NRPLUS MEMBER ARTICLE T he California Public Employees’ Retirement System (CalPERS) is in trouble. For the second consecutive year, the public-pension fund has failed to hit its 7 percent return target. As it faces a funding shortfall of more than $150 billion, CalPERS’s recent bout of underperformance raises concerns about California’s solvency at a time when state and local budgets are already stretched.
CalPERS chief investment officer Ben Meng has a solution: more risk. He announced Monday that the fund would increase its allocations to alternative investments, such as private equity and private credit, while leveraging its portfolio to enhance returns. Facing the headwinds of soaring valuations, historically low interest rates, and anemic economic growth, CalPERS can no longer meet its target with safe assets.
“There is no alternative,” said Meng, but that isn’t quite true: The pension fund’s assumed rate of return (or discount rate) could be reduced. The CalPERS board did just that in 2016, moving its 7.5 percent discount rate to 7 percent, and 42 public pension funds followed suit the next year. California’s modest 2016 revision increased the required contributions of public employers and certain employees, a small first step toward filling the fund’s gaping holes. With internal estimates pegging the expected return of the current CalPERS portfolio at 6 percent, hitting the current target would take a whole lot of leverage.
A 6 percent discount rate brings CalPERS’s unfunded liabilities up to roughly $250 billion. The greater the assumed portfolio return, the lower the contributions from public employers and workers. For fund managers, a lower target effectively admits defeat, and the CalPERS board comprises mostly union representatives who are not especially eager to mark down their net worth. With no one willing to pull back the curtain, the illusion of strong investment performance has long given cover to public officials who would rather ignore mounting pension shortfalls.
In the years following the 2008 recession, growing budget deficits pushed Governor Jerry Brown to propose an overhaul of the California pension system. He suggested trimming defined-contribution plans and combining them with 401(k)-style savings plans similar to those offered to private-sector employees. In the heavily progressive state legislature, his plan was dead on arrival. The modest reforms that ended up in the Public Employees’ Pension Reform Act (PERPA) of 2013, including a cap on payouts and an increase in contributions for new employees, barely made a dent in the state’s pension bill.
Inconsequential as PERPA was, it set off a years-long legal battle with a firefighters’ union that only ended last year, when the California Supreme Court ruled in Brown’s favor. Even after the 2013 reform, California’s pension plans pay out about twice as much as federal plans.
So the Golden State again finds itself on the precipice of a budget crisis. Despite highest-in-the-nation tax rates, California will be $54 billion in the hole in the coming fiscal year. Might as well roll the dice on some leveraged loans.
Leaving aside the increased risks, it’s far from certain that the new investment approach will improve performance. While Meng touted private equity (PE) as a “better asset” than stocks and bonds, PE funds have performed about as well as the stock market in the last ten years, according to Bain & Company. Leverage could magnify returns on winning investments, but it will exacerbate the pain of market downturns. And the coronavirus crisis has shown us how damaging one bad year can be.
To be fair, it’s not just CalPERS. Meng’s announcement reflects a gradual increase in risk-taking by public-pension funds over the last few decades. In 1992, the average public-retirement fund invested roughly half of its assets in stocks and alternatives, with the remainder going to comparatively safe bonds. Today, the average fund allocates 80 percent to stocks and alternatives.
The increased appetite for risk is partially the result of a secular decrease in interest rates. For decades, the assumed return of pension funds roughly equaled the yield on 30-year Treasury bonds, meaning pensions could meet their obligations with vanilla fixed-income investments. Today, 30-year treasuries return just over 1.4 percent, but pension funds have only modestly decreased their targeted return to an average of 7.3 percent.
A 2019 study by Federal Reserve economists found that those pension funds with the largest unfunded liabilities tend to take the most risk, and periods of low interest rates further increase risk-taking. With a national public-pension hole as large as $4 trillion and interest rates projected to stay at zero percent for the foreseeable future, other fund managers will likely follow Meng’s lead.
At this rate, the New Jersey Division of Investment will be day-trading cryptocurrencies by the end of the year.