CalPERS Urged to Increase Returns. Bad Idea.

Back in 2016, CalPERS decided to lower their expected investment return from 7.5% to 7.0% by 2020.  Now California’s cities are concerned that target may be too low:

The legislative representative to the League of California Cities urged the CalPERS Investment Committee Monday to think “out of the box” in finding a way to exceed its 7% investment return projections, saying that cities won’t be able to pay their monthly contributions to the pension plan if returns are that low.

CalPERS sets contribution rates based on a variety of factors including assumed rate of return, and lower returns means contributions will rise.  As of June 30, 2017, CalPERS reported their funded status was merely 68%, meaning they are currently projected to be short of their long-term obligations.  Funded status differs by municipality, and the League of California Cities notes that when CalPERS’ new projections come out in August, many cities’ funding ratio could fall into the 50s.

So can they do it?  Can CalPERS find “out of the box” ways to increase its return?

In a word, no.

Let’s look at what CalPERS has done in the past.  While CalPERS’ return for the 2016-17 fiscal year was a solid 11.2%, as of June 30, 2017 their 10 year annualized return was merely 4.4%, and this was after 8 years of a bull market.  Their 20 year annualized returns were 6.6% – less than their new assumed rate of return.  Any wonder why CalPERS lowered their return target?

I believe an investor is capable of earning superior returns.  However, the only way to outperform is to do something different from the market.  This requires skill, independent thinking, nimbleness, and – make no mistake – a greater tolerance for risk, including a willingness to occasionally underperform.  As investor Howard Marks wrote:

“Passive investors, benchmark huggers and herd followers have a high probability of achieving average performance and little risk of falling far short.  But in exchange for safety from being much below average, they surrender their chance of being much above average.”

Marks goes on to note what is required to outperform:

“[Y]ou have to assemble a portfolio that’s different from those held by most other investors.  If your portfolio looks like everyone else’s, you may do well, or you may do poorly, but you can’t do different.  And being different is absolutely essential if you want a chance at being superior.”

Most importantly, there’s no guarantee being different in pursuit of higher returns will work.  You can end up worse-off than if you stuck to a more conservative strategy.

Even if we grant CalPERS the skill to outperform (a dubious proposition for a large government organization), their sheer size makes outperformance all but impossible.  CalPERS has an estimated $360 billion in assets.  With that much money to move around, prices move simply because they are buying and selling.  They are too large to find niche investments among broad asset classes or to be opportunistic and take advantage of market swings (even if their organization could move at the necessary speed).  They are a benchmark hugger by necessity.  Indeed, CalPERS’ report listing all of their holdings is 369 pages long.  What new and differentiated investment are they going to find to increase their returns?  CalPERS can’t beat the market because they are the market.

CalPERS’ only possible option is to shift toward riskier asset allocations by moving more capital into stocks and speculative options like venture capital.  This isn’t “out of the box” thinking, it’s merely shifting to riskier boxes.  It might work…or it might not, leaving us with a bigger deficit down the road.

In short, CalPERS cannot invest their way out of this problem.  The public pension shortfall can only be solved by 1) increasing contributions, or 2) cutting pension benefits.  This is going to involve trade offs between raising taxes and/or cutting government services and benefits.  It is a political question that will be decided by a political process and the sooner we start, the better.

I don’t know what future returns we can expect for investors including CalPERS.  No one does.  Lowering the expected return closer to their actual long-term returns was a prudent action by CalPERS that helps us face funding shortfalls now.

Wishing for higher returns will only kick the can down the road and make our choices harder when the situation becomes critical.  Increasing risk in pursuit of higher returns will make the situation even worse for Californians if CalPERS comes up short.