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Is Calpers ready for riskier investments?

Calpers, the giant California state pension fund currently valued at $219 billion, is in a difficult position. This is from a Bloomberg story about the fund struggling to hit its 7.75 percent expected yearly return for 2010:

“That’s going to be tough this year and maybe for the next few years,” Calpers Chief Investment Officer Joe Dear said in a Bloomberg Television interview today. “This low-return environment is structurally driven, and there’s not a lot of policy to move it.”

In fact, it could be tougher than Dear is letting on. Calpers is only 70 percent funded, according to Bloomberg. That doesn't mean the fund can't pay out benefits. But it does mean that there's a mismatch between how much it has and how many employees are and will be relying on it. Calpers was fully funded in 2007, but the financial crisis has been hard on it. 

The investment environment for pension funds isn't actually very good right now. Bonds are yielding historically low rates and the stock market is bucking around like an old Ford pickup truck on a back road in Texas. The Federal Reserve has done everything it can to push investors into riskier assets, like stocks, but so far, the markets haven't been able to maintain any kind of sustained rally.

This means that pension funds are increasingly diversifying into high-risk/high-return stuff, like hedge funds and private-equity. This is an oversimplification, but hedge funds try to make money even when markets are going south, while private equity invests in startup companies and gets involved in the turnarounds of underperforming established ones. The payoffs can be big. But so can the losses. 

Both Harvard and Yale, the two richest U.S. universities, have pushed their endowments into these kinds of investments, and they've reaped the rewards. Both have seen double-digit gains in the riskier parts of their portfolios. So has Calpers: its private-equity investments have returned 25.3 percent so far this year, according to Bloomberg. That blows away the 6.5 percent that pension funds are expected to earn on average over the next 15 years. It also crushes the paltry 3.41 percent Calpers has returned since 2006.

You can see the looming problem here: Calpers needs that 7.75 percent annual return to stay fully funded. It's only ever beaten that rate on a 20-year basis, which works out to 8.38 percent.

The fund was earning more than 20 percent in 2010 through the first half of 2011, but it's shed $20 billion since then, according to Bloomberg.

Calpers doesn't have much of a choice now but to raise its risk tolerance. But this comes with a price. Gains and losses could be exaggerated. If inflation ever starts rising, Calpers will have a more difficult time tucking money into relatively safe investments, like U.S. Treasuries, given that the government has pushed the rates so low that they're lagging the rate on inflation by a decent margin. And of course it will probably want to make up that 30 percent funding deficit. 

A potentially troubling aspect of this situation is that pension funds are supposed to be very risk averse. But if Calpers continues along its current path, it will be moving huge amounts of money into riskier investments. Ironically, this may make them look…less risky! Money that was once scared of risk may chase returns that don't seem so scary anymore. 

That could distort Calpers' portfolio. Remember, we're not talking about bankers and entrepreneurs here. This is the retirement of California bureaucrats we're dealing with. Calpers needs to be careful.

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Photo: Max Whittaker/Getty Images