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Pension Funds

CalPERS considers 4 asset allocation options; local officials prefer avoiding major changes

Theodore Eliopoulos

As the CalPERS board and investment staff mull over a new asset allocation for the next four years, one group consisting of cities, towns and school districts is making it clear that the retirement system needs to steer clear of any major portfolio restructuring.

Several dozen representatives of municipalities and school districts warned the California Public Employees' Retirement System board Monday that they were concerned about being asked to contribute more to keep the retirement system operational, saying the money wasn't there and would lead to a funding crisis for them.

The board is expected to approve a portfolio during a series of meetings on Dec. 18-20 from one of four choices for the four-year period starting July 1, 2018. The global equity allocation ranges from 34% to 59% under the four options, while fixed income ranges from 19% to 44%. All of the portfolio options include a 13% allocation to real assets and 8% to private equity. Both asset classes are considered capacity constrained by investment staff, which does not believe it is feasible to increase the size of the asset classes and still find quality investments.

CalPERS' asset allocation as of Sept. 30 was 50% global equities, 19% fixed income, 9% real estate, 8% each private equity and inflation sensitive assets, 4% cash and 2% infrastructure/forestland. Its current policy allocation for equities is 46% but bull markets increased equity exposure to 50% at of the end of September.

CalPERS Chief Investment Officer Theodore Eliopoulos on Monday refused to comment on which of the four portfolio choices the investment staff was leaning toward, while members of the board were also mum about their preference.

Many of the local officials called on CalPERS officials to adopt a portfolio choice that essentially keeps in the place the pension system's current allocation to its two largest asset groups, a 50% global equity portfolio and 28% fixed-income portfolio.

While governmental units are already going to get a contribution increase under that scenario in coming years, the increase would be smaller than under other portfolio options being considered by the board, CalPERS documents show.

Even under that scenario of sticking closely to CalPERS' current portfolio, Drew Boyles, mayor pro tem of El Segundo, said his city will be seeing pension payments making up 25% of the city budget within five years from 16% currently.

"These increases are not sustainable," he said, warning of potential police and municipal worker layoffs.

There are small differences from the current portfolio in the option favored by municipal and school officials. The differences are that cash is cut to 1% from 4% in the portfolio option and the current 2% infrastructure/forestland allocation is combined with the current 9% real estate allocation for a larger, new 13% real assets allocation. Also, the current 8% allocation to inflation sensitive — consisting of inflation-linked bonds, Treasury inflation-protected securities and commodities — would be moved into the overall fixed-income portfolio.

Most importantly to the municipal and school officials, the portfolio carries a 7% expected rate of return annualized over a long-term 60-year period. In December 2016, the Sacramento-based CalPERS board voted to lower its rate of return to 7% from 7.5% over a three-period through July 2019. The $342.5 billion pension fund is estimated by its actuarial staff to have an overall 68% funding ratio.

Two other portfolio options presented Monday called for an even lower rate of return, meaning even more contributions would be required from the governmental entries.

Under one of those plans, CalPERS equity portfolio is reduced significantly to 34% of the portfolio and fixed income increases to 44%. But that plan would only produces a 6.5% return annualized over a 60-year period, CalPERS estimates. Under another plan, the equity exposure sees a less drastic reduction to 42%, while fixed income rises to 36%. The expected rate of return under that portfolio would be 6.75%.

Another plan raises global equity to 59% and lowers fixed income to 19%. That plan would raise the long-term expected rate of return to 7.25%, but contradicts past recent actions by CalPERS to reduce equity exposure.

Eric Baggesen, managing investment director, asset allocation/risk management, said at the meeting that the two options that raise the fixed-income allocation would carry interest rate risk.

"And interest rate risk in some environments can be a diversifying characteristic, but if you believe you're in an environment where you have the potential of rising interest rates, that can mean basically capital losses in your fixed-income portfolio, " he said.

But Mr. Baggesen said sticking closely to CalPERS current portfolio with its 50% equity allocation also comes with a big risk in case of an equity market downturn.

Even under the scenario of almost mirroring the current portfolio, CalPERS statistics show its long-term returns are far from guaranteed. That portfolio only has a 6.1% expected rate of return annualized over the next 10 year, which would increase to a 8.3% return for the following 50 years, resulting in the 7% return for the blended 60-year period.

But Mr. Bagegesen said predicting returns over such a long-time period is challenging.

He said CalPERS' last asset allocation plan, which began July 1, 2014, has not worked out exactly as planned investment-wise. For the three-year period ended June 30, CalPERS had a net return of 4.6%, below its then 7.5% expected rate of return.