In “Conan the Destroyer,” the 1984 sequel to “Conan the Barbarian,” Arnold Schwarzenegger reprises his role as a sword-wielding slave turned vengeful warrior hero. In “Destroyer,” the bodybuilder-actor goes about his adventures surrounded by a rag tag collection of sidekicks: an eccentric wizard, a bumbling thief, a hissing femme fatale and, in an epic turn of stunt casting, Wilt Chamberlain.
As Governor of California, Schwarzenegger has an epic fiscal struggle on his hands. He recently turned to an unlikely supporting cast some might even view as B-List: some graduate students at Stanford’s Institute for Economic Policy Research.
Schwarzenegger has been urging the State Legislature to do something about pension debts hanging around California’s neck like some mythically sized manhole cover. He tasked the Stanford students to analyze the condition of the Golden State’s three big pension funds, CalPERS, Calstrs and the University of California Retirement System. Collectively, these entities cover 2.6 million employees and retirees.
The Gov’s band of researchers, using an assumed rate of 4.14 percent, or the yield on a 10-year treasury, unearthed a sinister secret: the funds were short a combined $425 billion, or around eight times what the funds had acknowledged.
Conan’s wizard (Akiro, played by Mako) could not have conjured a gloomier spell. But CalPERS was quick to retort:
The report, the pension fund said in a written statement , “relies on outdated data and methodologies out of sync with governmental accounting rules and actuarial standards of practice.”
The use of Stanford graduate students and a risk-free approach as baseline can’t be just scoffed away. It was creative to use those students and not pay a consultant $375,000. It is a sobering reality for pension stewards to assume sub 5 percent return if only for scenario planning purposes.
But CalPERS has produced a 7.9 percent rate of return annualized over the past 20 years, or around what the Standard & Poor’s 500 index produces on average during any given 20-year period in history. The famous fund today stands in excess of $200 billion. It was around $80 billion when I started covering pension funds as an associate reporter at Money Management Letter in 1995.
If the fund had not diversified, if it had invested in treasuries only, billions of investment earnings would have been squandered — national pension reporter laureate Mary Williams Walsh at the New York Times possibly would have written a damning article with headline like, “Risk Averse to a Fault? California Pension Fund under Fire for Overly Conservative Approach” and a lead paragraph citing unnamed actuarial consultants and class-action lawyers who concluded independently that by investing solely in treasuries the fund cost retirees tens of billions.
However, the safekeeping of retirement assets is serious business and maybe the investment industry has been too aggressive in selling pension officials on the merits of various vehicles in the name of diversification, including hedge funds. The industry has been burned trying to push risk parameters but there are examples of missteps when even trying to play it safe. The Pension Benefit Guarantee Commission in the early part of the last decade decided it was going to forgo the whims of the equity market and embrace fixed income to mesh with its fixed liabilities, sort of a Ronco lock, set and forget approach, except that eventually a new PBGC head came in and said that was foolish and returned to stocks just in time for the meltdown. Market timing may be a fool’s errand when it comes to chasing upside but in terms of worst possible timing the PBGC proved the sky is the limit.
CalPERS walks the talk on diversification, even creating, a few years ago, an entire new bucket for inflation linked assets, including commodities. I realize in my last column I got preachy about how big swaps players, serving gorilla pension funds, are circumventing rules, however that doesn’t mean I think CalPERS should not be allowed to dabble in exposure to the asset class.
That CalPERS has any exposure to an asset class deemed by the New York Times to be too risky for a pension fund underscores the fund’s desire to be as utterly diversified as possible even if it means some headline risk.
Right now, the commodities investment, part of the inflation-linked bucket, is only a small percentage of the fund. The inflation-linked bucket is less than 3 percent (and contains in addition to commodities swaps some TIPs) but there is a commitment to grow that piece of the pie as a strategically non-correlated play, CalPERS has said, despite the fact that since embarking on this approach the inflation linked asset class (ILAC) has been sort of a disappointment, down around 4 percent on average over the past three years.
The easy story line here is: CalPERS dabbles in commodities and gets burned, just as it is easy for journalists to seize on the Schwarzenegger/Stanford press release that California’s pension funds are actually almost one half trillion, way worse than anyone thought.
Actuaries may have bigger fish to fry on the other side of the equation: people are living longer. Maybe retirees could agree to take a lump upfront sum and invest on their own, in individual accounts, such as what some have proposed for Social Security participants a la the Chilean model. Or maybe just leave it to the investment stewards at CalPERS to find a way to the get that 8 percent average return over the next 20 years and stay at least 80 percent funded or maybe even become over funded at which time some future barbaric political force can attempt to maybe even raid the fund, although that is another story.
