Great Expectations

David Crane
Lecturer at Stanford University, President of Govern for California, and Former Economic Adviser to California Governor Arnold Schwarzenegger

During a recent
public discussion about expected investment returns, the Chief
Investment Officer of a California public pension fund was quoted as
saying that "I would argue, and I have, with people who said it’s going
to be 6 percent or lower that they are basically saying the United
States is going to go in the drain in the next 100 years. I’m not
willing to go there."

By all accounts this CIO is a very smart fellow.  However, in making
that statement he’s up against some tough math because, for the 100
years of the 20th century – not exactly "in the drain" for the USA – an
investor with assets allocated like the typical pension fund would have
earned (you guessed it) around 6 percent.  

Somehow a perfectly good return in the 20th century has become a poor
expected return for the 21st century. How did that happen? As Warren
Buffett explained in a remarkably prescient article
in 1999, sometimes people extrapolate from statistically insignificant
periods to draw invalid inferences about future long-term performance.
For example, many people today came of age during the 17-year
investment boom from 1982 – 1999, but as Buffett pointed out, "The
increase in equity values [from 1982 to 1999] beats anything you can
find in history."

There were several reasons for the unique nature of 1982-1999, but the
key point is that that period, or any 17-year period, fails as a basis
for projecting long-term growth — especially for pension funds with
long-term liabilities (e.g.,
government employees who are 25 today will be receiving pension
payments 50+ years from now). As that same CIO rightly put it, public
pension investing is "a marathon, not a sprint."  More relevant for
pension funds is the 20th century as a whole.  For that period the Dow
Jones Industrial Average advanced from 66 to 11,497, for an average
annual return on stocks of 5.3 percent.  

Add 2 percent for dividends
and that takes you to 7.3 percent for the equity portion of a
portfolio, which in the case of pension funds usually comprises around
72 percent of assets. The other 28 percent is invested in fixed income
assets that may be expected to earn 4-5 percent.  Blended together and
after expenses of 0.5 percent, that’s a total return of 6 percent.
(Pension funds with a larger equity exposure, e.g., 80 percent instead of 72 percent, might expect closer to 6.25 percent.)

But despite knowing they’re in a marathon, our state pension fund
boards have long over-estimated investment returns. In fact, at the
very time that Buffett was warning investors in that 1999 article that
the fast investment growth of the previous 17 years was not a good
basis for projecting forward, one of those pension funds (CalPERS)
doubled down in the opposite direction by successfully pushing the
State Legislature to retroactively and permanently increase pension
benefits for state employees while reducing contributions. CalPERS said
its expected investment return would provide all the investment returns
needed to meet both existing and boosted pension costs and even to cut
contributions in the short term. The other major fund (CalSTRS)
employed a similar return assumption.

Since then, over the past eleven years, those pension funds have earned
less than 45 percent of their expected returns, taxpayers have had to
spend more than $20 billion to make up the difference, and hundreds of
billions more will be diverted from state budgets to pension costs for
years to come.

Why is all this relevant now? The answer is that the boards of CalSTRS
and CalPERS are in the process of evaluating investment return
assumptions. As of now, both are 30 percent above that 6 percent rate.
In fact, they’re even 15 percent above Warren Buffett’s expected
returns for his pension funds.  Simply put, they need to get real.

Unrealistic investment return assumptions allow generations to steal money from future generations. The boards of CalSTRS and CalPERS should remember who takes the risk of their great, and unrealistic, expectations.

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