In June 2020, the California Public Employees’ Retirement System (CalPERS) issued a concise FAQ on its investment strategy titled “Toward a 7% Solution”, which addressed key questions about CalPERS’ efforts to achieve its target rate of return on its investments of 7%. CalPERS stated that they need “better assets” and “more assets” to capitalize on their structural advantages: a long-term investment horizon (i.e. they are long-term investors) and access to private asset classes. They refer to private assets, such as private equity and private credit, as “better assets”, due to the potential for higher returns and lower expected volatility compared to publicly traded assets. CalPERS uses the term “More Assets” to indicate leverage or borrowing to increase their assets that are generating investment returns.

To the uninitiated, it seemed as though CalPERS planned on borrowing a significant sum of money to invest in private equity. While private equity may have lower volatility than publicly traded assets, compared to other asset classes in CalPERS investment portfolio, private equity has the highest. During the July 2020 CSMFO Board of Directors meeting, concerns with CalPERS’ new strategy was discussed, given their previous efforts to reduce risk (i.e. Risk Mitigation Policy) and the impact it may have on our members’ organizations. As a result, an ad hoc committee to review CalPERS new strategy was formulated.

Through the collective power of interpersonal connections, the committee was provided an opportunity to review the “Toward a 7% Solution” white paper and schedule a meeting to discuss the new investment strategy with CalPERS representatives. After each member independently reviewed the white paper, the ad hoc committee first met in August 2020 to develop a series of questions to pose to CalPERS to better understand the investment strategy. 

In September 2020, the ad hoc committee met with CalPERS representatives, including Chief Executive Officer Marcie Frost and Interim Chief Investment Officer Dan Bienvenue, to discuss the “Toward a 7% Solution” strategy.

Based on the meeting with CalPERS, the ad hoc committee’s findings were reported to the CSMFO Board on September 17, 2020, which are summarized below:

MORE ASSETS

• “More Assets” and “Better Assets” are two distinct investment strategies, not one. 
•  “More Assets” would permit up to 20% of the investment portfolio to be leveraged. However, CalPERS already leverages $32 billion of its total portfolio, of 8% as of July 1, 2020. With respect to risk/reward, the additional leverage would impact liquidity and amplify both positive and negative returns. 
• While smaller state public pension systems permit higher leverage, CalPERS does not envision a scenario where they exceed 20% leverage in order to achieve the target investment return.

BETTER ASSETS

• The move to invest in private equity via the “Better Assets” strategy is not new – CalPERS’ current asset allocation targets up to 8% for private equity, which is the only asset class that is projected to earn more than 7% over the next ten years. As such, the “Better Assets” strategy aims to increase the asset allocation to 10%. However, with the current low interest rate environment, and the attractive potential return of private equity, private equity investment opportunities are competitive. As such, while the current allocation target for private equity is 8%, the actual allocation is only 6.6% as of September 30, 2020. 

Under the current investment mix and leverage threshold, CalPERS has a 39% probability of achieving a 7% return on investment. Incorporating the “More Assets” and “Better Assets” strategies only increases the probability of achieving a 7% return to 45%.

ASSET LIABILITY MANAGEMENT CYCLE (ALM)

CalPERS began its quadrennial Asset Liability Management Cycle (ALM) in July 2020, with a completion targeted date of November 2021. The “More Assets” and “Better Assets” strategies will be evaluated within the context of the ALM process. The ALM process allows for stakeholder input along the way, giving CSMFO members an opportunity to influence the evaluation of the strategy.

It may be a challenge, however, for our voices to be heard. CalPERS representatives have already stated they will not be able to meet their 7% return without increasing the asset allocation in private equity and using more leverage. Further, CalPERS has already begun to pursue the “More Assets” and “Better Assets” strategies in September 2020.

The ALM process includes the following actions:

Asset

Adopt capital market assumptions about expected returns and risk for each asset class (public equity, private equity, fixed income, etc.) Develop candidate portfolios of how CalPERS could allocate its investments among assets and review the expected return and risk of each portfolio. 

Liability

Adopt actuarial assumptions and project future plan funding requirements based on an evaluation of plan experience data, including demographic, mortality, and inflation. Candidate asset portfolios are integrated into this liability model to determine the likelihood and risk of different portfolios providing the funding necessary to meet the plan’s obligations to members.

The ALM process culminates in adoption by the Board of an asset allocation policy that best balances, in its determination, the need to meet funding requirements while not taking on excessive risk. The Board also adopts the discount rate which is used to calculate member contributions.  Historically, the expected investment return of the portfolio has also functioned as the CalPERS discount rate. Marcie Frost, CalPERS CEO, indicated that other state pension plans have discount rates that differ from their expected rate of return, and that is an option that CalPERS may consider.

BOARD DIRECTION

After considering the ad hoc committee’s findings, the CSMFO Board directed the ad hoc committee to take the following actions:

1. Identify a CSMFO member to attend and observe CalPERS Board and Committee meetings and keep the Board updated on any pertinent actions relative to CalPERS’ “Toward a 7% Solution” strategy. Debby Cherney, CEO of the San Bernardino County Employees Retirement Association,  was appointed as the representative, and Rich Lee, Finance Director from the City of San Mateo was appointed as the alternate.
2. Identify contacts in other organizations (i.e. CSDA, League, etc.) and determine if there is any interest in collaboration with CSMFO. 
3. Follow up with a webinar to provide more information to CSMFO members. CalPERS will be presenting at a general session at the 2021 Annual Conference. Don’t miss out on your opportunity to learn more.