There have been many investment strategies over the years that have incorporated some aspect of leverage, but it is rare to see a public pension system decide to use leverage as an overlay on its plan’s asset allocation. The CalPERS Board of Directors recently adopted a new policy in a 7-4 vote permitting the use of leverage at 5% of the plan’s total assets. This strategy certainly comes with risk and it is the risk that needs to be evaluated relative to the potential gains.
I find it interesting that CalPERS has only recently reduced the long-term (20-years) expected return on assets (ROA) to 6.8% from 7% earlier in the year. In a WSJ article written by Heather Gillers, the writer refers to a CalPERS presentation that highlighted the fact that the current asset mix would only provide a 6.2% return going forward, which is clearly short of the new return objective. She also states that the use of leverage “reflects the dimming prospects for safe publicly traded investments by households and institutions alike and sets a tone for increased risk-taking by pension funds around the country”. But does it? Are more plans going to use leverage to create greater exposure to certain asset classes given the “dimming prospects”? We would certainly hope not, especially given the current investing landscape in terms of valuations and fundamentals.
As a reminder, the S&P 500 declined by nearly 50% during two major market drawdowns to start this century. As a result, the funded status for pension America collapsed, while contribution expenses skyrocketed! Using leverage at 5% of CalPERS’ current asset level means that potentially $25 billion in greater exposure will be created synthetically. Can you imagine what will happen to contribution expenses should this implementation results in greater losses WHEN the market corrects? In addition to approving the use of leverage, the Board also increased exposure to both private equity and private debt, but there are no guarantees that these strategies will achieve their forecasted returns.
The primary objective in managing a defined benefit plan is to SECURE the benefits at low cost and with prudent risk. Do the additions of leverage and greater exposure to both private equity and debt accomplish this objective? I think not!