Thursday, March 15, 2012

The True Cost of Avoiding Risk

We need higher returns!
The California Public Employees Retirement System (CalPERS) is one the largest investment portfolios in the world.

Totaling more than $220 billion, the investment strategies of CalPERS are widely followed among institutional investors.

So when CalPERS announced yesterday that it might be reducing its anticipated rate of return on its investment portfolio from 7.75% to 7.50%, it received considerable attention.

Moving from 7.75% to 7.50% may not seem like a big deal, except when you stop to consider that you're talking about billions of dollars.

Moreover, reducing the assumed rate of return on the CalPERS pension plan probably means that the contributions from the participants will need to be increased - just at a time when most municipal entities in California are already in precarious shape.

Here's how the Wall Street Journal described it yesterday:

A panel at Calpers voted Tuesday to lower a crucial investment target at the nation's largest pension fund, a step that could lead to higher retirement-plan costs or more job cuts in cities and counties across California. 

Calpers's pension and health-benefits committee recommended an assumed annual rate of return of 7.5%, down from the current 7.75%. If the pension system's board approves the change in a meeting Wednesday, it would mark the first time Calpers has lowered its overall investment assumption in nine years.

It would seem to me that this change is long overdue.

According CNBC, the average annual return for the CalPERS portfolio has averaged around 4.5% for the 10 years ending 12/31/10.

I have not been able to track down 2011 results, but even if they were good (and CalPERS CIO Joe Dear was quoted as saying they were "fabulous") it still means that the overall return for the fund for the past decade was well below its assumed rate.

With this in mind, then, it would seem logical that CalPERS should be allocating more assets to investment choices that offer at least the potential of boosting returns (i.e. stocks) while reducing their holdings of investments offering virtually no chance of getting anywhere close to 7.50% returns (i.e. bonds).

But that's not they're doing.

Here's a report from CNBC last September, right before the market started to rally:

The California Public Employees Retirement System is as worried as any investor about the uncertainty in the U.S. and Europe.

That's why Calpers, as it is known, is a "longterm trader" that is playing down equities, Chief Investment Officer Joe Dear told CNBC Wednesday. He indicated the Calpers portfolio is "underweight" equities by about 4 percent from its typical allocation

When you go to the CalPERS website, you see that just 48% of their portfolio is invested in public equities.

Meanwhile, 22% of the fund is invested in either "income" or "liquidity", both of which are essentially yielding less than 2%.

You would think that CalPERS would have investments with a very long term time horizon.  Most of the beneficiaries of the plan will be drawing their benefits for many years, but the yearly outflows are only a small fraction of the overall fund size.

But instead the group is investing with their eyes fixed firmly in the rear view mirror.  They have investments that will guard against inflation - with virtually no signs of inflation on the horizon.  They have huge investments in real estate and private equity, whose eventual returns are totally unknown.  They have hedge funds which, as a group, are probably barely earning their fees.

But common stocks - boring, large cap stocks trading at the most attractive level of valuation to bonds in more than 40 years - are getting a cold shoulder from the group, since they have been disappointing performers in the past decade.

This decision is not only likely to hurt returns, but also will cost the taxpayers of California. At a time when public services are being cut in many towns around the state, California municipalities are being forced to pony up more funds to keep the public pension plans funded.

Lessons to be learned for all investors.