CalPERS Abandons “Hail Mary” Investment Strategy – About Time

CalPERS knows when to fold ‘em. The California Public Employee Retirement System, the nation’s largest public pension fund (and one of the world’s largest), announced last week that it would no longer invest in hedge funds, where it had sought larger returns in the hopes of gaining greater investment returns. It’s the right move. But it’s really only correcting a mistake, for CalPERS should have never held ‘em in the first place.

Pension fund obligations are fixed. They must be paid, which means states need to fund pensions appropriately to meet those obligations. However, many states have not made the appropriate contributions, and they have justified this by calculating discount rates based on overly optimistic projections of future returns on investments. In this week’s issue, The Economist’s “Buttonwood” column explains:

It is more likely that a hedge-fund allocation is part of a “Hail Mary” bet, with pension schemes looking for something, anything, that will pep up returns, and help to reduce yawning deficits. CalPERS highlights the issue with its claim that it has adopted “a new asset-allocation mix that reduces risk to the portfolio, while still being able to achieve its return goal of 7.5%.”

The risk-free rate (the yield on the ten-year Treasury bond) at the moment is around 2.6%. One has to take on a substantial amount of risk to hope for a return five percentage points higher than that. CalPERS points to its 8.4% annual return over the past 20 years, but that is irrelevant: when yields fall to historic lows, as they have over those two decades, investors make a capital gain that boosts returns. One cannot expect such returns to continue without a similar plunge in yields in future, which is almost impossible. And a world in which Treasury bonds yielded even less would probably be characterised by slow growth and deflation—not an environment in which CalPERS’s equity portfolio would thrive.

Even if hedge-fund managers did outperform a market index on a reliable basis, it would not solve the problem of pension funding. 

So what can underfunded pension plans do? First, stop basing contributions on unrealistic discount rates. Second, move away from defined benefit pensions toward defined contribution systems. Of course, such reforms are politically difficult and would face fierce opposition from state employee unions. But, as Rhode Island State Treasurer Gina Raimondo’s recent win in the Ocean State’s Democratic gubernatorial primary shows, there comes a point when a problem can no longer be kicked down the road – and that’s when boldness pays.