Private Equity A Bright Spot For CalPERS, CalSTRS

Pensions: California Public Employees’ Retirement System; California State Teachers’ Retirement System

Total Assets Managed: $233 Billion (CalPERS); $151 Billion (CalSTRS) (June 30, 2012)

Fiscal 2012 Returns: 1% (CalPERS); 1.8% (CalSTRS) (June 30, 2012)

CalPERS Private Equity Allocation: 14% ($34 Billion) (March 31, 2012)

CalSTRS Private Equity Allocation: 14% ($21 Billion) (March 31, 2012)

Chief Investment Officers: Joe Dear (CalPERS); Christopher Ailman (CalSTRS)

The California Public Employees’ Retirement System, the nation’s largest pension, gained just 1 percent in fiscal year 2012, finishing with a value $233 billion, while the California State Teachers’ Retirement System, gained only 1.8 percent for the year. It ended with assets worth $151 billion. For comparison’s sake, the S&P 500 gained 3.1 percent for the period.

The meager returns are important because states and cities, which in most cases are already financially stressed-out, must make up the difference between current assets and future liabilities if investment expectations fall short. Alternatively, they will have to force pensioners to accept smaller payouts.

Christopher Ailman, chief investment officer at CalSTRS, summarized the year’s challenges in a statement saying it was “a very difficult market for long-term investors like CalSTRS, with wild fluctuations amid ongoing instability in Europe, slowing growth in China and India, a U.S. credit-rating downgrade and a sluggish economy.”

For fiscal 2012, nevertheless, private equity performed strongly for both pensions. CalPERS’s $34 billion private equity program, which represents 14 percent of overall assets, gained 5.4 percent in fiscal 2012, while CalSTRS’s $21 billion portfolio, representing 14 percent of overall assets, returned 5.9 percent for the year.

Private equity strongly outpaced stocks, which made up half the portfolios at both pensions. At CalPERS, stocks delivered a loss of 7.2 percent, while at CalSTRS, public equity lost 3.1 percent, the pension’s worst-performing area. The best-performing asset class at both pensions was real estate, which returned 15.9 percent at CalPERS and 9.2 percent at CalSTRS. 

Overall valuations remain sharply below where they were in the fall of 2007, when CalPERS hit a peak of $261 billion and CalSTRS hit a high of $180 billion. In fiscal 2009, CalPERS lost 23 percent of its value, its worst yearly performance ever, while CalSTRS lost 25 percent. And the shortfalls from the financial crisis remain even after two years of partial rebounds. CalPERS posted gains of 11.4 percent in fiscal 2010 and 20.7 percent in fiscal 2011, while CalSTRS posted positive returns of 12.2 percent in fiscal 2010 and 23.1 percent in fiscal 2011.  

Nevertheless, the meager performances in fiscal 2012 are worrisome for three reasons. First, pensions across the country remain substantially underfunded, adding to the long-term financial burdens of states and cities.

At the end of fiscal 2011, CalPERS was only 74 percent funded, while CalSTRS was just 69 percent funded. As a consequence, CalPERS needs an additional $85 billion to fully meet its expected obligations, while CalSTRS needs an additional $65 billion. Back in April, CalSTRS said that without any changes to its current trajectory, it would run out of money within 30 years, and that even superior investment returns would not be enough to get back to full funding.

Second, the low returns are worrisome because both CalPERS and CalSTRS failed to meet their own customized benchmarks. Each pension uses a customized benchmark that it creates using the average weighting of allocations and return goals for each asset class. CalPERS underperformed its own customized benchmark of 1.7 percent by nearly 0.7 percentage points, while CalSTRS underperformed its customized benchmark of 3.3 percent by nearly 1.5 percentage points. In rough terms, a pension’s failure to meet these internal benchmarks means that its money managers on balance failed to add value and that the pension’s beneficiaries would have better off, after fees, if it had instead invested their assets more passively.

A third worry is that the current record-low interest-rate environment makes it is increasingly unlikely that pensions will be able to meet their legislated assumed rates of return, which are typically set between 7 and 8.5 percent. If these rates, which are used to determine pension contributions, are too high over an extended period, some pension funds are likely to fall even deeper into the red, making it less likely that they will ever be able to meet future obligations.

Michael Lewitt, a portfolio manager at Cumberland Advisors, said in an interview with Reuters, our sister news service, that most assumed rates of return were “unrealistic,” adding, “they have been fooling themselves because there is no realistic case they can make that,” he said. 

CalPERS and CalSTRS have assumed rates of return of 7.5 percent, yet median returns for large public pensions were just 6 percent over the last 10 years, according to Callan Associates. CalPERS’s ten-year rate of return is 6.1 percent, while CalSTRS’s ten-year return is 6.5 percent.

Even so, Joe Dear, CalPERS’s chief investment officer, defended current return assumptions, saying that 7.5 percent (which was lowered from 7.75 percent in March) was a “realistic objective for our fund,” pointing to CalPERS’s 20-year average return of 7.7 percent.  

While it may make sense for many pensions to lower their assumed rates of return, most state and local governments are hesitant to to so since lowering such assumptions would mean increasing pension contributions or lowering benefits, both of which are politically difficult in an era when state and local budgets are so tight that many communities are laying off teachers, fire fighters and other public workers.