After years of bullish performance, CalSTRS pulls in its horns

After five years of beating its benchmark, CalSTRS investment earnings plunged during the year ending June 30, a 25 percent drop that was 6 percent below the median for similar funds.

Actuaries say that if the loss is not spread over several years, a standard “smoothing” process, employer-employee payments that now total 18 percent of payroll would need an additional 13 percent of pay.

A CalSTRS board committee that approved delaying staff bonuses in June rescinded that action last week, receiving approval of the full board for a broader look at pay policy this fall.

State Controller John Chiang recommended in a letter that the compensation committee “consider other options, such as reducing or eliminating incentive awards during years when overall fund investment returns are low or negative.”

Chiang, a CalSTRS board member, said he recognized that a retroactive change in incentive pay for the last fiscal year may not be possible and that most losses resulted from “economic and financial turmoil” in all markets. The controller said the California State Teachers Retirement System and the California Public Employees Retirement System both have “corporate governance” units that monitor private corporations on behalf of stockholders, pushing reforms.

“One of the fundamental principles of good corporate governance is that compensation, especially incentive compensation, be correlated to overall shareholder return,” he said.

Many private-sector financial firms have cut staff and incentive compensation “during these difficult times,” Chiang said. And at a time when CalSTRS may be asking the Legislature for a contribution increase, “should we be handing out bonuses to staff?”

CalSTRS, unlike CalPERS and many other retirement systems, cannot set its own contribution rates. Legislation is needed to increase annual pension payments to CalSTRS from teachers, school districts and the state.

Currently, the annual contributions total about 18 percent of pay — teachers 8 percent, school districts 8.25 percent, and the state 2 percent. The state also makes a supplemental payment, 2.5 percent, to help some pensions keep pace with inflation.

Most teachers, unlike many government employees, do not receive Social Security in addition to their pensions. Talk of “historic losses” at CalSTRS and a ballooning “unfunded liability” can create anxiety among retirees.

But CalSTRS is a long way from running out of money. Months after the stock market crash, the CalSTRS investment portfolio was worth $119 billion in June, $124 billion in July and the value presumably increased last month along with the market.

CalSTRS paid retirees about $8 billion last year. Contributions to CalSTRS last year totaled about $6.5 billion — $2.4 billion from teachers, $2.5 billion from school districts, and $1.6 billion from the state.

Even before the stock market crash, CalSTRS had an estimated “unfunded liability” of $22.5 billion over the next three decades. It was seeking a contribution increase of 3.7 percent.

Milliman, an actuarial firm, told the CalSTRS board last week that spreading the historic one-year loss of $41.7 billion over a three-year period would increase the needed contribution rate by an additional 7 percent of pay.

Not using a three-year “smoothing” period would result in the need for an immediate 13.46 percent increase.

But Milliman said that if smoothing is used to keep the contribution increase at about 7 percent for three years, the rate after that would jump up to 13 percent, even if CalSTRS investment earnings hit their annual target of 8 percent.

A number of skeptics think that assuming 8 percent annual earnings is overly optimistic. Board member Peter Reinke noted that some think a more realistic assumption would be 5 percent.

Milliman favors conservative asset smoothing. A survey of 115 public funds contained in the Milliman report showed most funds (66) with a five-year smoothing period.

The outlier, way off by itself, is CalPERS with a 15-year smoothing period. In a graph of the survey results, the four funds closest to CalPERS all have a 10-year smoothing period.

The bad news about the performance of the CalSTRS investment fund was delivered to the board by Allan Emkin of the Pension Consulting Alliance.

“To say that the period ending 6-30 was ‘calamitous’ under any circumstances would be an understatement,” Emkin said.

His report showed that the CalSTRS fund, valued at $160.7 billion on June 30, 2008, dropped to $119 billion by last June 30 — a loss of $41.7 billion or about 25 percent.

Emkin said CalSTRS “did suffer more” than most similar funds. The CalSTRS loss was 6.2 percent more than the median fund and 3 percent more than its own policy benchmark.

Most CalSTRS asset classes did better than the benchmark. The “dominant factor” in the overall loss, said Emkin, was a real estate portfolio with a large amount of “leverage” or borrowing.

The big loss last year came after a five-year run in which CalSTRS earned more than the median fund and the benchmark. There were some historic gains: a 23 percent increase in 2003 and a 21 percent increase in 2007.

A problem facing “maturing” pension funds such as CalSTRS (and an argument for smoothing) is that their contribution base is many times smaller than their investment fund, producing excessive “volatility” or big swings as the market rises and falls.

The CalSTRS board also got an early look at its proposed budget for next year. The current budget is about $161 million for continuous investment costs and $163 million for operations, which includes staff, equipment, office space and more.

The $163 million operations budget was an 18 percent increase from the previous year. The proposed budget for next year is $153 million, down $10 million because accounting rules forced a reclassification of the new CalSTRS building.

The new building, a sleek tower along the Sacramento River in which the CalSTRS board met for the first time last month, cannot be booked as an investment. So a $10 million annual lease payment is no longer needed.

Board member Tom Sheehy asked the staff for a comparison of the CalSTRS budget with the budgets of similar public employee pension funds.

“I think it’s important given the large drop in fund assets,” said Sheehy.

Reporter Ed Mendel covered the Capitol in Sacramento for nearly three decades, most recently for the San Diego Union-Tribune. More stories are at Posted 8 Sep 09

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