Great Expectations

Fox & Hounds Daily, 7/21/10.

By David Crane, Special Advisor to Governor Schwarzenegger for Jobs & Economic Growth

During a recent public discussion about expected investment returns, the Chief Investment Officer of a California public pension fund was quoted as saying that “I would argue, and I have, with people who said it’s going to be 6 percent or lower that they are basically saying the United States is going to go in the drain in the next 100 years. I’m not willing to go there.”

By all accounts this CIO is a very smart fellow.  However, in making that statement he’s up against some tough math because, for the 100 years of the 20th century – not exactly “in the drain” for the USA – an investor with assets allocated like the typical pension fund would have earned (you guessed it) around 6 percent.

Somehow a perfectly good return in the 20th century has become a poor expected return for the 21st century. How did that happen? As Warren Buffett explained in a remarkably prescient article in 1999, sometimes people extrapolate from statistically insignificant periods to draw invalid inferences about future long-term performance. For example, many people today came of age during the 17-year investment boom from 1982 – 1999, but as Buffett pointed out, “The increase in equity values [from 1982 to 1999] beats anything you can find in history.”

There were several reasons for the unique nature of 1982-1999, but the key point is that that period, or any 17-year period, fails as a basis for projecting long-term growth — especially for pension funds with long-term liabilities (e.g.,government employees who are 25 today will be receiving pension payments 50+ years from now). As that same CIO rightly put it, public pension investing is “a marathon, not a sprint.”  More relevant for pension funds is the 20th century as a whole.  For that period the Dow Jones Industrial Average advanced from 66 to 11,497, for an average annual return on stocks of 5.3 percent.

Add 2 percent for dividends and that takes you to 7.3 percent for the equity portion of a portfolio, which in the case of pension funds usually comprises around 72 percent of assets. The other 28 percent is invested in fixed income assets that may be expected to earn 4-5 percent.  Blended together and after expenses of 0.5 percent, that’s a total return of 6 percent. (Pension funds with a larger equity exposure, e.g., 80 percent instead of 72 percent, might expect closer to 6.25 percent.)

But despite knowing they’re in a marathon, our state pension fund boards have long over-estimated investment returns. In fact, at the very time that Buffett was warning investors in that 1999 article that the fast investment growth of the previous 17 years was not a good basis for projecting forward, one of those pension funds (CalPERS) doubled down in the opposite direction by successfully pushing the State Legislature to retroactively and permanently increase pension benefits for state employees while reducing contributions. CalPERS said its expected investment return would provide all the investment returns needed to meet both existing and boosted pension costs and even to cut contributions in the short term. The other major fund (CalSTRS) employed a similar return assumption.

Since then, over the past eleven years, those pension funds have earned less than 45 percent of their expected returns, taxpayers have had to spend more than $20 billion to make up the difference, and hundreds of billions more will be diverted from state budgets to pension costs for years to come.

Why is all this relevant now? The answer is that the boards of CalSTRS and CalPERS are in the process of evaluating investment return assumptions. As of now, both are 30 percent above that 6 percent rate. In fact, they’re even 15 percent above Warren Buffett’s expected returns for his pension funds.  Simply put, they need to get real.

Unrealistic investment return assumptions allow generations to steal money from future generations. The boards of CalSTRS and CalPERS should remember who takes the risk of their great, and unrealistic, expectations.

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