Later this month, we should hear some rare good news from CalPERS. Portfolio returns for the fiscal year ending June 30, 2017 may exceed 10%. The strong performance on the back of Donald Trump’s bull market that many think has ended may provide a respite for state and local governments struggling with increased pension contributions. But local officials should not be fooled by the push to ignore the pension problem that is sure to come, including from government staff. This one strong year –– following two very bad years –– does not change the underlying fact: CalPERS’ return assumption is aggressive, and, as a result, imposes unacceptable risk on public agencies and the taxpayers who fund them.
The California Public Employees’ Retirement System (CalPERS) Board finally voted last year to reduce its targeted rate of return from 7.5% to 7% starting in 2020. This is a sensible first move that will force state and local governments to budget their retirement obligations more accurately, but more work is needed to make CalPERS fiscally sound. CalPERS needs to further reduce its target rate of return so it can make pension funds safer and produce expectations in line with reality.
CalPERS’ target rate of return is more than a fanciful number pulled out of a hat: it is a directive for CalPERS investments and their level of risk. When CalPERS targets an above-market rate of return, the agency is also increasing its tolerance for risk. The riskiest assets have the highest average rates of return. This is because investors will obviously prefer less risky assets to riskier ones, so risky assets must offer a higher rate of return to justify taking on the extra risk.
That extra risk means CalPERS will have a more variable return. This year, returns will be good, but in some years, CalPERS will wildly miss its target. In 2015, CalPERS earned a return of 2.4%, and last year, CalPERS had a return of 0.6%. In bad years, this can be even worse. In fiscal year 2008, CalPERS had a return of -4.9%, followed by a -23.5% return the next year. CalPERS is still reeling from these recession losses.
CalPERS operates in a defined benefit system, where state and local governments are responsible to pay their employees a fixed amount regardless of the performance of their retirement funds, as opposed to the defined contribution system which is the preferred choice of the private sector. Substandard returns even in one year can leave defined benefit pension systems short of their long-term targets. In such an environment, it is especially imperative that investment returns are stable, so that pensions are not in jeopardy, and neither are the budgets of state and local governments.
Billionaire investor Warren Buffett warned of the consequences of targeting high rates of return ten years ago ––before the 2008 recession jeopardized the pensions of California’s employees. For his own company, Berkshire Hathaway, Buffett targets a return of 6%. There is evidence that investment yields will decrease as a result of economic changes like long-term lower economic growth and the Baby Boomers retiring. A report from J.P. Morgan Asset Management Company suggests that a rate of return of 5.5 to 6.0% is a realistic expectation for retirement portfolios going forward. As the market rate of return declines, CalPERS’ targeted rate of return increasingly deviates from the expected market rate, and CalPERS becomes more exposed to risk. Over time, this difference compounds. Despite a 20-year annualized return of 6.9%, CalPERS’ funding ratio fell from 110.9% to 64% over the last 20 years because of a 7.5% targeted rate of return.
A lower targeted rate of return can also save CalPERS money by steering the agency away from hedge funds and other high-cost funds. Free from the obligation of an above-market return, CalPERS would no longer have to seek actively managed funds. In 2016, CalPERS paid $490 million in performance fees to private equity firms. Instead, CalPERS could shift to safer, lower-cost index funds, such as the S&P 500 index fund. The S&P 500 index fund has a 7.2% annualized 10-year return, while CalPERS has a 4.3% return.
CalPERS recognizes this: they are shifting to a lower-risk asset allocation and projecting a 6.2% 10-year rate of the return. However, their actuarial assumptions do not align, and as a result, local governments are not recognizing the need for higher employer and employee contributions. Local governments base their pension liabilities on CalPERS’ pension assumptions. When CalPERS lowers its targeted rate of return, local governments become actuarially accountable for higher pension costs. Governments need to know that CalPERS will not live up to its targeted rate of return. One good year doesn’t fix the pension system. No one should be deluded into acting as if the problem is solved. A lower targeted rate of return allows local officials to set aside additional money to pay for pensions and negotiate future deals with employees that take increased pension expenses into account.
Why then, does CalPERS use such a high targeted rate of return? It’s because a more realistic rate of return would make it obvious how underfunded the pension system is. In the 2015-2016 fiscal year, CalPERS pensions were 69% funded, with a 7.5% targeted rate of return. Federal ERISA standards say that plans at 65% funding or below are in “critical status”. Newer numbers say CalPERS is 64% funded. If CalPERS further lowered their rate of return, the depth of California’s pension problem would be clear. This has negative political repercussions. Those repercussions do not justify jeopardizing the pensions of California employees.
David Schwartzman is a Policy Research Fellow at the California Policy Center. He is a rising senior studying economics, mathematics, and finance at Hillsdale College.