Friday, March 16, 2012

The Real Expense of Safety

This Just Doesn't Add Up!
N.B. The college tours continue:  my wife and I are taking our daughter Caroline to University of Virginia this weekend.  Caroline has already been accepted, but wants to take a final look before making any final decisions.

Accordingly, the next post of Random Glening will be Tuesday, March 20.

Yesterday I questioned the asset allocation decisions of the California Public Employees Retirement System (CalPERS).

Specifically, I noted that CalPERS allocates just 48% of their $220 billion investment portfolio to equities. Part of the remainder is stashed in low-yielding bonds, while the rest resides in "hold and pray" investments in private equity or real assets.

If the latter do not achieve the stated investment goals - which recent history would suggest is certainly a possibility - reaching CalPERS's assumed actuarial rate of 7.50% might be a challenge.

As luck would have it, columnist Steve Syre addressed the same subject in this morning's Boston Globe, except that Mr. Syre was focused on the $50 billion Massachusetts Pension Reserves Investment Trust (PRIT).

According to Mr. Syre, Massachusetts State Treasurer Steve Grossman believes the 8.25% assumed actuarial rate for PRIT is too high.  Instead, Mr. Grossman has proposed lowering the rate to 8%, which will increase the state's pension liability by $1.25 billion.

Fair enough.  But here's the problem:  PRIT has not earned anywhere close to 8% for the last decade, despite the fact that PRIT's relative performance compared to other state retirement plans is around average.

According to PRIT's annual report (found at, here are the fund's total investment results for the year ending June 30, 2011:

1 year:  +22.4%
3 years: +1.7%
5 years: +4.4%
10 years: +6.5%

Ah, you say, but this is in the past.  Going forward, is it not possible that we will see considerably better returns in the next decade?

Yes, I would agree, but only if the investments are focused on areas that offer at least the mathematical possibility of achieving a blended rate of 8%.

So I turned to how PRIT is invested, and here's what I found (all figures as of June 30, 2011):

Domestic equity:   22%
International equity (including emerging markets):  29%
Fixed Income: 19%
Private equity/real estate/natural resources:  22%
Hedge funds:  8%

However, in September 2011, PRIT decided to cut its equity allocation in favor of alternative investments:

As part of a new asset allocation mix approved in August, Mass. PRIM has allocated $1bn each to hedge funds and local currency emerging markets debt, a  new area for the top 10 US retirement system, and cut around $3bn from its equities allocation to fund the new mandates.

PRIM’s global equity allocation will drop to 43% from 49%, specifically cutting international to 17% from 21%, and domestic large-cap equities from 17% to  15%. The retirement system allocated 2% of its portfolio to local currency emerging  markets debt.

In other words, just like California, Massachusetts decided to cut its equity allocation last September, and so has so missed the entire +25% move in the S&P 500 since the end of September 2011.

This isn't just semantics, in my opinion.  This is real money.  By allocating assets away from the one class that could possibly deliver the returns necessary to achieve returns at least equal to 8%, PRIT has increased the state's pension liability, which will eventually have to met by the state's taxpayers.

Why didn't PRIT take the money from fixed income?  Why did they continue to allocate to hedge funds at a time when there is increasing evidence to suggest that hedge funds have largely failed to deliver the goods?  Why continue to hold more than 12% in illiquid real assets as an inflation hedge when deflation continues to loom as the greater threat?

Just asking.