Wednesday, July 18, 2012

About that CalPERS shortfall....

The California Public Employee's Retirement System (CalPERS) reported its investment results for its fiscal year ending June 30, 2012.  Unfortunately, recent results have been disappointing:

With three California cities electing to file for bankruptcy in the past month, in large part due to underfunded pension obligations, the last thing California needs right now is more bad pension news. Which is unfortunate, because the California Public Employees’ Retirement System, the nation’s biggest public pension fund, delivered a jolt of bad news this week when it reported a paltry 1% return on its investments in the fiscal year ended  June 30....

CalPERS’ 1 percent return is well below the fund’s discount rate of 7.5%, a long-term target that CalPERS lowered recently as it re-evaluated its economic assumptions in the current investing environment. Other pension plans have made similar adjustments recently. The rate is significant in that it determines the amount of money such funds need to invest now in order to meet future pension obligation needs.

Now, to be sure, recent markets have been frustrating.  Bond yields are at multi-generational lows.  Stock market returns have been generally positive, but most active managers have underperformed the S&P 500 as gains have been largely limited to just a few sectors.

But still.

I have written several posts over the past few months about decisions made by public pension plans that even at the time time seemed very short-sighted.

For example, CalPERS - a mammoth pension plan whose time horizon should be measured in decades rather than months - decided to reduce their allocation to stock last September:

 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.

"There’s so much uncertainty," said the CIO of the fund covering 1.6 million public employees. "You have massive uncertainty about the ability of political leaders to deliver the tough decisions that have to be made. All the growth forecasts for the developed markets are declining. That is not good for [the] equity outlook." 

With uncertainty and a cut in its stock portfolio, the fund has had to come up with alternatives in order to maintain a target of a 7.75 percent return, he said. 

Since then, the S&P 500 has risen +17%.

So what did they do with the funds?  Mostly CalPERS increased their allocation to alternative investments.

But the track record of alternatives is been mixed at best, as I wrote last December:

For example, this morning's New York Times discusses the increased allocation of public pension plans to private equity investments.

Private equity has an aura about it. The idea that a small group of incredibly savvy investors will be able to invest in the next Apple, Facebook or Google and deliver outsized returns is very attractive after the disappointing returns in the public market over the last decade.

Whether this is truly the case is debatable, but that hasn't stopped billions from flowing into private equity. Here's an excerpt from the article:

At the same time, pension plans everywhere are also desperate for yield. Pension plans are reportedly underfinanced by anywhere from $700 billion to as much as $4 trillion, depending on the calculations. Poor returns over the last few years have not helped. Over the last five years, the average state and local pension fund has returned 4.7 percent, according to Callan Associates.

Pension plans hope to make up these lost years and reach performance targets that in some cases are still set at a hopeful 7 to 8 percent a year. Private equity has traditionally been a high-performing asset class, and shifting more assets into this and other alternative investments like hedge funds is seen as a possible solution. Wilshire & Associates recently found that the average pension fund had increased its allocation to private equity to 8.8 percent in 2010 from 3 percent in 2000.

Finally, I would make four additional points about not only CalPERS but the investment strategy for any public pension plan, as I wrote in an email to a colleague this morning: 

 First, the shift in asset allocation in September was not based on the relative investment attraction of other asset classes. Rather, it was focused on the CALPERS view that stocks were poised to go lower based on events in the U.S. and Europe i.e. market timing; 

Second,  if anyone should take a long term view, it should be a massive pension fund.  Worrying about events in the next couple of months, when your liability stream is 20 or 30 years, at least, seems wrong;

3   Third, their decision has a real impact on the taxpayer.  Pension shortfalls are, of course, killing municipalities, and poor investment decisions mean that eventually the taxpayer will have to either pay more or other services reduced;

4   And, fourth, the expected rate of return for most other asset classes will not come close to the 7.75% actuarial rate, especially when looking at bonds.  It seems to me that if anything should be cut it should be fixed income not because rates couldn’t go lower, but rather that the math makes it basically impossible to meet the investment hurdle.