CalPERS Takes Risks, Looks to Private Equity to Mitigate Underfunding

Last week a New York Times piece detailed the strategy of the California Public Employees’ Retirement System’s (CalPERS) new investment chief, focusing on the public pension system’s plan to increase its portfolio’s share of private equity in order to reach its 7 percent assumed rate of return.

“Private equity isn’t my favorite asset class,” Theresa Taylor, the chair of the CalPERS board’s investment committee, said at a recent meeting The New York Times reported. “It helps us achieve our 7 percent solution,” she said. “I know we have to be there. I wish we were 100 percent funded. Then, maybe we wouldn’t.”

CalPERS has certain institutional advantages over many other public pension systems, namely its size and ability to pay for high-quality investment professionals that make private equity investments more manageable. However, the inclusion of more private equity also comes with increased financial risk and must be carefully handled.

While CalPERS has long-held private equity investments, the system is increasing the percentage of money allocated to this asset class in order to cope with the “new normal” of low dividend yields, ultra-low interest rates, and subdued economic growth. Traditional risk-free pension holdings, like bonds, no longer offer high enough returns to meet assumed rates of returns, so public pension plans across the nation are increasingly shifting to private equity and other risky assets to maintain the returns targets that have become more difficult to hit.

Unfortunately, these alternative investments come with a number of issues, including expensive investment managers, lack of transparency, and sensitivity to market shocks.

In an ideal world, CalPERS would not have to be this involved in higher-risk assets. But, a variety of challenges, including poor decisions made by the state legislature decades ago are now leaving California’s pension systems with few options as they seek to make up billions in underfunding.

California’s current pension challenges are a culmination of decades of mismanagement, including legislation that didn’t account for potential stock market shocks or recessions. In 1999, enjoying strong market returns and a pension funding surplus, California lawmakers passed Senate BIll (SB) 400, which increased pension payments to public workers without properly prefunding the additional benefits.

As a result, California Highway Patrol officers, for example, had their pensions calculated by multiplying 3 percent of their salary by the number of years they worked, which was an increase from 2 percent of their salary. However, after the dot-com bubble of the 1990s burst in the year 2000, investment returns fell, leading to a huge growth in unfunded pension liabilities.

Today, whenever investment returns fail to meet the pension plan’s overly optimistic expectations, California’s local governments and school districts find themselves being forced to increase their contributions to public pension plans, often at the expense of other items in their budgets.

A Reason Foundation analysis of the new CalPERS strategy highlighted the importance of planning for worst-case scenarios, like the current recession. While CalPERS’ move to take on more private equity investment may work out for the better in the long-run, the probability of the system hitting its 7 percent return only moved from 39 to 45 percent, which is a minor improvement and a stark reminder of the real risk of market underperformance that public pension plans face.

CalPERS is doing what it can to try to secure higher returns for its stakeholders. But legislators need to do their part through structuring pension reform policies that improve pension resiliency By focusing on having a sustainable public pension system that is prepared to weather inevitable market shocks and by keeping future pension benefit levels in check, the state legislature and CalPERS could avoid having to seek even more unrealistic investment returns in an effort to dig themselves out of debt.