CalPERS seeks safer path but can’t eliminate investment risk

08/23/2014 12:00 AM

10/07/2014 8:42 PM

CalPERS, still feeling the effects of the 2008 financial markets crash, is working to dial back the risk in its investment portfolio.

The changes figure to be incremental and won’t constitute a sweeping flight to safety.

The nation’s largest public pension fund has reduced its holdings in hedge funds in recent months and is examining whether it should pare back its investments in commodities and possibly other asset classes. The CalPERS investment staff is discussing the changes internally and could make some recommendations to the pension fund’s governing board this fall.

The discussions came in response to requests by board members in recent months for ideas to make the CalPERS portfolio less prone to severe downturns. Henry Jones, chairman of the fund’s investment committee, said last week that CalPERS is trying to find “risk mitigators.”

The move toward safety isn’t especially new. After losing billions on the housing market in 2008 and 2009, CalPERS weeded out some of the riskier investments in its real estate portfolio. Earlier this year, the fund adopted a new asset-allocation formula that puts more emphasis on bonds at the expense of stocks, which are more volatile.

CalPERS can’t run away from risk entirely, officials acknowledge. The California Public Employees’ Retirement System has set a goal of earning 7.5 percent a year on its investments in order to pay for the pension benefits promised to some 1.6 million Californians, and it can’t achieve those kinds of returns without taking chances.

“We end up having to have sort of a risk-seeking portfolio,” said Eric Baggesen, CalPERS’ senior investment officer for asset allocation and risk management, in an interview last week.

CalPERS earned 18.4 percent in the fiscal year that ended June 30, thanks largely to big returns in the stock market and private equity.

As the fund seeks to reduce risk, Baggesen said its portfolio won’t undergo wholesale changes. “I think radical is not the terminology that we would attach to this,” he said.

CalPERS’ strategies are closely watched by other institutional investors and have a direct impact on the cost of public pensions in California. In April 2013, the pension fund’s governing board adopted an accounting policy that effectively forces CalPERS to recognize the losses from the 2008 market crash more quickly. That’s translated into higher annual contributions from state and local agencies. Six months ago, CalPERS approved another rate hike, although this one was caused by actuarial studies showing retirees are living a lot longer than before.

The pressure to earn big returns persists even as CalPERS has more than recouped the losses from the market crash.

Its portfolio, which shrank from $260 billion to $164 billion, clawed back to the $260 billion level in April 2013. It hit $300 billion in early July and has been dancing around that level ever since.

But the swelling of its portfolio hasn’t fully restored CalPERS’ health.

Because it had a much smaller pool of cash to invest during the lean years, and its pension obligations continued rising as workers accumulated more service time, CalPERS has been unable to keep pace with its growing long-term retirement obligations. It is now only 76 percent funded. That means it only has three-quarters of the assets needed to pay for all its long-term obligations, although it has more than enough money to cover benefits for the foreseeable future.

As a result, Baggesen said, CalPERS is engaged in a near-constant balancing act between striving for profitability while trying to minimize risk.

CalPERS started making strides toward reducing risk five years ago, shortly after its portfolio bottomed out following the crash. The fund’s battered real estate holdings were overhauled. Raw land and other speculative investments were cleaned out, and CalPERS began putting money into safer deals such as leased-up office buildings and shopping centers. The reward was smaller, but so was the risk.

The fund took another step toward safety in February. Its governing board approved a new asset formula that seeks to reduce CalPERS’ ownership of public stocks and private equity to 59 percent of the total portfolio. Those assets constituted 63.6 percent of the portfolio as of July 31.

Other asset categories will increase. Notably, CalPERS plans to increase holdings of bonds and other fixed-income securities, which are less volatile, to 19 percent. They currently total 15.6 percent.

The move is designed “to take a little bit of the risk off the table,” said CalPERS spokesman Joe DeAnda.

Going forward, Baggesen said, the CalPERS staff is looking at reducing two of its smaller portfolios: commodities and hedge funds. CalPERS has about $2.5 billion invested in commodities and $4.5 billion in hedge funds.

Although commodities performed well in the past year, they have generated average returns of less than 4 percent over the past five years. By comparison, the overall portfolio has earned annual returns averaging more than 12 percent the past five years.

Hedge funds have also consistently lagged the overall CalPERS portfolio performance: just a 7 percent return in the latest fiscal year and a 5.6 percent average over five years.

CalPERS has been involved since 2002 in hedge funds, which are unregulated pools of securities available only to large investors. Hedge funds aren’t necessarily high-risk vehicles – some of them are devoted to plain-vanilla instruments such as Treasury bills – but they are known for charging investors high management fees compared to other asset categories. CalPERS paid its hedge fund managers $115 million during the 2012-13 fiscal year, the latest data available.

Given the cost and the profit performance, CalPERS has concluded it’s time to reduce its exposure. Its hedge fund investments have declined by about $1 billion in the past year, to $4.5 billion.

“We’re only going to take risk where we think we’re going to be compensated appropriately for taking it,” Baggesen said. “We had too much capital at risk there.”

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