The market decline this year has been bad news for many, including CalPERS, CalSTRS, and the governments and taxpayers responsible for funding these pension systems. Aside from the obvious investment return damage inflicted by sharp declines in the Dow Jones, the seemingly-impending recession is also likely to impact the “alternative investment” portfolios public pension systems maintain.
The market-inflicted punishment should be a teachable moment about taking risks with public pension investments. Most public pension systems report on a fiscal year that ends on June 30. When the systems report their numbers this summer, their investment returns will not only reflect the recent downturn but also the bull market conditions that prevailed through most of their fiscal year.
In late March, the California Public Employees’ Retirement System’s (CalPERS) reported asset value was $334.98 billion, which is $35.32 billion, or 10.5 percent, below the level reported as of June 30, 2019.
CalPERS assumed its investments would grow by 7 percent this fiscal year. If there’s not a massive market rebound between now and June, employer contributions would increase on July 1, 2022, to make up for the shortfall. The CalPERS employers that would have to pay for that increase include the state government and several hundred local governments.
But the reported decline in assets may understate the financial damage suffered by CalPERS this year because it does not include impacts on private equity, real estate, infrastructure and forestland investments that are claiming an increasing share of pension portfolios. CalPERS tries to invest about one-fifth of its overall portfolio in these asset classes but is by no means the most aggressive pension investor in “alternative” investment categories. The Texas Teacher Retirement System, for example, invests more than a third of its portfolio in alternatives.
Alternative investments are normally placed in funds that report their asset values quarterly. Most of these funds are not required to publicly report their investment portfolios and most of their investments are hard to value because they are not publicly traded.
To their credit, CalPERS and the California State Teachers’ Retirement System (CalSTRS) are more open about their alternative investments than pension systems elsewhere. The statewide pension systems in Texas, for example, do not publish lists of the alternative investment funds they hold. So, while we’re using examples from CalPERS here to illustrate the risks of alternative investing, this issue is not unique to CalPERS or California.
CalPERS recently reported a $500 million position in the private equity fund Carlyle Partners VI and CalSTRS invested $250 million in the same fund, which says it “conducts leveraged buyout transactions in North America in targeted industries.” Among those targeted industries —oil and gas exploration. But the recent collapse in energy prices is hurting Carlyle-owned companies such as Centennial Resource Development and Chesapeake Energy, which have both lost well over half their value in 2020.
Another private equity group CalPERS invests in, CVC Capital Partners, has a major holding in an Italian casino operator, Sisal Group SpA. Although this company has diversified into online gaming, Italy’s COVID-19 lockdown promises to have catastrophic effects on the firm.
Originally, pension funds turned to alternative investments because they were believed to offer higher and more stable investment returns than publicly-traded stocks. That proposition will now be tested by economic conditions during and after the coronavirus pandemic.
But we already know one thing: the management fees and other overhead costs of alternative investments are steep. CalSTRS recently reported investment costs of 3.84 percent—over $700 million in fees— on its private equity portfolio, compared to 0.18 percent in fees on its publicly-traded stock portfolio.
Pension funds pay high fees and take on risks hoping to meet their overly optimistic annual investment return targets. But it wasn’t always this way. Throughout most of the 1950s, CalPERS had a 2.5 percent investment return target, which it reliably achieved by investing exclusively in government and corporate bonds.
While we may not want to return to the 1950s and days of “Leave it to Beaver,” public employers and the taxpayers that support these pension funds would be better served by more conservative forecasting and investing.