CalPERS Outlines Key Economic Risks for Next Decade

Declining interest rates, increasing profit margins less likely to repeat, and high valuations across domestic markets topped the list.

Sitting at just 71% funded, the California Public Employees’ Retirement System (CalPERS) outlined in its December 21 Board of Administration meeting agenda the key challenges facing the system in order for it to hit the 100% funded sweet spot.

Declining interest rates, increasing profit margins less likely to repeat, and high valuations across domestic markets topped the list of challenges facing the pension program over the next 10 years. Slowing global economic growth, fewer opportunities to generate excess returns, and underfunded status limit options underscored the pension’s concerns.

The unpredictability of the current economic environment was one of the chief uncontrollable factors facing the pension.

Interest rate risk played a key role in the pension’s September 2019 update to its fixed income asset allocation guidelines. CalPERS is reeling in interest rate risk using duration management, which will be maintained at +/- 10% of the benchmark.

The pension’s fixed income portfolio generated a 9.6% net return in the 2018-2019 fiscal year.

“We saw good returns in several key areas. Our long duration fixed income portfolio contributed positively as interest rates fell,” Chief Investment Officer Ben Meng said at the time.

The list of risks may be familiar to those paying close attention to investors’ concerns these days. Rich Nuzum, president at Mercer, shared CalPERS’s sentiment on interest rate challenges. “For most of our clients—their boards of directors, their actuaries, their stakeholders more broadly—still expect them to deliver a reasonably high expected return,” he said.

The pension plan’s investments last year generated a 6.7% portfolio return. Its holdings are currently evaluated at $395 billion.

Nuzum said a high single-digit expected return, around 8%, was easy to get 20 years ago. “But as we look forward for the next 20 years, we believe dollar-denominated investment-grade bonds are likely to only give us 3.3%, and we project global developed market large capitalization stocks will only give us 6.4%, Nuzum told CIO. “So, whatever return number stakeholders have come to believe is normal, based on their historical experience, is going to be much more challenging to achieve going forward.”

Risks to investors are wide and varied, and their ideas are even including President Donald Trump’s tweets. Christopher Ailman, chief investment officer for the California State Teachers’ Retirement System (CalSTRS), said last year that despite the “Goldilocks economy,” he’s keeping a sharp eye on the president’s Twitter page.

Climate risk is also on CalPERS’s plate, and the pension plan is focusing on it by creating a three-pronged approach: engagement, advocacy, and integration. Engagement occurs by being involved in climate-conscious organizations that are seeking to perpetuate a low-carbon strategy, such as Climate Action 100+, Principles for Responsible Investment, and Ceres – Investor Network on Climate Risk.

Climate risk poses a risk to approximately one-fifth of CalPERS’ equity portfolio, according to their first climate change risk report. Energy stocks, construction, transportation, agriculture, food and forestry holdings were exposed to the most significant risks. CalPERS said the equity could be subject to policy, market and technology changes occurring in international jurisdictions.

However despite the risks, Meng said the pension fund will not divest from fossil fuel companies, and said the pension plan should not “constrain itself to a limited set of investment opportunities.

CalPERS and investment management firm Wellington Management launched a framework designed to help companies assess and disclose the potential risks of climate change on their business. “It is critical for us to understand how our companies are planning to adapt to the physical risks of climate change,” Beth Richtman, CalPERS’s managing investment director of sustainable investments, said in a statement.

“We advocate for changes that minimize the financial risk to our investments while quickening the pace to a low-carbon economy,” the pension said on their website.

The pension is trying to return to the glory days of pre-recession funded ratios. It had a 128% funded ratio in 1999, then dropped sharply from 101% in 2007 to 61% in 2009. The pension plan projects the funded ratio to hit 92% by 2028 if its investment returns hit 8%, 86% if investment returns reach 7%, and 80% if they hit 6%.

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