CalPERS, the giant Californian state pension fund, recently evaluated an investment beliefs framework it introduced in 2013. Christopher O’Dea assesses the reassessment

Two years into a wide-ranging programme to embed a set of 10 investment beliefs as decision-making guidelines, the board of the $300bn (€266bn) CalPERS has room to improve how the board and staff implement the first belief, that liabilities influence asset structure (see CalPERS investment beliefs).

The findings were part of an assessment of the beliefs programme that Towers Watson delivered to the CalPERS board at the fund’s May meeting. While concluding that the programme is a “successful work-in-progress”, the report states that “there remains a disconnect” between the current application of the beliefs in investment work and the “target state” of having the beliefs drive investment activities. 

CalPERS investment beliefs were completed in September 2013 to “provide a basis for strategic management of the investment portfolio, inform organisational priorities, and ensure alignment between the Board and CalPERS staff”, according to the Towers Watson report. The review was undertaken to assess how effectively the beliefs were being used, identify ways to enhance the new framework in light of experience, and bolster the commitment of key stakeholders – including the investment staff and the board – to the initiative. CalPERS recognised “that moving to a new way of operating, as occurred in introducing the beliefs approach, always requires ongoing commitment to embed the change elements in business-as-usual”.

That has introduced an evolutionary element to the CalPERS organisation. “The investment beliefs are not a checklist to be applied to every decision,” the report says. “They are a guide for making decisions that often require balancing multiple, inter-related decision factors.” Perhaps most relevant in the current macroeconomic and financial context, the investment beliefs “acknowledge CalPERS responsibility to sustain its ability to pay benefits for generations”.

Living up to that responsibility is proving to be challenging. According to the report, CalPERS can do a better job implementing belief number one. Towers Watson surveyed CalPERS staff, the board and consultants, and benchmarked responses against a reference group of 20 large institutional investors, including pension funds, sovereign wealth funds and one endowment collectively responsible for $6.4trn in assets. Fifteen of those investment entities have published investment beliefs.

CalPERS key facts

• Assets: $304bn (€269bn)
• Location: Sacramento, CA
• Members: 1.72m
• Implemented beliefs in 2013
• Beliefs now under review

The report says the implementation of belief number one is “difficult” in some respects. Feedback from consultants indicated that “there is not a strong consensus of implementation on belief number one as yet”. The findings from interviews with staff echoed the sense that CalPERS has room to focus more intensively on the goal of paying liabilities. Staff surveys indicated “some sense that belief number one was not acted on with conviction,” the report says. While staff recognised the emphasis on benefits payment was part of CalPERS’ mission, staff input indicated that “in implementation there is a challenge if the ‘liabilities influence’ is strong enough.” Part of the problem might be the board’s orientation – the report stated that CalPERS’ board believed recognising that liabilities influence asset structure “is in tension with the historic endowment mindset of CalPERS”.

That mindset has to change, state budget policy experts say. It is becoming increasingly difficult for investment operations at CalPERS and other large US public employee pension plan to cover the gap between member contributions and benefits payments, says Donald Boyd, a senior fellow at the Rockefeller Institute of Government at the State University of New York. “Public pension plans are getting older,” says Boyd. “The typical fund has more going out than coming in before investment returns because the retirees are older, and the ratio of young payers to retirees is falling.”

The result, Boyd says, is that plans have less time to recover from investment shortfalls – raising serious questions about the conventional wisdom that pension funds are long-term investors. CalPERS’ second investment belief is that the fund has a long time horizon, which enables it to invest in illiquid assets. But when it comes to long time horizons for pension investors, “there’s no evidence that’s true”. says Boyd. 


CalPERS: balancing long and short-term goals

There are two problems with the notion. “The first fallacy is thinking we’ll get our return target in the long run,” continues Boyd. That concept is critical for American pension funds, which use an assumed rate of return to calculate how much investment income they need to generate. “The second fallacy is thinking that you, the pension fund, are taking the risk” on any given asset to which an investment team allocates capital. “Its taxpayers, and people who want to drive to work on solid roads that are taking the risk, because it’s the government that has to make up any shortfall if a plan can’t pay benefits.”

Overall, American taxpayers don’t like taking the risk that public pension plans present. That’s why US state and local governments allocated about $105bn for public employee pension plan contributions last year, Boyd says, compared with the $125bn that actuaries said was the amount needed to keep plan funding levels from falling further behind schedule. According to Andrew Biggs of the American Enterprise Institute, a conservative think tank, the average public plan’s funded ratio stood at 76% in 2014, leading public employee groups to claim that public pensions are well funded. But only 41% of public plans in the US received their full contribution in 2014, down from 65% in 2008.

CalPERS is well aware of the situation. “Ensuring the ability to pay promised benefits by maintaining an adequate funding status is the primary measure of success for CalPERS,” according to the detailed text of belief number one. “CalPERS have a large and growing cash requirement and inflation-sensitive liabilities.” As such, “assets that generate cash and hedge inflation should be an important part of the CalPERS investment strategy.”

Accordingly, the investment beliefs say “concentrations of illiquid assets must be managed to ensure sufficient availability of cash to meet obligations to beneficiaries.” That creates tension between the need for current cash flow and the “endowment mindset” that CalPERS board focuses on: unlike Yale, which is included in the reference group, CalPERS is not an endowment with an effectively perpetual investment horizon.

CalPERS’ need to generate cash is rising, and its being noticed where it matters – on the editorial pages of newspapers across California, indicating increasing political pressure on the system to head off a looming funding crisis before state funds are required. CalPERS “faces unacceptable risk of serious funding shortfalls during the next major market downturn,” said the Vallejo Times-Herald. 

In 2007, the newspaper pointed out, the agency had 101% of the assets needed to ensure it could pay earned benefits after investment returns – that dropped to 61% in 2009, and has recovered to just 77% now, about average. The paper pointed to CalPERS Chief Actuary Alan Milligan as warning that if CalPERS does not mitigate risk, and markets move adversely, the fund “may be truly in a position where, can we even get out of that situation?”

One of the investment beliefs calls for development of a broad set of investment and actuarial risk measures and a clear risk management process. “The path of returns matters, because highly volatile returns can have unexpected impacts on contribution rates and funding status,” according to belief number nine. But the belief also calls for attention to long-range factors such as climate change, leading to tension between short-term and long-term goals. “Belief number nine needs more work,” according to the report. “The way risk is interpreted in decision-making is unsettled.”

That reflects a larger gap between the board and investment staff when it comes to assessing how well the beliefs programme has worked in practice. 

The CalPERS board is meeting in July to address the overall findings. Towers Watson advised two sessions, one focusing on resolving the tension between the need to generate cash to pay benefits and the call for a broad risk framework, and another to explore how beliefs about illiquid assets as well as environmental, social and governance (ESG) principles can be integrated into investment policies. 

While the investment beliefs programme may be an overall success, there is plenty of work yet to do so CalPERS will not be taking the summer off. Declining to comment on the beliefs programme, a spokesman said: “We’re planning to address this with our board at the July meeting. Staff is still working to address many of these questions and won’t be able to comment until after that meeting.”

CalPERS’ investment beliefs

1. Liabilities must influence the asset structure.
2. A long time investment horizon is a responsibility and an advantage.
3. CalPERS investment decisions may reflect wider stakeholder views, provided they are consistent with its fiduciary duty to members and beneficiaries.
4. Long-term value creation requires effective management of three forms of capital: financial, physical and human.
5. CalPERS must articulate its investment goals and performance measures and ensure clear accountability for their execution.
6. Strategic asset allocation is the dominant determinant of portfolio risk and return.
7. CalPERS will take risk only where we have a strong belief we will be rewarded for it.
8. Costs matter and need to be effectively managed.
9. Risk to CalPERS is multi-faceted and not fully captured through measures such as volatility or tracking error.
10. Strong processes and teamwork and deep resources are needed to achieve CalPERS’ goals and objectives.