CalSTRS Tackles the Risk of Running Out of Money

The fund is confronting its worst-case scenario: What happens if it fails to deliver the expected 7.5% return over time?
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Investment staff at the California State Teachers’ Retirement System (CalSTRS) have kicked off a deep dive into the risk of shortfall: How it could happen, its likelihood, and strategies for making sure it doesn’t.   

Pension reforms passed earlier this year set the $188 billion defined benefit plan on the path to full funding by 2046—assuming it earns 7.5% annual returns between now and then.

But what if it doesn’t?

CIO Chris Ailman posed that question to during the fund’s September 5 investment board meeting. A number of top asset managers and economists have predicted market returns below historic averages for the coming years, and CalSTRS has chosen to confront that possibility head-on.

 Shortfall Risk: The likelihood that a defined benefit pension system will not have enough money set aside to meet the pension obligations of its retirees in the future. —CalSTRS/PCA definition 

Economic growth risk is the foremost factor determining asset returns, according to Pension Consulting Alliance (PCA), CalSTRS’ primary investment adviser. Weak growth brought on by cyclical recessions, another financial crisis, or geopolitical events poses the largest threat to the fund’s short-term returns. In turn, these draw-down events present the likeliest path to sub-7.5% returns over the long term and, taken to an extreme, plan insolvency. 

“Mitigating short-term drawdown risk may improve the likelihood that the long-term pension reform measures will succeed,” PCA said in its presentation. But CalSTRS faces a “key tradeoff” in hedging. “Addressing major crisis risks could push the long-term expected rate of return lower,” the consultancy continued.

During the discussion, PCA Founder Allan Emkin, Ailman, and others expressed trepidation over equities’ long bull run and lofty valuations. According to research by Investment Officer Josh Diedesch, the US stock market’s price-to-earnings ratio (20) suggests annual returns below or barely surpassing the 7.5% threshold for the next five years. 

As Ailman put it during his opening CIO report, the “US bull market is getting long in the tooth.” 

During their next meeting in November, Ailman and the investment committee are set to undertake a close review of their options for mitigating drawdown risk amid the frothy market—and, by extension, the risk of a shortfall.

“I can’t think of another client that has addressed the topic this clearly before anything has happened. Your being ahead of the curve is incredible,” remarked Emkin, a veteran consultant.   

  CalSTRS_Shortfall

Source: PCA 

 

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