California Teachers Pension Fund Raises Maximum Leverage to 10% of Fund Assets; State Faces $38B Shortfall in 2024

Relevant Documents:
Board Meeting Agenda Packets, Jan. 11
California Budget Summary, Jan. 10
Board Meeting Educational Item, Nov. 1, 2023

The California State Teachers’ Retirement System, or CalSTRS, raised maximum leverage to 10% of the total fund from the current 5% as part of an investment policy statement revision adopted during an investment committee meeting on Thursday, Jan. 11.

The decision comes a day after California Gov. Gavin Newsom submitted his 2024-’25 budget in which he proposed a $4.2 billion annual state contribution to CalSTRS, which is $302 million more than was approved in the 2023 Budget Act. Broadly, the state is facing a $37.9 billion shortfall in 2024, according to the governor’s proposed budget.

One of the largest pension funds in the country, CalSTRS had $280.59 billion in actuarial assets as of June 30, 2022, for a funded ratio of 74.4%, according to an actuarial valuation prepared by Milliman.

The increased leverage cap is a risk mitigation tool to help the fund navigate a potential economic downturn, members of the investment committee said during the meeting, pointing to several instability factors in the coming year, such as elections and conflicts across the globe. Leverage used by the fund could include borrowing with banks and other lenders as well as derivative instruments, according to the November agenda.

“It’s very hard to invest in a falling market, particularly when you don’t have liquidity, because it would force you to sell a long-term asset to meet a short-term liability, which is the worst thing you can do,” said general investment consultant Allan Emkin during the meeting.

The target leverage is still 0%, but the new policy will “allow for the use of leverage, on a temporary basis,” and “provide the flexibility to position the portfolio and manage liquidity over a business cycle,” the agenda materials say. It will also allow the fund the option to take advantage of any discounted assets.

“In ‘normal’ market environments, the Total Fund needs very little leverage to achieve its objectives; in times of market stress, however, the fund may benefit from using additional leverage to smooth reduced cash flows, rebalance the portfolio, and continue to pay benefits,” the November agenda says.

Total leverage has historically been lower than 2% of the total fund’s net asset value. It hit a peak of 4% in 2022, when equity markets and bond markets were falling. Most of that leverage was in the form of derivatives used to ensure asset classes stay within their allocation bands, while the rest is in the form of medium-term borrowing in revolving credit facilities, according to the November agenda.

Leverage from 2020 to 2023 is shown in the chart below:

The new policy has also widened the asset allocation ranges by two percentage points. Fixed rate, for instance, has a policy target allocation of 14%, now with an allowable range 5% more or less than the target number. That 5% range was increased from 3% before the new policy update.

“Widening asset allocation ranges to provide flexibility in deciding when to rebalance back to the SAA (Strategic Asset Allocation) targets. Over a business cycle, there are periods when private market investments are slower to reprice and return cash while the public markets quickly reprice and can be converted to cash,” the agenda says.

The new recommended ranges for different asset classes are shown in the chart below:

During the meeting on Thursday, CalSTRS Chief Investment Officer Christopher Ailman announced that he will be retiring in June after serving in this position for over 23 years.