Thursday, March 29, 2012

Pension Plans and the Quest for Earnings: CalPERS and Canada

We recently discussed the issue of pension plans and the earnings they are required to attain in order to meet their financial commitments in Pension Plans: What Might They Earn in the Stock Markets? The conclusion was that they would have an extremely difficult time meeting their targets through traditional investment strategies.

Many plans were adjusted over the past few decades to be consistent with rather rich pickings in stocks and bonds. The investment returns of that era are not likely to be repeated. Most US pension plans have earnings targets in the 7.5-8.0% range. A recent Wall Street Journal article discussed the struggles of the plans in the context of a decision by CalPERS, the biggest California public employees’ pension plan, to lower its earning target to 7.5% from 7.75%. This might see like a small change, but this rate exponentiates over many years in calculating required cash flows so it provides considerable leverage. Since pension benefits are guaranteed by state law in California, increased contributions by state agencies or employees will be required to cover the change in expectations.

"Peter Ng, employee benefits director in Santa Clara County, Calif., said the county's $240 million pension bill would jump by as much as 12% as a result of Calpers's lower assumed rate of return. About 15,000 park rangers, correctional officers and other county employees are part of Calpers."

CalPERS’ chief actuary had actually recommended a larger cut to 7.25%. How is the fund actually performing?

"Calpers, formally the California Public Employees' Retirement System, had a 1.1% return in the year ended Dec. 31. The fund's annual return was 8.3% for the latest three-year period and 5.1% during the past decade."

Given these numbers one might justifiably ask "How do you get to 7.5% over the long term?" The answer seems to be that you change your mode of investing in order to take advantage of the higher earnings available from riskier investments. If one visits the CalPERS website one finds a description of something called the Alternate Investment Management Program.

"The Alternative Investment Management (AIM) Program specializes in private equity investments. With over $49 billion of total exposure to this asset class, CalPERS is one of the largest private equity investors in the world. The AIM Program's goal is to perform as "the investor of choice" and leverage marketplace opportunities in order to achieve superior risk-adjusted returns. We accomplish this through three investment components - Partnership, Direct, and Fund-of-Funds."

CalPERS had $225 billion in assets as of the end of 2011. Consequently, the $49 billion in private equity investments is a significant fraction of the total. CalPERS has also moved into other nontraditional forms of investments.

A recent Reuters article focuses on the strength of Canada’s public pension funds and the aggressive investing posture they have assumed.

"Between them, CPPIB [Canadian Pension Plan Investment Board] and four other big Canadian players control over half a trillion dollars in assets, about the size of the total Swiss economy and more than the $410 billion managed by the Chinese sovereign wealth fund China Investment Corp."

These funds have managed to keep a low profile while they have been acquiring assets around the world.

"London's Heathrow Airport, toll roads in Chile, real estate from Manhattan to Sao Paulo, gas pipelines in the United States, water treatment plants in Britain, timberlands in Australia - all are fully or partially owned by pension plans of Canada's teachers, city workers and citizens."

Apparently, a period of general economic malaise is a good time to be wealthy.

"In an era of debt-laden cities, states and countries, there is no shortage of parties seeking investors for a highway, office tower or pipeline."

"’When governments hit the wall, the opportunities do arise. And they arise particularly in the infrastructure space,’ said Michael Nobrega, chief executive of OMERS, which manages the funds of Ontario municipal workers."

"In fact, pension plans and Chinese sovereign wealth funds are among the few players left with the liquidity to invest big, and the pension funds often have the edge."

The Canadian funds began operating in this mode in the 1990s, gradually moving resources from stocks and bonds to private investments in global markets. Along the way they have accumulated the staff and competence one would expect to find in private firms.

"A second reason for the Canadian inroads is the expertise of the fund's investment teams. CPPIB, Caisse and OMERS have as many as 800 each on staff to find attractive investments, put together bid proposals and close the deals."

"In contrast, U.S. funds tend to farm out sometimes huge amounts of capital to external managers because they lack the in-house talent to deploy the money."

The return on investment by the Ontario teachers’ fund is used as an example of how this approach has fared.

"’When statistics are published that show we earn 10 percent over 20 years and that for the past 10 years we've been the highest absolute return in the world and the highest value added return, people pay attention,’ he said."

"In 2010, the latest year for which figures are available, Ontario Teachers' had a rate of return of 14.3 percent."

If this sounds too good to be true—perhaps it is. When the global economy picks up and more players copy their game plan, the Canadians will be forced to move into riskier ventures in order to maintain such high levels of return. One will have to wait and see how this plays out. On the other hand, it is not clear that they have any alternative to the path they are following.

Those who are depending on pensions to carry them through their retirement years probably don’t like to associate the concept of risk with their plans’ investment strategies. They had better get used to the idea—there does not appear to be any other option.

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