Nearly all of the nation’s larger public pension funds, 99 percent, have better investment earnings than CalPERS since the economy began a steep drop five years ago, a Wilshire consultant report said last week.
Now the nation’s largest public pension fund, a former investment leader said to have had a “herding effect” on other pension funds in one academic study, is several years into an attempted overhaul.
A conceptual change that emerged from a study two years ago is intended to use “risk” as a way to classify and monitor investments. The shift has begun, but it’s still evolving amid a search for more answers.
Another change would build up the CalPERS investment staff and rely less on outside managers. A new proposal would add 44 investment positions at a cost of $6.5 million, offset by reducing fees paid outside managers by $100 million to $200 million.
The biggest loser, real estate, has moved toward predictable leases and away from speculative developments. A new private equity manager, Real Desrochers, brings more internal management to key investments expected to yield above-market returns.
The one bright spot, bonds, has seen about $7 billion moved in-house. But overall, Wilshire said, earnings continue to be hampered by a stock portfolio skewed toward foreign holdings and a real estate debacle that may be felt for another 10 years.
In a report marking his third anniversary on the job, Joe Dear, the chief investment officer of the California Public Employees Retirement System, last week talked about the problems and the progress.
“From October 2007, our peak value of $260 billion, to March 2009 to $160 billion — we dropped $100 billion of assets,” Dear said. “We got most of that back. We are at $235 billion of assets.”
Dear mentioned three lessons learned: classic portfolio theory that aims to reduce risk by investing in different types of assets faltered, having “silos” or little exchange between units is dangerous, and ready access to cash or “liquidity” is important in a crisis.
The move toward a risk-based view of assets is a response to the nearly lockstep plunge of most types of assets. Dear said managerial “silos” that kept one unit in the dark about the actions of another may have contributed to real estate losses.
“Fixed income on the third floor . . . was getting out of mortgages because they didn’t like the market, and on the fourth floor the real estate group was selling assets at a very good profit and then turning around and buying more expensive assets with more leverage (debt),” he said. “That produced a return disaster for us which to this day has impacted our long-term performance.”
CalPERS sold $16 billion worth of income-producing and other low risk real estate, a staff report said in April 2010, and then spent the money while buying $30 billion worth of higher risk real estate as the market peaked in 2005 and 2006.
When the financial crisis hit in the fall of 2008, CalPERS and other major investors had to scramble to get cash to cover, among other things, the “securities lending” that usually provides a small profit and is said to aid market operations.
“If you don’t have liquidity, and we didn’t, then you are forced to sell your best assets at fire sale prices and mark down the portfolio,” said Dear, “and that’s what happened to us, primarily because of the securities lending portfolio.”
Most famously, CalPERS is said to have raised $370 million by selling 2.3 million shares of Apple in 2008 worth about $1.35 billion now. Apple has a $100 million cash surplus and may announce a major dividend or other action today.
Three years ago CalPERS also was hit by a pay-to-play investment scandal. A CalPERS probe found that a former board member, Al Villalobos, received $50 million in “placement fees” from private equity firms for helping them get CalPERS investments.
“What I came to learn is that when you are told there are placement agents in your organization it’s kind of like being told there are termites in your house,” Dear said. “It may be a really isolated, small infestation but you have to fumigate the whole place to get rid of them.”
Dear said placement agents provide a “valuable service” and have a market function. But during a CalPERS-sponsored special review, he said, staff had to revisit gifts received during the previous years, not the “greatest morale booster.”
The CalPERS private equity manager, Leon Shahinian, resigned. Villalobos and a former CalPERS chief executive, Fred Buenrostro, are accused of bribery-related charges in a civil lawsuit filed by the state attorney general.
Another issue that has heated up during the last three years is whether CalPERS pensions are “sustainable” or will eat up too much of state and local governments. Critics say the CalPERS earnings forecast is too optimistic and conceals massive debt.
Last week the board lowered the earnings forecast from 7.75 to 7.5 percent, increasing state and local government pension costs. The change reflects an expectation of lower inflation, not new doubt about hitting the earning target in the decades ahead.
“I’m quite confident of our ability to achieve a long-term target rate of return,” Dear said.
A board report last week showed that CalPERS is paying $1.2 billion a year in fees to outside money managers, $19.2 million for consultants and $29.5 million for CalPERS investment staff.
Board member Dan Dunmoyer suggested CalPERS think about the incentive of a high salary, perhaps $1 million, for investment staff capable of producing perhaps billions in earnings. Dear agreed with Dunmoyer that high salaries probably would be “unrealistic” politically, though a recent Economist article said Canada does it.
Janine Guillot, CalPERS chief investment operating officer, said the pension fund is not trying to compete with the private sector but can offer benefits that are attractive to many.
“My big worry is the junior people,” said Guillot. “You see it in our recruiting statistics, where our junior positions are staying open much longer.”
Board member J.J. Jelincic said a new CalPERS requirement that outside real estate managers put someone on the account full time has resulted in high salaries.
“There are people working on only our account that are making in excess of $1 million a year,” Jelincic said, “and I will tell you it is not a great staff morale booster when they collect that data.”
Board member Richard Costigan, who also serves on the State Personnel Board, said the personnel board hears cases about “contracting out” state work to the private sector, but not on the scale of the $1.2 billion CalPERS fees to outside manager.
Costigan said there is “significant pressure” on CalPERS investment staff to achieve “returns without the reward.” He said investment work is different “and I think at some point we have to acknowledge that.”
The board held a workshop last week on hedge funds, which use options, borrowing, investing across asset classes and other flexible strategies. CalPERS has about 2.3 percent of assets in hedge funds, low compared to some pension funds with 20 to 40 percent in hedge funds.
“You started the public pension plan move (into hedge funds) and other pension plans in the U.S. followed and then European pension plans followed you,” a former World Bank official, Afsaneh Beschloss of the Rock Creek Group, told the board.
A paper issued last November by researchers at the University of Dayton found that the amount of risk taken on by public pension funds is influenced by governmental accounting standards, a low funding level and state imposed financial constraints.
“There also appears to be a herding effect in that a change in CalPERS portfolio beta or equity allocation is mimicked by other pension funds,” said the paper by Nancy Mohan and Ting Zhang.
The Wilshire report shows CalPERS earnings at the end of last year: 5.29 percent for the previous 10 years (71st percentile among funds with more than $10 billion), 0.57 percent for five years (99th percentile), and 1.24 percent (44th percentile). (See Wilshire report, attachment 4, Part 1, p. 20)
–Ed’s Note: Reporter Ed Mendel covered the Capitol in Sacramento for nearly three decades, most recently for the San Diego Union-Tribune. More stories are at http://calpensions.com/