Income ex Cash Board of Pensions Fixed Income

5.0

Bloomberg Barclays Govt/Credit

4.0

Bloomberg Barclays Global Aggregate

3.5

Bloomberg Barclays Government

2.3

BofA ML 3 Month T-Bill

0.9

0

5

10

15

20

% Return Source: BNY Mellon

At the start of 2017, the consensus forecast was that U.S. interest rates would increase in 2017. The market anticipated interest rate increases in June, September and December, subject to employment and economic conditions. Few anticipated the continued improvement in oil prices or the weakness of the U.S. dollar against virtually all currencies. With stable levels of unemployment and inflation, the Federal Reserve did increase rates three times in 2017, to close at a Fed Funds rate of 1.5% on December 31, 2017. The 10-year Treasury opened 2017 at 2.45%, then declined to 2.04% in August before increasing to 2.41% on December 31, 2017. Duration is an important part in the structure of any bond portfolio. While a complicated calculation, duration is often reported in years. Duration measures the sensitivity of the price of a fixed income investment to a change in interest rates. In a period of rising interest rates and falling bond prices, portfolios benefit from having a short duration. In periods of declining interest rates and rising bond prices, a longer duration portfolio would have the best return. As shown on the graph that follows, despite no increase in long-term rates in 2017, the duration of the Barclays U.S. Aggregate, a popular benchmark for active fixed income investors as well as passive bond index funds, was 6.0 years on December 31, 2017. This is significantly longer 44

than the average duration of 4.8 years from 1988 to 2017 as corporations have increased the term of their debt to take advantage of record low interest rates. The longer duration of 6.0 years results in a portfolio that is more sensitive to increases in interest rates.


The graph that follows shows the impact of a 1% plus or minus change in U.S. interest rates on U.S. Treasury securities with maturities ranging from short, the 2 year, to very long, the 30 year Treasury. The impact of rising interest rates will have a smaller impact on a bond with a 2 year maturity than one with a 30 year maturity. If investors believe that interest rates will increase by 1%, an investment in a 30 year Treasury will have a (17.9)% change in price while the 2 year Treasury will decrease in value by only (1.9)%.


The structure of the Fixed Income Composite is shown in the graph that follows. The breakdown is by investment manager strategy, with 38% of the composite managed by core managers. There is a 16% dedicated allocation to global high yield. Short duration and cash represent 18% of the composite. Global developed and emerging markets represent 17% of the composite. 45

The unconstrained portfolio represents 8% and TIPS 3% of the composite on December 31, 2017.

Mindful of the volatility in interest rates on a long duration portfolio, we reduced the duration of our internally managed Treasury Inflation Protection Securities (TIPS) portfolio from a duration of 16.2 years on January 1, 2017 and 15.6 years on September 30, to 5.9 years by December 31, 2017. The TIPS portfolio returned 6.3%. Our short duration portfolio, with a duration of less than 2 years, returned 1.2%. The short duration portfolio exceeded its benchmark for 2017 while the TIPS portfolio slightly underperformed due to longer term rates coming down in 2017 benefiting longer duration portfolios. A shorter than benchmark duration for core fixed income portfolios reflected our managers’ views on reducing interest rate risk and was important for success in 2017. Core fixed income manager performance was impacted by shorter than index duration as well as the allocation to, and superior selection of, corporate bonds. Two of the three core fixed income managers met or exceeded the exceeded the 4.0% return of the Bloomberg Barclays Government/Credit Index. The 5.0% return of the fixed income component included the returns from core fixed income managers, TIPS and the short duration manager as well as a 6.3% return from our global high yield portfolio. The dollar denominated emerging market debt portfolio returned 12.1%; the local currency emerging market debt investment returned 14.9%. Both strategies exceeded the benchmark returns. The global sovereign bond portfolio return of 8.3% exceeded the 7.5% return of the Citigroup World Government Bond Index. With the expectation of increasing U.S. interest rates in 2014-2015, the unconstrained strategy was approved and initially implemented in late 2013. With no meaningful increase in interest rates, this strategy provided a 2.4% return in 2017, as U.S. interest rates remained flat in 2017. 46

The cash and the short duration portfolios comprised 18.1% of the fixed income component on December 31, 2017, a slight increase from the 16.1% allocation on December 31, 2016. A strategic short duration fixed income allocation of approximately 125% of annual benefits payments was approved by the Investment Committee in July 2008. The short duration strategy detracted from the performance of the fixed income component of the Balanced Investment Portfolio in 2017. Excluding cash and the short duration portfolio, the fixed income component had a return of 6.0% in 2017.

Fixed Income Market Historical Performance The chart that follows provides the historical performance of the U.S. fixed income market, as represented by the returns of the Bloomberg Barclays Government/Credit Index. Investors in fixed income can experience negative returns during periods of rising interest rates or when spreads widen on corporate bonds and other types of credit based instruments. However, if we compare annual performance in a graph similar to those of long-term performance for U.S. and international stocks, fixed income has had far fewer and less severe years of negative performance. Over the last 10 years, as shown on the 10-year trend line in the graph, the Bloomberg Barclays Government/Credit Index had a return of 4.1%, below the 45-year average return of 7.2%. Fixed income markets as represented by Barclays Government/Credit Index had negative returns in 1994, 1999, and 2013 or only three out of 45 years.

Fixed Income Returns in Historical Perspective January 1, 1973 – December 31, 2017 50

31.1

30 21.3

19.2

15.6

45-Year Average 7.2%

10 4.0

-2.2

-3.5

-2.4

-10 1973

1979

1985

1991

1997

Bloomberg Barclays Capital Govt/Credit

47

2003

2009

10 Year Trend

2015

4.1

Fixed Income Investment Performance Fixed income performance depends on multiple factors. Historically, the most influential factors are: the level and direction of interest rates, portfolio duration, credit quality and investor appetite for risk, as reflected in the spread over U.S. Treasuries for corporate bonds. Interest Rates The Federal Reserve’s target for the federal funds rate was 4.25% at the start of 2008. This is the interest rate at which private depository institutions, primarily banks, lend balances at the Federal Reserve on an overnight basis to other depository institutions. On December 16, 2008, after six reductions in the first ten months of 2008, the Federal Open Market Committee made the unprecedented move of setting the funds target rate in the range of zero to 0.25%. No change in the fed funds target rate was made until the rate was increased to 0.25% in December 2015 and 0.50% in December 2016 and with three increase in 2017, 1.25% on December 31, 2017. As shown on graph that follows of the U.S. Treasury yield curves for December 31, 2013 (dotted line) and December 31, 2017 (solid blue line), despite the increase in short interest rates from 0.1% in 2013 to 1.8% in 2017, there has been no increase in the interest rate for 10 and 30-year Treasuries as the yield curve flattened. The 10-Year Treasury was 3.0% in 2013 and 2.4% on 2017. The 30-Year Treasury was 4.0% in 2013, with an unanticipated decline to 2.7% in 2017. Investors expected that as the Federal Reserve increased the interest rate at the short end of the curve, there would be a parallel shift and the interest rate on intermediate and long Treasury securities would move in line with the increase in short rates. This has not happened since 2013 and long interest rates for 10 and 30-year securities are at a lower interest rate than in December 2013.


48

As shown on the historical yield curve graph that follows, the interest rate for the benchmark 10-year U.S. Treasury was 6.5% on December 31, 1999 (green line). By December 31, 2007, rates had declined to 4.0% (red line) with the 10-year at 4.0%. After the global financial crisis in the fall of 2008, the Federal Reserve dropped short rates to 0.1%, with a 10-year Treasury at 2.2% (light blue line). As noted above, as short rates increased, investors expected an increase in rates on longer term securities. As shown on the yield curve for 2017, (dark blue line) while short term rates increased, long-term rates declined.

Source: Treasury.gov

Investors and savers have become numb to brutally low interest rates in the U.S. We have experienced historically low interest rates for almost a decade, since the global financial crisis of 2008, so it is important to step back and review where yields have been over the longer time periods and put the current 2.4% yield on a 10-year Treasury in perspective. In July 1954 the yield on a 10-year U.S. Treasury bond was 2.3%. Yields had an uneven but steady progression to higher levels, culminating in the 15.3% yield on a 10-year Treasury in September 1981. While yields experienced modest increases and decreases on an annual basis, over the next 30+ years, interest rates generally declined, providing investors in long bonds more than 30 years of superior returns. As shown on the graph that follows, the U.S. experienced interest rates persistently below 4% on the 10-year Treasury from the late 1920s through the 1950s. Low rates can persist for a long time.

49

Sources: Bloomberg from 1953 to 2017, Robert Shiller from 1900 to 1953

Credit Quality and Spreads Credit ratings are generally given to bonds based on Standard & Poor’s and Moody’s analyses of the ability of the issuer to pay interest and repay principal on schedule to bondholders. As reflected in the graph below, U.S. Treasury bonds provided investors with safety and liquidity and a 2.3% return in 2017. Investors in corporate bonds hope to give up some safety and liquidity to obtain a higher return. Investors in AAA corporate bonds had a slightly better return than U.S. Treasuries, with a return of 2.4%. BBB securities had a return of 7.5%. This meant there was no reason for investors to invest in BB or B securities, which produced returns lower than the BBB and at higher risk. Investors with a high tolerance for risk could have invested in CCC securities for a 10.4% return in 2017.

50

Source: Bloomberg

The U.S. Treasury bond is typically considered the highest quality long-term fixed income investment with the greatest liquidity and no default risk. As such, it is the benchmark security used by investors to price all other long term bonds. The spread for investment grade corporate bonds is a risk premium, or additional yield that investors require for any bond that is not a U.S. Treasury bond. The graph that follows provides a historical overview of the relationship of the yield on high yield bonds and U.S. Treasuries. The yield spread is the additional cushion of safety required by investors to purchase high yield bonds instead of comparable maturity U.S. Treasury bonds. High yield spread movements mirrored the pattern of investment grade corporate bonds to Treasuries in 2008, with spreads tripling in the second half of 2008, to close the year at 1,673 basis points, just below the historic high of 2,031 basis points reached in November 2008. In 2012, high yield spreads continued to fall as income-seeking investors were willing to accept less liquidity and to assume the additional credit risk of high yield bonds. Spreads also narrowed in 2013 and through the first half of 2014, declining from a spread of approximately 492 basis points at the start of 2013 to just below 370 basis points in June 2014. In 2014 about 20% of the high yield bond index was comprised of energy and energy-related companies. With the collapse in oil prices in the second half of 2014, spreads on high yield bonds widened to almost 529 basis points by December 31, 2014, just below the 20-year average spread of 570 basis points. Oil prices had a significant impact on spreads again in 2015 as the price per barrel dropped 31% creating a more difficult environment for the energy sector. High yield spreads widened by 44% in 2015 peaking in January 2016 at 823 basis points. As the oil market stabilized in 2016, spreads came back down to just above 400 basis points at year end. Spread compression continued in 2017 as high yield bond prices continued to increase ending the year with spreads at 335 basis points, well below the 20 year average.

51

Emerging Market Debt Emerging market debt has greatly increased in importance and market size over the last 30 years. In 1989 it represented approximately 1.0% of the global bond market with the U.S. dominating at 61.3% of the global bond market. As of June of 2017, emerging market debt as a percentage of the global bond market has increased twenty fold to 20.1%, while the U.S. share has decreased by almost half to 37.4%. Emerging market bonds, both local currency and USD denominated, were the top performing fixed income sectors in 2017 with returns of 15.2% and 10.3%, respectively. As shown in the chart that follows, spreads for both emerging market sovereign bonds and emerging market corporate bonds have come down to their lowest point in over a decade. As investors move farther out the risk curve in search of yield and diversification, emerging market bonds will continue to play an important role in the global bond market and in portfolio composition.

52


Default Rates The default rate for U.S. dollar-denominated bonds is the par value of defaulted securities as a percentage of the par value of outstanding issues. As shown in the graph that follows, default rates hit a multi-decade peak in 2009 (2nd highest recorded rate to 1933) with a default rate of 5% for all corporates. Speculative grade bonds had a default rate of 12.1% for high yield borrowers primarily due to weak underwriting standards in the 2004 to 2006 period. This led to only the fourth time since 1920 where defaults of high yield issuers exceeded 10.0%. The incidence of corporate defaults then declined from 2009 through 2014 as banks and other lenders provided corporations extra time to work through potential breaches in loan covenants, extended maturities and refinanced debt to avoid foreclosures and bankruptcies. As a result, investors remained enthusiastic buyers of high yield debt refinancing during a low interest rate environment. Defaults began reverting back to long-term averages in 2015 and in 2016 as the rate for all corporates increased to 1.7% and 2.1% for speculative bonds. Estimates for 2017 (final numbers are not available until the end of February) show an estimated decrease in the default rate to 1.7% due to an improved U.S. economy and global synchronized growth improving the cash flow of many companies.

53

Source: Moodys Default Study

Private Partnerships Component of the Balanced Investment Portfolio 8.5% of the Balanced Investment Portfolio on December 31, 2017 Private Partnerships are used in the Balanced Investment Portfolio to supplement the traditional asset classes of stocks and bonds. Private partnerships provide access not available in the public markets to investment opportunities with potentially superior long-term returns and to managers with long-term records of creating value for their investors. In 2017 three new commitments were approved for limited partnerships in distressed debt, secondary partnership investments and international private equity. All of the commitments were to firms with which the Board of Pensions had successful prior investments. When reviewing performance, some of the differences can be attributed to the one quarter lag in performance reporting making it important to remember that private limited partnerships are long-term investments with a minimum of a ten year horizon. With strong performance from global equity markets, U.S. and international private equity failed to meet their public market benchmarks. However, the return for the private partnership component exceeded the return of the Balanced Investment Portfolio for the three, five and ten years ended December 31, 2017.

54

PRIVATE PARTNERSHIPS INVESTMENT PERFORMANCE HIGHLIGHTS PERIODS ENDED DECEMBER 31, 2017 Annualized Rate of Return (%) 1 Year

2 Years

3 Years 5 Years

10 Years

US PRIVATE EQUITY Russell 3000 +300 bps *

18.4 24.4

16.7 20.1

15.2 14.2

16.5 18.8

11.0 11.6

NATURAL RESOURCES

13.1

7.7

-1.1

4.1

11.3

Russell 3000 +300 bps *

24.4

20.1

14.2

18.8

11.6

INTERNATIONAL PRIVATE EQUITY

12.0

9.5

4.8

4.9

2.6

MSCI ACWI ex US +300 bps *

31.3

19.0

11.3

10.3

5.2

DISTRESSED DEBT ex REAL ESTATE

15.6

12.8

9.4

10.9

8.1

CG High Yield Cash Pay +300 bps*

10.0

15.3

8.9

8.3

10.6

DISTRESSED DEBT - REAL ESTATE

10.1

8.7

10.3

11.7

CG High Yield Cash Pay +300 bps*

10.0

15.3

8.9

8.3

10.6

8.7

8.0

11.9

12.7

9.5

Russell 2000 +300 bps *

17.8

21.2

13.0

17.3

11.7

BOP TOTAL PRIVATE PARTNERSHIPS BOP Balanced Investment Portfolio

14.2 17.0

11.8 12.9

8.7 8.0

10.6 9.3

8.3 6.2

BOP PRIVATE PARTNERSHIPS

VENTURE CAPITAL

---

* The Index +300 basis points is calculated monthly and linked to provide an annualized number that will be different than the sum of the annual return of the Index +300 basis points.

Assets in private partnerships are diversified among different types of investments, including distressed debt, real estate, venture capital and three different types of private equity: U.S., international and natural resources/energy. Some of these categories blur in practice: for instance, some general partners invest for control of portfolio companies through either debt or equity securities depending in part on valuation of the respective securities at the time of investment. The current breakdown of private partnerships by type of investment at market value on December 31, 2017 appears in the following chart.

55

Private Partnership Asset Allocation and Actual Market Value on December 31, 2017

Private Partnerships Current Market Value $816 Million = 8.5% of Balanced Portfolio MV Natural Resources/Energy 28.9%

Distressed Debt 17.3%

Venture Capital 5.1% Real Estate 6.1%

U.S. Private Equity 27.4%

International Private Equity 15.2%

Total assets $9,616 million

Investments in private partnerships are diversified by fund type, by fund manager and also diversified over time, since fund returns are strongly affected by cyclical factors which do not become apparent until long after investors have finalized their commitments to a specific fund. Spreading the investment periods of private partnerships over time potentially avoids concentration in periods which ultimately provide substandard returns. Private Partnerships by Vintage (Investment) Year The chart that follows shows private partnership commitments in the Balanced Investment Portfolio by vintage year, the year the general partner began investing capital committed to the partnership. Vintage year may differ from the year the Board of Pensions made the legal commitment to the partnership; the general partner may not begin investing funds immediately after a fund’s close because it is still investing a prior fund or because of disruptions in the investment market place. Commitments to private partnerships are shown by vintage year as a percentage of the total commitments to private partnerships in the Balanced Investment Portfolio and, within each vintage year, by type of partnership.

56

Private Partnerships Commitments by Vintage Year as of December 31, 2017

25

Of Total Commitments

%

20 15 10 5 0

1998

2001 2000

2002

2003

2005 2004

2007 2006

2008

2009

2011 2010

2013 2014

2012

2015 2016

International PE

U.S. PE

Venture Capital

Distressed Debt

Natural Resources/Energy

Real Estate

2017 Not Funded

Private Partnership Capital Calls and Cash Distributions When the Board of Pensions makes a legal commitment to invest in a private partnership the cash for investment will be called over a period of years. As each partnership sells its holdings, the general partner makes cash distributions to the Board of Pensions. The private partnerships in the Balanced Investment Portfolio have returned more cash than they called in recent years, although cash generation from these partnerships is highly unpredictable. Private partnership cash flows for the last five years are shown in the chart that follows.

Private Partnerships Comparative Cash Flows for years ended 12/31 200 180 160 140 120

$ millions

100 80 60 40 20 0

2013 Calls Dist $111 $142

2014 Dist Calls $174 $162

2015 Dist Calls $161 $127

2016 Dist Calls $152 $165

2017 Dist Calls

$193 2017 201320132014201420152015201620162017 $145 dist calls dist calls dist calls dist calls dist calls

International PE Venture Capital Natural Resources/Energy

U.S. PE Distressed Debt Real Estate

57

Marketable Diversifying Strategies Component of the Balanced Investment Portfolio 5.2% of the Balanced Investment Portfolio on December 31, 2017 The marketable diversifying strategies component of the Balanced Investment Portfolio currently includes inflation protection and absolute return investments in commingled funds as well as real estate securities. Absolute return investments offer returns which are potentially uncorrelated to public market securities. Inflation protection investments include real estate and commodities. Absolute return strategies include risk parity portfolios. Other types of marketable diversifying strategies have been included in the Balanced Investment Portfolio previously and may be included in the future. The investments in inflation protection strategies were initiated in 2005 to provide protection during periods of increasing U.S. inflation. Inflation has not been a problem and these investments have underperformed the Balanced Investment Portfolio. In 2017, the two inflation protection portfolios returned 7.1% and 6.8%, versus the 7.1% return of the benchmark of the CPI + 5%. Inflation protection strategies lagged the benchmark in all time periods ended December 31, 2017 that were longer than two years. The Balanced Investment Portfolio is invested in three absolute return strategies. One is a global macro strategy that returned 1.3% in 2017. Two risk parity strategies exceeded expectations. One returned 16.0% and one returned 11.7% compared to the 7.1% benchmark return. The real estate securities portfolio returned 10.2% compared to the 4.3% return of the S&P U.S. REIT Index. The total marketable diversifying strategies component returned 7.8% compared to the 7.1% return of the CPI+5% or 7.1% in 2017.

MARKETABLE DIVERSIFYING STRATEGIES INVESTMENT PERFORMANCE HIGHLIGHTS PERIODS ENDED DECEMBER 31, 2017 Annualized Rate of Return (%) 1 Year 2 Years BOP MARKETABLE DIVERSIFYING STRATEGIES Consumer Price Index +5% nnuay BOP Balanced Investment Portfolio

3 Years 5 Years

10 Years

7.8

8.4

2.4

1.3

2.2

7.1

7.1

6.6

6.4

6.6

17.0 6

12.9

8.0

9.3

6.2

7.

The graph that follows reflects the diversification of the marketable diversifying strategies component of the Balanced Investment Portfolio on December 31, 2017.

58

Marketable Diversifying Strategies Current Market Value $503 Million = 5.2% of Balanced Portfolio MV Absolute Return 63.9%

Real Estate 10.6%

Inflation Protection 25.6%

Total assets $9,616 million

Portfolio Accounting The total return on the Balanced Investment Portfolio is measured using the actual market value of assets held on January 1, 2017, and the actual market value of assets held on December 31, 2017. The beginning asset value is increased by interest income and dividends and decreased by fees and benefits paid during the year. In 2017, the portfolio paid out $407 million in benefits in excess of dues received. The portfolio had net realized gains of $422 million on securities sold in 2017 and unrealized gains of $864 million due to appreciation in the market value of securities still held in the portfolio on December 31, 2017. MARKET VALUE RECONCILIATION BOARD OF PENSIONS BALANCED INVESTMENT PORTFOLIO $Millions Market Value on January 1, 2017 Net Income Net Realized Gain Net Unrealized Gain/(Loss) Cash Flows into Portfolio Benefit Payments/Transfers Investment and Custody Fees Market Value on December 31, 2017

59

$8,586 166 422 864 11 (407) (26) $9,616

Plan and Program Participation The assets of the Board of Pensions Balanced Investment Portfolio are unitized so that each participating plan and program owns units in the portfolio rather than individual securities. This reduces the investment and custodial fees for all plans and programs. The valuation of units is done monthly by BNY Mellon, custodian for all assets, using an accounting process similar to that used to develop the net asset value of a mutual fund. Plans, with the exception of the Benefit Supplement Fund, Medical Plan Long-Term Reserve and Medical Plan Contingency Reserve, own only units of the portfolio and have the same asset allocation and investment performance as the Balanced Investment Portfolio, dependent upon the time the plan or program adopted a 100% allocation to the portfolio. The Benefit Supplement Fund and both Medical Reserve accounts own units of both the Board of Pensions Balanced Investment Portfolio and the Board of Pensions Fixed Income Portfolio. The Fixed Income Portfolio, valued at $60 million on December 31, 2017, can be used by plans and programs with differing investment horizons, enabling us to customize their long-term asset allocation. The table that follows shows the market values of plans and programs participating in the Board of Pensions Balanced Investment Portfolio and the Board of Pensions Fixed Income Portfolio at BNY Mellon. PLAN AND PROGRAM PARTICIPATION December 31, 2017 $Millions

% of BOP Balanced Investment Portfolio

Pension Plan Death and Disability Plan Supplemental Death Benefits Plan Post-Employment/Post-Retirement (PEPRM) Medical Plan Contingency Reserve Endowment Fund Benefit Supplement Fund Retirement Housing Fund General Assistance Fund Chaplains Deposit Fund Restricted Gifts Fund SR Plan

$8,544 857 43 8 52 24 22 8 40 4 10 4

88.84% 8.91 0.45 0.08 0.54 0.25 0.23 0.08 0.42 0.05 0.11 0.04

Board of Pensions Balanced Investment Portfolio

$9,616

100.00%

Board of Pensions Fixed Income Portfolio

60

Cash Management Portfolio Plan Assets

102

Pension Plan Medical Active ABP Medical Dental Medical Supplement

68 686 22 2 10

Total Investments at BNY Mellon

$9,779

The Assistance Fund, Medical Plan Long-Term Reserve and Medical Plan Contingency Reserve own units of the Board of Pensions Balanced Investment Portfolio and the Board of Pensions Fixed Income Portfolio.

Note: Due to rounding, percentages may not total 100%.

60

Partnerships We Can Be Proud Of The Board uses multiple investment managers for each asset class in the Board of Pensions Balanced Investment Portfolio. The Investment Team and the Investment Committee evaluate, retain and monitor managers for specific assignments within the total portfolio. The managers are responsible for the selection of individual securities or companies for their portfolios. Custodian: The Bank of New York Mellon Corporation, Pittsburgh, PA U.S. Equity Adage Capital Management, Boston, MA BlackRock Institutional Trust Company, San Francisco, CA Brown Investment Advisory, Baltimore, MD Dodge & Cox, San Francisco, CA Jennison Associates, New York, NY PRIMECAP Management Company, Pasadena, CA Royce & Associates LLC, New York, NY T. Rowe Price Associates, Inc., Baltimore, MD Wasatch Advisors, Salt Lake City, UT Wells Capital Management, Menomonee Falls, WI

International Equity Baillie Gifford, Edinburgh, UK BlackRock Institutional Trust Company, San Francisco, CA Franklin Templeton Institutional, Fort Lauderdale, FL Genesis Investment Management, London, UK Impax Asset Management, London, UK Lazard Asset Management, New York, NY Marathon Asset Management LLP, London, UK Silchester International Investors Limited, London, UK Tweedy, Browne Company LLC, New York, NY Walter Scott & Partners Limited, Edinburgh, UK

Fixed Income Colchester Global Investors, London, UK Dodge & Cox, San Francisco, CA GMO, Boston, MA Oaktree Capital Management LP, Los Angeles, CA Pacific Investment Management Company, Newport Beach, CA Reams Asset Management Company, Inc., Columbus, IN Standish, Pittsburgh, PA

Private Partnerships: Private Equity, Distressed Debt, Venture Capital, Natural Resources/Energy Actis Capital Management, London, UK Capital International, Los Angeles, CA The Carlyle Group, Washington, DC Cerberus Capital Management LP, New York, NY Commonfund Capital, Inc., Wilton, CT Davidson Kempner, New York, NY HIG Realty Partners, New York, NY KKR, New York, NY Lime Rock Resources, Houston, TX Madison Dearborn Partners LLC, Chicago, IL Merit Energy Partners, Dallas, TX Oaktree Capital Management LP, Los Angeles, CA Pacific Investment Management Company, Newport Beach, CA Riverstone Holdings LLC, New York, NY Silver Lake Partners, Menlo Park, CA Templeton Asset Management Ltd., Fort Lauderdale, FL Värde Partners, Inc., Minneapolis, MN Warburg Pincus LLC, New York, NY Wind Point Partners, Chicago, IL Yorktown Partners LLC, New York, NY

Marketable Diversifying Strategies: Absolute Return, Real Return and Total Return AQR Capital Management, LLC, Greenwich, CT Bridgewater Associates, Inc., Westport, CT Parametric, Seattle, WA Security Capital, Chicago, IL Wellington Management Company LLC, Boston, MA

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Conclusion – What is Real? What Do We See? What Do We Hear? What Do We Value? What can we expect in 2018? Our job as investors is to know what is real; see with eyes not clouded by the lure of easy money and easy decisions; hear what is going on around us as the sounds of change ricochet at an ever increasing pace through our global investment world; and remember what we value, that we take care of our own, our Plan members. As we dust off our crystal ball for 2018, we should remember that it has been an interesting three years for global investors. Global markets rocked us in 2015 with a Balanced Investment Portfolio return of (1.1)%. We positioned ourselves and our portfolios for success in 2016, with an overarching theme of “Holding On”. Investors faced a 2016 global economy and global markets with a “Whole Lotta Shakin’ Goin’ On”. We held on and were rewarded with strong investment performance in all asset classes in 2016 and a total return of 8.9%. In 2017 we faced surprising low volatility in stock and bond markets and spent time questioning what is real in a new U.S. political and economic environment. We expected seismic events to shake the global economy and markets in 2017 and instead markets were becalmed by the lowest volatility in recent memory. The Balanced Investment Portfolio returned 17.0%. While investment performance is of paramount importance, we have several missions, and risk management is an integral part of our stewardship, if not our primary responsibility. It is difficult, if not impossible, to protect the Balanced Investment Portfolio from unexpected global risks that might have a probability of 0.3% or less, but such risks, known as tail risks by statisticians, are very real. Investors should recognize that in an interconnected global economy, we should expect systemic global shocks. We need to be mindful of what could be unusual, high risk events and their potentially devastating impact on investment portfolios. We need to raise questions with our managers that may appear to be out of the box and unrelated. We must always remember that the possible, improbable and “impossible” are with us every day as part of a normal distribution of events. As always, the hard part is to know where we are on the risk curve today and where we could be tomorrow.

2018 Outlook 

In October 2016 the Board of Directors approved the reduction in the expected long-term investment return assumption for the Balanced Investment Portfolio from 7 percent to 6 percent. Despite an outstanding 2017 for virtually all asset classes, all long-term asset class assumptions for the next decade plus have made a parallel downward shift. We believe we have a well-diversified portfolio and will not change the long-term asset allocation to potentially increase return with increasing risk and decreasing liquidity.

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Despite overall valuations that are a bit pricey, stocks remain the asset class for 2018. Growth in the U.S., Europe and Japan has been stronger than expected, with consumer confidence rebounding from historic lows. The U.S. stock market should benefit from reduced corporate taxes and repatriation of cash held offshore. The impact of repatriation should be on large capitalization companies, while small companies will benefit from reduced corporate tax rates. Once again it should be a year for managers gifted in security selection. We believe we have retained those managers as we have noted in our list of partnerships we can be proud of.

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We believe stocks are likely to outperform bonds in 2018, yet it is unclear which regions are most likely to outperform. Emerging market stocks provided outstanding performance in 2017, yet valuations are still attractive.

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After a strong 2017, active international developed market managers will have the opportunity to reposition portfolios to recognize outsized gains in technology stocks in 2018. The potentially negative impact of new regulations on European banks has again been deferred, but there will be increased regulatory and market issues in the telecommunications and technology sectors and many governments will continue to grapple with large debt levels. The U.K will wrestle with the impact of BREXIT, the decision to leave the EU. We believe our managers will select the best companies, but at this time do not plan to increase the allocation to international developed markets.

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We continue to expect (since 2014) that long duration fixed income assets will be less attractive in 2018 as the Federal Reserve continues to increase rates. Spreads on high yield and investment grade corporate bonds are less attractive than they were in 2016. However, we still see opportunities in global high yield in 2018.

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We do not expect inflation will be a problem in 2018. We will update our 2014 Inflation Study and evaluate inflation protection strategies that could benefit the Balanced Investment Portfolio in periods of inflation.

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Opportunities in private limited partnerships will be evaluated throughout 2018. The red flags waving for both private equity and real estate partnerships reflect the concern that fund sizes have increased to and exceeded pre-2007 levels. Existing partnerships are retaining “dry powder” for new deals while new partnerships are oversubscribed by investors not wanting to miss out on an increase in the allocation to illiquid partnerships. The combination of dry powder and new cash means more money chasing fewer deals in 2018. Our focus in 2018 should be on niche managers raising smaller funds.

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As we did in 2017, we will continue to use short-term market outperformance or volatility in individual asset classes to raise cash to pay benefits. In 2018, benefits payments will require cash in excess of dues of more than $407 million.

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We are long-term investors. We have a long-term strategic asset allocation based on our liabilities, or the future benefits for our Plan members. We will not increase portfolio risk by using short-term trading strategies to improve investment performance.

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We are socially responsible investors and partner with the denomination’s Committee on Mission Responsibility Through Investment (MRTI) to assist in the mission of the denomination on issues of corporate governance, global social issues and the environment.

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We will faithfully pursue the goals of our assigned mission, recognizing the multiple needs of those we serve in the Presbyterian Church (U.S.A.).

February 2, 2018 Judy Freyer Telephone: 215/587-7245 Email: [email protected] The 2017 Investment Review was prepared by the Investment Team of the Board of Pensions of the Presbyterian Church (U.S.A.). Text and commentary: Judith D. Freyer, CFA

Graphic design: Peter T. Maher, Jr., CFA

Additional research and assistance: Mary Elizabeth C. Pfeil, CFA; Donald A. Walker III, CFA; Matthew M. Cleary; Michael J. Kwiatkowski, CFA, Lydia M. Yost; Kristen A. Flowers and Martha D. Smyrski. 63

Notes: The Velveteen Rabbit (or How Toys Become Real) is a children's book written by Margery Williams Bianco and illustrated by William Nicholson. It chronicles the story of a stuffed rabbit's desire to become real through the love of his owner. The book was first published in 1922. A stuffed rabbit sewn from velveteen is given as a Christmas present to a small boy. The boy plays with his other new presents and forgets the velveteen rabbit for a time. These presents are modern and mechanical (for 1922), and he ignores the oldfashioned velveteen rabbit. The wisest and oldest toy in the nursery, the Skin Horse, who was owned by the boy's uncle, tells the rabbit about toys magically becoming Real due to love from children. The rabbit is awed by this idea; however his chances of achieving this wish appear slight. Original book jacket below.

Pilgrim at Tinker Creek is a 1974 nonfiction narrative book by American author Annie Dillard. Told from a first-person point of view, the book details an unnamed narrator's explorations near her home, and various contemplations on nature and life. The title refers to Tinker Creek, which is outside Roanoke in Virginia's Blue Ridge Mountains. The work touches on themes of faith, nature, and awareness. The book is analogous in design and genre to Henry David Thoreau's Walden (1854). In “Seeing”, the second chapter, Dillard shows a new way of not only seeing, but thinking about the world in relation to how humans perceive it. The things we observe define our lives, helping us live life more fully, looking deeper, and avoiding superficiality. Below is the original book jacket and photo of Tinker Creek in the upper Roanoke River.

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The Cherry Orchard is the last play by Russian playwright Anton Chekhov. Written in 1902, it is often identified as one of Chekhov’s best plays, along with The Seagull, Three Sisters, and Uncle Vanya. The play concerns an aristocratic Russian landowner who returns to her family estate (which includes a large and well-known cherry orchard) just before it is auctioned to pay the mortgage. Unresponsive to offers to save the estate, she allows its sale to the son of a former serf; the family leaves to the sound of the cherry orchard being cut down. The story presents themes of cultural futility – both the futile attempts of the aristocracy to maintain its status and of the bourgeoisie to find meaning in its newfound materialism. It dramatizes the socio-economic forces in Russia at the turn of the 20th century, including the rise of the middle class after the abolition of serfdom in the mid-19th century and the decline of the power of the aristocracy. Below is a photo of Cherry Orchard memorabilia, Chekhov Gymnasium and Literary Museum.

"We Take Care of Our Own" is a song written and recorded by American musician Bruce Springsteen. It is the first single from his album, Wrecking Ball. The song made its live debut on February 12, 2012, at the 54th Grammy Awards. This song was played throughout Barack Obama's 2012 presidential campaign and after his victory speech at his headquarters in Chicago. Sales of the song rose 409% following Obama's speech at the Democratic National Convention. The lyrics express Springsteen's frustration that after several years of economic hard times, people are less willing to help each other. Photo of The Boss.

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