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 weekWarren 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’sargument 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’sreport 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.”
Ed’s Note: Reporter Ed Mendel covered the Capitol in Sacramento for nearly three decades, most recently for the San Diego Union-Tribune. More stories are at http://calpensions.com/