CalSTRS’s Too-Great Expectations

In a Wall Street Journal article published yesterday, CalSTRS’s Chief Investment Officer Christopher Ailman lamented earning a 7.1% compounded annual rate of return over the last 20 years, less than his pension fund expected.

Apparently Ailman doesn’t realize that 7.1% exceeds historical returns, as explained by Warren Buffett in his 2007 annual letter:

“The average holdings of bonds and cash for all pension funds is about 28%, and on these assets returns can be expected to be no more than 5%. During the 20th Century, the Dow advanced from 66 to 11,497. This gain, though it appears huge, shrinks to 5.3% when compounded annually. An investor who owned the Dow throughout the century would also have received generous dividends for much of the period, but only about 2% or so in the final years. It was a wonderful century. Dividends continue to run about 2%. Even if stocks were to average the 5.3% annual appreciation of the 1900s, the equity portion of plan assets — allowing for expenses of .5% — would produce no more than 7% or so.”

Based on that math, the typical pension fund should not expect a return greater than 6.4% (i.e., 28% times 5% plus 72% times 7% = 6.4%). Yet CalSTRS expects 7.5%, 17% higher (earlier in that 20-year period CalSTRS expected even higher returns). Looked at Buffett’s way, 7.1% was a wonderful return — and materially higher than CalSTRS should’ve expected.

Rising public pension costs are not caused by abnormally low returns but rather by abnormally high expectations, as explained here. The negative consequences of such unreasonable expectations fall on schoolchildren and current and future teachers, as explained here. Lowering the expected rate of return to a reasonable level won’t help address existing unfunded pension liabilities but will help prevent new unfunded liabilities by requiring realistic (i.e., larger) upfront contributions.

PS: Ailman placed blame on two recessions in the last decade but as Governor Brown has repeatedly pointed out, recessions always happen. Indeed, there were 20 recessions/depressions in the 20th century, an average of two per decade. To repeat: The problem is not markets but rather public pension boards setting unreasonably high expected rates of return.

N.B.: A 5% yield on bonds and cash is of course much higher than prevailing interest rates today. At (say) a 3% yield on bonds and cash, the blended expected return would be 5.9%. But note also that CalSTRS keeps a more aggressive (i.e., riskier) portfolio than the typical pension fund. Its June 30 2015 report shows it keeps only 17.5% of its assets into cash and bonds. But even then it should not be expecting a return of greater than 6.7% (i.e., 17.5% times 5% plus 82.5% times 7% = 6.7%), but also it should be expecting much greater volatility in its returns.

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