Regular readers will recall that I frequently promote the Wisconsin Retirement System as a model in which its shared-risk structure, along with sound governance in general, keeps the plan fully funded, year after year. If assets tumble, retirees’ cost-of-living adjustments are reduced, or, as needed, the benefits themselves are reduced. In addition, as needed, both employer and employee contributions are adjusted from year to year to account for other sorts of gains or losses.
Last week, I discussed the case of the multiemployer pension plan for musicians, in which class action plaintiffs/lawyers accused the plan of investing too aggressively and I observed that the entire governance structure is designed so that employees and employers are represented by the trustees making those decisions, who must bear in mind the trade-offs between risk and reward, knowing that conservative investments mean lower benefits promised and riskier investments increase, well, the risk of future insolvency or, at any rate, future contribution hikes. And the week before, I described a Supreme Court ruling that determined that employees in single-employer pensions had no standing to sue for overly-risky pension fund management because it was the employer who both took the risk and was at risk of higher pension contributions in the future if their gambles didn’t pay off.
Now we have another example of pension risk-taking, as Ben Meng, the Chief Investment Officer at Calpers, the pension plan for public employees in California, announced plans for more risk-taking, in a commentary in the Wall Street Journal.
“[E]even before the pandemic, we knew that our goal of achieving a risk-adjusted return of 7% would require addressing the market’s triple threat of low interest rates, high asset valuation and low economic growth. In late 2019 we mapped out an investment strategy to deliver sustainable results.
“The solution is based on ‘better assets’ and ‘more assets’ and will capitalize on Calpers’s advantages: a long-term investment horizon and access to private asset classes.
“Calpers must diversify and increase exposure to private assets, such as private equity and private credit. We refer to these as ‘better assets’ because they have the potential for higher returns and lower expected volatility when compared with publicly traded assets.
“’More assets’ refers to a plan to use leverage, or borrowing, to increase the base of the assets generating returns in the portfolio. Leverage allows Calpers to take advantage of low interest rates by borrowing and using those funds to acquire assets with potentially higher returns.”
“To meet its future obligations, Calpers must generate a 7% annual return. Yet an in-house study in 2019 found that its chances of meeting that target over 10 years are just 39%. . . .
“Without any changes, the long-term return on Calpers’s portfolio is estimated at 6%. . . .
“Implementing leverage has the most potential to backfire. While borrowing money can boost profits, it can also magnify losses and exacerbate return swings.
“’We will have to live with the possibility of market drawdowns as the price for increasing the probability of achieving our ambitious target rate of return,’ Meng said. ‘There is no alternative.’”
Of course, that’s not correct; the alternative is fairly straightforward: accept a lower return. The determination that the expected rate of return on assets must not sink below 7% is what is compelling Meng and Calpers to take these risky actions. And the nature of public plan accounting — that they are doubly-dependent on a high return on assets because that expectation determines the valuation interest rate regardless of what actual returns look like from year to year — creates perverse incentives to take even greater levels of risk.
In the case of a private-sector corporate pension plan, executives know they must balance risk and reward. They disclose their level of pension risk to their investors, and are, by and large, seeking to reduce that risk. In the case of a multi-employer plan, likewise, trustees know that they’ll have to balance ire of participants now, if they feel they’re not getting enough pension accrual benefits for their contributions, vs. ire later, if those contributions must be increased to pay pensions for those long-since-retired because they were too ambitious in their risk.
But Meng and Calpers? They act as if they are wholly isolated from the effects of the risk they’re taking on. If their investments pay off, they’re lauded for their skill; if not, there’s no harm done in the unfunded level worsening or taxpayers paying the bill for funding improvements at some undefined time far in the future — taxpayers to whom Calpers and the entire public pension structure feels no accountability. It’s “heads I win tails you lose.”
After all, to revisit the Wisconsin system, visualize Meng as investment manager of that system and giving his pitch not to a roomful of executives, but to retirees and telling them, “if my plans work out, you’ll see steady cost-of-living increases; if not, we’ll cut your benefits.” How many of them would agree?
As always, you’re invited to comment at JaneTheActuary.com!
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