Our discussion last week about representatives of
the League of California Cities urging CalPERS, the state’s huge
pension fund for public employees, to juice up investment returns generated a
lot of interesting feedback.
It is clear that public-pension funds need some help. Rather than offer
specific investment recommendations, I am going to make some suggestions to
help them think about what they should be considering when reviewing their own
It is important for managers and public representatives to understand whatthey know, what they don’t know,
and what they can’t possibly know. Some of the biggest mistakes in asset
management come from not knowing the answers to those deceptively simple
What do we know? Begin with that simple question of what any pension fund,
consultant, or investment committee member knows. I’ll limit it to five
issues that can be answered with a high degree of confidence.
What’s in the portfolio? This should be a simple question, especially
when it comes to publicly traded equities and fixed income. You can find out
exactly what those holdings are. However, the increase in alternative
investments such as private equity, hedge funds and venture capital during the
past few decades means that parts of the portfolio are opaque. Being aware of
exactly what is in the portfolio is a key to answering many of our other
What are our future liabilities? This usually can be answered with
some confidence: you know how many people participate in your pension, their
average ages and typical career lengths. A fair estimate should allow the
calculation of future yearly obligations. The caveat is the further out we
look, the greater the possibility of unforeseen events that might affect your projections.
What are our funding contributions? How much of our current
obligations are funded? And what does the present funding level look like
relative to future needs? Note that this is a political decision made by state
or city legislators, who typically want to get re-elected and are averse to
raising taxes. All that is really known with a high degree of confidence is the
present funding levels.
What are our costs? Part of this can be known with great
specificity — namely, contractual management fees and published costs of mutual
funds and exchange-traded funds. Some costs, such as trading fee and salaries,
can be estimated with a reasonable degree of confidence. But some items —
namely, performance fees — can only be known retrospectively, based upon how
well a manager performs.
How much risk are we assuming? There is a range of risks that a
fund portfolio can have relative to the safest investment (aka risk-free) U.S.
Treasuries. Do we understand what our risk profile is and how much more or less
risk we might be taking?
What is unknown? The next set of questions pension funds
should be considering is the unknowns: we can break this down into three broad
categories of what might happen in the future:
Future market action: We don’t know about future profits, how individual
stocks or regions will perform, or about inflation and interest rates.
Basically, anything that could occur in capital markets and the economy in the
future is an unknown.
Political action: Pensions are funded via direct contributions by cities
and states. We know many pension funds are underfunded; we have also seen resistance
from municipalities to allocate enough money to cover pension obligations.
Although some states have specific rules about minimum funding of pensions, not
all do. There is a variable political component to this.
Performance (and fees): The performance of active managers cannot be
known in advance. Yes, there are hopes and wishful thinking, but it is not the
same as actual returns. And, for pensions that have sizable investments in
alternatives, the performance portion of the fees are similarly unknown.
Last, many people seem to operate under a set of false beliefs that
manifest themselves in the form of costly investment decisions. This is a
challenge for both the future beneficiaries of any pension and the state that
is obligated to fund them. Not coincidentally, lots of these costly errors are
the result of doing business with individuals or firms with a vested interest
in selling a product to the fund, or consulting on such products.
I believe pension funds should make the effort to have simpler, less
expensive investments. Outperformance is hard to achieve, while holding down
costs is something more attainable. But in the meantime, understanding what
pensions do and don’t know is a great first step.
Click here for the original article from Bloomberg.