Because we’ve been using CalPERS as a vehicle for exposing the severity of capture among investors in private equity, we may have been remiss in not spending enough time discussing the overarching problem virtually all pension funds face, that of underfunding. This challenge is made more difficult to remedy by central bank policies that punish savers and worst of all, long term investors like pension funds and life insurers. We did discuss a recent, important story by the Financial Times’ John Dizard, with the subheading: Quantitative easing is leading to the insolvency of insurers and pension plans.
As Dizard points out, the problem is acute in Europe, but that does not mean it is not a serious issue here. Pension plans made return assumptions that seemed reasonable when interest rates were higher, and more important, real interest rates were positive. That meant an investor like CalPERS could put a chunk of its money in bonds, which in many ways is the ideal vehicle for meeting pension fund obligations (longer maturities, at least in a stable interest rate environment, can allow for matching of cash flows to expected future payouts; equities serve to increase returns; other asset classes serve to lower risk). But Greenspan drove real interest rates negative for a sustained period in the dot-bomb era, and we’ve had an even longer, deeper spell after the crisis. This has wreaked havoc on even those pension funds that had typical return assumptions and had been doing a pretty good job of putting aside funding.
CalPERS to its credit is less underfunded than is much smaller sister CalSTRS, but its funding is below 80%, which means it is in trouble. An Orange County Register column in November did a good job of explaining the issue:
Since March 2012, the CalPERS Board of Administration has set the portfolio’s expected annual rate of return at 7.5 percent. The annual rate of return is very important as it is part of a formula that determines how much the state will contribute to CalPERS from the General Fund.
With a sluggish national and global economy for the past three years, CalPERS has been missing its expected annual-return target of 7.5 percent…For this most-recent fiscal year, 2015 [ending on June 30], CalPERS reported an annual return of only 2.4 percent, thereby missing its annual target by more than 5 percent.
This poor performance has forced the CalPERS board into considering whether to lower the expected annual return rate to either 7.35 percent or 7.25 percent. Missing the expected return rate by more than 5 percent means taxpayers will be expected to make up the $15 billion shortfall (5 percent of the $300 billion portfolio) from the General Fund.
This $15 billion shortfall comes on the heels of CalPERS announcing that it presently has a negative cash flow (more money being paid out than coming in) due to the number of retiring baby boomers tapping into the fund. CalPERS further announced that the number of retirees will soon exceed the present number of active state and local government employees.
These two factors will result in CalPERS having an annual negative cash flow for at least the next 15 years.
There are only four ways to fund CalPERS: 1) larger state government contributions; 2) larger local government contributions; 3) larger state and local government employee contributions; 4) an annual investment rate of return in excess of the expected annual rate of return.
The first two listed options would require an additional burden to California taxpayers, who are already the most taxed state residents in the nation. Method 3 – larger contributions from local government workers toward their own retirements – despite being the fairest, will face a significant fight from unions representing state and local employees. Method 4 assumes the general good health of the national and global economies, neither of which is showing any reason to be bullish.
Even if the CalPERS board lowers the expected annual rate of return, and state and local government employees pay a bigger share of their own pension costs, a significant funding shortfall remains due to decades of neglect. Long-term strategic leadership and solutions are required to get back on stable operating and financial footing.
This backdrop helps explain CalPERS’ desperate attachment to private equity. As a contact who has been in the business explained, “Private equity is selling hope.”
CalPERS is being pressured by Governor Jerry Brown, who could help solve CalPERS’ problem by handing it a chunk of cash, to lower its target returns to realistic levels soon. He has made what sound like a modest request, of lowering the target from 7.5% to 6.5% over five years. CalPERS has rejected that idea and approved a plan in November to move to the lower target over about 21 years, a ludicrously attenuated time period (see the press release here and the policy details here).
As North Carolina’s former chief investment officer, Andrew Silton explains, this plan isn’t even credible, since it is not committing to a super gradual glide path, but instead will reduce the target in years when the fund outperforms its benchmark. But as Silton stresses, the idea that this outperformance is a “surplus” (particularly for a plan that is underfunded) is absurd, since in other years, CalPERS will underperform. And given how hard most experts expect it will be for central banks to get out of the ZIRP/QE corners they’ve painted themselves in, the idea that CalPERS can expect enough outperformance over time is optimistic:
Meanwhile the finance and administration committee has tacitly acknowledged that the pension’s investment assumption is unrealistic by adopting a formula to lower the assumption in years when the capital markets are ebullient. For example, if the CalPERS portfolio earns 4% more than its 7.5% assumption in any given year, the future assumption would be reduced by .05%. If the portfolio beats its assumption by 7%, the assumption would drop by 0.10%. The idea is to use some of the “surplus” to fund a move toward a more realistic investment assumption. Unfortunately, excess performance in a given year isn’t a surplus; it’s just a random result that will be followed at some point by performance that falls short of the assumption. CalPERS is adopting this policy because they know that their portfolio (even with its unwavering commitment to private equity) can’t earn 7.5%, and because they know that state and local government are either unwilling or unable to increase the contribution required to meet the obligation to the beneficiaries.
Translation: this is a kick-the-can-down-the-road strategy. And it is about as realistic as the one the Troika is using with Greece. Worse, it’s hard to know which is worse: whether CalPERS actually believes this loopy plan is viable, or whether it is cynical came up with a complex program to con the great unwashed public.
The San Diego Union-Tribune correctly took CalPERS to the woodshed over this scheme. From its editorial last week, Gov. Brown is right to lambaste state pension giant:
For years, the governor and many outside experts have urged CalPERS to scrap its overly optimistic assumptions about how much its investments would grow annually, assumptions that serve to mask how underfunded the agency is. Brown believed he had made his case to the CalPERS board for significant changes in the status quo. That’s why he has been sharply critical of the board’s recent decision to lower its estimate of future investment returns from 7.5 percent to 6.5 percent — but over a 20-year span, not immediately.
That’s a trivial response to a real problem. Unfortunately, it’s what one should expect from an agency that has a long history of irresponsibility. From telling the Legislature in 1999 that there was no fiscal downside to a 50 percent retroactive increase in pensions to reflexively denying that soaring pension costs were hurting local governments, CalPERS has seen its role as defending the interests of government union employees, not taxpayers.
Brown has three years left in office. He should use that time to push for more prudent — and trustworthy — CalPERS leadership.
It’s noteworthy that the Union-Tribune, looking at a different set of issues than we’ve focused on, comes to the same conclusion: that CalPERS has deep-seated management and governance problems. And to put none to fine a point on it, they are all symptoms of CEO Anne Stausboll’s misrule.
Yesterday, CalPERS issued a wounded response, trying to present the Union-Tribune as ill-informed. Key sections:
This Board action was a result of an 18-month analysis that looked at several strategies to mitigate risk. We sought input from leaders representing our members, as well as cities and counties across the State who belong to our system. Industry experts provided guidance and our professional staff provided their best recommendations. The result was a measured and balanced approach that will incrementally lower our assumed rate of investment return, help pay down the pension fund’s unfunded liability, and provide greater predictability and less volatility in contribution rates for employers.
The editors need only to look at their story archives to read of the economic strain that still exists in many of California’s local public agencies, and the impact that a rapid reduction of our assumed investment rate would have on their ability to pay for pensions and deliver vital services to citizens.
Translation: the path of least resistance was to pretend we could sorta earn our way out, since no one wants us to make them raise taxes. And we found some experts who would sprinkle holy water on our scheme.
Sticking your head in the sand is no way to deal with an institution’s biggest problem. But Anne Stausboll is 59. She is engaging in the classic “IBG/YBG: I’ll be gone, you’ll be gone” strategy. This lame 21 year fantasy assures the underfunding problem will be dumped on her successor. This is cowardice and rank opportunism. I hope California taxpayers see through this and demand their legislators to get involved, since the board is happy to enable this irresponsible behavior by rubber stamping staff proposals.
As Silton concluded:
When pension plans, or for that matter any organization, face big challenges its board needs to be very active. At CalPERS, we have a lot of video evidence that only one trustee is asking probing questions and that the staff and governance committee would like to limit his inquiries. In my view, all of the trustees should be asking tough and probing questions. The board and committee meetings should be interactive and at times even raucous. After all they’re facing tough problems. Moreover, the trustees should have an independent and unbiased fiduciary counsel who exclusively advises them on their role as fiduciaries.
I doubt CalPERS will change because they’ve lost their way.
That means change needs to be forced on them by California citizens pressing for more media scrutiny and letting their legislators know that they need to step in to deal with the oversight vacuum at the board. The problems at CalPERS are destined to get worse, but the sooner an intervention takes place, the lower the eventual cost will be.