California’s Pension Systems Need To Continue Lowering Return Expectations and Reducing Risk
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Commentary

California’s Pension Systems Need To Continue Lowering Return Expectations and Reducing Risk

CalPERS achieved an investment return of 6.7 percent during the latest fiscal year, and similarly, CalSTRS saw a 6.8 percent net return, both short of the 7 percent benchmark established by their managing boards.

Preliminary reports indicate the California Public Employees’ Retirement System (CalPERS) and California State Teachers’ Retirement System (CalSTRS)—the state’s two primary pension systems for public workers—underperformed their long-term investment return target in the recently completed fiscal year. While a single year of results itself is not cause for alarm, it does add to the growing signs that California’s public pensions are facing economic headwinds and should consider reducing risk for the sake of both taxpayers and the public workers who depend on the funds for their retirement.

CalPERS achieved an investment return of 6.7 percent during the latest fiscal year, and similarly, CalSTRS saw a 6.8 percent net return, both short of the 7 percent benchmark established by their managing boards. Each single year of investment returns below the assumed rate of return means that the assets did not grow as much as expected, increasing the pension plan’s unfunded liability over the previous year, all other things being equal.

Pension investment returns aren’t expected to hit the mark every year. It can be difficult to discern a fund’s true long-term performance, however, since the results will depend on the range of years examined. For example, CalPERS posted long-term returns above the expected 7 percent if ranges of either 10- or 30-year periods are used (9.1 percent and 8.1 percent respectively), but was below the 7 percent target (5.8 percent for both) if using 5- or 20-year averages.

While this variability can frustrate pension experts and muddy their discussions on risk-taking, such wide swings are a clear illustration of what is plaguing most public pension plans around the country: a “new normal” market environment of ultralow interest rates and the resulting pressure institutional investors like pension funds face trying to achieve their investment targets.

In decades past, pension funds could count primarily on more stable investments like bonds with a steady, long-term rate of return of around 8 percent. Now the market has undergone clear changes, with much lower long-term returns on bonds. To keep up with previous expectations, pension funds are increasingly devoting assets to alternative investments like private equity and hedge funds, which can help boost their overall returns, but often bring increased risk and volatility as well.

Having been fully funded at the turn of the century, CalPERS and CalSTRS have yet to recover from the one-two punch that was the dot-com bust of the early 2000s and the 2008 financial crisis. Despite the fact that markets have fully recovered since that time, CalPERS is short on the money needed to fulfill pension promises made to its members by nearly $139 billion, and CalSTRS is short by over $107 billion.

Both systems already took important steps to lower risk in recent years when the boards of both systems decided to reduce their assumed rates of return  to 7 percent, moves former Gov. Jerry Brown supported as a way to make a “more sustainable system.”

These decisions involved fiscal tradeoffs, since lowering investment return targets inevitably translates into higher required governmental appropriations to pensions. Expected returns not achieved in the market need to be made up somehow, and state agencies and local governments throughout California are still reeling budgetarily from the lower investment return assumption the two pension plans already adopted in recent years.

But given a dampened near term investment forecast, additional reductions would be prudent. CalPERS’ chief investment officer told the plan’s board of trustees this summer that “our expected returns are 6.1 percent, not 7 percent” over the next decade. Given such an extended outlook of underperformance, the sooner state and local government bodies can start planning for even higher budgetary contributions and difficult tradeoffs, the better.

Leonard Gilroy is vice president of government reform at Reason Foundation, a nonprofit think tank advancing free minds and free markets. He also serves as senior managing director of the Pension Integrity Project at Reason Foundation, which assists policymakers and other stakeholders in designing, analyzing and implementing public sector pension reforms.

Zachary Christensen is a policy analyst for Reason Foundation's Pension Integrity Project.