Pension360

The Chairman of Korea’s National Pension Service (NPS) — the third largest pension fund in the world — was placed under emergency arrest on Wednesday as part of a corruption probe that has already ensnared the country’s president.

Prosecutors are looking into whether NPS Chairman, Moon Hyung-pyo, coerced the fund to vote in favor of a merger of two companies.

More details from Reuters:

The special prosecutor has been looking into whether Moon pressured the pension fund to support the $8 billion merger last year of two Samsung Group [SAGR.UL] affiliates while he was head of the Ministry of Health and Welfare, which runs the NPS.

Investigators are also examining whether Samsung’s support for a business and foundations backed by the president’s friend, Choi Soon-sil, who is at the center of the influence-peddling scandal, may have been connected to NPS support for the merger, a prosecution official told Reuters last week.

The NPS voted in favor of the merger without calling in an external committee that sometimes advises it on difficult votes.

[…]

 

At a parliamentary hearing this month, Samsung Group scion Jay Y. Lee denied allegations from lawmakers that Samsung lobbied to get the NPS to vote in favor of the merger, or that it made contributions seeking something in return.

Navnoor Kang, who oversaw the $50+ billion bond portfolio for the New York State Common Retirement Fund, was arrested last week and charged with accepting bribes — included cocaine and prostitutes — in exchange for steering billions of dollars of business to two different broker-dealers.

Had the Common fund called Kang’s previous employer when they hired him, they might have learned how Kang was fired for misconduct, according to the Wall Street Journal.

From the Wall Street Journal:

In hiring Mr. Kang, the fund skipped what in hindsight would prove a crucial step: It failed to call his most-recent employer to ask about his performance there, according to a person familiar with the matter.

That call may have disclosed that Guggenheim had fired Mr. Kang a year earlier for swapping trading commissions for concert tickets and other gifts, a violation of the firm’s internal reporting requirements, according to a federal complaint.

[…]

Guggenheim had fired Mr. Kang in January 2013 after the trader violated the firm’s policies, according to the SEC complaint. His troubles there had begun late in 2012, when he told colleagues he was attending a Rolling Stones concert with Gregg Schonhorn, who worked for a broker and was drawing trading commissions from Guggenheim, according to a person familiar with the matter.

State Comptroller Thomas DiNapoli has ordered a review of the hiring practices at the pension fund. Details from the Albany Times-Union:

In an interview on Talk 1300’s “Live from the State Capitol,” DiNapoli said that federal investigators had been given access to whatever they needed as they probed the alleged bribery scheme involving Navnoor Kang, but his office learned the depth of the issue when U.S. Attorney Preet Bharara announced charges against Kang on Wednesday.

“Should it have happened? Absolutely not,” DiNapoli said. “Do we need to look at our internal policies and procedures to see if there is something else we could do? Yes. Do we need to look again about vetting and hiring? We’re looking at that.”

DiNapoli has directed his office’s inspector general and the head of his office’s investigations unit to review the matter at hand and hiring procedures, which include a background check process.

 

Reporter Ed Mendel covered the California Capitol in Sacramento for nearly three decades, most recently for the San Diego Union-Tribune. More stories are at Calpensions.com.

A key committee last week approved a drop in the often-criticized CalPERS investment earnings forecast, gradually raising record rates already being paid by state and local governments. The change was then approved, as expected, by the full board.

The earnings forecast will drop from 7.5 percent to 7 percent, giving the nation’s largest public pension fund one of the most conservative forecasts, possibly setting a nationwide trend in the view of some.

But the painful and costly drop in the forecast used to “discount” or offset future pension obligations is still well above the 6.2 percent earnings forecast expected by CalPERS consultants during the next decade, which drove the action to drop the forecast.

Acting this month, rather than in February as some expected, seemed to reflect a general agreement and sense of urgency among employers and employees. As of last June, the CalPERS funding level fell to 68 percent of the projected assets needed to pay future pensions.

“It’s a little bit of pain for everyone,” said CalPERS President Rob Feckner, noting that five groups had come together on the action: labor, employers, the Brown administration, CalPERS staff, and the CalPERS board.

The committee approved a plan that would lower the earnings forecast or discount rate over three years, beginning with the state next year. Schools were split from the state and would begin in 2018 along with local governments.

The rate increase from a lower discount rate is phased in over five years. Some employee rates will go up, particularly for those hired after a pension reform in 2013 requiring them to pay half the “normal” cost, excluding debt from previous years.

When fully phased in the lower discount rate will cost the state an additional $2 billion, Eric Stern of Brown’s Finance department told the committee, half from the general fund that contributes $5.4 billion to CalPERS this year and the other half from special funds.

The rate increase comes in the middle of the usual four-year cycle for setting a discount rate. Wilshire and other consultants think that for several reasons global economic conditions have deteriorated since the current discount rate was reaffirmed at 7.5 percent two years ago.

Another sign of how seriously CalPERS regards the market change was the announcement Monday that, in a closed September session, the asset allocation of the $303 billion portfolio had been changed to reduce growth investments and the risk of losses.

Global equity investments were reduced from 51 percent to 46 percent of the portfolio, private equity dropped from 10 percent to 8 percent. Inflation assets increased from 6 to 9 percent, cash from 1 percent to 4 percent, and real estate from 12 to 13 percent.

Ted Eliopoulos, CalPERS chief investment officer, said the announcement was delayed to allow time for CalPERS to make some of the fund transfers. CalPERS investment changes often are not announced until later to avoid moving the markets.

At the Finance committee yesterday, board member J.J. Jelincic said the new asset allocation dropped the earnings forecast to 6.25 percent. His motion to drop the discount rate to 6.25 percent died without a second.

Staff told the committee that Jelincic’s assumption that the new allocation is expected to yield 6.25 percent is correct for the next decade. But the 7 percent discount rate is supported by the long-term yield over three decades.

At the Investment committee on Monday, Jelincic said CalPERS members need to know what’s being done with their money. His request for the public release of part of the transcript of the closed session, along with the agenda item, was referred to legal counsel.

Part of the urgency for action is that the underfunded California Public Employees Retirement System is unusually vulnerable to a major investment loss, unlike 2007 when it went into the deep recession and stock market crash with a funding level of 101 percent.

Two years ago, when the current 7.5 percent discount rate was reaffirmed, the funding level was estimated to be 77 percent, up from a low of 61 percent in 2009 after the CalPERS investment fund dropped from about $260 billion to $160 billion.

But since 2014, the economic outlook has declined and CalPERS investment earnings were well below the 7.5 percent target (0.6 percent last fiscal year and 2.4 percent the previous year), dropping the funding level to 68 percent as of June 30 this year.

“In all the data that (staff and consultants) have presented to us and that I’ve read, you drop to a level of 50 percent and it’s a point of no return as we know a pension system today,” board member Henry Jones said. “You may return, but it won’t be the same.”

Some think raising rates and the discount rate high enough to project 100 percent funding would become impractical. CalPERS is a mature system with the number of retirees soon expected to outnumber active workers.

Investment funds must be sold to pay pensions now, about $5 billion this year to add to $14 billion from employer-employee contributions to pay $19 billion for the pensions of the retirees. Reducing this growing “negative cash flow” is one of the reasons for raising rates.

Critics contend that an overly optimistic discount rate hides massive national state and local government pension debt. They argue that a risk-free discount rate should be used to aid “intergenerational equity” and reduce debt passed to future generations.

But the cost of using a risk-free rate to discount risk-free pension debt, following a basic finance principle, also would be massive. The yield on a 20-year Treasury bond early this month was about 3 percent.

Since the recession, CalPERS employer rates have increased roughly 50 percent. The discount rate was dropped from 7.75 to 7.5 percent in 2012. An actuarial method that no longer annually refinances debt was adopted in 2013.

The rate increase from a longer average life expectancy for retirees adopted in 2014 is still being phased in over a five-year period.

Some board members, perhaps referring to advance coverage of their meeting in the national media, said that a widely watched lowering of the discount rate by CalPERS would set a good example for other public pension funds.

“The recommendation before us gives us a chance to be a leader in the nation in responsible pension funding, and I think from a reputational perspective that is something it’s time for this system to take the lead on,” said board member Richard Gilliahan, Brown’s Human Resources director.

Board members also expect criticism that the discount rate was not dropped far enough. But state Controller Betty Yee and other board members said they will continue to work on the issue during the process leading to the scheduled rate review in 2018.

“This is all about the long-term sustainability of the fund,” said Richard Costigan, the Finance committee chair. “We are going to continue to have a robust discussion. This is just the start.”

Leo Kolivakis is a blogger, trader and independent senior pension and investment analyst. This post was originally published at Pension Pulse.

Gillian Tan of Bloomberg View reports, Pension Funds Should Look North For Inspiration:

When it comes to at least one type of investing, U.S. pension funds should take a (maple) leaf out of their Canadian counterparts’ playbook.

Despite being among the largest private equity investors, U.S. pension funds such as the California Public Employees’ Retirement System and the California State Teachers’ Retirement System have been slow to transition from a hands-off approach to one that involves actively participating in select deals, a feature known in the industry as direct investing.

A More Direct Approach

The benefits of direct investing are lower (or sometimes no) fees and the potential to enhance returns, and that makes it an attractive proposition. But so far, U.S. pension funds have been pretty content as passive investors for the most part, writing checks in exchange for indirect ownership of a roster of companies but without outsize exposure to any (click on image).

State of the States

State pension funds are comfortable writing checks to private equity firms but could bolster their returns by investing directly in some of those firms’ deals (click on image).

Not so Canadian funds. A quick glance at the list of the private equity investors — commonly referred to as limited partners — that have been either participating in deals alongside funds managed by firms such as KKR & Co. or doing deals on their own since 2006 shows that these funds have had a resounding head start over those in the U.S.

Notably Absent

Large U.S. pension funds are nowhere to be seen among private equity fund investors that participate directly in deals, a strategy used to amplify their returns (click on image).

Canadian funds’ willingness to pursue direct investing is driven in part by tax considerations: they can avoid most U.S. levies thanks to a tax treaty between the two North American nations, while they are exempt from taxes in their own homeland. But U.S. pensions would still benefit from better returns, so it’s curious that they haven’t been more active in this area.

There’s plenty of opportunity for direct investing. Private equity firms are generally willing to let their most sophisticated investors bet on specific deals in order to solidify the relationship (which can hasten the raising of future funds). It also gives them access to additional capital.

Rattling the Can

Private equity firms recognize that offering fund investors the right to participate directly in their deals bolsters their general fundraising efforts (click on image),

The latter point has been a crucial ingredient that has enabled larger transactions and filled the gap caused by the death of the so-called “club” deals (those involving a team of private equity firms) since the crisis.

Seal the Deal

U.S. private equity deals which are partly funded by direct investments from so-called limited partners reached their highest combined total since 2007 (click on image).

There are some added complications. Because some of the deals involve heated auction processes, limited partners must do their own diligence and deliver a verdict fairly quickly. That could prove tricky for U.S. pension funds, which would need to hire a handful of qualified executives and may find it tough to match the compensation offered elsewhere in the industry. Still, the potential for greater investment gains may make it worth the effort — even for funds like Calpers that are reportedly considering lowering their overall return targets.

With 2017 around the corner, one of the resolutions of chief investment officers at U.S. pension funds should be to evolve their approach to private equity investing. They’ve got retired teachers, public servants and other beneficiaries to think about.

This article basically talks about how Canada’s large pensions leverage off their relationships with private equity general partners to co-invest alongside them on bigger deals.

It even cites one recent example in the footnotes where the  Caisse de dépôt et placement du Québec, or CDPQ, in September announced a $500 million investment in Sedgwick Claims Management Services Inc., joining existing shareholders KKR and Stone Point Capital LLC.

Let me cut to the chase and explain all this. An equity co-investment (or co-investment) is a minority investment, made directly into an operating company, alongside a financial sponsor or other private equity investor, in a leveraged buyout, recapitalization or growth capital transaction.

Unlike infrastructure where they invest almost exclusively directly, in private equity, Canada’s top pensions invest in funds and co-invest alongside them to lower fees (typically pay no fees on large co-investments which they get access to once invested in funds where they do pay fees). In order to do this properly, they need to hire qualified people who can analyze a co-investment quickly and have minimum turnaround time.

Unlike US pensions, Canada’s large pensions are able to attract, hire and retain very qualified candidates for positions that require a special skill set because they got the governance and compensation right. This is why they engage in a lot more co-investments than US pension funds which focus exclusively on fund investments, paying comparatively more in fees.

[Note: You can read an older (November 2015) Prequin Special Report on the Outlook For Private Equity Co-Investments here.]

On top of this, some of Canada’s large pensions are increasingly going direct in private equity, foregoing any fees whatsoever to PE funds. The article above talks about Ontario Teachers. In a recent comment of mine looking at whether size matters for PE fund performance, I brought up what OMERS is doing:

In Canada, there is a big push by pensions to go direct in private equity, foregoing funds altogether. Dasha Afanasieva of Reuters reports, Canada’s OMERS private equity arm makes first European sale:

Ontario’s municipal workers pension fund has sold a majority stake in marine-services company V.Group to buyout firm Advent International in the first sale by the Canadian fund’s private equity arm in Europe.

Pension funds and other institutional investors are a growing force in direct private investment as they seek to bypass investing in traditional buyout funds and boost returns against a backdrop of low global interest rates.

As part of the shift to more direct investment, the Ontario Municipal Employees Retirement System (OMERS) set up a private equity team (OPE) and now has about $10-billion invested.

It started a London operation in 2009 and two years later it bought V.Group, which manages more than 1,000 vessels and employs more than 3,000 people, from Exponent Private Equity for an enterprise value of $520-million (U.S.).

Mark Redman, global head of private equity at OMERS Private Markets, said the V.Group sale was its fourth successful exit worldwide this year and vindicated the fund’s strategy. He said no more private equity sales were in the works for now.

“I am delighted that we have demonstrated ultimate proof of concept with this exit and am confident the global team shall continue to generate the long-term, stable returns necessary to meet the OMERS pension promise,” he said.

OMERS, which has about $80-billion (Canadian) of assets under management, still allocates some $2-billion Canadian dollars through private equity funds, but OPE expects this to decline further as it focuses more on direct investments.

OPE declined to disclose how much Advent paid for 51 per cent of V.Group. OPE will remain a minority investor.

OPE targets investments in companies with enterprise values of $200-million to $1.5-billion with a geographical focus is on Canada, the United States and Europe, with a particular emphasis on Britain.

As pension funds increasingly focus on direct private investments, traditional private equity houses are in turn setting up funds which hold onto companies for longer and target potentially lower returns.

Bankers say this broad trend in the private equity industry has led to higher valuations as the fundraising pool has grown bigger than ever.

Advent has a $13-billion (U.S.) fund for equity investments outside Latin America of between $100-million and $1-billion.

The sale announced on Monday followed bolt on acquisitions of Bibby Ship Management and Selandia Ship Management Group by V.Group.

Goldman Sachs acted as financial advisers to the shipping services company; Weil acted as legal counsel and EY as financial diligence advisers.

Now, a couple of comments. While I welcome OPE’s success in going direct, OMERS still needs to invest in private equity funds. And some of Canada’s largest pensions, like CPPIB, will never go direct in private equity because they don’t feel like they can compete with top funds in this space (they will invest and co-invest with top PE funds but never go purely direct on their own).

[Note: It might help if OPE reports the IRR of their direct operations, net of all expenses relative to the IRR of their fund investments, net of all fees so their stakeholders can understand the pros and cons of going direct in private equity. Here you need to look at a long period.]

There is a lot of misinformation when it comes to Canadian pensions ‘going direct’ in private equity. Yes, they have a much longer investment horizon than traditional funds which is a competitive advantage, but PE funds are adapting and going longer too and in the end, it will be very hard, if not impossible, for any Canadian pension to compete with top PE funds.

I am not saying there aren’t qualified people doing wonderful work investing directly in PE at Canada’s large pensions, but the fact is it will be hard for them to match the performance of top PE funds, even after fees and expenses are taken into account.

Who knows, maybe OPE will prove me wrong, but this is a tough environment for private equity and I’m not sure going direct in this asset class is a wise long-term strategy (unlike infrastructure, where most of Canada’s large pensions are investing directly).

When it comes to private equity, Mark Wiseman once uttered this to me in a private meeting: “Unlike infrastructure where we invest directly, in private equity it will always be a mixture of fund investments and co-investments.” When I asked him why, he bluntly stated: “Because I can’t afford to hire David Bonderman. If I could afford to, I would, but I can’t.”

Keep in mind these are treacherous times for private equity and investors are increasingly scrutinizing any misalignment of interests, but when it comes to the king deal makers, there is no way Canada’s top ten pensions are going to compete with the Blackstones, Carlyles and KKRs of this world who will get the first phone call when a nice juicy private deal becomes available.

Again, this is not to say that Canada’s large pensions don’t have experienced and very qualified private equity professionals working for them but let’s be honest, Jane Rowe of Ontario Teachers won’t get a call before Steve Schwarzman of Blackstone on a major deal (it just won’t happen).

Still, despite this, Canada’s large pensions are engaging in more direct private equity deals, sourcing them on their own, and using their competitive advantages (like much longer investment horizon) to make money on these direct deals. They don’t always turn out right but when they do, they give even the big PE funds a run for their money.

And yes, US pensions need to do a lot more co-investments to lower fees but to do this properly, they need to hire qualified PE professionals and their compensation system doesn’t allow them to do so.

After twice vetoing similar measures, New Jersey Gov. Chris Christie last Thursday signed a bill that will require the state to make quarterly pension contributions, as opposed to one annual lump-sum payment.

The bill cleared both state legislative chambers unanimously in November.

However, there’s skepticism around the new law because it still doesn’t require the state to make full payments — and New Jersey has historically shorted its contributions or skipped them entirely.

More from NJ.com:

The new law will require governor to make pension payments on a quarterly basis by Sept. 30, Dec. 31, March 31 and June 30 of each year, instead of at the end of the fiscal year in June. In exchange, the pension fund would reimburse state treasury for any losses incurred if the state has to borrow money to make a payment.

State lawmakers voted overwhelmingly last month to approve the measure. It cleared the state Senate by a 35-0 vote and the state Assembly 72-0.

[…]

Hetty Rosenstein, state director Communications Workers of America, praised the bill, but stressed she’s focused on demanding the state make full payments.

“CWA supports quarterly pension payments,” she said. “However, unless the full amount due to the plan is appropriated, quarterly payments are meaningless. History shows we simply cannot rely on the word of the governor or Legislature when it comes to the pension.”

Leo Kolivakis is a blogger, trader and independent senior pension and investment analyst. This post was originally published at Pension Pulse.

Heather Gillers of the Wall Street Journal reports, America’s Largest Pension Fund: A 7.5% Annual Return Is No Longer Realistic:

Top officers of the largest U.S. pension fund want to lower their investment targets, a move that would trigger more pain for cash-strapped cities across California and set an increasingly cautious tone for those who manage retirement assets around the country.

Chief Investment Officer Ted Eliopoulos and two other executives with the California Public Employees’ Retirement System plan to propose next Tuesday that their board abandon a long-held goal of 7.5% annually, according to system spokesman Brad Pacheco. Reductions to 7.25% and 7% have been studied, according to new documents posted Tuesday.

The last time the California system lowered its investment expectation was in 2012, when the rate was dropped to 7.5% from 7.75%.

The new recommendation comes just 13 months after the fund known by its acronym Calpers agreed to a plan that would slowly scale back its target by as much as a quarter percentage point annually—and only in years of positive investment performance. Now Mr. Eliopoulos and other officials are concerned that plan may not be fast enough because of a mounting cash crunch and declining estimates of future earnings.

“There’s no doubt Calpers needs to start aligning its rate of return expectations with reality,” California Gov. Jerry Brown said in a statement provided to the Journal.

The accounting maneuver would have real-life consequences for taxpayers and cities. It would likely trigger a painful increase in yearly pension bills for the towns, counties and school districts that participate in California’s state pension plan. Any loss in expected investment earnings must be made up with significantly higher annual contributions from public employers as well as the state.

“Lowering the rate of return sooner is undoubtedly going to make it more difficult for cities that are teetering on the edge financially,” said Bruce Channing, chair of the city managers’ pensions committee for the California League of Cities.

Nearly three quarters of school districts said in a survey conducted by Calpers that the impact of dropping the rate would be “high” or “extremely high.”

A drop in Calpers’s rate of return assumptions could also put pressure on other funds to be more aggressive about their reductions and concede that investment gains alone won’t be enough to fund hundreds of billions in liabilities. Because of its size, Calpers typically acts as a bellwether for the rest of the pension world. It manages nearly $300 billion in assets for 1.8 million members.

Pensions have long been criticized for using unrealistic investment assumptions, which proved costly during the last financial crisis. More than two-thirds of state retirement systems have trimmed their assumptions since 2008, according to an analysis of plans by the National Association of State Retirement Administrators.

The Illinois Teachers Retirement System in August dropped its target rate to 7% from 7.5% in August, the third drop in four years, and the fund’s executive director has said the rate will likely be reduced further next year. The $184 billion New York State and Local Retirement System lowered its assumed rate from 7.5% to 7% in 2015.

Amit Sinha of The Thought Factory blog also wrote an opinion piece for MarketWatch, What Calpers decides about its investment-returns forecast matters for pension plans (and taxpayers) across the U.S.:

The investment team at Calpers has been signaling that the current assumption of 7.5% long-term investment returns may be too high, and it would probably peg it around 6% instead.

The 7.5% rate is hardly unusual among government pension funds. But as the $300 billion gorilla in the pension world, any change — likely to be discussed at its Dec. 19 board meeting — will be watched by other pension plans that could then have a harder time justifying their own targeted returns.

This chart of expected-return assumptions of some of the larger pension plans shows that while about 40% of the largest corporate plans assume returns 7% and below, only 9% of public pensions assume returns 7% and below (click on image).

There is an element of subjectivity in estimating future returns, and the decision comes loaded with behavioral and political implications. The number determines how well-funded a pension plan is, which in turn determines the amount a state or municipality needs to pay into their pension system. A higher number can make the pension plan appear healthier, requiring lower contributions today.

If the funded status appears artificially high, one risk is that officials can promise a level of benefits that they may be unable to maintain. In the future that can lead to higher taxes, fewer services and even a cut in actual pension benefits.

The flip side is that reducing the expected return to 6% may double the immediate contributions of some municipalities, according to Pension & Investments, adding to local budget stresses.

Look at what has been happening in Dallas over the past month. The troubled $2.1 billion Dallas Police and Fire System suspended lump-sum withdrawals and has asked the city for a one-time infusion of $1.1 billion, an amount roughly equal to Dallas’ entire general fund (but nowhere close to what the pension fund needs to be fully funded).

This case highlights two negative behavioral implications of using artificially high future investment assumptions to value pension benefits. First, the impression of being well funded can lead to making promises you cannot keep. In 1993 Dallas provided generous benefits without appropriately accounting for how it might be able to meet them. Second, expecting higher returns can drive money into riskier investments with the promise of higher returns. In the case of Dallas, the pension system invested in real-estate deals that didn’t deliver as expected.

My friend and author Ben Carlson has collated a few more examples of troubled pension plans here.

Widening out across the nation, the extent of underfunding is likely not $1 trillion across states — but $6 trillion.

Why is this?

The financially accurate approach to valuing future liabilities is using a discount rate that you are relatively certain of earning, such as a Treasury or high quality bond rate. Private pensions are required to account for their liabilities using high-quality bond rates. As the chart below shows, the rates that public pensions are required to use to account for their liabilities are significantly higher than the rates used by corporate pensions. This results in understating public pension liabilities, and creates an incentive to make expected returns as high as possible (click on image).

The investment consultant Callan Associates created this series of pie charts to highlight the increased complexity that pension plans need to take on in order to meet a 7.5% return assumption today. In January 1995, the 10-year Treasury yield was around 7.75%, allowing you to earn 7.5% returns over 10 years with relative certainty; currently it is just under 2.5%, thereby pushing investors into assets such as equities and alternatives that might provide higher returns, but come with greater risk. The S&P 500 for example, returned an annualized return of 10% since 1995, but came with higher volatility, including a 50% decline in value during the financial crisis (click on image).

Calpers has a relatively well-balanced asset allocation, as this table shows, and shooting for higher returns would mean increasing the risk profile of the fund, which may not be prudent (click on image).

Critics of moving to a more financially accurate method of pension accounting rightly point to the immediate pain that would cause. If municipalities in California have to double their contributions by reducing discount rates from 7.5% to 6%, then it would be a disaster for them if they used a discount rate similar to that of corporate pensions.

However, there is something flawed in this logic. Instead of acknowledging the problem and then finding a solution, the critics would rather pretend the problem doesn’t exist. It’s the difference between “you owe $6 trillion, let’s work out a way for you to pay it off over time” and “you only owe $1 trillion, no big deal”.

Unless the true extent of underfunding is brought to light, we may be providing beneficiaries with a false hope that their promised benefits are secure. If taxpayers reach the limit of what they are willing to contribute, and state and federal governments are unable or unwilling to step in, then a cut in benefits may end up on the cards.

Even if over the next few years we see stellar investment returns (and I hope we do!), this conversation needs to happen. Instead of increasing benefits or reducing contributions, excess investment returns should be used to fill the widening hole. And the first step toward that is recognizing the size of that hole.

What Calpers decides to do with its expected-return assumption is likely to be a political decision, driven by compromise. The hope is that it can open up a much-needed debate that leads taxpayers, beneficiaries, pension committees and governments down the path of better understanding who is going to bear the risk of things not going as planned.

But if we hide the numbers, it’s hard to make the right decisions.

Amit Sinha has worked in the investment industry for over 16 years and in his spare time writes about bringing financial concepts, technology, design and behavior together. You can follow him on his blog The Thought Factory.

I’ve already covered why CalPERS needs to get real on future returns, stating the following:

The main reason why US public pensions don’t like lowering their return assumptions is because it effectively means public sector workers and state and local governments will need to contribute more to shore up these pensions. And this isn’t always feasible, which means property taxes might need to rise too to shore up these public pensions.

This is why I keep stating the pension crisis is deflationary. The shift from defined-benefit to defined-contribution plans shifts the retirement risk entirely on to employees which will eventually succumb to pension poverty once they outlive their meager savings (forcing higher social welfare costs for governments) and public sector pension deficits will only be met by lowering return assumptions, hiking the contributions, cutting benefits or raising property taxes, all of which take money out of the system and impact aggregate demand in a negative way.

This is why it’s a huge deal if CalPERS goes ahead and lowers its investment return assumptions. The ripple effects will be felt throughout the economy especially if other US public pensions follow suit.

Unfortunately, CalPERS doesn’t have much of choice because if it doesn’t lower its return target and its pension deficit grows, it will be forced to take more drastic actions down the road. And it’s not about being conservative, it’s about being realistic and getting real on future returns, especially now that California’s pensions are underfunded to the tune of one trillion dollars or $93K per household.

It’s not just CalPERS. From Illinois to Kentucky, US public pensions need to get real on future return assumptions or pray for a miracle that will never happen.

And the Dow 20,000 won’t save them or other pensions which are chronically underfunded. This too is a pipe dream which ignores the simple fact that no matter how good investment teams are at US public pensions, investment gains alone will never be enough to shore up public pensions over the long run.

Why? Because pensions are all about managing assets and liabilities. Those liabilities are long-dated (go out 75+ years) so for any decline in interest rates, the increase in liabilities is disproportionately larger than the gain in assets (in finance parlance, the duration of liabilities is much larger than the duration of assets, so any decline in rates will impact liabilities negatively more than it impacts assets in a positive way).

Now, a lot of people are getting excited about rates going up at the same time as assets going up. After the Fed raised rates on Wednesday, I was shocked to see how many industry professionals were parading in front of CNBC cameras claiming that “inflation concerns are on the rise” and the “Fed will surprise markets by raising rates a lot more aggressively in 2017″.

Total nonsense! Keep dreaming! I stand by everything I wrote last Friday when I went over the unleashing of animal spirits and think a lot of people aren’t paying attention to the surging greenback making a 14-year high (and going higher) and how it will tighten US financial conditions, lower US inflation expectations (via lower import prices) and hurt the domestic economy and possibly spur another Asian financial crisis, starting in China.

I know, president-elect Donald Trump and his powerhouse administration will “make America great again” allowing US public pensions to get back to the good old days when they were using 8%+ investment return assumptions to discount their future liabilities.

Like I said, keep dreaming, these markets seem so easy when they quietly keep rising but that’s when you need to be paying the most attention because the trend is your friend until it isn’t and when things shift, they shift very abruptly, especially when expectations are priced for perfection in terms of fiscal and monetary policy.

All this to say that 7.5% annualized return over the next ten years is a big pipe dream and no matter how much US public pensions allocate to illiquid or liquid alternatives, they will never attain this bogey without taking huge risks which will likely set them back further in terms of funded status.

I am open to all criticisms, suggestions, counterpoints, but I pretty much stand by everything I’ve written above and think that the day of reckoning for many US public pensions is right around the corner. Better to be safe than sorry which is why CalPERS is right to lower its future return assumptions. Others will necessarily have to follow or risk a much worse outcome down the road.

Let me repeat, I don’t care if you’re CalPERS, CalSTRS, Ontario Teachers’, HOOPP or if you have George Soros, Ken Griffin, Jim Simons, Steve Schwarzman and Ray Dalio all sitting on your investment committee, investment gains alone are not going to shore up your pension when times are tough, especially if it’s already chronically underfunded.

At one point, pension plans need to adjust benefits too or shore up public pensions via more taxpayer dollars. That’s when the real fun begins.