CalPERS and the Need for Better Investment Strategies

The California Public Employees’ Retirement System, also known as CalPERS, is facing a significant challenge with $180 billion in unfunded liabilities as of its latest report. In an effort to tackle this debt, CalPERS has recently approved a plan to increase its investments in private markets, a strategy that raises concerns about risks and effectiveness for both taxpayers and public employees.

Investing in private markets means purchasing non-publicly traded assets, which include private loans, real estate, and private equity and venture capital. CalPERS has announced plans to boost its investments in private equity and private credit by 20%, bringing this segment to represent 40% of its total portfolio.

This shift comes at the expense of reducing its holdings in public equity and fixed-income investments. Over the last 20 years, CalPERS has achieved an average annual return of 6.7%. In contrast, if fund managers had opted for a more straightforward and passive approach, such as a 60/40 public stock and bond index portfolio, they would have realized a 7.7% average return. Furthermore, CalPERS underperformed compared to the S&P 500, which yielded a return of 9.7% during the same period. This pattern of lower returns continues throughout 5-, 10-, and 15-year time frames.

Private investments are often marketed as a means to generate higher returns alongside diversification. However, the reality often falls short when accounting for risks, fees, and market conditions. Currently, private equity appears to be the best-performing asset class for CalPERS on paper, boasting a 20-year annualized return of 12.3%. However, this figure originated during the early years of private equity when competition was less fierce, making it easier to secure high returns. Recent estimates suggest that private equity returns since the 2008 financial crisis have not measured up, particularly when assessed against public market returns that account for risks and fees.

For the fiscal year 2023-2024, CalPERS has allocated $790 million for administrative expenses and an additional $1.7 billion in management fees for third-party investments, bringing the total management cost of the pension fund to a staggering $2.5 billion. Despite these hefty costs, the average return for CalPERS over the last 23 years stands at a mere 5.6%, significantly lower than its assumed return rate of 7.6% during that same timeframe.

CalPERS is not alone in this predicament. Its transition toward an increased focus on private investments reflects a broader trend among public pension plans that are taking on higher risks in hopes of addressing ongoing underperformance and escalating unfunded liabilities.

When CalPERS fails to achieve its targeted investment returns, the burden of covering the resulting shortfalls falls solely on California’s state and local governments and, ultimately, taxpayers. The obligations associated with public pension liabilities are legally binding, which means there is no possibility of defaulting on these debts. Therefore, when public pension investments do not perform as expected, it is the government employers—and consequently the taxpayers—who must bridge the financial gaps.

Due to consistent underperformance, CalPERS raised its debt estimates. As of 2023, the state’s unfunded pension debt is pegged at $90 billion, a figure that only accounts for state liabilities. Local government liabilities are estimated to be nearly equivalent. This situation has forced an increase in employer contributions from taxpayers—from 19.5% of payroll in 2014 to 32.4% in 2023.

The rising costs associated with pension contributions leave California's cities, counties, and school districts with diminished resources for vital public services, including education, infrastructure, and safety. If these funding shortages persist, governments may be compelled to make tough decisions, such as hiking taxes, issuing bonds that contribute to long-term debt, or cutting essential services.

However, a more favorable approach may exist. Since 2000, CalPERS has recorded a 23-year average return of just 5.6%. Meanwhile, the Public Employees’ Retirement System of Nevada, with a fund size of $58 billion, has achieved an impressive 6.9% return over the same period while maintaining a lower risk profile. Nevada PERS has accomplished these returns with only three employees managing the fund's investments, leading to lower costs and better long-term outcomes by focusing primarily on publicly traded index funds.

It is crucial for CalPERS to shift its focus towards more proven and effective strategies that not only reduce costs but also consistently deliver superior results for taxpayers and public employees alike. Instead of persisting with high-cost, risky, and underperforming private investment strategies, CalPERS should consider embracing efficient and low-cost investment alternatives such as index funds, which have consistently outperformed its existing strategies across multiple benchmarks.

CalPERS, investments, taxpayers