On Sunday the Financial Times printed a disturbing article about a plan by California’s largest pension fund, CalPERS, to borrow to invest more into private equity. See Top US pension fund aims to juice returns via $80bn leverage plan.
Leveraged investment is risky to begin with and even riskier when the investment is into private equity but the combination is potentially lethal when cash is required to meet liabilities maturing in the not distant future. The duration of pension liabilities owed by the governments and school districts for which CalPERS manages pension assets is only 12 years or so. Borrowing to invest in private equity to meet liabilities that on average mature in 12 years is just nuts.
CalPERS is adopting this program for a reason the fund’s Chief Investment Officer admits in the article: “There are only a few asset classes with a long-term expected return clearing the 7 per cent hurdle.” But that hurdle is just an arbitrary marker set by CalPERS’s board for the purpose of calculating amounts to be contributed by employees and employers when pension promises are made. The higher the hurdle, the lower the contributions, a combination that encourages magical thinking about future investment returns. But when those earnings don’t materialize, deficits arise for which only employers are on the hook. Because employers are funded by taxes, that’s how CalPERS swings for the fences with your money.
The correct approach is to reduce the hurdle rate, not to increase the risk. 15 years ago that’s what I and others pleaded with state officials to do. But they chose to keep the rate impossibly high, deficits inevitably followed, and employers have been forced to boost pension spending at more than twice the rate revenues have grown, leaving less for classrooms and other services and devouring proceeds from tax increases.
This is one reason the Legislature should ask voters to approve a change in the governance of state pension funds, which since 1992 have been governed for the benefit of employees even though taxpayers have all the risk. In the meantime, legislators and the governor should discourage magical thinking by CalPERS’s board.
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