Pension Peril: They are confident, but is it justified?
Written By: Tom Hankes | Posted: Saturday, July 2nd, 2011
Pension fund managers and other institutional managers are confident in their strategies and the average investor probably would not question their strategies unless he bothered to take a peek under the hood. Consider this excerpt from a June 15th article by Jeff Cox of CNBC.com news: "The collective state governments are looking at a combined budget deficit of $112 billion this year, amounting to a staggering 17.6 percent of their total budgets, according to figures from the Center on Budget and Policy Priorities. Last issue, I suggested to you that excessive confidence in the safety of municipal bonds was potentially unjustified. Few investors can envision danger when we've had essentially an unbroken path to profits over the last 30 years or so except for a couple big bumps in the road in 2000-02 and 2008-09. Yet the Cox quote above ought to tell you that maybe something different, dramatically different, is on the horizon and you might wonder how it will affect you. Underperformance of the State's pension funds will have a cost. It will have major effects on the government services you receive and it may impact many of your tax liabilities. State, municipal and county officials all over the US are struggling mightily with economic forces they have never faced before and it's no different in Wisconsin: unemployment, health care, food stamps, etc.
If you review the allocation of major institutional investors, you will note that little has changed in the last 11 years. Consider CalPERS and CalSTRS, the two big California pension funds for public retirees and retired teachers. CalPERS has an allocation of 67.1% to global equities. CalSTRS's allocation is 54.1%. The CIO (Chief Investment Officer) of CalPERS recently noted that he was shooting for a 7.75% return on investment. Skepticism is appropriate here; let's consider the tough math involved: The non equity piece of CalPERS is 20% fixed income, maybe earning 2.5%/year on a "weighted" basis and the unidentified remaining 13% consists of cash, real estate, REITs and commodities. They will be lucky if they lose less than 3% over the next few years on the last three categories. With a rough, back of the envelope calculation, the fund will maybe break even on 33% of their investments. Therefore, to reach their 7.75% goal, they need to earn about 11.5% annually on all their equities. This is at a period of high equity valuations and a record low 3.4% cash/assets ratio held by institutional investors. Historically, this level of cash means a market peak, not a time to be backing up the truck to buy equities. Pension funds are not known for their great investment timing. CalPERS purchased its first commodity investment in 2007 after a huge price advance and then greatly increased it just in time for the crash in 2008-09. CalPERS also invested in a land deal in Arizona in 2006, right at the peak of the real estate boom. Five years later, they sold and locked in a 92% loss. In my view, the fund will face a major hurdle just breaking even over the next few years. As the saying goes, "their odds are slim to none and slim's outta town". Only time will tell. The Wisconsin Retirement Core Fund has 55% of its assets in equities. Assuming conservative break- even returns on all the other categories (bonds, real estate, private equity), they would need to earn 14.5% annually on the equity piece. How likely is this scenario?
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