Wednesday, March 23, 2011

CalPERS Rosy Assumptions

CalPERS, the pension fund in charge of California's $230B portfolio, recently noted they rejected adjusting their expected return over the next 10 years from 7.75% down to 7.5%. That 'saved' them $400MM this year! While you shouldn't quibble over things like 0.25%, understand they basically expect a 5% real return to their investment portfolio.

Here's data from 1990 through June 2010 on Calper's performance vs. some common benchmarks:

Avg. Ann Return
SP500 5.8%
Gov't Bond7.2%

Now, over this historical period interest rates declined from 8% to 3%, which added about 2% to the annual returns (asset prices rise when you decrease the discount rate). That isn't likely to repeat. At best rates will be stable, but probably they will increase. This will drag down not only their bond returns, but equity as well (bond and stock returns generally positively correlated). Thus, they are anticipating the same 5% return over inflation that occured with the one-time secular interest rate decline these managers experience over their working life (which tends to make one think it's simply a given).

Either someone invents cold fusion, the Mayan alien astronauts bring us all sorts of manna when they return in 2012, or we will monetize our debt to pay for all these off-balance sheet liabilities. I'm betting on the latter.


Rajat said...

"asset prices rise when you decrease the discount rate"

I understand that bond prices rise when inflation falls because the coupon is fixed, but should it necessarily happen for equities, given that dividends are presumably positively correlated to inflation?

Eric Falkenstein said...


mOOm said...

Wouldn't you expect in the very long-run that stocks would have a higher rate of return than government bonds? So even if CALPERS is overoptimistic, stock returns in the next 20 years might be better than in the last?

W.C. Varones said...

Good post, but you neglect dividends in the S&P 500 returns. That's worth a couple percent annual over the last 20 years.

Which means

1) CalPERS hasn't outperformed a dumb mix of stocks and bonds over the last 20 years


2) With dividend yields now below historical norms (as are bond yields), CalPERS has even less of a chance of repeating the last 20 years' 7.5% returns.

Anonymous said...

CALPERS provides yet another example of confusing the informaiton conatined in oast returns with the situation that created those returns - falling interest rates in the case of fixed income, beginning valuations for equities. This seems ot be endemic in the world of pensions. It would appear to me that the accounting and actuarial professions have facilitated a serious malmeasurement of future pension obligations, causing overpromises and underfunding.


Matthew Gunn said...

A recent Stanford study discounted CalPERS liabilities at the risk free rate and found an approximately $500 billion unfunded liability. Since government pensions are guaranteed and the State cannot legally default, some kind of government, near risk free rate is the correct discount rate to use.

Unsurprisingly, CalPERS does not agree. "CalPERS does not believe that using a risk-free rate as suggested in the study is appropriate since the fund can earn a premium over the risk-free rate with high certainty by investing in a diversified portfolio with an acceptable level of risk."

The CA government in essence holds a tremendous level of market risk. Since CA requires a 2/3 vote to increase taxes, my best guess is that K-12 school kids and Medicaid recipients ultimately bear the risk associated with public employee pensions. We'll see.

Anonymous said...

Couple mistakes here:

(1) There's no empirical relation between interest rates and stock valuations, although many people fervently believe there ought to be a relation.

(2) Debt monetizing is a gold standard concept which doesn't apply to a fiat money system.

Anonymous said...

And another one...your return numbers are wrong.

Unknown said...

If someone did invent cold fusion, it would somehow be more expensive than coal-fired power, and need billions of dollars in govt subsidies and loan guarantees to work.