CalPERS Now Looking to Borrow to Better Drive Returns

CalPERS, like other public pension funds, have fallen well short of their funding requirements. This has caused them to open up a little, in a way that is at least a start.

The California Public Employees’ Retirement System, known as CalPERS/Calpers, is the largest public pension fund in the United States, with $400 billion in assets. Like other public pension plans, they have a certain level of performance that they need to hit, 7% in their case, in order to sustain the plan and pay out amounts owing to pensioners in the plan.

In spite of the simply fabulous bull market that we have been in since 2009, where the S&P 500 has averaged a total return of 15% per year over this period, Calpers and other pension funds have not only failed to capture the additional gains that these heady times offered, they have actually fallen further behind their 7% goal.

Their current course, all things being equal, is being projected to have them continuing to fall further behind. Calpers projects a growth rate of only 6% over the coming years for instance, and this is the same rate of return that got them into the trouble that they are in now. One percent off target may not seem like much, but over time, this adds up to shortfalls in the billions, with nowhere to turn but the market to try to fix this and save themselves.

If they could go back in time by a decade, where getting much better returns than what they need should have been like shooting fish in a barrel, this would be challenging enough, and would require them to make some pretty drastic changes to their approach, ones that they aren’t even close to entertaining.

The path going forward will require a bigger adjustment than this, specifically targeting investments that at least have the potential to achieve their goals, because it is expected that you will have to be a good fisherman now in a much more subdued market overall where wise selection isn’t just the best way as it has been, it may be the only way to succeed at the rate they require.

To manage this, Calpers and other pension funds will have to not only cast off the inefficient ideas about investing that they have solely relied on, ideas that are largely still in force in the investment industry, they will have to bring themselves to really think outside the box and direct their attention away from trying to manage risk on a short term basis and focus it on the risk of failure altogether, when they let their fear of temporary drawdowns supersede the real fear they should be feeling about the fund going bust.

The way pension funds are structured, they are perfect for taking the long-term view of investing, and they do for the most part, but you can’t do this halfway. Either you have confidence in this or not, and looking to water down your returns with investments that have notably inferior returns in a manner that has no practical value as far as managing risk goes but does elevate the risk of failure to the point where the course is set for their doom can no longer be seen as an acceptable approach.

The problem with pension funds is that they take too conservative of an approach to managing their assets, which we have spoken about in some depth in other articles involving pension funds. In a nutshell though, what happens is that they manage drawdown risk in a manner well beyond what is actually required, which serves to choke off their overall returns and keep them lower than what is needed for the funds to even be sustained long term.

Just like the risk with our own retirement plans only really comes home to roost when we retire and start needing to tap into our retirement savings, where the real risk is measured by the risk of shortfalls, the same principle applies to public pension funds, where their true risk is their risk of not maintaining their pension obligations. This is their only risk actually, as any concerns about drawdowns need to necessarily leave them subject to not being able to fulfill their obligations, not that they just want to try to flatten the curve for its own sake, at a huge cost that will eventually lead to systemic failure.

When we choose a target that will get us there over the long run, like this 7%, we need to also calculate the additional amounts that will allow us to catch up to a fully funded state before we can be satisfied with long term maintenance requirements, because we need to get there first before maintaining it even comes up. It should be painfully clear that even this 7% is too modest, without the possibility of argument, as this will lead to failure eventually because the shortfalls will remain and eventually haunt them. Unless our strategies become aligned with the level of return that we actually need to sustain the plan and survive long-term, we not only risk failure, we have set it as our objective.

The old way of thinking, the thinking that has gotten Calpers in this much trouble, is in need of serious adjustment, where strategies that do not provide an opportunity to do anything but fall further behind and meet disaster down the road need to be discarded. They may need 9% or more for quite some time to catch up, but they certainly aren’t likely to get it when they use a means substantially similar to what has led to this mess.

Calpers’ chief investment officer Ben Meng is at least breathing some fresh air into the world of pension funds as he re-examines the degree of conservatism that the fund has practiced and is at least willing to open things up more to at least try to give the fund a better fighting chance at survival. Whether or not Meng is on the right track with this new approach, seeing things loosen up more is not optional, and these funds either need to choose this or face drastic consequences.

In terms of their overall funding, 2020 has made the situation worse for the fund, causing them to really stagger and move further away from their long-term funding needs. This problem is very widespread, where the top 100 largest pension funds in the U.S. have now seen their funding levels drop to 66% on average, making the task of bringing these funds up to minimum levels even more daunting.

Given the uncertainty of stock returns over the next few years, where it’s going to be a lot tougher for Calpers to hit their objectives, combined with historically low treasury yields that also come with a lot more risk given their very elevated prices, this adds a lot more to the challenge and does not allow for much margin of error, where pensions either need to get their act together in a big way or they will risk falling into even bigger trouble.

Meng admits that his fund has been too conservative, and just seeing that at least provides them some hope, even though Meng has a long way to go to realize just how much change will be needed to fix this. At the heart of this problem isn’t the fact that they haven’t added a “a few points” to their private equity allocation, or to just tweak things a little away from treasuries and more toward investments that can actually achieve the gains that they need to stay solvent, it is in the foolish way that they view drawdown risk, which has them over-hedging and choking their returns and their survival prospects.

Recognizing the Problem is a Necessary First Step

You have to start somewhere though, and Meng at least is starting to get the idea that funds cannot hedge themselves to death, and avoiding rather meaningless drawdowns like what was visited upon them lately that will cost you your life eventually just isn’t a wise course.

The recent turn of events that we have faced, the very thing that pension funds and others are willing to sacrifice so much return to protect against, should serve to clarify this mistake even more. It does not make sense to give up such huge amounts, walking away from the opportunity to grow your fund by an extra 8% per year, just for the sake of being “protected” against drawdowns that we have seen this year. If you give up 80% but only get a couple of percent back, and you think that this is a good deal, that’s outrageously foolish.

The goal over the last 10 years should have been to make hay while the sun shines, and take far more advantage of the bull market with stocks than these pension plans have, instead being content to hedge so much that their returns actually were below the long-term average at a time when the market more than doubled these returns.

However, if we can at least learn from this colossal mistake, we can at least be willing to turn things around now before it is too late, if it isn’t too late already, rather than relying on crumbling laurels that have failed at the best of times and are now facing much tougher times going forward.

The only possible way out of this is for pension funds to take a hard look at their hedging strategies alongside the risk of systemic failure that has become such a monster now. They are worried too much about specks in their eyes that will naturally be washed out by a few tears and try to poke too much at their eyes instead, and paying far less attention to their being on a course toward going blind.

This is a mistake that is made by just about all investors to some degree, investors who really dislike the normal ups and downs of stocks and pay way too much attention to the journey and not near enough to the destination, the only part that really matters. If you are going to invest for the long run, like these pension plans particularly do, you don’t want to let your fear of a few bumps along the road slow you down so much that you just don’t get where you need to be just because of this fear.

Making big changes at a time where the road is bound to be a lot bumpier than we have been accustomed to over the last decade makes the challenge of fixing things all the bigger, where you may be expected to have to settle for lower than average returns for a while as you correct your allocations to ones that will at least allow you to have a fighting change longer-term.

Calpers needs more than 7% to catch up, and this is a time where they needed to have more hay in their barn than they need, not a lot less, where they can live off the excess while we seek to extract ourselves from the economic devastation that we now face as a result of the economic contraction we put ourselves under due to the pandemic.

If your horizon is long-term, like pension funds clearly are, you need to ensure that your strategies align with this view, which does not include events such as the coronavirus selloff that we just saw. Those overly conservative will point to events like this with glee and tell us that’s why their plan works, but this only makes sense if we need to sell our investments at the drop of a hat, not years later when all this will just be a little step back on our way up the mountain.

Meng may say that they need to be less conservative and take on more risk, but he needs to realize the sheer enormity of the problem. He does deserve praise for being willing to stick a toe into waters that pension funds normally do not dare, such as the 20% leverage he is going to be adding to the fund, or his willingness to go a little lighter on the hedging and take on a little higher percentage allocation on private equity, which at least outperforms bonds, but we all need to ask if this is actually going to be enough and just isn’t a matter of trying to put lipstick on this big pig that is wallowing in the dirt so much.

What Calpers really needs is to cast off all of the old ideas that they and other pension funds have stubbornly clung to, such as the need to hedge so much in the short run, and look to re-examine all of their approaches in reference to their bigger goal of their being able to keep paying out pensions as agreed.

The standard practice with asset allocation with pension funds is to look to smooth out curves they don’t really need to worry about smoothing. This is the sole reason behind their missing to even get stock market returns, because if you have a lot of your assets in lower performing instruments, this is going to really dilute your returns. When you do so much of this that your fund is sinking more and more into the quicksand, you won’t pull yourself out of this by just doing the same old things.

Calpers needs to rethink whether it serves their purpose to be holding any amount of bonds, not just look to cut down on them a little as they are considering doing. It shouldn’t be hard to figure out that an investment which at best isn’t even going to provide returns that are half what you need takes you in the wrong direction, this isn’t a solution, it’s a big problem in itself. Ridding themselves of these underperforming investments completely is a necessary first step, where they at least have the potential to save themselves, where Calpers needs to start not just by picking off a few flecks of their dilapidated paint, they need a whole new paint job.

Calpers is only projecting a 6% growth rate over the next 10 years on the course that they are currently on, and they need to realize that there are actually two ways to improve this performance, by seeking higher returns for their other assets or simply discarding the ones that underperform so much.

Seeking the Returns They Require to Survive Needs to be the Priority Here

They really need to be working both sides of the street actually, to not only increase their returns to where they need to be, but to also catch up the ground that their more conservative approach has lost, and build a buffer so that they can manage temporary drawdown risk that way, not that this is even important.

To do this successfully, each investment must be looked at in terms of its contribution to exceeding this 7% goal, where investments that do not exceed this need to be ditched, including stocks, bonds, private equity, or whatever else the fund may choose to hold. If assets are allowed to drag things down the way that they have, there will be no success. If you fail during one of the best times to invest ever, this is no time for minor tweaking as this is going to require fundamental change.

Meng is happy enough these days just to do a little tweaking, and is particularly eyeing adding a little more to the private equity portion of the fund. This is already a millstone around the neck of pension funds, and while they have performed well at various times in the past, this doesn’t include the recent past and the recent past needs to matter the most.

Meng claims that his research has shown that private equity has averaged an annual return of 8.3%, versus the 6.8% he claims stocks have averaged, and the 2.8% that he has fixed income pegged at.

The only 6.8% that he has calculated stocks earning tells us how far back his analysis goes, and if we do look back that far, we cannot do this in a linear fashion as more results are just so much more relevant than results from many years ago. Treating 1979 and 2019 with the same weight is a crazy idea, because markets evolve and they sure have evolved a lot over this long period.

If we look at the last 10 years, both private equity and publicly traded equities have both averaged in excess of 15%, with stocks coming out a little on top. This tells us how much further Meng’s research goes, far into the nether world which should not even matter at all if we are seeking to properly identify what we may expect in the coming years based upon what is actually going on.

More recently, stocks have carved out a significant lead over private equity, and last year doubled their returns. Some institutional investors are becoming a little wiser to this at least, when they look at their results and see private equity dragging down their numbers and coming with even more risk. Private equity has been measured to be about 20% riskier than stocks these days, and much of this comes from the sheer illiquidity of private equity, where it’s a lot more difficult to get out of private equity positions because they aren’t traded on exchanges and are limited to back room deals only.

On Meng’s scratch pad, private equity returns are showing him a bigger number nonetheless, and he’s eager to leverage this, illusion or not. He literally is looking to leverage this as he’s getting ready to borrow 20% against the fund’s assets, amounting to $80 billion, to allow the fund to move more into both private equity and private credit.

The private credit idea is an even worse idea than the private equity one, especially when you need to borrow to lend money. There just isn’t any way you’re going to get a net return that is in accordance with your objective, and while borrowed money is in a real sense found money, where net returns are additive to your overall results and not comparable like when you use your own money, especially when you need far greater returns than these investments provide to survive, private credit is questionable enough when you use your own money and much more questionable when you lend out someone else’s money this way.

This may be suitable enough for a large bank to get involved in, but Calpers is about as far away from a large bank as you can get, especially in the face of their dilemma. Banks can thrive on much lower than market returns, while Calpers cannot. At best, private credit may achieve returns a little better than traditional fixed income sources, but they also come with greater risks, and even if they didn’t, this isn’t even close as far as returns go to where Calpers needs to be.

There is only one way out of this for Calpers, given their predicament, and that is to allocate their assets according to need, to stick to the ones that have the potential to provide the returns that they need to survive, rather than sticking to a plan that still will have them well short.

It is interesting that Meng has taken a conservative fund like this and has dared to leverage it as much as he has, and 20% leverage might not seem like much but that’s lot for a fund this size. Using leverage requires greater skill, and you first have to master the game of investing without leverage before you should want to play this more advanced one, and there is much to be done first with their unleveraged positions, where they should be looking to close the huge gap between their returns and what could be achieved passively by just investing in stock indexes.

Given that even Meng’s 6.8% average annual return for stocks might end up being pretty ambitious for the next while given how much tamer stocks in general are expected to be. The same factors are expected to mute private equity returns as well, and the way out of this isn’t through either private equity or broad range stock investing, it is through being more selective with public stocks, the only avenue that may be available during these more muted times overall.

It’s a stock picker’s market now, as opposed to recent times where you could just pick baskets of stocks at random and still do pretty well. A fully awake Calipers would quickly come to the realization that what they seek and more is there for the taking, just by confining themselves to investments that do meet their needs, and they just need to bring themselves to do it.

Meanwhile, starting to wake up a little is better than nothing, and although a small first step, it’s at least one that shows that one big public pension fund is at least starting to realize that they either change or die. The next lesson is realizing how much they need to change, and hopefully, they survive to lesson 3, the part where they actually implement the needed changes. For Calipers and other pension funds, this coursework is not optional.

Editor, MarketReview.com

Robert really stands out in the way that he is able to clarify things through the application of simple economic principles which he also makes easy to understand.

Contact Robert: robert@marketreview.com

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