The nation’s two largest public pension funds last week reported slim annual investment earnings, CalPERS 1.1 percent and CalSTRS 2.3 percent, as experts continue to say hitting their long-term earnings target, 7.75 percent, will be difficult.
While CalPERS reported weak earnings in 2011, a prominent private-sector investment manager, Robert Arnott of Research Affiliates, told the board last week he thinks the most they can expect from stocks and bonds next decade is 4 percent.
Another major investor, Laurence Fink of BlackRock, told the CalPERS board during a similar educational session in 2009 that during the next 15 years: “You’ll be lucky to get 6 percent on your portfolios, maybe 5 percent.”
A Wall Street Journal columnist, Jason Zweig, said last week Warren Buffet’s Berkshire Hathaway pension fund projects a return of 7.1 percent. He said William Bernstein of Efficient Frontier Advisors expects roughly 6.5 percent from stocks.
Consultant Girard Miller said in Governing magazine this month, while discussing 12 basic public pension issues, that earnings “closer to 7 percent” are more realistic until global debt is reduced.
The California Public Employees Retirement System board decided last March to leave its earning assumption unchanged at 7.75 percent, despite a recommendation by actuaries to lower the forecast to 7.5 percent.
Even a small drop in the earnings forecast could boost the annual employer payment to the pension fund. CalPERS, which may revisit the forecast in March, is not turning a deaf ear to the experts.
“Like all talented investment managers, and Rob Arnott is one of the most talented, he laid out a problem—in a low return environment conventional approaches to asset management are likely to disappoint—and a solution—invest unconventionally,” the CalPERS chief investment officer, Joe Dear, said by e-mail when asked for a comment.
“He did not say we can’t earn our target rate of return. He said to do that we’ll have to have an investment strategy that is different. Much of what he suggested, such as fundamental indexing, and higher exposures to emerging markets, we are already doing. The low return environment makes achieving our return objective more difficult, but not impossible.”
Why experts think this is a “low return environment” was explained by Pension Consulting Alliance, a CalPERS and CalSTRS adviser, in a report in October to the Rhode Island state pension fund, which was overhauled by legislation in November.
“Factors that provided a tailwind in the past are expected to present a headwind,” said the PCA report by Allan Emkin.
Low interest rates (the 10-year U.S. Treasury bond yield dropped from more than 8 percent in 1990 to about 2 percent now) means that the bond portion of investment portfolios will have lower yields.
Large government and private-sector debts run up in recent years means debt repayment can crowd out purchases and projects, limiting economic growth and potentially lowering stock returns.
Population trends in developed economies such as the United States, Europe and Japan (getting older and growing slower) mean their economic growth is likely to be slower, potentially lowering stock returns.
Under Rhode Island investment policy, the report shows a 50.3 percent probability of exceeding a 6.75 percent annual return during the next decade, the highest in a range decreasing to a low of a 36.9 percent chance of exceeding 8 percent.
“Over the next decade long-term investors should expect lower capital market returns than historical averages,” the report concludes.
A big problem facing public pensions, which often expect to get two-thirds or more of their money from investment earnings, is the need to predict the future. A typical worker receiving a vested pension right at age 25 could live another 55 years or more.
But as the PCA report shows, even predictions for the next decade have little certainty and a wide range of probability. After the short-term swings, the theory is that returns over a number of decades will tend to “revert to the mean” or an average.
A Stanford professor, former Assemblyman Joe Nation, D-San Rafael, issued a report last month showing what happens if the three state pension funds (CalPERS, CalSTRS and UC Retirement) earn the long-term historical average, 6.2 percent a year.
Nation said in a Sacramento Bee op-ed article the long-term “shortfall is $290.6 billion, or about $24,000 per California household. Like a mortgage accruing interest that’s not being paid, that shortfall grows every day the problem is not addressed.”
His report also showed results for a 9.5 percent return and a 4.5 percent return. Nation’s graduate students issued a well-publicized report two years ago showing a $500 billion shortfall using a risk-free bond rate, 4.1 percent, advocated by economists.
The amount of pension debt, the shortfall or “unfunded liability,” is an important part of the debate over the need for a cost-cutting pension overhaul. But it’s an issue not likely to be settled because of the uncertainty in predicting the future.
Looking ahead is often based on looking back. Strongly disagreeing with Nation’s report, the CalPERS chief actuary, Alan Milligan, said stock dividends over the long term have been more than 4 percent, not the 2 percent used for the report.
Nation said a 2 percent dividend was used in Warren Buffet’s argument in 2007 that pension earning assumptions are too high. Milligan said if the correct 4 percent dividend is used, the 6.2 percent return in Nation’s report becomes about 7.75 percent.
“You end up right where we are,” said Milligan. “I hear those arguments about our rates of return being unrealistic. But I’m sorry, It’s not true.”
Furthermore, Milligan said, a survey of about 680 private-sector pension plans by SEI, an investment management firm, found that the median expected earnings return is about 7.7 percent.
Milligan said the recommendation last March to lower the CalPERS earning forecast to 7.5 percent was intended to preserve “conservatism,” a cushion if earnings turned out to be lower than the 7.75 percent expected when that forecast was adopted.
He said the board decision to leave the forecast at 7.75 percent still accurately reflects expected earnings. But in the new “low return environment,” the conservatism cushion is gone and the risk of not hitting the earning target has increased.
“Given that the state of the economy has put severe pressure on employers’ budgets, we recognize that it may be appropriate to reconsider the level of margin for adverse deviation,” said Milligan’s report to the board last March.
“The balancing of the level of risk taken on the funding of the plan with the impact on employers, stakeholders and the public in general is fundamentally a task of the board.”
Reporter Ed Mendel covered the Capitol in Sacramento for nearly three decades, most recently for the San Diego Union-Tribune. More stories are at https://calpensions.com/ Posted 30 Jan 12
Calpensions 
January 30, 2012 at 2:54 pm
At the market’s lowest point in 2008, CalPERS assets had dropped by $100 billion. Today CalPERS has regained $70 billion and in September, its market value of assets is $235 billion. In the last 24 years, CalPERS has had 20 years of positive returns, 16 of which were 10 percent or greater.
While certain reforms are always required—- the pension has ups and downs– it’s the average that counts– last year was 20% I think…
January 30, 2012 at 6:23 pm
While certain reforms are always required—- the pension has ups and downs– it’s the average that counts– last year was 20% I think…
Half-truth #2: “There is no crisis. Once the stock market recovers, there is no problem.”
Some of today’s pension Pollyannas claim that when stock-market trends return to their historical averages, everything works out. That is simply ignorance and puffery from people who don’t even bother to understand pension math. The actuarial projections used by most public pension plans are already assuming that 85-year historical returns will continue indefinitely, even though many of the major investment consultants have already dialed down their projections for the next decade. Perpetual stock-market increases of 10 percent annually are already baked into the funding ratios that now hover just above 70 percent on average nationwide. Even if stocks return next year to their previous peak levels (DJIA 14,100), that wouldn’t restore pre-recession funding ratios. That’s because there have been no capital gains from equities for the five intervening years while the underlying liabilities have grown about 50 percent. Stocks may have good and bad growing seasons, but there is never a crop failure on the liabilities farm. As I explained last year, stock indexes would have to double in the next two years to restore most pension funds to their 2007 funding ratios. To return the average pension fund to full funding, stock markets would have to produce 14 percent compounded returns the rest of this decade, with no intervening recession. That would put the Dow Industrials at 30,000 in January 2020. I’ll gladly give even odds against that scenario to anyone who wants to buy into that long-shot.
http://www.governing.com/columns/public-money/col-Pension-Puffery.html
January 30, 2012 at 6:32 pm
I always find this column interesting, although I confess that I don’t have the financial knowledge to fully appreciate every term or analysis. However, I wonder how many PERS/ STERS covered people -the State rank & file-read columns like this and try to keep themselves abreast of the ever changing landscape. I rarely detect,from the nature of the comments, people who could actually be impacted by the circumstances offering thoughts or reactions. Do they care ?
January 30, 2012 at 7:57 pm
Mr.. Wonder Dog– Well your post assumes quite alot– mine simply says history shows the average over time— it’s a public record—- last year was 20% !
Wasn’t it?
I am not in Calpers but I think they are way diverse from the stock market– while that is clearly a chunk of what they do I bet they have wider portfolio than that… While their is clearly an issue now– looks to me like with their changes they will make it ok!
January 30, 2012 at 9:49 pm
Yes, we care Flak88. I have the time to read these forums, because I am retired. The others are busy, at work. There are many retiree organizations involved, following legislation, and putting in their two cents, wherever they can.
January 30, 2012 at 10:17 pm
B Gary-it is not my post, just copied tio from Milers website. I am rarely posting on these forums anymore b/c it is a waste of time. I was just re posting a passage that addressed your claims, the link is on my first post. You disagree with it fine.
January 30, 2012 at 11:41 pm
lol— the Poodle! A waste of time? Wow– what took you so long to figure that one out sleepy!
February 1, 2012 at 6:06 am
Sounds like the CalPERS CIO is saying, and has been alluding to for several months, that we have a problem that is beyond his control. He said, among other things in many previous “muted” comments that, according to this article, “the board decision to leave the forecast at 7.75 percent still accurately reflects expected earnings (a stretch based on the consultants comments and common sense). But in the new “low return environment,” the conservatism cushion is gone and the risk of not hitting the earning target has increased (taking on increased risk at the tax apyer expense).”
Hmmm… and he (the CalPERS CIO) goes on to say:
“Given that the state of the economy has put severe pressure on employers’ budgets (no shidt), we recognize that it may be appropriate to reconsider the level of margin for adverse deviation,” said Milligan’s report to the board last March.
“The balancing of the level of risk taken on the funding of the plan with the impact on employers, stakeholders and the public in general is fundamentally a task of the board (that would be the same CalPERS Board of Directors that completely ignored common sense and ALL the above mentioned advice from the CalPERS paid consultants that were mentioned above).”
And what has the underachieving CalPERS Board of Directors done to address the CalPERS CIO concerns – Nothing, Nada, Zilch. The fools are too busy trying to figure out how it will impact their collective bargaining. We NEED A NEW AND IMPROVED CALPERS BOARD OF DIRECTORS AND WE NEED IT NOW!
February 1, 2012 at 4:19 pm
lol— weak spin Mr. Cap !
February 1, 2012 at 6:01 pm
The CalPERS BOD does not participate in collective bargaining, Cap. I provided you, before, with thumbnail sketches, from their bios; ten of the 13 members are not current or former union activists. Go ahead and do you own, continuing, critique, of CalPERS–I am sure, you are that obsessed with CalPERS–you should leave mention of unions and collective bargaining out of it.
February 2, 2012 at 4:41 am
“B. Gary Says:
February 1, 2012 at 4:19 pm
lol— weak spin Mr. Cap !”
Is that it?
February 2, 2012 at 4:43 am
“SeeSaw Says:
The CalPERS BOD does not participate in collective bargaining, Cap.”
You completely missed my point.
February 2, 2012 at 4:50 am
That’s it Cap…..sorry……..all spin……..
February 4, 2012 at 10:27 am
As previously stated, “Sounds like the CalPERS CIO is saying, and has been alluding to for several months, that we have a problem that is beyond his control. He said, among other things in many previous “muted” comments that, according to this article, “the board decision to leave the forecast at 7.75 percent still accurately reflects expected earnings (a stretch based on the consultants comments and common sense). But in the new “low return environment,” the conservatism cushion is gone and the risk of not hitting the earning target has increased (taking on increased risk at the tax apyer expense).”
Hmmm… and he (the CalPERS CIO) goes on to say:
“Given that the state of the economy has put severe pressure on employers’ budgets (no shidt), we recognize that it may be appropriate to reconsider the level of margin for adverse deviation,” said Milligan’s report to the board last March.
“The balancing of the level of risk taken on the funding of the plan with the impact on employers, stakeholders and the public in general is fundamentally a task of the board (that would be the same CalPERS Board of Directors that completely ignored common sense and ALL the above mentioned advice from the CalPERS paid consultants that were mentioned above).”
And what has the underachieving CalPERS Board of Directors done to address the CalPERS CIO concerns – Nothing, Nada, Zilch. The fools are too busy trying to figure out how it will impact their collective bargaining. We NEED A NEW AND IMPROVED CALPERS BOARD OF DIRECTORS AND WE NEED IT NOW!”
SeeSaw, the CalSTRS B.O.D. has actually listened to their consultants and reduced their assumed rate of return to 7.5%. Unfortunately that increases the unfunded liability by 6 billion but it does come a step closer toward honesty. What is this so called proactive CalPERS B.O.D waiting for ? Do you have an opinion or would you prefer to wait until CalPERS tells you how to respond?
February 6, 2012 at 1:08 am
I am not a financial expert, Cap. Therefore, I will rely on what CalPERS says–CalPERS is my bread and butter.
February 7, 2012 at 7:17 am
CALPERS Awesome!