Thursday, July 21, 2016

CalPERS Smears Lipstick on a Pig?

Timothy W. Martin of the Wall Street Journal reports, Calpers Reports Lowest Investment Gain Since Financial Crisis:
The largest U.S. public pension posted its lowest annual gain since the last financial crisis due to heavy losses in stocks.

The California Public Employees’ Retirement System, or Calpers, said it earned 0.6% on its investments for the fiscal year ended June 30, according to a Monday news release.

It was the second straight year Calpers failed to hit its internal investment target of 7.5%. Workers or local governments often must contribute more when pension funds fail to generate expected returns. Calpers oversees retirement benefits for 1.7 million public-sector workers.

Calpers’ annual results are watched closely in the investment world. It is considered a bellwether for U.S. public pensions because of its size and investment approach. Many pensions currently are struggling because of a sustained period of low interest rates.

“This is a challenging time to invest,” Ted Eliopoulos, Calpers’ chief investment officer, said in the release.

The last time Calpers lost money was during fiscal 2009 when the fund’s holdings fell 24.8%.

The giant California plan ended 2016 with roughly $295 billion in assets, and more than half of those funds are invested with publicly traded stocks. Those investments declined 3.4%, though the performance beat internal targets.

Fixed income produced the largest returns at 9.3%, though the results under performed Calpers’ benchmark. The California retirement giant’s private-equity portfolio posted returns of 1.7%.

Real estate holdings returned 7.1%, but that was below Calpers’ internal target by more than 5.6 percentage points.
Rory Carroll of Reuters also reports, CalPERS reports worst year since 2009 amid market volatility:
California's largest public pension fund posted a 0.61 percent return on investment in its most recent fiscal year, its worst showing since 2009, which it blamed on global market volatility.

The result marked the second straight year the California Public Employees' Retirement System or CalPERS failed to meet its assumed investment return of 7.5 percent.

If the $302 billion public pension fund consistently misses the 7.5 percent target, state taxpayers could be forced to make up any shortfall in pension funding.

Last fiscal year, CalPERS returned 2.4 percent on its total portfolio, marking a significant decline from previous years when the fund earned double digit returns of more than 10 percent. The result for the year ending June 2016 was the worst since an investment loss of 23.6 percent in 2009.

The yearly rates of return, once audited, help determine contribution levels for state agency employers and for contracting cities, counties and special districts in fiscal year 2016-2017.

Speaking at a CalPERS meeting, Chief Investment Officer Ted Eliopoulos said performance for the year was driven primarily by global equity markets, which represent a little over half of the fund's portfolio. Equities delivered a return of negative 3.4 percent.

"When 52 percent of your portfolio is achieving a negative 3.4 percent return, that certainly sets the main driver for the overall performance of the fund," said Eliopoulos, who had projected flat returns for the year in June.

Inflation assets returned a negative 3.6 percent return, helping drag down the fund's overall performance, Eliopoulos said.

Fixed income and real estate investments were bright spots in the portfolio, posting 9.3 percent and 7.1 percent returns respectively.

In response to the drop from previous years, Eliopoulos said CalPERS would reduce risk from its portfolio and have simpler investments that do not require paying fees to money managers.

Fund officials, recognizing that the wave of retiring baby boomers means it will pay out more in benefits than it takes in from contributions and investment income, have projected that the fund could have negative cash flow for at least the next 15 years.
And James Rufus Koren of the Los Angeles Times reports, CalPERS posts worst year since 2009, with slim returns:
California’s largest public pension fund made a return of less than 1% in its most recent fiscal year, the fund’s worst performance since 2009.

The California Public Employees’ Retirement System said Monday that its rate of return for the year ended June 30 was just 0.61%. What’s more, Ted Eliopoulos, the pension fund’s chief investment officer, said the poor year has pushed CalPERS’ long-term returns below expected levels.

“We have some challenges to confront,” Eliopoulos said during a conference call. “We’re moving into a much more challenging, low-return environment.”

CalPERS assumes that, in the long-term, it will earn investment returns averaging 7.5% a year. If the fund fails to meet that goal, the state’s taxpayers could be forced to make up any shortfall in pension funding.

Now, after two consecutive years of lackluster returns, CalPERS’ long-term averages have fallen below that crucial benchmark. Over the past 20 years, average investment returns now stand at 7.03%. Returns over the last 10 and 15 years now average less than 6%.

At this time last year, the fund had averaged annual returns of 7.8% over a 20-year period.

Over the past few years, many public pension funds have lowered their expected annual returns, according to pension consulting firm Milliman, and CalPERS could do likewise. That would increase pension costs for state and local government agencies that have employees covered by the pension giant.

Such a change is likely more than a year away, though. CalPERS next year will reassess its investment strategies, a process that, starting in 2018, could lead the pension fund to change how it manages its money and to lower its return expectations.

“We quite clearly have a lower return expectation than we had just two years ago,” Eliopoulos said. “That will be reflected in our next cycle. We are cognizant that this is a challenging environment for institutional investors.”

CalPERS last lowered its expectations in 2012, cutting anticipated returns to 7.5% from 7.75%, where they had stood for more than a decade.

CalPERS officials had recommended the rate be cut further, to 7.25%. But government agencies that pay into the pension system on behalf of their employees said that large of a reduction in expected returns would cut too deeply into their budgets.

As expected returns go down, the amount local governments have to pay for pension benefits rises. And small changes in expected returns can add up to big changes in what government agencies have to pay.

The shift from 7.75% to 7.5% in 2012 increased the state’s annual pension bill by $167 million. That doesn’t include the additional cost to local governments.

Last year, the CalPERS board approved a plan that could gradually lower the pension fund's expected rate of return to 6.5%, but — paradoxically — only cuts the expected rate in years of outsized investment gains.

CalPERS saw positive returns in a few types of investments last year. Its bond portfolio saw a particularly dramatic uptick of 9.3%, in line with a global bond rally driven by economic turmoil.

But the same factors that drove up the value of bonds cost CalPERS in other areas, specifically its stock investments, which make up more than half of the pension fund’s portfolio and lost 3.4% for the year.

During the same period, the Global Dow index, which tracks global stocks, fell 8.5%.

CalPERS also lost money on its investments in forest land, where its holdings lost 9.6% of their value. Forest land accounts for only 1% of the pension fund’s overall portfolio, however.

In a statement Monday, Eliopoulos said he was proud of eking out a positive return in a year of market volatility.

Since an investment loss of nearly 24% in the year ended June 30, 2009, CalPERS has seen annual returns fluctuate wildly, with double-digit gains in some years and tiny gains in others. For the years ended in June of 2012 and 2015, the fund earned 1% and 2.4%, respectively.
Dan Walters of The Sacramento Bee also reports, CalPERS’ unfunded liabilities grow as investment earnings lag:
You can smear lipstick on a pig, but that doesn’t change its innate porcinity.

Officials of the California Public Employees Retirement System, the nation’s largest pension trust fund, tried Monday to cast its very anemic investment earnings – well under 1 percent – in a positive light.

“Positive performance in a year of turbulent financial markets is an accomplishment that we are proud of,” CalPERS’ chief investment officer, Ted Eliopoulos, said in a statement as the fund’s 0.61 percent investment performance for 2015-16 was released.

That’s not as outlandish as it sounds because CalPERS is not alone. Pension funds and other big-scale investors around the world are seeing very slight, or even negative, results in an era of political and economic volatility, particularly in Europe, and interest rates near zero.

Eliopoulos said a a 3.4 percent loss in stocks, which are 52 percent of the CalPERS portfolio, dragged down its overall performance.

But the fact that CalPERS is not alone is not comforting. It means there’s almost nothing Eliopoulos can do on his own to generate higher returns – and, in fact, he sees an extended period of low trust fund earnings.

Over the last two years of earning just a fraction of the assumed 7.5 percent “discount rate,” CalPERS has fallen behind its assumptions by $30-plus billion. Thus, the entire trust fund has shrunk in relative terms because “contributions” by state and local governments and their employees fall well short of pension payouts and the earnings needed to bridge the gap haven’t been there.

With the fund stuck at around $300 billion for two years, it’s about $100 billion short of fully funding its pension obligations, and falling shorter each day. And that shortfall is based on its 7.5 percent discount rate, even though the average return has been under that mark for decades.

CalPERS has ramped up mandatory employer contributions to more than $10 billion a year and will continue as long as investment earnings lag.

But how far can they go? The state, counties and most special districts don’t have huge pension costs relative to their budgets – just 2.9 percent of the state budget. But cities are hit hard because they devote much of their budgets to police and fire personnel who have the most expensive benefits.

Soaring pension costs have contributed to the bankruptcies of three cities, and under the revised schedule that went into effect July 1, contributions of 50 percent of payroll, or more, for police and fire personnel are not uncommon.

If one cannot fairly fault CalPERS for anemic earnings, its overseers can be fairly criticized for maintaining the 7.5 percent earnings assumption that their own advisers say is too high.

Lowering it to a more realistic level, say to the 5-6 percent range, would sharply increase the unfunded liability and thus ramp up political pressure for more tax dollars from employers, or perhaps for modifying pension promises. It would risk a backlash in the form of one of the many pension reforms that have surfaced in recent years.

But just as a pig with lipstick is still a pig, a pension fund in crisis is still in crisis, and ignoring that reality benefits no one, including pensioners.
Lastly, and most importantly, let's go over CalPERS's news release, CalPERS Reports Preliminary 2015-16 Fiscal Year Investment Returns:
The California Public Employees' Retirement System (CalPERS) today reported a preliminary 0.61 percent net return on investments for the 12-month period that ended June 30, 2016. CalPERS assets at the end of the fiscal year stood at more than $295 billion and today stands at $302 billion.

CalPERS achieved the positive net return despite volatile financial markets and challenging global economic conditions. Key to the return was the diversification of the Fund's portfolio, especially CalPERS' fixed income and infrastructure investments.

Fixed Income earned a 9.29 percent return, nearly matching its benchmark. Infrastructure delivered an 8.98 percent return, outperforming its benchmark by 4.02 percentage points, or 402 basis points. A basis point is one one-hundredth of a percentage point.

The CalPERS Private Equity program also bested its benchmark by 253 basis points, earning 1.70 percent.

"Positive performance in a year of turbulent financial markets is an accomplishment that we are proud of," said Ted Eliopoulos, CalPERS Chief Investment Officer. "Over half of our portfolio is in equities, so returns are largely driven by stock markets. But more than anything, the returns show the value of diversification and the importance of sticking to your long-term investment plan, despite outside circumstances."

"This is a challenging time to invest, but we'll continue to focus on our mission of managing the CalPERS investment portfolio in a cost-effective, transparent, and risk-aware manner in order to generate returns for our members and employers," Eliopoulos continued.

For the second year in a row, international markets dampened CalPERS' Global Equity returns. However, the program still managed to outperform its benchmark by 58 basis points, earning negative 3.38 percent. The Real Estate program generated a 7.06 percent return, underperforming its benchmark by 557 basis points. The primary drivers of relative underperformance were the non-core programs, including realized losses on the final disposition of legacy assets in the Opportunistic program.

"It's important to remember that CalPERS is a long-term investor, and our focus is the success and sustainability of our system over multiple generations," said Henry Jones, Chair of CalPERS Investment Committee. "We will continue to examine the portfolio and our asset allocation, and will use the next Asset Liability Management process, starting in early 2017, to ensure that we are best positioned for the future market climate."

Today's announcement includes asset class performance as follows (click on image):

Returns for real estate, private equity and some components of the inflation assets reflect market values through March 31, 2016.

CalPERS 2015-16 Fiscal Year investment performance will be calculated based on audited figures and will be reflected in contribution levels for the State of California and school districts in Fiscal Year 2017-18, and for contracting cities, counties, and special districts in Fiscal Year 2018-19.

The ending value of the CalPERS fund is based on several factors and not investment performance alone. Contributions made to CalPERS from employers and employees, monthly payments made to retirees, and the performance of its investments, among other factors, all influence the ending total value of the Fund.

The Board has taken many steps to sustain the Fund as part of CalPERS' Asset Liability Management Review Cycle (PDF) that takes a holistic and integrated view of our assets and liabilities.
You can read more articles on CalPERS's fiscal 2015-2016 results here. CalPERS's comprehensive annual report for the fiscal year ending June 30, 2015 is not yet available but you can view last year's fiscal year annual report here.

I must admit I don't track US public pension funds as closely as Canadian ones but let me provide you with my insights on CalPERS's fiscal year results:
  • First, the results aren't that bad given that CalPERS's fiscal year ends at the end of June and global equity markets have been very volatile and weak. Ted Eliopoulos, CalPERS's CIO, is absolutely right: "When 52 percent of your portfolio is achieving a negative 3.4 percent return, that certainly sets the main driver for the overall performance of the fund." In my last comment covering why bcIMC posted slightly negative returns during its fiscal 2016, I said the same thing, when 50% of the portfolio is in global equities which are getting clobbered during the fiscal year, it's impossible to post solid gains (however, stocks did bounce back in Q2).
  • Eliopoulos is also right, CalPERS and the entire pension community better prepare for lower returns and a lot more volatility ahead. I've been warning about deflation and how it will roil pensions for a very long time. 
  • As far as investment assumptions, all US public pensions are delusional. Period. CalPERS and everyone else needs to lower them to a much more realistic level. Forget 8% or 7%, in a deflationary world, you'll be lucky to deliver 5% or 6% annualized gains over the next ten years. CalPERS, the government of California and public sector unions need to all sit down and get real on investment assumptions or face the wrath of a brutal market which will force them to cut their investment assumptions or face insolvency. They should also introduce risk-sharing in their plans so that all stakeholders share the risks of the plan equally and spare California taxpayers the need to bail them out.
  • What about hedge funds? Did CalPERS make a huge mistake nuking its hedge fund program two years ago? Absolutely not. That program wasn't run properly and the fees they were doling out for mediocre returns were insane. Besides, the party in hedge funds is over. Most pensions are rightly shifting their attention to infrastructure in order to meet their long dated liabilities. 
  • As far as portfolio returns, good old bonds and infrastructure saved them, both returning 9% during the fiscal year ending June 30, 2016. In a deflationary world, you better have enough bonds to absorb the shocks along the way. And I will tell you something else, I expect the Healthcare of Ontario Pension Plan and the Ontario Teachers' Pension Plan to deliver solid returns this year because they both understand liability driven investments extremely well and allocate a good chunk into fixed income (HOOPP more than OTPP).
  • I wasn't impressed with the returns in CalPERS's Real Estate portfolio or Private Equity portfolio (Note: Returns in these asset classes are as of end of March and will end up being a bit better as equities bounced back in Q2). The former generated a 7.06 percent return, underperforming its benchmark by 557 basis points and suffered relative underperformance in the non-core programs, including realized losses on the final disposition of legacy assets in the Opportunistic program. CalPERS Private Equity program bested its benchmark by 253 basis points, earning 1.70 percent, but that tells me returns in this asset class are very weak and the benchmark they use to evaluate their PE program isn't good (they keep changing it to make it easier to beat it). So I'm a little surprised that CalPERS new CEO Marcie Frost is eyeing to boost private equity.
In a nutshell, those are my thoughts on CalPERS fiscal 2015-16 results. Is CalPERS smearing lipstick on a pig? No, the market gives them and everyone else what the market gives and unless they're willing to take huge risks, they need to prepare for lower returns ahead.

But CalPERS and its stakeholders also need to get real in terms of investment projections going forward and they better have this conversation sooner rather than later or risk facing the wrath of the bond market (remember, CalPERS is a mature plan with negative cash flows and as interest rates decline, their liabilities skyrocket).

Hope you enjoyed reading this comment, please remember to kindly donate or subscribe to this blog on the right-hand side to show your support and appreciation for the insights I provide you.

Below, Ted Eliopoulos, CalPERS Chief Investment Officer, comments on positive investment performance during a challenging fiscal year.

Also, Réal Desrochers, head of the Private Equity Program at CalPERS discusses what they look for in terms of general partners (GPs) and how they need to shift the portfolio in the future.

One area where CalPERS can improve on private equity is by disclosing all the fees it pays out to external managers. But don't hold your breath on that as it's a hot political potato.

On that last point, you should all read Yves Smith's latest comment, CalPERS Reported That It Made Less in Private Equity Than Its General Partners Did (Updated: As Did CalSTRS), it's excellent.

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