How Pension Funds Die, CalPERS Edition

Authored by John Rubino via DollarCollapse.com,

Say you’re running a big pension fund that – according to the politicians who are handing out ultra-generous benefits to public sector employee voters – has to generate 7% annual returns in order to meet the resulting obligations.

But the bonds you used to rely on now yield between 0% and 2%, depending on how far out on the yield (that is, risk) curve you’re willing to go.

Stocks, meanwhile, have been rising, but can also go way down. You remember the near-death experiences of 2008 and this past March, and you never, ever want to experience another such nightmare.

So what do you do? Well, if you’re extremely brave and your family already has plenty of money, you stand up, tell your bosses that their goals are impossible to achieve, and hold your head high as security escorts you to the door.

If you’re less brave and/or rich, you might roll the dice and bet the farm on high risk/high potential return strategies, and just hope that it all works out. Worst case, you’ll collect another couple years of big paychecks before security comes for you.

That’s what the biggest pension fund just decided to try.

CalPERS gambles on risky investment move

The California Public Employees Retirement System, the nation’s largest pension trust, benefited greatly from the runup in stocks and other investments during the last few years, topping $400 billion early this year.

CalPERS needed it because it was still reeling from a $100 billion decline in its investment portfolio during the previous decade’s Great Recession and was tapping state and local governments for ever-increasing, mandatory “contributions” to keep pensions flowing and reduce its immense “unfunded liability.” But it faced a backlash from local officials who said vital services were being cut to make their CalPERS payments.

Just when CalPERS appeared to be climbing out of its hole, the COVID-19 pandemic erupted early this year, sending the economy into a tailspin. Virtually overnight, the fund saw its value take a $69 billion hit as the stock market — CalPERS’ biggest investment sector — tanked. Stocks have since recovered, but CalPERS is still down about $13 billion from its high early this year.

Further investment erosions would, almost automatically, trigger even greater CalPERS demands for contributions from government employers, but the recession is also eating into their tax revenues, creating substantial budget deficits.

It underscores CalPERS’ vulnerability to capital market gyrations. Investments more immune to fluctuations would be safer but they offer very low returns and CalPERS could not safely meet its lofty earnings goal — an average of 7% a year.

It’s a vicious circle of conflicting demands and priorities, driven by an official policy of providing generous, inflation-adjusted pensions for government workers, bolstered by the political clout of public employee unions.

CalPERS desperately needs an escape route and has chosen the perilous path of debt. It plans to borrow billions of dollars — as much as $80 billion — to fatten its investment portfolio in fingers-crossed hopes that earnings gains will outstrip borrowing costs. It mirrors the recent and risky practice of local governments borrowing heavily to pay their pension bills via “pension obligation bonds.”

“More assets refers to a plan to use leverage, or borrowing, to increase the base of the assets generating returns in the portfolio,” the system’s chief investment officer, Ben Meng, wrote in the Wall Street Journalrecently. “Leverage allows CalPERS to take advantage of low interest rates by borrowing and using those funds to acquire assets with potentially higher returns.”

What could possibly go wrong?

The new scheme is an implicit admission that CalPERS can’t meet its 7% mark without increasing its exposure to the vagaries of the market. “There are only a few asset classes with a long-term expected return clearing the 7% hurdle,” Meng wrote.

Perhaps, then, the real problem is the 7% goal, much higher than those of private industry pension plans.

The author of the above article is appropriately skeptical. But it’s a safe bet that both public sector unions and local government officials are applauding CalPERS’ move because it buys them more time on the gravy train.

The near-universal hope is now that either an existential financial crisis forces the current national government to fold a pension bailout into a broader “everything bailout” or a newly-installed Democrat administration starts its reign by rewarding the public sector unions that helped elect it with a sector-specific bailout.

Both of these hopes are completely plausible, so it’s hard to fault CalPERS’ logic. But from a bigger-picture perspective, this kind of moral hazard appears to sit firmly at the intersection of greed and cowardice and is exactly the kind of thing that kills both pension funds and entire societies.