Why the California pension system is in the crapper despite recent good results

Whelp… it looks like index funds didn’t save CalPERS. Back in 2014, the California pension systems (CalPERS and CalSTRS) yanked a bunch of money out of actively managed funds and shoved them into passive index funds. 

Yay passive investing. 

Uh. Wait. CalPERS and CalSTRS are still underfunded and still not making headway, aren’t they? Yes, they are currently collecting more than they’re paying out but… they are also riding the wave of stock price appreciation which is likely to come to an end soon. 

CalPERS, and really all government pensions, suffer from the same problem. They assumed they could make a 7+% return on assets, and they failed. They failed miserably. They haven’t make anything close to that over the last 25 years and the losses have compounded. One could argue that California, like many other pension plans, promise benefits which are way, way, too generous. Let’s leave that aside for just a moment because almost by their very definition, pensions are generous retirement plans so I’m not sure it’s even possible to have too much Cadillac in a Cadillac plan. What’s key here is not that it’s a Cadillac plan. What’s key is that if you’re going to have a Cadillac plan, you better fund it with premium gas and not the cheap stuff. And yet, that’s precisely what pension plans have done — they’ve funded Cadillac plans with cheap gas and now it’s blowing up on them.

Because they assumed a high rate of return, they underfunded the pension system. And before you think “oh my state’s pension is probably fine”… No. Stop it. Stop being ridiculous. Every state pension fished from the same investment pool, made similar pension promises, and is in the same sh*thole as California. 

Federal pensions — ditto. Private pensions — double ditto. 

These plans should have been funded with conservative life insurance and annuity policies to guarantee the pension but nooooooooooo. That would have been bad because reasons.

It reminds me of what the late, great, actuary Jeremy Gold argued for in the pension industry — more robust funding of retirement plans. Mayhaps you have heard of Gold but… in all likelihood you have not unless you read pension news on the regular. 

He is the mathematician who discovered there was a problem in both public and private pension systems. Pensions are organized retirement plans managed by professional money managers. They are usually (but not always) defined benefit plans, meaning they promise a specific payout at retirement. For example, a pension might promise a teacher or a firefighter a monthly pension of $2,000 per month or maybe $5,000 per month. In order to pay for this benefit, money has to be set aside and invested for long periods of time in a way that will guarantee this payout. 

The parallels between a pension and, say, a 401(k) are obvious to some folks. The differences are mainly that a 401(k) ends up being managed by the investor drawing the income whereas pensions have actuaries figuring out how money should be allocated in the investment account and how much money needs to go into it to make it work. Oh yeah, one more thing… pensions are guaranteed (or at least they ought to be in principle) while 401(k) plans are not.

Anywho, Gold figured out the nation’s pensions were very underfunded… 25 years ago. Most pension plans refused to listen to him because it meant increasing contributions to retirement plans and no one wanted to do that. 


They have no choice. Literally, no choice left. Even if they increased contributions, it won’t help some of these pension plans. They’re bust. Pensioners won’t get their promised payouts and they (probably) won’t hear about it until the check doesn’t arrive in the mail. 

Poof! No more money. Bye bye retirement.

Jeremy Gold is a fascinating guy. 

He’s the first one in the pension and retirement industry to openly state the obvious: that $1 million in stocks is the same as $1 million in bonds. The difference is the risk you take in stocks is more than the risk you take in bonds. Always has been. Always will be. This is why stocks have a higher *expected* return than bonds. But… as Gold pointed out, it’s an expected return, not a guaranteed one. And, in many cases, it’s very far away from a guaranteed return (called, the “riskless rate”).

The mistake pensions made was… they looked at the equities market and thought “we could make 7.5% – 7.75% returns on our pension funds”. Of course, the rate of return you earn on your investments determines how much you have to save. If you expect to earn a high rate of return, then you can afford to lower your contributions to a retirement plan. 

But… this creates an interesting sort of problem. When you invest in low risk assets, like fixed income securities or (gasp!) whole life insurance and fixed annuities, you have to save more money. You have to save more money because the rate of return is lower. But… this also means you end up with higher contributions and a larger “cushion” in principal payments to your savings plan. This tends to make for a very safe retirement (or pension) plan. But, alas, it requires a healthy savings habit — something few people are willing to cultivate in themselves.

Let’s say you have to contribute $500 per month to a whole life insurance policy earning 4% annually to meet your financial goals. Maybe a stock investment only requires you to save $300 per month to meet the same goal. On the surface of it, the stock investment looks like a better deal because “it’s cheaper”. You don’t have to save as much to hit your goal. But… that cheapness is an illusion. We can show this by looking at it from a different perspective.

Just for a moment, let’s eliminate all interest on both accounts. 

This removes all risk and return from the equation and focuses purely on the savings you’re accumulating. 

The difference in this scenario comes down to $500 vs $300. Be honest. Would you trade $500 for $300? 

Hopefully not. 

Now… would you trade $300 for $500?

If you have any functioning brain cells, you absolutely would. 

This is the problem pensions had and still have. 

They effectively took $500 of guaranteed money and traded traded it for $300 of non-guaranteed money. The rate of return represents the money paid for risk. In the guaranteed side, 4% interest is considered “riskless” because the investments are guaranteed. On the stocks side, not only do pensions have less money shoved into the plan (fewer principal/contribution payments), they are taking enormous risk hoping to achieve 7.75% returns — 3.75% over the riskless rate. The farther you get away from a guaranteed return, the more risk you take. 

Pensions (and, this also applies to most individual investors saving for retirement) are hoping the stock market will bail them out of a low savings rate. That has not happened. Pensions, and also individual investors, have banked on an 8% and in some cases a 12% return on their investments. Over the past 20 years, they have received, on average, a 6.5% return from the S&P500. And, most studies done on investor returns show investors (and also pensions) have earned far, far, less than 6%.

So… those low contributions became a risky bet that didn’t pay off. The stock market exists to create liquidity and to allow investors to share in the risk of owning a business, not to hand-deliver investment returns at the snap of a finger. What you buy, when you buy stocks, is an opportunity to share in the risk (loss) of the company in exchange for potential profits. Now… there’s nothing wrong with that. But.. .if you’re going to take risk, you need to be able to afford said risk and… the pensions cannot afford it and neither can most individual investors.

This doesn’t stop them from taking those risks, of course. People buy things they can’t afford all the time. Doesn’t mean it’s a good idea. 


Act as if. 

Act as if you are only going to earn a guaranteed rate. Then, save money based on that guaranteed rate. Take risks that you can afford to take. Don’t risk money you can’t afford to lose. 

I know. I know. Seems like common sense… but, it is (sadly) not common practice. 

Anywho, what can you do about it? If you have a pension, and nothing else, you probably need to develop your own personal savings plan. If you don’t have a guaranteed savings, there’s plenty you can do, like… start a guaranteed savings plan.

David Lewis, AKA The Rogue Agent, has been a life insurance agent since 2004, and has worked with some of the oldest and most respected mutual life insurance companies in the U.S. during that time. To learn more about him and his business, go here.