The California Public Employees' Retirement System decision on March 19 to reduce its assumed rate of return by a quarter point — to 7.5% from 7.75% — has rippled across the pension community.
The downward revision can be seen as a bellwether for pension funds around the country, bringing into focus the factors challenging public pension plans’ ability to meet their obligations to retirees, including rising and unfunded liabilities, tighter state and municipal finances, and volatile capital markets.
But the most glaring problem is the simplest to understand: Pension plans are not able to consistently generate adequate returns from public markets to meet their needed return targets.
When pension investments yield lower returns, employers — in this case the State of California and participating municipalities — must pay higher pension contributions to ensure the fund has the needed resources to pay retirement obligations. A target reduction of a mere one quarter of 1% is expected to cost California more than $300 million per year as well as increasing obligations of local municipalities and school districts. This could put even more pressure on cash-strapped state and municipal budgets and force taxpayers to ultimately foot the bill. The results could mean fewer schools, police officers and firefighters in California communities. But this is not an issue for California alone. Pensions & Investments data show that four of the nine largest public pension funds maintain assumed rates of return of more than 7.5%.
With U.S. public markets underperforming over the past decade, large pension funds have increasingly turned to alternative asset classes, including private equity, for their proven track record of generating superior investment returns. Given the challenges facing pension funds, this would seem like an easy decision. But private equity as an asset class has recently come under political fire for its business model and long-accepted tax treatment of investment gains. Unfortunately, some have conflated the tax debate with the value debate, a confusion that makes good headlines but runs counter to the interests of the workers and retirees whose financial security is dependent upon a healthy and stable pension system.
There should be no question about the value that private equity provides to pension funds and other investors, the companies in which it invests and the U.S. economy to which it contributes. Private equity’s value proposition to pension funds has been proven over extended time horizons. Two separate studies have shown that private equity beats the Standard & Poor’s 500 index over three decades by 4.5 percentage points and 3 percentage points per year, respectively. (The studies are: “The Performance of Private Equity,” by Chris Higson and Rudiger Stucke, 2012; and “Private Equity Performance: What do we know?” by Robert Harris, Tim Jenkinson and Steven Kaplan, 2012.)
As an asset class, private equity consistently generates annual, double-digit returns that strengthen the financial security of millions of working and retired Americans. During fiscal year 2011, CalPERS’ portfolio generated only a 1.1% return, which was buoyed by the 12.4% return provided by private equity in the same period. Similarly, as of Sept. 30, the Cambridge Associates U.S. Private Equity index delivered a 13.8% return over the past year and an annual 11.6% return over the past 10 years.
Beyond private equity’s outsized significance for public pensions, it is important to acknowledge the essential role the industry plays in our economy. The private equity industry drives economic activity and growth across the U.S. economy by investing in promising companies and those in need of a turnaround. Private equity operates nearly 14,000 U.S.-based companies, which employ 8.1 million people. Private equity investment grows key sectors of the economy, including technology, health care, and energy — vital industries for the U.S. economy.
As the election year rhetoric escalates toward a fever pitch and the value of private equity investing comes into question, we should not lose sight of the fact that private equity investing has helped public pension funds meet their obligations by generating superior returns for millions of workers. To be sure, private equity is an engine of positive economic change.