September 17, 2014

CALIFORNIA GETS TO ZERO ON HEDGE FUNDS:

This is splendid news for all the people of California, though, of course, it will be a bit hard on the hedge fund managers. Notwithstanding the prospect of desperate fund managers having to fly commercial and sell the third home, other states should follow suit.

However, it’s worth noting what this means: California has given up on the hope of above-market returns from hedge fund investments. There is a reason that public-sector pensions have been pouring money into hedge funds: It’s become clear that they are dramatically underfunded. California, for example, is about 25 percent underfunded, according to its chief actuary, with only a 50 percent chance of meeting its 7.5 percent target for annual investment returns.

A state can deal with a pension shortfall in two ways: It can raise contributions, or it can try to get higher returns out of the assets it already has. As mentioned above, this isn’t really a strategy that’s open to a fund as large as Calpers, but that hasn’t stopped Calpers from trying. After a series of grossly irresponsible pension enhancements at the height of the stock market bubble, Calpers tried to make up for the shortfalls by using accounting gimmicks to lengthen the schedule of top-up contributions and pushing into riskier investments.

Now the riskier investments have failed, and the accounting gimmicks were mostly based on the hope that the higher returns would bail Calpers out at some unspecified later date. That leaves the California taxpayer with higher contributions. This has already become a problem with many state and local governments; expect it to become a problem for many more.

It’s nice that they’re finally recognizing reality. It would have been better if they’d been more realistic all along.

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