California’s giant state pension fund
The state’s giant pension scheme has an enviable record over many decades. Diversification is its secret, says Amanda Leek
‘A recent dalliance with hedge funds was ended’
For 84 years, California’s public sector workers have relied on the state’s giant pension scheme to fund their retirement and healthcare. The scheme – which is now known as Calpers – has 1.6 million members, comprising current workers, retired people and their families.
The fund has a record of producing enviable investment returns – an annualised rate of 9.4pc over 30 years – but has found this more difficult to maintain recently. In a story that too many investors will recognise, Calpers is having to reassess its approach in the face of lower returns.
What can its history and current methods teach individual investors?
Origins of Calpers
In 1930, an amendment to California’s constitution was passed that enabled the state to provide retirement benefits for employees for the first time. Two years later Sers was created – the state employees’ retirement system. In 1992 this was changed to Calpers – the California public employees’ retirement system.
The scheme’s safety-first approach was evident from its first investment mandate, which allowed only bonds to be held. By 1953, a greater emphasis on diversification started to take hold and the state passed a law that allowed Sers to invest in real estate as well as bonds.
In 1966, Sers was allowed to invest in stocks – but this was limited to 25 pc of the portfolio until 1984, when it started to investigate international opportunities.
Today, Calpers invests in more than 10,000 public companies worldwide and more than 60 pc of the total fund portfolio is invested in private and global equities.
California’s politicians had a say in the investment decisions made by the scheme until 1992, after which the board was given complete autonomy over investments. Campaigners said that it was to prevent Governor Pete Wilson using the fund to cover state debts at the time. Successs followed and, by 1996, the portfolio hit the impressive mark of $100bn.
A significant change came in 1999, when a Senate Bill gave state workers enhanced retirement benefits on the assumption that the estimated cost of $600m a year would be easily covered by investment gains.
Strong returns in the preceding years encouraged that view. In 1990, Calpers was 71 pc funded – meaning that it had the money to match 71pc of its liabilities. By 2000 this figure had reached 116 pc.
This was during the dotcom boom, however, and rosy economic times had given investors a false sense of security.
Recent history – and a squeeze on returns
The 21st century so far has been harder for investors, including Calpers. The fund had grown to $260.6bn on 31 October 2005. In 2008, the worldwide financial collapse sent it plummeting 32pc to $179.2bn in the years that followed.
The fund has recovered in size since, to about £290bn, but was just 73.3 pc funded by 2015. The scheme’s investments returned 2.4 pc that year –far below its 7.5 pc annual target.
Ted Eliopoulos, chief investment officer at Calpers, said recently: “We are now in an era at Calpers, in contrast to previous eras, in that we’re paying out more in benefits than we’re taking in contributions. The investment office is responsible for making up that shortfall.”
Part of the problem has been that, as interest rates have come down over the past 30 years, what used to work in the scheme – a large proportion of interest-bearing assets like bonds – can no longer be relied upon.
In response to critics who have claimed that Calpers’ 7.5 pc assumed rate of return was unachievable, the fund has been defiant, saying that it has earned an average of 7.6 pc annually over the past 20 years – and 9.4pc over 30 years.
Mr Eliopoulos said: “That is the first time the fund has outperformed both of these time periods since 2007, which represents another milestone in the recovery of our portfolio since the financial crash of 2009.
“The strength of our long-term numbers gives us confidence that our strategic plan is working.”
How is Calpers doing it?
The pension fund’s strategy can be summed up in a word; diversification. It is on record as saying that the starting point, and the most essential element, of achieving a successful return on investment is diversification among stocks, bonds, cash, and other investments.
In fact, Calpers believes that more than 90 pc of the variation in investment returns for any large, well-diversified pool of assets can be attributed to asset allocation decisions, rather than exactly what investments are chosen within those asset classes. Asset allocation targets and ranges are set by a committee with the objective of exceeding expected returns over rolling five-year periods, and to minimise or buffer the risk of loss in any single investment.
Calpers has been compared to endowment-investing models used by other public bodies, such as Harvard and Yale universities. These consist of roughly 70 pc traditional asset classes, including public and private equities, bonds and cash, and 30pc in alternative asset classes, such as real estate, infrastructure and even timber forests.
Calpers, though, has more than 90pc invested in traditional asset classes. A recent dalliance with hedge funds – the complicated funds that try to beat the markets with idiosyncratic investment theories – was ended in 2014. Hedge funds underperformed Standard & Poor’s 500 stock index for five years, leading to the $4bn of Calpers cash invested in them being redirected to other investments.
Calpers said that it would have had to increase hedge fund investments to at least 10 pc of the total portfolio for the returns to have a material impact, but that the fees made the option unfeasible.
“Hedge funds are certainly a viable strategy for some, but at the end of the day, when judged against their complexity, cost and the lack of ability to scale at Calpers’ size, the hedge fund programme doesn’t merit a continued role,” Mr Eliopoulos said in 2014.
Ethical approach
Calpers has led the way in sustainable and ethical investing. It divested its tobacco holdings in 2000 and also sold investments in two gun-makers in 2013. Each year, a number of companies are selected as part of its Focus List programme and the board of Calpers uses its might as a shareholder to influence them.
It aims to improve the companies’ corporate governance practices and environmental and social sustainability. The motivation is not only to make more benevolent companies, but also higher returns.
This has been described as “the Calpers effect”. In 1994, a study in the Journal of Applied Corporate Finance found companies on the list tended to trail the S&P 500 before inclusion, but outperformed it after being added.
It is now Calpers’ policy to increase investment in companies on the Focus List, on the basis that they tend to outperform.
The lessons from Calpers
Perhaps the biggest lesson for individual investors is to diversify. This is more important because the scheme’s approach also means taking on more risk in order to achieve its stated aims. It is harder than ever to get an income from bonds, so investors should consider moving some of their bond holdings to equities that yield income.
Equity income investment trusts are popular among investors looking for income. Their structure means that income payments can be maintained with cash reserves, or even borrowing, in periods when dividends from underlying companies fall away. Many have records of increasing their dividend running to several decades. City of London, for example, will have raised its dividend for 50 years in a row in 2016.
Calpers is diversified, but has moved away from complicated investments such as hedge funds. Individuals should do the same and resist funds or other investments if they don’t understand how they work.
It is also a reminder that cost can be the difference between hitting your investment goals and not. Low-cost, “passive” funds that track indices may return more than more complicated funds in the long term because their costs are lower.
Finally, consider an ethical approach – not simply because you may feel better, but also because companies willing to become more sustainable from a social, environmental and corporate point of view often go on to perform better than those that do not.
The iShares MSCI USA ESG Select Index is an exchange-traded fund which is bought and sold like a share in a company. It tracks large and mid-cap stocks screened for positive environmental, social and governance characteristics.