# traditional pension plans in the US: trouble (ii)

CalPERS

The California Public Employees’ Retirement System (CalPERS) is a bellwether for government employee pension plans around the US.

not fully funded

By its own calculations, CalPERS is not fully funded, meaning that it does not have enough money on hand today to meet the future pension obligations of its members.  That’s even assuming, as it officially does at the moment, that it can earn on average 7.5% on its investments yearly.

assuming a 7.5% annual return

How reasonable is it, though, to think that CalPERS–or anyone else in a similar situation–can earn 7.5% on a diversified portfolio of stocks and bonds?

reasonable?

Let’s assume an asset allocation of 50% stocks and 50% bonds, just to make the arithmetic simple.

bonds first.  Let’s say that the yield on Treasure bonds rises to 4% over the next several years and stays steady at that level from that point on.  When we’re there, CalPERS can earn the coupon each year by holding them, or 4%.  A 4% return on half the portfolio is a contribution of 2% to the entire portfolio   Note:  we already know that the return will be less than that over the time it takes for interest rates rise back to normal.

stocks.  To achieve a 7.5% return on the entire portfolio, assuming bonds deliver 2%, stocks will have to chip in 5.5% per year to the total.  This means achieving an average 11% annual return on the stock half.  How reasonable is this?  Well, over the past ten years the S&P has risen by 58%, or on average by a little less than 5% per year.  If we assume that inflation will remain contained at around 2%, an 11% return would be a whopping 9% real annual return.  Over long periods of time, stock markets around the world have averaged at best a 6% real annual return.

change the asset allocation?

Yes, we could up the overall return by shifting the asset allocation away from bonds and toward stocks.  But the stock portion would have to be above 90%–making calPERS’ assets vulnerable to wide business cycle swings in their value–before it could achieve a 7.5% annual return, assuming a 6% real return on stocks.

In short, the numbers don’t add up.  The biggest issue isn’t CalPERS’ ability, or lack of it, to manage money well.  It’s that the actuarial assumption of future returns is too high.

Over the recent decade or more, pension plans like CalPERS have tried the “magic” solution of alternative investments–hedge funds and private equity–to try to square the circle.  But most hedge funds continually produce returns to clients that are below the S&P 500.  And, again, the allocation to such dubious, and illiquid, vehicles has got to be very large to move the total return needle, even if one believed the promoters’ marketing claims.

changing the actuarial assumption

Interestingly, California has just announced that it is going to accelerate the process of lowering the assumed return on CalPERS investments to what sounds like a target of 6.5%.  To me, this is clearly the right thing to do, and the sooner the better.  But it will also show that CalPERS is more deeply underfunded than today’s official figures suggest.  It will likely mean that state and local governments will have to up their contributions to the fund.

That’s doable for California.  But what about the country’s government pension fund basket cases, like Illinois and New Jersey?  Following suit will show voters for the first timethe reality of how bad the situation is there.

the basics

Corporate pension plans of one type or another have been around in the US since the late nineteenth century.  In their simplest form, they offer specified payments in retirement to company workers who meet criteria spelled out in advance.  Since 1974, these plans have been subject to federal regulation under the Employee Retirement Income Security Act (ERISA) which sets out standards companies must comply with.

Although pension plans are an obligation of the firm, companies don’t ordinarily keep on hand in the plan today enough money to meet all future obligations.  Instead, they (or outside actuarial firms they hire) make intricate calculations of what future payments are likely to be and when they are likely to occur.  Then, using the investment returns that on average they believe their investment managers can achieve, they figure out how much must be in the plan right now to fund expected obligations.

open secrets, sort of

–We know professional analysts have a hard time forecasting what will happen even one year ahead.  What does this say about forecasts that claim to look decades into the future?

–Most traditional pension plans have less in the till today than actuarial calculations say they need.

–The return assumptions used are typically, let’s say, heroic.

public sector workers

The uncertainty inherent in what I’ve just written is why most publicly traded US companies have long since switched from traditional pension plans, where the corporation has responsibility for the risk of miscalculation, to 401ks, where the employee bears it.

There still are significant numbers of traditional pension plans, however.  They’re in the public sector.

dealing with underfunding

To my mind, a substantial reason for the popularity of hedge funds over the past fifteen years or so has been their claim of superior performance as far as the eye can see.  The director of an underfunded pension plan knows that his story is not going to end well as things stand now.  He has two choices:  ask his boss, the governor/legislature, for instance, to fix the problem by allocating (a ton of) more money to the plan; or he can find managers who can consistently exceed the returns the actuaries assume and gradually close the funding gap that way.  Not wanting to be the bearers of bad news, directors have by and large chosen door #2.

the actuarial assumptions

Adding to the woes of pension plan directors, the California Public Employees Retirement System (CalPERS), a leader in the public pension plan sphere, has begun to call into question the assumption that it can churn out average annual gains of +7.5%.

The surprise here, if any, is that CalPERS has finally decided to deal with this chronic problem.

More tomorrow.

# Calpers: one pension, two sets of books

For some time, the Los Angeles Times has been running articles aleerting readers to the troubles that California’s famous Calpers retirement system is having.  In a nutshell, the assets Calpers has on hand to meet future municipal employee pension benefits fall far short of what it will likely need.

The New York Times chimed in last week with a story about the troubles that individual cities, worried about their future and seeking to extract themselves from Calpers, are experiencing.

There are two parts to the latter:

–the “official” Calpers books give a relatively rosy picture of the current situation for each municipality.  They do this essentially by assuming the pension plan will eventually grow itself out of the problem.  The issue here is that their actuarial assumptions have lnot been adjusted down enough to account for today’s low-inflation, near-zero interest rate world.  In a sense, that pie-in-the-sky attitude would be ok with cities that want to leave Calpers   …except that Calpers presents potential leavers with a far different–and much higher–bill to bring their accounts up to full funding so they can depart.

–The Stanford Institute for Economic Policy Research has developed a Pension Tracker website where Californians in many areas can quickly look up how deeply in the hole their cities are.

Irwindale, a small town in the San Gabriel Valley of Los Angeles County, has the dubious honor of being #1 on the Stanford list of most exposed to pension shortfalls.  Irwindale’s Calpers account is short by \$134, 907 per household of having its municipal pension funded.  Irwindale has other woes–Huy Fong Srirscha, for example.  But with the Stanford pension info a mouse click away, who is likely to move to Irwindale?    …or to other cities high on the unfunded list?

Worse than that, I’d certainly be thinking of moving elsewhere.

California may be the most high profile instance of municipal pension underfunding, but it’s certainly not the only one.

# CalPERS is exiting its hedge fund investments

the CalPERS decision

The California Public Employees Retirement System (CalPERS), the largest public pension system in the US and an early adopter of hedge funds, has announced that it will terminate its entire \$4 billion in hedge fund investments over the coming year.

The decision comes after a review of CalPERS’ hedge fund performance by its investment staff following the death from cancer of the organization’s Chief Investment Officer, Joseph Dear.  Mr. Dear, a strong proponent of alternative investments such as hedge funds, took the reins at CalPERS in early 2009.  His appointment came in the wake of a sharp, recession-induced drop in the value of CalPERS’ assets–and as an alternatives-related “pay to play” scandal involving pension consultants and so-called “placement agents” was unfolding (see my post).

The stated reason for the move is that hedge funds are too complex and too high-cost.  Reading between the lines, this seems to me to mean that the hedge funds CalPERS used didn’t provide either the promised diversification or superior returns.  My guess is that the professional staff, who have the best understanding of the products, wanted to act quickly, before a new political appointee could arrive to muddy the waters.

In one sense, the CalPERS move should come as no surprise.  Although there are a small number of hedge funds run by superb investors, the average offering has pretty steadily underperformed the S&P 500 for over a decade.  In addition, the elevated fee structure results in most of what profits there are going to the fund manager, not the client.  These factors call into question the rationale for having made the investments in the first place–to reduce the underfunding of pension plans through superior investment performance, so that higher contributions to the plans by the corporation or government body that sponsors them can be avoided.  The evidence seems to me to be that hedge funds generally make the underfunding problem worse, not better.

On the other hand, it takes a substantial amount of courage to fire managers who have strong local political connections.

investment significance

CalPERS is a trend-setter.  It may well be in this instance, too.  A lot depends on whether the next CIO supports the investment staff decision to end hedge fund exposure or overrides objections.  In the former case, this could signal the gradual return to less speculative trading-oriented, more fundamentally driven securities markets.