CalPERS looks to lower return expectations

Fund eyes proposals to reduce volatility by cutting back on risk

Cheryl Eason
Cheryl Eason said under the proposals, returns won't be as bad during the off years.

CalPERS officials want to lower the pension fund's volatility by reducing the system's 7.5% assumed rate of return over time.

To do this, they would cut the fund's allocation to riskier investments such as stocks and increase bonds and other less volatile asset classes in a move that officials acknowledge would constrain returns in up markets but reduce losses in down markets.

The board of the nation's largest defined benefit plan is scheduled to discuss two staff proposals at its Aug. 18 meeting — both of which would lower the assumed rate of return of the California Public Employees' Retirement System's $302.2 billion investment portfolio over the next 20 to 30 years. Board members could act on the proposals at their October meeting, according to CalPERS documents.

“The returns will be slightly less during the good years, but they also won't be as bad during the bad return years,” said CalPERS' Chief Financial Officer Cheryl Eason in an interview.

The system's staff projects the current CalPERS rate of return could drop by as much as a full percentage point to 6.5% over the 20 to 30 years, according to a May presentation to its board. The actual reduction the board might approve to the return rate could change as discussions continue, said board member Henry Jones, who chairs the system's investment committee.

The financial crisis — which saw CalPERS lose about 25% of assets — has taught the retirement system the need for risk mitigation and a less volatile portfolio, Mr. Jones said in an interview.

“It is essential that we do this,” said California Controller Betty T. Yee in an interview with P&I. Ms. Yee added that if CalPERS does not reduce volatility, it could jeopardize its ability to pay retirees in the future.

CalPERS officials say either plan could be put in place in time for the fiscal year that begins July 1, 2016. Scenarios under the proposals project reductions in the assumed rate of return when returns exceed the 7.5% current assumed rate of return or after every four-year period if returns don't meet expectations.

Less vulnerable portfolio

CalPERS reported returns of 2.4% for the fiscal year ended June 30, preliminary numbers released last month show.

Ms. Eason said lowering the rate of return would also enable officials to build a portfolio less vulnerable to market swings. The current 7.5% rate of return has a 12% volatility rate. Reducing the rate to 7%, as one scenario does, would translate to a 10% volatility rate. A 6.5% rate of return would equate to a volatility level of 8.5%, she said.

Stocks make up about 54% of the CalPERS' portfolio, while fixed-income investments make up about 25%. Ms. Eason said replacing stocks with bonds would be a key way to lower portfolio volatility, but officials say any volatility reduction plan would also involve changes in other asset classes, including private equity and real estate.

Along with reducing volatility, officials also plan to increase contributions from many of the more than 3,000 government units that participate in CalPERS — municipalities, non-teaching personnel at school districts and the state — to enable CalPERS to reach full funding, Ms. Eason said.

Ms. Eason said CalPERS also needs to shed risk because investment income is becoming increasingly important to pay benefits as the number of active members declines relative to retirees. Contributions to the system alone wouldn't be enough to fund the benefits.

CalPERS estimates it is 77% funded, according to the system's annual financial report for the fiscal year ending June 30, 2014.

Higher contributions

While public entities participating in CalPERS would have to contribute more under the proposals to offset the lower expected rate of return, a less volatile portfolio also would mean fewer swings in contribution levels, helping those entities budget for the future, Ms. Eason said.

But Chris McKenzie, executive director of the League of California Cities, said municipalities that contribute to CalPERS are already strained by increasing contributions.

He said contributions to CalPERS on average will double over the next six years due to a reduction in the assumed rate of return to 7.5% from 7.75% adopted in 2012 and policies that spread system losses over a longer period of time.

Mr. McKenzie said the association will not take a formal position until it receives feedback from a survey of members that will be conducted soon.

While both proposals would raise contribution levels, Ms. Eason said it would be done in a more controlled way. One staff proposal would reduce the rate of return in years when CalPERS has strong investment gains. It would cut the 7.5% assumed rate of return by 5 to 25 basis points for each four-percentage-point gain in investment return above the current rate in a given year.

The other plan would require reductions in the rate of return at set points once every four-year period if performance was not robust enough to merit a decrease in the return rate. And the reductions in the rate of return would also reduce risk by requiring replacement of riskier assets with less volatile investments.

The proposals follow a November 2014 CalPERS report warning that the sustainability of government plans whose members are part of CalPERS could be put in jeopardy if the fund experienced another loss like the approximately 25% in 2008-"09.

The report said the funding level of plans administered by CalPERS is generally between 65% and 85%, adding that “the probability of some plans falling below 50% funded at some point in the next 30 years ranges from 23% (for the schools pool) to 35% (for the California Highway Patrol Plan).”

“It is likely that this probability is even higher for some select public agency plans,“ the report said.

CalPERS Chief Investment Officer Theodore Eliopoulos said at a May workshop that overall, the fund wants to avoid falling to the 50% funding level. At the same meeting, Mr. Eliopoulos said the retirement system would be giving up investment returns if it reduced volatility, though he noted it was “dramatically lowering (the chance of) a really bad outcome.”

While CalPERS board members expressed general support for the proposals at the May meeting, one board member, J.J. Jelincic, said he is concerned about sacrificing investment returns by taking less risk. “I am not sure de-risking is the way to go,” he said. “I think we can hit 7.5% return over the long term,” he said.

Keith Brainard, research director of the Austin, Texas-based National Association of State Retirement Administrators said half of 126 surveyed state and municipal plans lowered their assumed rates of return to an average 7.68% at the end of 2014 from 8% as of June 30, 2010.

Mr. Brainard called the CalPERS' proposals “creative” because officials there want to reduce the rate gradually to avoid major spikes in employer contributions.

But Jeffrey MacLean, CEO of investment consulting firm Verus, Seattle, said CalPERS' time frame for the portfolio volatility reductions is so long that significant investment losses could mute its effectiveness.

“Anytime you start stretching things out 30 years and you make it conditional upon things that may or may not happen you are basically espousing a philosophy as opposed to a plan that is necessarily workable,” he said. n

This article originally appeared in the July 27, 2015 print issue as, "CalPERS looks to lower return expectations".