CalPERS is about to roll out an unusual new investment policy that could reduce risks but also lower its portfolio’s profitability.
The new policy, to be discussed next week by members of CalPERS’ governing board, could prove controversial. Reducing profits could prompt the California Public Employees’ Retirement System to once again impose higher contribution rates on the state and on local governments.
CalPERS staff, in a report released Monday, said the new plan is designed to shore up the pension fund’s long-term financial stability even if it sacrifices some short-term profits.
The CalPERS board is considering the new “funding risk mitigation policy” at the same time CalSTRS, the teachers’ pension plan, is undergoing its own long-term analysis of how to reduce risk and volatility.
The proposed strategy at CalPERS, which controls $294.9 billion in assets and is one of the world’s most influential pension funds, caps more than a year of internal discussion on how to deal with increasingly volatile financial markets. It revolves around the CalPERS “discount rate,” the pension fund’s official forecast of annual investment returns, and is based on the idea that a year of very strong investment performance can often be followed by a difficult year.
Under the policy, CalPERS would reduce its discount rate, currently at 7.5 percent, when its most recent annual investment returns exceed the discount rate by a certain percentage. For instance, the rate would drop by 0.05 percent if CalPERS racks up investment profits that exceed the current rate by 4 percentage points. Stronger years would trigger bigger declines in the discount rate.
The pension fund would then adjust its portfolio accordingly, pushing more dollars into safer investments, which would be expected to generate lower returns. The staff report doesn’t outline which investments would be emphasized under the new plan.
The plan “establishes a mechanism whereby CalPERS investment performance that significantly outperforms the discount rate triggers adjustments to the discount rate, expected investment return, and strategic asset allocation targets,” according to the staff report, submitted to the CalPERS board’s finance and administration committee for a meeting next Tuesday. “Reducing the volatility of investment returns will increase the long-term sustainability of CalPERS pension benefits for members.”
Pension experts said the mechanism is unusual, if not unprecedented, but could make sense at a time when many pension funds are acknowledging that it’s difficult to maintain aggressive investment strategies. Keith Brainard, research director at the National Association of State Retirement Administrators, said public pension funds have been criticized for refusing to bank their profits and dial back risks.
“Some of those gains could have been booked,” Brainard said. The proposed CalPERS policy “seems consistent with the notion of taking gains when markets are strong, (in order) to reduce risk going forward,” he said.
CalPERS earned just 2.4 percent on its investments in its most recent fiscal year, well below the 7.5 percent forecast, in large part because of disappointing returns in the stock market. The portfolio earned 18 percent the year before. CalPERS has said it has earned an average of nearly 11 percent a year for the past five years.
Already, CalPERS has been phasing in higher pension contributions. The rate hikes are designed to make up for the multbillion-dollar investment losses suffered in 2008 and cover rising pension expenses stemming from larger government payrolls and predictions that retirees will live longer. When fully phased in, the moves will cost state and local taxpayers about $600 million a year.
The CalPERS system is 77 percent funded, meaning it has 77 percent in assets for every dollar of long-term obligations. Some pension experts say 80 percent funding is acceptable, while others say pension systems should be fully funded to be considered financially sound.