The nation’s largest public pension system, the California Public Employees Retirement System (CalPERS), recently announced that the fund will have to take a new approach if it wants to hit its assumed investment return target of 7 percent. In an attempt to do so, CalPERS will embrace a new two-pronged investment approach that combines a push towards higher earnings and riskier assets with the ability to leverage the fund to retain liquidity when market opportunities present itself and borrowing costs are low.
Like all pension funds, CalPERS is tasked with meeting its investment target to ensure adequate dollars are available to pay for retirees’ benefits now and in the future. That task becomes harder during moments like our current recession when interest and inflation rates are at historic lows. Additionally, the gap between CalPERS’ investment return assumption and the yield on an ultra-safe 10-year U.S. Treasury note has been widening dramatically over the past 30 years. This departure can be seen on the interactive chart below.
CalPERS’ new approach—dubbed “More and Better Assets”—is the latest in a string of decisions made by the CalPERS board over the past few years intended to strengthen the resiliency of the plan, which currently sits at just 71 percent funded. “More assets” refers to the board decision to allow CalPERS’ investment office to strategically use leverage (borrowing) to infuse the fund with cash to make investments at times when administrators seek to avoid liquidating other investments already in the CalPERS portfolio. “Better assets” refers to CalPERS’ intention to increase the share of its portfolio allocated to private equity and debt assets that the plan hopes will generate a higher risk-adjusted long-term return.
When CalPERS studied their capital market assumptions in 2019, they found that their expected average return on the portfolio over the next 10 years was 6.2 percent, with only a 39 percent probability of hitting their 7 percent assumed rate over that period. Increasing that probability of hitting the plan’s assumed return should be goal number one for the investment office.
There are a number of differing views on CalPERS’ recent move to “More and Better Assests”. Some pundits have taken the position that CalPERS is making a sensible and tactical decision consistent with the prudent moves made by other peer pension systems to keep funding on course. Other commentators have suggested that the system is borrowing money to purchase billions in high-risk alternative investments in one fell swoop as a last-ditch desperate attempt to avoid a financial spiral. As this article will detail, the truth is somewhere in between and can perhaps best be understood when evaluated from the perspective of how much the new policy will improve the financial resiliency of CalPERS over the long term.
“Better Assets”—CalPERS’ Private Equity Strategy
Given the current low growth environment, CalPERS is betting that private equity (PE) and private debt are among the few asset classes with a long-term expected return above their assumed 7 percent. Capital market assumptions provided by reputable financial firms show that private equity, when evaluated on its own terms as a standalone asset class, generally tends to have a higher risk in terms of expected annual return volatility, as compared to public equities and other common investments.
This seems to imply that CalPERS is embracing an inherently riskier investment strategy, but there are other mitigating factors:
- What ultimately matters most to a pension system is the overall risk profile of the portfolio, not any particular asset class within that portfolio. Mathematically, it’s certainly possible to increase the share of assets with higher risk (as measured by standard deviations) within a portfolio while actually lowering the risk of the overall portfolio because of the degree to which specific assets in question correlate with each other. The degree to which specific assets are correlated or not affects how much room the investment team has to ultimately try to optimize the portfolio and maximize returns.
- CalPERS’ current exposure to PE sits at 7.5 percent of its portfolio. Part of their “better assets” strategy is to boost that number to 10 percent over the coming decades. This would put their allocation to PE in line with the largest 20 pension funds in the country, and only slightly above the current national average of 9 percent.
- The size of CalPERS grants more access to better private equity fund managers, known in the industry as general partners (GPs). In the PE universe, there is a large gap between the median returns earned by top GP’s and the worst performing GP’s. In short, quality matters, and in practical terms CalPERS can technically manage a decent amount of long-term investment risk from the outset through its decisions on which GPs to partner with.
Given that institutional investors typically maintain diversified portfolios that incorporate some degree of alternative investments and that CalPERS trustees need to fulfill their fiduciary responsibility to maximize returns to benefit the members, taking on some additional, uncorrelated balance sheet risk may ultimately prove to be a smart strategy to boost their chances of hitting their 7 percent investment return target. Note, however, that this strategy is far from guaranteed.
In addition, CalPERS’ further expansion into private assets is separate and distinct from their proposed strategic use of leverage. This strategy does not exist in a vacuum, and in fact, the fund may use leverage to further diversify the portfolio by purchasing public assets while increasing exposure to higher returning assets.
“More Assets”—CalPERS’ Leverage Strategy
In addition to strategically increasing its exposure to PE and private debt, the CalPERS governing board also authorized administrators to pursue leverage—essentially borrowing money from private banks at preferred rates—of up to 20 percent of their portfolio value (or $80 billion dollars) as part of their long-term strategy to boost returns. There appear to be no immediate plans to use any of this borrowing capacity—let alone, up to 20 percent of the portfolio, as some journalists have concluded—nor does management expect that borrowing would reach such levels. After all, the CalPERS board authorized significant borrowing capacity, not actual borrowing from specific entities.
There also appear to be no plans to deploy any future borrowed funds literally for the purpose of increased PE investment. Rather, borrowed funds can be used to make tactical investments that make sense at that particular time and opportunity, not limited purely to PE or other alternatives. Also, CalPERS needs to have cash on hand to meet “capital calls” from PE funds to which it has made commitments. These calls can be unpredictable, and, without available cash acquired through leverage, would oblige CalPERS to sell public equities at an inopportune time.
Like investment in PE, the prudent use of leverage is not necessarily bad. For example, it could make sense to borrow funds to invest in a down-market instead of cashing out current assets to do so, especially amid a low interest rate environment that makes it relatively inexpensive to borrow money. CalPERS seems to prefer to implement this strategy directly rather than through expensive, external managers as evidenced by their withdrawal from most outside money managers.
In perspective, despite the concurrent announcement of both initiatives, “Better Assets” and “More Assets” are really two distinct strategies. CalPERS does not appear to be “borrowing to double down on risk,” as some pundits have asserted. Rather, they are making an investment decision to take on more private equity investment, which—given their current low exposure to the class and their relative size as the behemoth in the national pension world—can certainly make sense. And at the same time they may choose to borrow funds—rather than sell assets or tap cash reserves—to make targeted, opportunistic investments in the future in order to maximize the chance of achieving their lower-but-still-ambitious 7 percent average investment return assumption.
But, even though CalPERS may not technically be borrowing to purchase high-risk assets, it is still absolutely leaning into more risk. CalPERS CIO Ben Meng admits that the “More and Better Assets” strategy does increase the risk profile of the plan. According to Meng, implementing the strategy over time will increase the probability of hitting the 7 percent long-term return target from a 39 percent to a 45 percent chance, which is underwhelming and still poor odds by any measure, especially for a constitutionally ironclad benefit that is 100 percent guaranteed. Stated differently, if the strategy works, CalPERS might simply have a chance at returning to full funding and shedding all pension debt service costs, but if it fails, the problem is going to worsen, not improve. Hence, the new strategy could potentially improve the financial resiliency of the plan but it is no guarantee, and thus additional actions are warranted.
With such certainty on the liability side, policymakers, employees, retirees, employers and taxpayers should all uniformly demand that public pension systems like CalPERS—especially ones like CalPERS and CalSTRS that place the risk of cost increases to service unfunded liability growth solely on employers and taxpayers—should ensure that pension administrators aim for a more appropriate and achievable investment target.
A sensible shift would be for CalPERS to target the near-term investment forecast—the plan expects only to achieve an average 6.2 percent over the next decade—instead of the longer-term forecast, which is where the 7 percent assumption is rooted. This is because past performance is no indicator of future results, especially in the wake of a historic global economic lockdown due to a pandemic. There’s no reason to believe that we will return to an era of permanent 7 percent average returns.
While CalPERS should use the tools at its disposal to fulfill its fiduciary duty of maximizing returns for the system, it would also be prudent for policymakers to hope for the best but start planning for the worst. After all, the implementation of Meng’s strategy is still expected to result in a 55 percent chance that CalPERS experiences returns somewhat below their long-term investment return assumption.
This is not a sustainable situation, and no one knows that better than CalPERS itself. CalPERS has been a national leader at de-risking in recent years, steadily lowering its assumed rate of return over time in response to the “new normal” lower return environment, and they should continue to stay on that path. Current and expected near term fiscal conditions are not going to be conducive to making major moves on this front immediately, but the continuation of recent moves to more conservative assumptions is still warranted, even if on a slower near-term pace commensurate with fiscal conditions. If the CalPERS board chooses not to continue improving assumptions on its own, the legislature could—and should—require it by law.
Further, while private equity and debt have an obvious appeal given their generally higher expected returns, folding these investments into the portfolio also carries additional risk due to their illiquid nature and poor transparency. This transparency issue is somewhat mitigated by California’s alternative investment law, AB2833—which requires investments in asset classes identified as “alternative” assets (private equity, hedge funds, real estate, private debt, energy holdings, natural resources) to disclose the name of the holding, the capital committed, and the annualized return. But the law does little to explain why these assets are underperforming nor whether they are expected to regain losses in the future.
Stakeholders need transparency to trust that these alternative assets are valued effectively, that actuarial assumptions are calculated properly based on these assets, and that they can hold asset managers accountable for substandard benchmark performance.
Lastly, planning for the worst requires a gauge and a plan of action. This means that the state should require CalPERS and CalSTRS to conduct and publish annual pension risk assessments (stress testing) to show a range of future potential outcomes. They should also require the systems to develop contingency plans around contributions, funding policy and potentially flawed aspects of plan design in the event of future downside market and market shock scenarios.
With CalPERS employers already struggling to meet their contribution requirements, and the liability relief from the reforms made with the Public Employees’ Pension Reform Act (PEPRA) still decades away, the CalPERS board has few levers left to get the plan’s funding back on track. The “More and Better Assets” strategy is the first lever to be pulled. If the strategy works and asset returns stabilize the plans growing costs and unfunded liabilities, CalPERS has a real path towards being fully funded long-term.
However, if the strategy fails, contribution rates will be forced to increase, putting even more pressure on the cities and special districts of California. At that point, it should be time to look at the benefit design of CalPERS and assess whether more drastic measures need to be taken to protect the employees, retirees and taxpayers of California.