Report: CalPERS’ Strong Real Estate Returns Unlikely To Last

CalPERS real estate returns

CalPERS has seen strong real estate returns since 2011. But a consultant for the pension fund warns in a new report that the consistent double-digit returns are unlikely to continue.

[The report, from Pension Consulting Alliance, can be read here, or at the bottom of this post.]

More details from Randy Diamond of Pensions & Investments:

The PCA report, which is contained in agenda materials for CalPERS’ Nov. 17 investment committee meeting, said sustaining those returns is unlikely because of a challenging and highly competitive investment market.

The report cites increased competition from sovereign wealth funds, high-net-worth investors and other large direct investors in real estate as among the reasons for the potentially declining results. It says persistently low interest rates are fueling the demand for income-producing assets.

In 2011, CalPERS changed the focus of its real estate program to focus on investing in income-producing properties — and away from opportunistic real estate — after suffering massive losses following the crash of the real estate market.

CalPERS spokesman Brad Pacheco said in an e-mail: “We recognize that recent high returns will be difficult to achieve in the current real estate market. Our goals now are to diversify portfolio risk and generate steady, modest gains.”

CalPERS manages $25.6 billion in real estate assets, and is planning to expand its real estate portfolio by 27 percent by 2016.

The report:

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CalSTRS Weighs Worst-Case Scenarios in Latest Meeting

CalSTRS' Projected Funded Ratio. Credit: Chief Investment Officer and PCA
Credit: Chief Investment Officer and PCA

California’s pension reforms are designed to fully fund CalSTRS in the next 35 years. But that timeline assumes the fund will meet or exceed its assumed rate of return – 7.5 percent – year in and year out.

But what if CalSTRS doesn’t meet its investment return targets?

That was the topic of the fund’s most recent investment board meeting. Reported by Chief Investment Officer:

CIO Chris Ailman posed that question [of failing to meet return expectations] 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.

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 pose 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.”

The topic will be broached again at the next board meeting, according to Chief Investment Officer.