For as long as I've been paying attention to the American financial sector, the California Public Employees Retirement System has been a major mover in the stock market, whose investment decisions are as closely watched as those of the Fidelity Magellan fund, Berkshire-Hathaway and other nine-zillion pound gorillas of yore. So it was news to me, and may be news to you, that within living memory CalPERS was a mostly-bonds investor as staid and cautious in its strategy as the little old lady from Pasadena.
Ed Mendel's excellent long post on CalPERS' 1984 shift into higher-risk, high-return stock market investing is an object lesson in the way public entities can only respond to healthy increases in revenue one way -- through unhealthy increases in spending. Some history:
As the stock market began a decades-long boom, the Legislature placed a measure on the ballot, Proposition 6 in November 1982, allowing up to 60 percent of pension fund investments to be in stocks. It was rejected by 61 percent of the voters.
After a series of hearings the Legislature, with only two "no" votes, placed Proposition 21 on the June 1984 ballot to replace the 25 percent cap on stocks with a broader guide based on what a "prudent person" would do.
The stock market bet brought handsome rewards. Just a few years ago, returns on investment were paying 75 percent of CalPERS revenues, with another large chunk coming from the state's general fund and a small portion from employee contributions. The inevitable result: impossibly high projections of future returns, and a massive increase in pension payouts. Mendel again:
When funds had surpluses from a booming stock market, pensions were increased to levels now said by some to be "unsustainable." CalPERS famously told legislators a major increase for state workers, SB 400 in 1999, would leave state costs little changed for a decade. But expected investment earnings fell far short, causing a dramatic increase in state costs to $3.9 billion in the new fiscal year…
Critics say pension funds understate the debt owed for future pensions by assuming costs will be covered by overly optimistic earnings, about 8 percent a year.
It turns out the stock market doesn't go up all the time. Beginning in 2008, CalPERS lost somewhere between a quarter and a half of its portfolio. Even with the recent series of fools' rallies on Wall Street, returns on investments have shrunk to 63 percent of CalPERS' ongoing funding. And the taxpayers are on the hook to cover the shortfall. Should CalPERS return to a more stodgy investment strategy, the growth of pension payouts creates a massive liability for the state:
What happens when the debt is calculated with the less risky and much lower earnings from government bonds, a little over 4 percent, was shown in a study done by Stanford graduate students in April.
The Stanford report said the shortfall or "unfunded liability" for the three state pension funds (CalPERS, CalSTRS and UC Retirement) was a "hidden debt" of $500 billion, not $55 billion as reported by the retirement systems.
Nevertheless, reducing CalPERS' exposure to the market is probably the smartest move, if only because it reduces the incentive to keep spending. It's too easy to blame the shortfall on market setbacks. Market setbacks are an inevitable fact of life, but decisions to overspend are something you can avoid. Mendel resisted my invitation to say the pension "crisis" is strictly a spending rather than a revenue problem, saying "I don't know that you can separate the two." Nevertheless, he notes that after a decade of high returns on Wall Street, "they assumed they could make this gigantic increase in payments."
Even the chastened CalPERS is still making improbable projections of 7-to-8 percent on the market in order to sustain its inflated payments. To maintain the fund's current level of payouts, the Dow would have to reach 25,000 within a few years. Supposing that happened, history indicates the result would not be that CalPERS balances its books but that it ups its payouts. In public sector finance, everybody is Scottie Pippen.