Lessons From CalPERS' Current Return Targets

Includes: DIA, QQQ, SPY
by: Roger Nusbaum

Joe Dear, CIO of CALPERS, was on the network news during the week defending the decision to keep the pension's 7.75% return target after averaging only 4.5% over the last 10 years. He said that if they were using a typical 60/40 asset allocation based in the U.S. that 7.75% would not be attainable. However, since they will move away from that and since they will find managers that can add alpha he believes that 7.75 is an attainable objective over the long term. He also noted that 7.75% is still below the median target for pension plans in the U.S.

What could possibly go wrong with a plan that relies on generating alpha and an assumption that returns will improve by 72% on an annualized basis? Actually I think there are all sorts of learning opportunities here and despite the absurd risks embedded I think these are very useful comments.

First there are political issues that are essentially immutable but need to be understood. If they lower the targeted return then that increases the shortfall. I believe I heard that the pension was only funded at 60% but after last year it had improved to being 70% funded (if you know different numbers please leave a comment). Whatever the actual stats, the process of calculating the funding includes assumed future returns. So a lowering of the assumed return increases the shortfall, which creates political problems (yes, this is bad).

The other sort of political point is that Dear cannot go on CNBC and say "yeah, we're going to stick with 7.75% but really we'd be lucky to get 5% so obviously our numbers will be way off and a lot of current pensioners and people looking to retire soon are going to get hurt when we blow up, which by my calculation, using a realistic return assumption, will be in 2017 or 2018." Something like that and they would set the state on fire.

Dear's comment about 7.75% being less than the median target for other pensions is a complete throwaway. If the fund does blow up, the fact that their assumption might have been less will be no solace to anyone getting wiped out by this and if a failure were to result in legal or civil proceedings I can't imagine that would have any impact on the outcome.

Things start to get more interesting in his acknowledgment that a 60/40 U.S. based portfolio offers little chance of getting the job done. Obviously this is a nice bit of confirmation bias as I have been saying the same thing since before I started blogging. In making this argument my focus is on long term fundamentals, about seeking investment destinations where authorities are not taking desperate measures to keep things going, where debt statistics aren't obviously lousy, demographics don't stink and maybe the country is becoming more relevant in the world economic order.

Often this line of thinking will draw comments on Seeking Alpha pointing out how Germany did over the last few months or some equally short term time frame with something that contradicts my thesis. This has been my thesis for a long time and over the longer term it has been playing out. But over the short term anything can happen regardless of fundamentals so, with a nod to Karl Popper, the market action for six months or a year does not invalidate the thesis. Of course the thesis could turn out to be wrong but it is not the market action of a single year by itself that would make it wrong.

Dear is not an idiot, unless he is an idiot for being subject to the politics embedded in working for a public pension. And if he thinks there is a better chance of achieving the desired return outside of the basic 60/40 U.S. based framework then we might want to heed that. We probably don't have access to the real estate exposure they do (although I don't want that exposure anyway) or the hedge funds they do but we can easily access foreign markets and this is getting progressively easier as time goes on.

The other point to hit on is the assumption of alpha and the need for alpha in order for the numbers to work. A few weeks ago I paraphrased Felix Salmon who noted that whatever the the stock market does in your investing lifetime, you will probably lag behind it a little bit. This pertains to both individuals and professionals. I would add this does not have to be universally true as some professionals and some individuals will outperform the market over the long term, which is encouraging. But if this is true then it must also be true that some other professionals and individuals will badly underperform the market. Our way of trying to add value is to try to avoid the full brunt of down a lot and try to be correct on some fairly big, long term macro themes. But if I somehow knew that the market would go up 10% every single year and that I would be up 9% every year I would make that work just fine in my own financial plan.

The above is obviously about being a diligent, or even aggressive saver. If you save properly and can be somewhere close, performance wise, to a normal, long term market result your plan should work assuming prudent spending decisions. The advantage you have over any pension is that you have a better chance of making the number you ultimately have work. If you think you need $1 million and you end up with $875,000 you can make that work because, well, you have to. If the pension has 1 million benefit recipients then they must pay those 1 million people and must pay them a certain amount - until it goes bust.

If a pension is underfunded then the managers and anyone else involved with running the fund obviously want to improve the liability situation. The potential failure in the case needing alpha just for the math to work is truly a dilemma that no one should want personally. If you're 50, have $400,000 saved, live a $100,000 life style that you don't want to give up then you have a real problem. Whether or not you've admitted it to yourself or not, something is going to have to give. Personally, I am very motivated to avoid that situation.