History Supports CalPERS’ Estimate of Yield

What do you think you can earn on stock and bond investments in the 1990s? Seven percent a year? Ten percent? More?

It’s a tough question, all right, but it’s important for every investor to think about how to answer it. Being realistic about future returns on financial assets like stocks and bonds can help you decide between those investments and others that compete for your money--such as a home, bank CDs, etc.

Public pension funds have to wrestle with the same question of “what will we earn?” They have to pick an expected return on their portfolio and, from that, calculate the level of additional contributions needed from the state and state employees to guarantee those workers’ future retirement benefits.

In the continuing fight between Gov. Pete Wilson and the California Public Employees’ Retirement System fund, with its $62.4 billion in assets, Wilson has proposed that CalPERS raise its investment sights. The fund expects to earn 8.5% a year from its mammoth portfolio in the early 1990s. Wilson wants the fund to assume that it will earn 9.5%.


The net effect of raising CalPERS’ target return would be to lower the level of contributions the state would have to make. You can understand why Wilson--and apparently, many allies in the Legislature--feel that’s an attractive way to help ease the state’s current and (possibly) future budget shortfalls. One percentage point on $62.4 billion is $624 million, which is a nice chunk of change.

The problem is, many experts say that pension funds would be crazy to bet that they can earn the same stellar stock and bond returns in the 1990s that they earned in the 1980s. The markets’ gains in the ‘80s are viewed as wild aberrations in the historical context--sort of like a solar flare. Odds are, returns will be much lower in the ‘90s. This is no time to raise your sights.

Take a look at the accompanying chart, which shows average annual returns for six decades on three benchmark portfolios: pure stocks, pure bonds and a 60% stocks/40% bonds mix.

That 60/40 mix is the key portfolio from a pension fund’s point of view, because most funds split their money largely between stocks and bonds.

What the numbers tell you:

* In the 1980s, the average annual return on a 60/40 stocks/bonds mix was a stunning 15.82%. That was the best return on that portfolio in any of the six decades shown. In fact, no other decade was close; runner-up was the ‘50s, at 11.98%.

* Outside of the ‘80s, the 60/40 portfolio returned less than 8% a year for most of this century. Even with the “solar flares” of the 1950s and 1980s, the portfolio’s annualized return for the full 60 years was just 8.06%, according to investment tracker Dimensional Fund Advisors Inc. in Santa Monica.

From the state’s point of view, it’s certainly tempting to look at the CalPERS fund’s returns in the last few years--a 13.3% annualized rate since 1985--and say that the fund’s 8.5% target is too low.


But the long-term picture suggests that CalPERS is right to stay where it is, because returns inevitably move back to middle ground.

“It’s probably fair to say that our assumption has been conservative in recent years,” says DeWitt Bowman, the fund’s chief investment officer. “But it’s not too conservative if you look out 50 years. And we have to take that long-term view.”

David Tirapelle, the state’s personnel department director, a CalPERS director and Wilson ally, argues that 9.5% would still be “a conservative number.”

And even if the fund were to fall short of that target for a few years, the strong returns of recent years mean that “you could go the other way (under-perform) now for a few years and not hurt the fund,” he says.


CalPERS, of course, doesn’t buy that. This gets into the argument of whether CalPERS now has too many or too few dollars for future retirees’ benefits.

Both sides can twist theoretical numbers to argue either way. But it doesn’t change the fact that historical returns on stocks and bonds support CalPERS’ 8.5% annual target.

Among major public pension funds, CalPERS is right about in the middle with that 8.5% number. The $24-billion Texas Teachers Retirement System fund has a target of just 8%.

At the other end of the spectrum is the $10-billion Pennsylvania State Employees Retirement System, which expects to earn 9.9% a year in the 1990s.


Back up a bit, here: If the historical return on a stock-and-bond mix is 8.06%, isn’t CalPERS still asking too much with an 8.5% target? Some experts think that it’s OK to bet on a little more because of what’s viewed as a sea change in the bond market during the 1980s.

Rex Sinquefield, a principal at Dimensional Fund Advisors, notes that interest rates have risen markedly since the 1970s because of bank deregulation and other factors. It’s likely that rates will stay on this new plane rather than fall back to levels in pre-deregulation days, Sinquefield says.

Thus, he says, bonds alone will probably pay more in the 1990s than the 60-year annualized return of 4.55%. So keeping a total (stock and bond) investment target above 8% isn’t far-fetched; even going from 8.5% to 9.5% “is not outrageous,” he says.

But Sinquefield also agrees that the more prudent plan for a public pension fund would be to stick with a lower number. “The way to protect yourself is to say, ‘Let’s be a little bit conservative,’ ” he says. In any given period of years, he notes, “there’s tremendous variability in investment returns.”


What happens if, five years from now, a public fund that expected to earn 8.5% a year has earned just 7%? The shortfall would have to be made up by taxpayers.

That’s why setting a fund’s sights too high is so dangerous: If you keep your target up, and base your retiree benefits on that target, you’re leaving yourself vulnerable to a big deficit later on.

For politicians, of course, it’s easier to take a short-term view of the situation, grab what you can from the CalPERS fund now and bet that the investment markets somehow will be as good to you over the next five years as they were over the last five.

But this isn’t Las Vegas--this is peoples’ retirement money we’re talking about. If conservatism doesn’t apply here anymore, we’re in big trouble.


What Will Investments Earn in the 90s?

The California Public Employees’ Retirement System fund assumes its overall investment return will be 8.5% a year over the next few years. Gov. Wilson wants the fund to raise that objective to 9.5%. But historically, a typical portfolio of stocks and bonds has returned far less than 9.5% a year over long periods--so raising the target could be imprudent, some experts say.

Average annual Stocks Bonds Stocks and bonds returns, by decade 1930s -0.05% 4.87% 3.16% 1940s 9.17% 3.23% 7.01% 1950s 19.35% -0.08% 11.98% 1960s 7.81% 1.45% 5.58% 1970s 5.86% 5.52% 6.06% 1980s 17.55% 12.62% 15.82%

Stocks are S&P; 500 index; bonds are long-term Treasury bonds; stocks/bonds is mix of 60% stocks and 40% bonds


Source: Dimensional Fund Advisors