As Colorado’s Pensions Add Risk, California Seeks to Reduce It


Even as Colorado’s state public pensions seek to add risk to their portfolio, California CalPERS is seeking to reduce risk and volatility in its own plan.  In doing so, it sends up a flare for other pension plans.  It also confirms one of the key assertions of defined benefit plan critics: the aggressive return assumptions, combined with permissive discount rate assertions, in US public pension plans incentivize those plans to chase those returns, and add risk in doing so.

In a piece I wrote back in March for Watchdog Arena, I noted that Colorado PERA’s Board of Trustees had voted to shift several percentage points of investment from stocks and bonds into riskier alternative assets and real estate.  This portfolio isn’t necessarily out of line with the majority of US public pension asset allocations, but it does represent adding risk – and therefore volatility – in an attempt to increase returns.

Yesterday, Pensions and Investments reported that CalPERS is looking at reducing its expected 7.5% rate of return to as low as 6.5%.  Doing so, the plan says, would allow it to shift its investments out of stocks and alternative assets into more predictable, less volatile bonds.

“It is essential that we do this,” said California Controller Betty T. Yee in an interview with P&I. Ms. Yee added that if CalPERS does not reduce volatility, it could jeopardize its ability to pay retirees in the future….

Ms. Eason said lowering the rate of return would also enable officials to build a portfolio less vulnerable to market swings. The current 7.5% rate of return has a 12% volatility rate. Reducing the rate to 7%, as one scenario does, would translate to a 10% volatility rate. A 6.5% rate of return would equate to a volatility level of 8.5%, she said.

In doing so, CalPERS doesn’t implicitly accept the critics’ assertions – it explicitly accepts them.  They would lower the expected rate of return specifically so they could “safely” move assets into less risky (albeit less remunerative) investments.  Public pension officials in the US have long denied a linkage between the two, so it will be interesting to see how they react to this admission.

By most measures, CalPERS is better funded that Colorado PERA, although not particularly well-funded.  It admits to a funding level of 77%, compared to PERA’s claimed funding level of 62%.  These claims both discount the pension liabilities at 7.5%, the assumed rate of return.  Lowering CalPERS’s expected rate of return to 6.5% would, correspondingly, lower its funded level by lowering its discount rate.  A study by State Budget Solutions, however, using the states’ cost of borrowing as the discount rate, placed the funding levels at 39% and 32%, respectively.