A careful look into whether CalPERS is ticking along or a ticking time bombCategories: California Developments
from RIABiz by Wayne Friedman, September 4, 2013
The California Public Employees’ Retirement System — right up the road from us in Sacramento — has won international acclaim as an investor — for better or worse. Part of what puts CalPERS on everyone’s map is its sheer size at about $260 billion of managed assets. Another part of the picture is that it has always been willing to pay up for careful management of those megabillions — and its transparency about all the moves it makes is truly exemplary. But while the investing public focused on the pitiable state of the 401(k) system, the old ‘safe’ system seems to be wobbling its way out of existence. See: Why the industry needs to accept some blame for ‘flaws’ in PBS Frontline’s ‘Retirement Gamble’. This article and a follow-up article by Lisa Shidler are intended to give our readers a view on an investing situation outside the RIA microcosm but very much within its macrocosm. The zeros on the end of the numbers involved are different but the principles, expense and discipline issues could hardly sound more familiar.
The people who run the California Public Employees’ Retirement System are staring into an abyss as they contemplate past losses realized during the market crashes around 2000-02— cumulative losses of 16% — and 2008, a loss of 28% — and the unfunded pension liabilities that could swallow them whole if decisive, enlightened and seminal action isn’t taken soon.
California taxpayers fund CalPERS’s pensions and ultimately guarantee them — now with $260 billion-plus in assets. But it also has growing unfunded liabilities — pegged at about $80 billion or so by CalPERS (much higher by some critics).
Bringing that number down — and assuring 1.6 million Californians the retirement they were guaranteed without jacking up taxes — depends on whether CalPERS hits its presumed 7.5% investment rate of return over the next couple of decades.
Still too high
This presumption seems too optimistic, and when a more pessimistic presumed rate is applied to projections, a much more daunting picture emerges, according to Joe Nation, professor of the practice of public policy for the Stanford Institute for Economic Policy Research, and a former Democratic state assemblyman.
“The short answer is that a 7.25% assumption is still too high,” he says. “I think a range of 5% to 6% is more appropriate given historical returns. [But] if they assume a lower rate of return, their unfunded liability increases.” By how much? Nation believes that could be north of $170 billion — or more.
If some reason it comes it under that, say 4.5%, that places CalPERS in a scary $290 billion range. “CalPERS typically claims a much lower unfunded liability than actually exists —- precisely because they assume a higher-than-justified investment rate of return,” he says.
Right now CalPERS’ assets are only greater or equal to its 60% of its liabilities, says Nation. By way of comparison, private-sector pension plans are labeled “at risk” if their funded status is below 80%.
The “funded status” is a very unstable number because it’s based on the market value of its assets, and that number changes yearly depending mainly on how its investments perform in the market. After the 28% loss in 2008, the funded percentage dropped to 60%, but it was back to 75% at the end of fiscal year 2010-’11 and should be higher following the 12.5% gain in FY 2012-2013.
Here’s the good news: CalPERS posted a nice 12.5% rise on its investments for the fiscal year ended June 30 — this after a lowly 1% rise the year before. It earned 19% on its publicly traded equity holdings; with the S&P 500 index performing at an 18% rate of return during the same time frame. CalPERS, after all, uses index funds for the bulk (67%) of that investing. See: Regulatory Wire: The public is depressed about financial reform and an exemption for auto dealers is just a warm-up.
“When things got rough, we didn’t panic,” Joseph Dear, chief investment officer of CalPERS, said in a meeting of the system’s governing board in July. “We stuck with our exposure to growth assets and applied the lessons we learned from the past. The numbers show us that our approach is working.”
CalPERS keeps readjusting its goals for some of its investment mix. In June, a decision was made to adjust downward the rate of return assumption of its fixed-income and inflation-linked portfolio. To many, it set in motion a possible bigger decision that could lower its overall rate of return to 7.25% from 7.5% next year. Still, others believe it could result in a just readjustment of its investment mix with no change to its overall portfolio expected rate of return.
A CalPERS spokesman told RIABiz.com the June action might not necessarily lead to big changes: “It was an exercise tied to our asset liability management study that will inform our strategic asset allocation decisions later this year. The board adopted a set of capital market assumptions for each asset class. Individual asset classes are measured against benchmarks; only the total portfolio is measured against our expected rate of return, currently 7.5%.”
CalPERS’ liabilities will be a continued and growing problem, Nation says — something which should scare California municipalities and taxpayers. He doesn’t believe CalPERs can sustain the 7.5% rate, which means that “the unfunded liability jumps to at least a couple hundred billion, likely more.”
The largest 100 public pension funds had around $1.2 trillion of unfunded liabilities, according to a study in 2012 by the actuarial firm Milliman. The same study finds an aggregate level of funding of 67.8%.
Remember 1997…CalPERS was not always underfunded.
Though for many registered investment advisors a 7.5% return rate would be an appropriate return rate for the average investor these days, it is a different story for public pension funds.
Where CALpers $ is going
“The caveat is that the lower your [rate of] return assumption, the more you’ll need to save,” says Michael Kitces, partner/director of research of Pinnacle Advisory Group Inc. “In the context of pensions, changing the return assumption can be harsher, as the moment the return assumption is changed, the plan will immediately show a potentially huge shortfall and compel a huge contribution at once to fund it to the new assumption.”
Investments break down this way for CalPERS for the bulk of its $263.9 billion in assets as of April 30, 2013: 65% ($170.5 billion) in growth investment; 52% ($138.5 million) in public equity; 12% ($32 million) in private equity; 16% ($42.8 billion) in income investments; 9% ($24.5 million) in real assets; 8% ($21.1 billion) in real estate; 4% ($10.5 billion) in liquidity investments; and 4% ($9.8 billion) in inflation-targeted assets.
Like many an individual investor or 401(k) participant, the root of the uphill investing scenario can be traced back to what appears to be a loss of investing disclipline — especially at times when markets were in frothy stages and headed for a fall, like 2000 and 2008. The pressure to jump away from an indexing approach and toward more active and speculative investments can be quite unbearable.
One thing for sure, CalPERS is a long way from the days of just putting all its investments in index funds or bond funds — which seems out of favor among almost all public pension funds. See: Executive leaves Bloomberg with ambitious plan to unify the retail bond market.
“At the end of the day, I’m a big fan of indexing,” says Brad Barber, professor of finance at the University of California, Davis Graduate School Management. “Among academics the jury is still out as to whether it makes sense to make allocations to hedge funds [for example]. I think there is some evidence private equity does add some value. But it’s not clear that it offers market returns as a fair compensation for risk, he says.
!http://www.riabiz.com/i/23789510/b(Brad Barber: I’m a big fan of indexing. How you do you structure financial markets and how do they structure [around] government regulation in a way to to encourage the optimal allocation of capital?
In looking at its 10-year average rate of return, CalPERS was at 7.6% — in 2003 it was up 23.30%; 2004, 13.40%; 2005 11.10%; 2006, 15.70%; and 2007,10.20%. Then in 2008, where the economic downturn started, it lost 27.80%. In 2009, it was back up 12.10%; 2010, 12.60%; 2011, 1.10%; and 2012, 13.10%. But, adding in early years 2000 through 2003, when including rougher, negative return investment years, its average is around 2 percentage points lower, in the mid-5% range.
“If you are cutting edge, you sometimes make mistakes. I’m sure you can find holes,” says Jeffrey Hopson, managing director, senior equity analyst of asset management and investment services at Stifel Nicolaus & Co.
Concerning the seemingly high 7% plus rate of return, Hopson says this needs to be taken into perspective. “There are political implications [for CalPERS]. For a corporate pension plan you would be more critical of that rate.” Hopson says a number of public pension plans might be in the same high-level predicament.
But not everyone is in agreement here. Pinnacle’s Kitces says: “Rates of return have been as controversial in the advisory world as in the pension world, with little agreement on what a reasonable number is to use. I’ve seen advisors using numbers anywhere from about 8% (which is about the ultra-long-term historical average), down to 7% or 7.5%, and some in the 6.X% range.”
The assumed rate of return also depends on the risk taken in the portfolio and the investment strategy taken, according to Robert Boslego, managing director of Boslego Risk Services, a consulting firm in Santa Barbara, Calif.
Typically equity does better than debt (bonds) and private equity beats public equity. CalPERS keeps 52% of its portfolio in foreign and domestic public equities. Compare that to perhaps the most successful publicly known investing effort — the Yale Univeristy endowment under David Swensen. It stays 85% invested in private equity, making — all things being equal — its presumed long-term rate of return much higher than CalPERS’, Boslego adds.
Many CalPERS observers continue to worry that future liabilities could levy undue damage. But it’s not just a change in investment targets that need adjusting. Some are calling for a total transformation to head off a potential catastrophic financial situation.
Some recommend that CalPERs follow the likes of Rhode Island and Utah which moved to a hybrid plan with a 401(k) component. Basically it transitions from a more costly defined-benefit plan to a much lower-cost defined-contribution arrangement.
But is a longshot for California do the same — considering major political and union forces.
Realistically for CalPERS, “Concessions from everyone are required, including current working members,” says Nation. “Many are paying more already, but they are still very short of what is needed.”
Big changes mean less return
In August 2012, CalPERs made some changes — such as raising the retirement age and offering up less in retirement compensation benefits. Nation says at best this might cut down on future unfunded liabilities by perhaps 10%. California cities are still on the hook, which, in turn, means more from taxpayers.
Another alternative could be a plan to let each California institution/public employee group that gains from CalPERs’ pension plans for their employees be directly responsible for their individual costs.
Harold Hellenbrand, provost/vice president for academic affairs at California State University, Northridge, says: “It makes sense philosophically and politically. As an inhabitant of CSU I don’t like the idea, but I can’t critique it. Linking the benefits to the costs, you have dealt with the consequences.” In return, Hellenbrand says, perhaps it might allow institutions to have more freedoms.
Right now almost two-thirds of pension funds’ current retirement payments to members comes from investment earnings. For every dollar of paid to CalPERS’ pensions, 66 cents come from investment earnings, 21 cents from CalPERS employers, and 13 cents from CalPERS members.
Looking ahead, CalPERS continues to explore other investment/funding options, especially when it comes to so-called “sustainability” investment — those that include environmental, social, and governance investment-minded companies. This was the subject of a recent event held by the UC Davis Graduate School of Management.
Not everyone agrees that this kind of investment strategy works. Olivia Mitchell, professor of business economics/public policy and executive director of the Pension Research Council, says: “’Sustainability’ is in the eye of the beholder. Thus what one plan sponsor [or individual investor] ranks highly may not be what another would select as a criterion. Hence, difficult to say overall what impact this approach might take.”
Barber, the UC Davis professor, says the CalPERS conference was not intended to remedy any of CalPERS’ longtime problems — but to offer up more discussion and pose broader investment questions.
“Given the landscape they operate in, [questions arise as to] how can they manage the assets they own and what should they do?” he says. “The other part is — how you do you structure financial markets and how do they structure [around] government regulation in a way to to encourage the optimal allocation of capital? They are struggling with both of those issues.”