State Teacher Pension System Investment Earnings Failure Triggers Risky Borrowing Ploy

While no one is panicking, precisely, just yet, public school teachers in San Bernardino County and elsewhere throughout out California becoming increasingly nervous with regard to their pension system.
The California State Teachers’ Retirement System is faced with the prospect of dwindling flow of money into its coffers, one which, if left unaddressed, would escalate from what is now politely referred to as an unfunded liability of hundreds of billions of dollars to the full-blown collapse of the entire operation.
On January 11, the investment committee of the California State Teachers’ Retirement System Board is set to consider whether it should borrow more than $30 billion to help it maintain enough liquidity to make its pension payments to already retired teachers throughout the state and continue maintaining its current investment portfolio, which will hopefully generate returns to keep the system intact.
If the committee elects to make the change, staff will be authorized and empowered to borrow as much as 10 percent of the system’s current $318 billion portfolio. The proposal calls for “leverage” to be used “on a temporary basis to fulfill cash flow needs in circumstances when it is disadvantageous to sell assets,” according to a document generated by the California State Teachers’ Retirement System’s investment advisor, the Meketa Investment Group.
Within the documentation to be considered by the board on January 11, leverage in this context is defined as “an investment strategy where money or capital is borrowed to increase the potential return of an investment or portfolio.” The document said, “Proposed policy would set a limit on the total fund net leverage at 10%.”
In essence, according to the system’s advisors, gargantuan investment funds can take advantage of their size through movement and placement of the capital they control into varying funds, which prop up the value, and therefore the profitability of those funds, providing returns on the investments. If the investing entity withdraws a significant amount of its investment at a given time, the value of the investment per share is very likely – almost inevitably – going to take a hit, causing the value of the shares to drop, and therefore the investor’s investment pool to shrink and returns on investments to diminish.
In the case of the California State Teachers’ Retirement System, known by its acronym CALSTRS, retirees are constantly drawing upon the money in the system, diminishing the amount available for investment purposes. According to the parameters that have been set up, as long as the investment pool continues to generate returns of 7 percent on average annually, the system is able to maintain itself, i.e., provide pension payments to retirees and keep its investments in place to continue to generate returns. If, however, earnings fall below the 7 percent threshold, the system is put into the position of having to liquidate or sell off some of its investments to use that capital to make the pension payouts. With less capital invested, returns diminish overall despite the rate of return. Such a sell-off of investments could further trigger a diminution in the value of the remaining investments within the larger investment market, causing the return to diminish to below 7 percent. Such a downward spiral, if sustained or exacerbated over an extended period, could lead to the collapse of the entire system.
Over the previous five years, from 2017 to 2022, the pension fund sustained an annualized average return exceeding the functional threshold, that is, of 7.2 percent. In Fiscal Year 2022-2023, CALSTRS managed a 6.3 percent net return on its investments. Hence, the investment committee has taken up consideration of the strategy to be contemplated on January 11. The calculation in that strategy is that if there are no wild deviations in the stock market and real estate markets, given the advantage that CALSTRS has in terms of its overwhelming volume of capital to invest, the intelligence, skill and insight of its investment advising team and the relatively even and rising trend in the value of those markets over the past several years, the California State Teachers’ Retirement System, the second largest pension system in the country, will not only see a return of 7 percent on its investments but an additional percentage return sufficient to allow it to make up for the cost of the interest it must pay in borrowing the money to invest.
The danger, of course, is that because of a downward fluctuation in either the stock market or the real estate market or both, earnings might fall to below 7 percent.
CALSTRS staff, after consulting with Carlsbad-based Meketa, downplayed that risk in a memo to the board generated for the January 11 meeting.
In September, the board was briefed by staff and Meketa as to the strategy.
“As discussed previously, the small increase in risk is a result of the increased active risk of the fund as the allocation deviates from targets,” according to a staff memo. “In staff’s judgment, the proposed ranges strike an appropriate balance between the risk associated with wider ranges and the benefit of greater staff flexibility. And the changes pose low risk to the funding plan, as shown by the minimal affect expected on key funding plan metrics.”
The more money for investment available, the more likely those guiding the investment strategy will have to make an immediate or quick purchase of a promising stock or property that comes onto the market, according to those in charge of the investments.
Meketa has privately assured the California State Teachers’ Retirement System staff that increasing the fund’s leverage will entail minimal risk. CALSTRS, which already leverages roughly 4 percent of its portfolio, has profited by doing so. What is being contemplated is merely a change in scale. Nor will the retirement fund become reliant on the money to be borrowed but simply have it available as an “intermittent tool” to adjust cash flow and make investments of opportunity when they materialize to enhance the investment portfolio, according to Meketa.

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