CalPERS and the Risks of Private Investment

The California Public Employees’ Retirement System (CalPERS) currently faces $180 billion in unfunded liabilities, a daunting challenge that threatens its ability to support taxpayers and public employees alike. To address this significant debt, CalPERS has recently approved a strategy to boost its investment in private markets. However, this approach raises concerns about potential risks and the actual benefits that may not materialize.

Investing in private markets focuses on acquiring non-publicly traded assets, including private loans and real estate, as well as private equity and venture capital. CalPERS intends to increase its stake in private equity and private credit by 20%, which will result in these investments making up 40% of its portfolio. This shift comes at the expense of reducing investments in public equities and fixed-income securities.

Historically, CalPERS has had an average annual return of 6.7% over the past 20 years. In comparison, a passive investment in a 60/40 public stock and bond index portfolio would have yielded an average annual return of 7.7%. Furthermore, CalPERS has not surpassed the performance of the S&P 500 index, which achieved a 9.7% return over the same time frame. This trend of underperformance is consistent across the last 5, 10, and 15 years as well.

Proponents of private investments often argue that they can provide returns that exceed those of public market investments. However, these claims need to be carefully evaluated. In many cases, the promised higher returns fall short once fees, risks, and market conditions are considered. Although private equity has been highlighted as a top-performing asset class for CalPERS, boasting a 12.3% annualized return over 20 years, it is essential to note that this figure includes the early days of private equity when there was less competition for deals. Since then, estimates suggest that post-2008 private investment returns have not kept pace with public markets, especially when assessed on a risk-adjusted basis.

For the fiscal year 2023-2024, CalPERS has earmarked $790 million for administrative expenses and an additional $1.7 billion for third-party management fees. This brings its annual management costs to a staggering $2.5 billion. Despite these significant expenditures, CalPERS’ average return over 23 years stands at just 5.6%, which is markedly below its assumed rate of return of 7.6% over the same period. This disconnect raises serious questions about the effectiveness of its current investment strategy.

CalPERS is not the only pension fund grappling with these challenges. The growing trend among public pension plans is to increase exposure to private investment in hopes of compensating for ongoing underperformance and rising unfunded liabilities.

When CalPERS misses its investment return targets, the fallout falls on California’s taxpayers, who must cover any resulting shortfalls. Public pension liabilities are legally binding, meaning that reneging on them is not an option. As a result, when investments underperform, government employers—essentially taxpayers—are forced to fill the gap.

Due to continuous underwhelming returns, CalPERS has had to raise its debt estimates, leading to a new projection of $90 billion in unfunded pension debt for the state of California in 2023 alone. Local governments carry a similar burden of unfunded liabilities, compounding the issue. To manage this escalating situation, taxpayer contributions to government employer pension funds have surged from 19.5% of payroll costs in 2014 to 32.4% in 2023.

The increasing pension costs put immense pressure on California’s cities, counties, and school districts, limiting their budgets for essential public services, including education, infrastructure, and public safety. Should these funding gaps persist, government entities are likely to confront difficult decisions such as raising taxes, issuing bonds that incur more long-term debt, or cutting services.

There is a more prudent alternative. While CalPERS has recorded a 23-year average return of 5.6%, the Public Employees’ Retirement System of Nevada— valued at $58 billion—has achieved a 6.9% return over the same time period. The key difference? Nevada PERS took on less risk and operated with just three employees managing the fund, resulting in limited expenses and a focus primarily on publicly traded index funds.

In light of these findings, CalPERS should reconsider its investment approach and prioritize proven, effective strategies that are cost-effective and consistently provide better returns for all stakeholders involved, including taxpayers and public employees. Instead of persisting with high-risk, high-cost private investment schemes, CalPERS would benefit from adopting more efficient, low-cost investment models, such as index funds, which have outperformed its current strategies across the board.

CalPERS, Investment, Taxpayer