By Ed Mendel.
When its investment fund had a huge loss during a stock market crash a decade ago, plunging from about $260 billion to $160 billion, CalPERS was caught by surprise and had to sell assets at a market bottom to pay bills.
Despite a fund reaching $368 billion last week during a record bull market, CalPERS is far from recovering its 100 percent funding in the year before the 2008 crash. It still has only 70 percent of the projected assets needed to pay growing future pension costs.
Gone is the careless optimism of CalPERS a decade before the crash.
Sponsoring a generous state worker pension increase (SB 400 in 1999), CalPERS told legislators the cost would be covered by a surplus, “continued excess returns”, and inflating the value of assets — without “costing an additional dime of taxpayer money”.
Last month the CalPERS board, at the request of several members, received a staff report on planning for the next “drawdown,” defined as a 20 percent drop in the market for at least three months.
The new CalPERS chief investment officer, Ben Meng, who began work in January, told the board his day-one project was the development of a “liquidity management and action plan” to pay bills and take advantage of investment opportunities during a drawdown.
News that the current economic recovery is the longest in U.S. history implies that a drawdown may be near, Meng said, but “we also know that economic recovery does not have to die of old age.”
He pointed to two extremes after a downturn in 1990-91. Japan is at one end, still not fully recovered. Australia is at the other end, “experiencing economic recovery for close to 30 years.”
In the past, Meng said, economic cycles have averaged roughly ten years, with six or seven good years and two to three bad years. The “unconditional probability” of a drawdown in the next 12 months is about 15 percent.
But if the economy is late in the cycle, the probability of a drawdown is much higher. Meng said the San Francisco Federal Reserve Bank recently estimated the probability of a drawdown in the next 12 months is 44 percent, the New York Federal Reserve 30 percent.
“It is important to know that the estimate is based on history and backward looking,” Meng said, “so it’s only if history is any indication.”
Even if there is no drawdown, the CalPERS funding shortfall could widen. An earnings forecast given the board last month expects the CalPERS portfolio to earn 6.1 percent over the next decade, below the target of 7 percent.
CalPERS is a long-term investor, and over 60 years the forecast is 7 percent. Meng’s takeaways: The 6.1 percent estimate could vary and is not alarming, a drawdown can wipe out several good years, and drawdown probability and severity tend to be underestimated.
Meng said normally during a recession Federal Reserve interest rates are lowered to aid recovery. But rates are already low, he said, calling it “uncharted territory” because interest rate cuts in the last three recessions were larger than current interest rates, 2.25 to 2.5 percent.
“This all sounds very scary for our members,” said board member Theresa Taylor, recalling that the 6.1 percent forecast has been discussed for several years. She said CalPERS had good investment earnings in recent years and forecasts are not an exact science.
Board member Lisa Middleton, appointed by Gov. Newsom in May to replace Bill Slaton in the local government seat on the 13-member board, referred to the jump in record-high CalPERS employer rates from lowering the earnings forecast used to discount debt.
“Knowing the impact that taking the discount rate from 7 1/2 percent to 7 had on municipalities across the state,” said the Palm Springs city council member, “seeing a 6.1 percent number is …”
“Concerning,” Meng offered.
“I’m looking for the right word, and it’s not coming,” Middleton said. “Scary is only the beginning.”
A chart in the CalPERS drawdown report uses the example of the S&P 500 stock index to show the difficulty in replacing an investment loss. Recovering from a 50 percent investment loss requires a 100 percent increase in earnings.
“If you’ve got a dollar and you lose 50 percent of that, you go to 50 cents,” as board member Henry Jones put it. “And you go 50 percent up, you don’t go back to a dollar, you go to 75 cents.”
Meanwhile, during the recovery period investment earnings are replacing the loss rather than adding to the previous total funding at a compounding rate, while in the case of CalPERS pension debt or the unfunded liability continued to rapidly grow. It’s about $140 billion now.
Another reason that CalPERS funding has not recovered is a delay in increasing rates paid by employers, which did not begin until 2012, four years after the stock market crash in 2008.
Rates employees pay to CalPERS are bargained by unions or set by statute, often ranging from 10 to 15 percent of pay. Unlike employer rates, employee rates are not increased to pay off debt or unfunded liability, usually resulting from below-target investment earnings.
CalPERS employer rates have soared, causing some local government officials to warn of bankruptcies. Police and firefighter rates have reached 70 percent or more of pay for two dozen local governments, a CalPERS funding level and risks report said last November.
“The greatest risk to the system continues to be the ability of employers to make their required contributions,” the report said.
Meng said a drawdown plan is needed to reduce the impact on employer-employee rates. An optimistic earnings target, 7 percent, and riskier investments help keep pensions affordable for employers, but also make CalPERS more vulnerable to drawdown.
Four steps already taken that make CalPERS less vulnerable to a downturn are the lower discount rate, an asset allocation with less risk, a $6 billion extra state contribution, and reducing the amortization period for new debt from 30 to 20 years.
A group from several CalPERS departments is said to be making progress on a “liquidity management and action plan” to avoid running out of money to pay bills during a drawdown while also having money to take advantage of new investment opportunities.
Meng said he is personally involved in a project for “a more real-time monitor and scenario analysis” and faster response to a drawdown, which may require asking the board to update policies designed for normal times.
“One of the ways we generate additional liquidity (money for an investment opportunity) is put on leverage on the total fund, so we borrow money,” Meng said in response to a question from a board member.
Other board members urged early communication with CalPERS members and other stakeholders to build support for the part of plan that calls for staying the course during a drawdown, avoiding risky changes or the panic selling of assets that locks in losses.
Reporter Ed Mendel covered the Capitol in Sacramento for nearly three decades, most recently for the San Diego Union-Tribune. More stories are at Calpensions.com. Posted 1 Jul 2019