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EIGHT-FOOT GREEN WAVES were pounding outside the Monterey Best Western hotel as Rob Feckner was renominated as president of the California Public Employees’ Retirement System’s Board of Administration. It was January 23, 53 degrees on the beach and not much warmer inside. I’d mistakenly counted on some California sunshine when Joseph Dear, CalPERS’s chief investment officer, invited me to come speak to his board about long-term risk and the system’s $230 billion portfolio. I’d also forgotten that Californians rarely heat their rooms in the winter.

From the rear of the Grande Ballroom, I could barely hear Feckner’s nomination by one of his fellow board members, but the speaker suggested that they were all “relieved by his steadying leadership,” or something like that — an implied contrast to earlier, scandalous tenures. Tall and thoughtful, with a neatly trimmed beard, Feckner is an employee of the Napa Valley Unified School District, with long experience in California politics. He’d been president of the California School Employees Association and had put in years of service on the CalPERS board. He was unanimously reelected.

With equal speed the board reelected vice president George Diehr, a statistics professor from California State University San Marcos. The whole process took less than five minutes. Then the board turned to a grueling daylong evaluation of portfolio risk and reward.

The CalPERS board is trying to extract itself from a cat’s cradle of deep portfolio losses in 2007–’08, governance scandals and funding sticker shock in Sacramento. It is also making an excruciating investment call. How much should CalPERS reach for yield on its $230 billion of assets to grow out of its funding hole — estimates suggest that CalPERS has funded only 60 to 70 percent of its liabilities — and how much volatility should it risk?

Public pension boards are in a tight spot. Governors are screaming at them for busting state budgets, retirees blame them for shrinking asset portfolios, and the media accuse them of self-dealing in cahoots with money managers. Who would want this job, particularly in the Golden State?

The good citizens of California can’t accuse the CalPERS board of indulging in luxury at the taxpayers’ expense. The Best Western was frugal and a bit gritty. The Grande Ballroom looked more like the setting of a school board or municipal council meeting in Middle America than a meeting place for the board in whose collective hands rests the fate of the largest public employee pension fund in the U.S.

California is ultimately on the hook for these pension obligations, responsible for CalPERS’s 440,000 current beneficiaries and the 800,000 workers enrolled in the system. Sacramento is looking to CalPERS to grow out of the funding hole by getting high returns on its investment portfolio, and has set an annual bogey of 7.75 percent. The board in turn is looking to CIO Dear to work that magic. He had called in three outside experts as a sort of warm-up band before his own presentation on the portfolio strategy that January day. I was one of the three.

How did CalPERS fall into this money pit? In retrospect, 1999 was a turning point, although no one knew it at the time. Under the leadership of then–board president William Crist, whom I deeply admired for his advocacy of strong corporate governance in the 1980s and ’90s, the CalPERS board pressed for legislation that simultaneously reduced state payments into the fund while increasing benefits. CalPERS was flush with cash and overfunded, with portfolio assets at 110 percent of estimated liabilities.

In 1999, Crist said, “This is a special opportunity to restore equity among CalPERS members.” After all, he argued, many businesses were using their overfunded pensions to pad their reported P&Ls and reduce payments to their pension plans. According to a Los Angeles Times story, “They [the CalPERS board] were assured by their actuary that the fund, now worth $157.5 billion — the largest in the U.S. — was comfortably overfunded and that the system could weather any market downturn. ‘Everyone knows that markets ebb and markets flow,’ said Crist at the time.”

Throughout the 1980s and ’90s, CalPERS led the way in shifting public pension assets away from low-yielding fixed income to stocks and alternative assets, including a large foreign equity exposure and a variety of high-yielding investments such as hedge funds and real estate — a variant of the so-called Yale model championed by Yale University endowment chief David Swensen. And it worked. For 1999 the fund earned 13.5 percent on its investment portfolio and climbed to the 110 percent funding level.

CalPERS was widely perceived to be cleverly making lots of money for its beneficiaries while pressing for corporate governance reforms worldwide, and was thought to be a paragon of virtue on both fronts. As I was researching the links between capital markets and corporate governance in the 1990s, I often observed Cal­PERS board members at meetings of the International Corporate Governance Network in fashionable cities like Amsterdam and Milan, the sober civil servants from Sacramento being circled by Armani-clad money managers in what I thought was merely a contrast of cultures. I was writing a book on the pivotal role of public pension funds in improving shareholder protections at their portfolio companies, an idea originally suggested to me by Ira Millstein, senior partner at Weil, Gotshal & Manges and éminence grise of corporate governance. At the time, CalPERS was everybody’s hero — mine too.

What was not to like about this deal — higher payouts to retirees, lower bills for the state? With the enthusiastic support of California’s politically powerful unions, the legislation (SB 400) sailed through Sacramento with minimal debate. It passed the senate on a 39-to-0 vote and the assembly on a 70-to-7 vote. At the time, the annual price tag for these higher benefits was estimated at a modest $600 million a year. And indeed, state and other employer unit payments to Cal­PERS fell from $1.2 billion in 1996 and ’97 to a mere $150 million in 1999 and 2000.

But the math of reduced payments in and increased benefits out soon caught up with CalPERS’s balance sheet, which got pounded by equity losses in the dot-com bust — an ominous reminder of the biblical truth that equity markets giveth and equity markets taketh away. The years that were fat had begun to thin.

Despite Crist’s optimistic promise, state payments rapidly swelled. Then-Governor Arnold Schwarzenegger and the legislature were outraged as choppy markets and generous benefits combined to balloon the bill charged to the state from the $150 million level to a whopping $2.5 billion in 2004. Schwarzenegger went ballistic and tried to switch state employees over to a 401(k) pension plan but ran into a buzz saw of political opposition in the Democratic-controlled legislature.

In his 2005 budget Schwarzenegger attacked the basic concept of a defined benefit plan, asserting that future state employees should convert to defined contribution plans. In this argument he presaged the intense, bitter collision between public employee unions and newly elected Republican governors that exploded into the headlines in 2011 in Wisconsin and continues to smolder in state capitals around the country.

The CalPERS board pushed back at the assault on defined benefit plans, voting to oppose the measure. So did the board of its sister pension fund, the California State Teachers’ Retirement System. The Terminator immediately fired four of his appointees to the CalSTRS board. But CalPERS’s governance rules were set in the state constitution, insulating them from direct political interference, so it would take a statewide vote to amend them — a very high bar for political action, akin to the 1978 constitutional amendment that capped California’s property tax, famously known as Proposition 13.

CalPERS’s portfolio recovered from the 2001 dip and returned to an upward trajectory, reaping big gains from its large exposure to listed equities, private equity and real estate, hitting a high of $260 billion in the fall of 2007. Then it abruptly cratered by 38 percent, to $160 billion, within a single year as the recession pummeled the portfolio. All pension funds got hammered; those with the biggest equity and long-dated exposure got hit the worst. They were also blindsided by a shuddering increase in asset correlations, moving almost to 1 in some cases. For CalPERS and other adherents of the Yale model, most prices moved against them at the same time.

This collapse set off a deep groundswell of political agitation against CalPERS, even though, as plan CEO Anne Stausboll correctly observed: “We don’t set the benefits. Our job is to keep the promises made.” Critics included grassroots groups like the Howard Jarvis Taxpayers Association, which had initiated Prop 13 and still had the playbook for pressing a statewide amendment. Other bills were introduced in Sacramento that would cap the growth in pension benefits, increase the contribution rate from employees’ paychecks, eliminate “spiking” of pension claims in the final years of employment, switch new employees to 401(k)-type plans and alter Cal-PERS’s accounting and disclosure rules along private sector lines.

Then the waters got even choppier. In May 2010 then–Attorney General Jerry Brown brought lawsuits against former board member Alfred Villalobos and ex-CEO Federico Buenrostro. State marshals seized Villalobos’s property, including two Bentleys, two BMWs and a Hummer — this was California, after all. (I spent a good deal of the 1980s in Silicon Valley and still regard my former state with a combination of affection and periodic disbelief.)

Citizen groups agitated to replace the board, merge CalPERS with other state pension plans or shut it down altogether. California Representative Devin Nunes introduced a bill in Congress that would force CalPERS and other public pension funds to bring their accounting rules in line with private standards. A series of studies by the Stanford Institute for Economic Policy Research unfavorably contrasted the accounting methods of the state pension funds with those of the private sector, contending that the unfunded liability of CalPERS would balloon if officials used more-conservative return assumptions. CalPERS faced a Greek chorus of outrage from Golden State politicians echoing San Jose Mayor Chuck Reed’s charge that “skyrocketing retirement costs are destroying our ability to provide basic services.”

Chatting with the board members during coffee breaks at the Best Western, I could hear the resonance of these past political antagonisms. It was pretty clear to me that the three ex officio board members, including State Treasurer Bill Lockyer and State Controller John Chiang, had a different set of worries than the board members representing the employees and retirees. Yet they were all in the same fiduciary boat. The CalPERS board members managed to row together reasonably well, although they were something short of one big happy family. Then again, I’d been in some pretty confrontational board meetings in Silicon Valley and had witnessed firsthand some partisan vitriol during my service in Washington. The tone of the CalPERS board discussions, both at the Best Western and in previous sessions that I’d watched on YouTube, was serious, civil and professional.

The CalPERS problem played out against the backdrop of a deep, even more bitter political battle over California’s budget, which is a deep sea of red ink. Just the previous week Governor Jerry Brown had launched yet another effort to get the state assembly to embrace a combination of budget cuts and tax hikes to bring the $9.2 billion deficit under control. I chatted with Lockyer at the Monterey meeting. Soft-spoken, serious and affable, he looked like a man with a very tough job. “How’s the budget Long March?” I asked. “This has got to take exceptional political courage by Jerry Brown. Every other country I look at, as soon as the politicians embrace an austerity package, they get voted out.” Lockyer looked out at the ocean with a weary smile.

The waves of negative publicity year after year left many California voters with the mistaken impression that corruption had caused the funding gap, rather than the more complex combination of benefit increases and free-falling financial markets. The politics of funding, the portfolio squeeze and the governance of CalPERS itself had become intertwined.

Much to their credit, in my view, the Cal­PERS board members came to the conclusion that the three problems were feeding on one another and had to be dealt with firmly and more or less simultaneously.

• The size of the unfunded pension obligation increased the risk that the governor and state assembly in Sacramento would balk at funding the pension system, try to convert it to a defined contribution scheme or even shut it down altogether. This also implicitly put pressure on CalPERS to take higher risks with its investment portfolio to grow out of the hole rather than stick the employer units (read, Sacramento) with higher contributions.

• On the other hand, CalPERS’s portfolio losses in the 2007–’08 recession, especially some high-profile write-offs on big real estate projects, tempted the state to impose strict investment guidelines and accounting rules on the plan. But altering these rules would have the unintended consequence of making it harder to achieve high portfolio returns and would highlight the system’s calculated unfunded liability.

• Past governance failures reinforced the board’s inclination to defensively second-guess portfolio managers, upping the pressure for CYA (cover your anatomy) behavior on both the operational and investment sides of the pension system. As one of my trader friends likes to say, it’s hard to intelligently manage a portfolio with your head under the desk.

“The links between fund governance, investment performance and pension funding are complicated,” says Weil Gotshal’s Millstein. “And the effects of shortcomings in any single area tend to be long-lived. These are big institutions and large amounts of money. But they can be turned around, and, to their credit, the CalPERS board is moving in the right direction.”

With remarkable resolve, the CalPERS board decided to streamline its management structures while adopting a set of tough governance reforms to rebuild the fund’s reputation for integrity in the eyes of California voters and pension beneficiaries. The board reopened the portfolio strategy, looking closely at the return and volatility trade-offs involved in trying to grow out of the funding gap. The Monterey meeting was one of many steps in that process.

As board president Feckner points out: “We didn’t bury our heads in the sand. We rolled up our sleeves and took a long, hard look at how we could make governance changes that would improve our effectiveness and enhance transparency, accountability and ethics. We all agreed that we had to explore any and all changes.”

The wind outside had backed off a bit, and it was starting to thaw inside the Grande Ballroom. A couple of guys in suits and silk neckties filed up to the head table. This was the first investment expert panel, a contrast to the board members in shirtsleeves or sweaters (although one board member was wearing what looked like a ski jacket, which I wished I had worn). Robert Arnott, former finance scholar and now chairman of Research Affiliates in Newport Beach, California, was up first. His talk, illustrated by a lavish PowerPoint presentation, was both polished and blunt.

I knew Arnott’s tightly argued academic work on the equity risk premium, or ERP. His pitch was consistent with his empirical research. He basically told the board members that they were in for a rough road, facing both lower yields and higher volatility, and that they were unlikely to reap the kind of high returns on equity holdings that had made them flush in the 1980s and ’90s.

Arnott had a pair of killer slides on the ERP. These charts showed the four sources of equity returns over the past 30 years, with 2.8 percent coming from real growth of earnings, 2.7 percent from dividends, 3 percent from inflation and 3.2 percent from higher valuation of earnings. “Stocks have given us 11 percent in the last 30 years. So why shouldn’t we achieve much the same in the years ahead?” he asks rhetorically.

“Consider the world of 30 years ago. Stocks were yielding 5.5 percent; now they yield just over 2 percent. There goes 3 percent of our prospective return. Also, the drop from a 5.5 percent yield to 2 percent created outsize gains of 3 percent per year, due solely to rising valuation multiples and falling yields. The sensible assumption is that valuation multiples and yields in a decade will be about where they are today. There goes another 3 percent. Bottom line is that we think 5 to 6 percent is a reasonable expectation for stocks over the coming decade.”

The board took Arnott’s pitch with what seemed to me to be a slightly uncomfortable silence. I figured everybody in the room was intently aware that CalPERS had about $110 billion, or half of its portfolio, in listed stocks, whose official return was targeted at 7.75 percent.

I sympathized with the board’s dilemma. I’d been uncomfortably calculating the likely return on the stocks in my personal portfolio over the previous few months and had realized that I had to either write down the expected return or go make some more money. Every saver, personal or institutional, was in the same boat.

“Stocks are a wonderful tactical asset,” Arnott concludes. “They have no inherent advantage that makes them better, especially to those who think that the price doesn’t matter for the patient long-term investor. I don’t know how many decades of carnage will be needed to kill that urban legend.”

PENSION FUND AND PERSONAL retirement math is pretty basic. You can estimate future retirement costs with actuarial precision, and you know your current assets. Assume a reasonable rate of return on those assets, and the difference is what the state needs to pay in each year. As usual, the devil is in the rate-of-return detail. What is a reasonable expectation for the long-term mean return on CalPERS’s portfolio as markets go through these cyclic gyrations? What’s realistic, and what’s urban legend?

Some critics contend that the system should use a risk-free rate to discount future liabilities and then use close to risk-free assets to fund the liabilities. Pension liabilities are a sure thing, and the risk-free rate is the only corresponding sure thing in the future, according to this argument. Some members of the ecosystem of portfolio consultants and investment bankers who dwell around the deep money pools of public pension funds have joined forces to support this analytic approach, which they label as “liability-driven investment,” or LDI.

Others counter the LDI case by arguing that pension funds have long-dated liabilities and can therefore rely on long-dated returns; they focus their analytic approach on the asset side of the equation to achieve higher returns within acceptable bands of volatility. If they can achieve consistent high yields, then this should also be the discount rate for the liabilities, the logic goes.

CalPERS was clearly not an outlier in its 7.75 percent return target. In its 2011 analysis of 125 public pension funds, Wilshire Associates found that state pension funds’ median assumption of portfolio return was 8.0 percent, a full 150 basis points above the return that Wilshire thought funds would achieve. I asked Rob Arnott how so many state pension plans could persist in making optimistic return assumptions.

“If pension funds can hire reputable consultants who tell them that they can earn 8 percent, they can assume 8 percent,” he said. “The conflicts of interest are vast. Suppose I’m a consultant and say, ‘Bonds give us 2 to 3 percent at current yields, stocks give us 4 to 6 percent at current valuation levels, so we think you should fund the pension based on a return assumption of 4 percent.’ No public fund will hire me, even though I’m more sensible than the advisers who merely extrapolate the past. And there will be no consequences for the boards, because they’re operating on the basis of advice from reputable consultants.”

After Arnott’s presentation I chatted over a spare (but thankfully warm) buffet lunch at the Best Western with the genial Henry Jones, the board member elected by the retired beneficiaries. He chairs CalPERS’s finance committee and knows his way around a balance sheet, having previously worked as CFO of the Los Angeles Unified School District, which has a $7 billion budget, and headed up its Annuity Reserve Fund Board.

I stood on the balcony of the Grande Ballroom, drinking in some fleeting sunshine before it was my turn at the lectern. I started by saying, “As you hold the CalPERS portfolio profile in one hand and the risk simulation in the other, how do you qualitatively assess if this is the right combination of risk and return for the pension fund? Like all boards or investment committees, your job is to apply your sense of the way the world works to the quantitative forecasts and see if it makes sense. CalPERS has the luxury of being a truly long-term investor. What will the long-term future look like when it comes to returns and volatility? Will it look more or less like the past, a ‘mean reversion’ world? Or will it be discontinuous?”

Joe Dear had invited me after reading an article I wrote for Institutional Investor in July 2011 about the global macro reference scenarios and structured ways to think about risk and return in qualitative terms. As I researched the Cal­PERS presentation, I took my cue from David Nierenberg, founder of Camas, Washington–based D3 Family Funds and an adviser to the Washington State Investment Board. He told me that when he thought long and hard about WSIB’s portfolio risk and return, he engaged in what he called “structured worrying.” I’ve been systematically researching the reference scenarios that traders use at global macro hedge funds and writing in Institutional Investor about how these scenarios affect financial portfolios.

So for CalPERS I tried to think about a set of reference scenarios with a horizon of ten years. For structure I turned to “Global Trends,” a rolling 15-year forecast produced every four or so years by the Central Intelligence Agency’s National Intelligence Council. The next one comes out in December of this year — prudently, after the presidential election. I helped write portions of the 2005 version when I was at the CIA, and I used some of its lessons when I moved to the Pentagon. In Washington we were very concerned about whether we were facing a mean-reverting or a discontinuous world.

For the CalPERS board I picked out four key scenarios that featured in past “Global Trends” forecasts: central bank monetary policy, sovereign solvency, a rising China and hydrocarbon supply, with each scenario having two potential outcomes over the long run. One outcome was based on a mean-reverting world, which looked pretty much like the past two decades and was generally positive in portfolio effects. The other was discontinuous and, it turns out, generally negative.

I predicted how each outcome would drive the CalPERS portfolio in terms of return — meaning the risk-free rate, the equity risk premium and inflation. Then I walked through the contrasting effects of each outcome in terms of volatility, including the amplitude of price shocks, the frequency with which these shocks could occur and the cross-correlation among asset classes. I’d spent several weeks testing and refining these predictions with portfolio managers and Wall Street traders.

After walking through the pairs of outcomes for all four scenarios, I tried to summarize: “A mean-reverting world is generally favorable for your portfolio. The risk-free rate is flat or down. The equity risk premium may stay at the upper end of Arnott territory, though still below historical levels. Inflation, on balance, will be higher. Both the amplitude and frequency of price shocks will be moderated, although cross-asset correlation will continue to climb.”

I continued: “In sharp contrast, a discontinuous world may be very hard on the Cal­PERS portfolio. The risk-free rate remains low and flat. The equity risk premium will be generally lower. The outlook for inflation is mixed. Volatility is up across the board.

“How do you use these two alternative worlds to qualitatively assess the Cal­PERS portfolio strategy?” I concluded, with a Power­Point flourish. “If you assess that some or all of these discontinuous outcomes are probable — and the discontinuous outcomes do cluster together — then you must also conclude that the future environment for the CalPERS portfolio looks more discontinuous than mean-reverting. In sum, more volatility for any given level of return or less return for accepting any given level of volatility.”

Judging by the questions from the board members, it was clear that they’d followed the argument and digested the implications. After I sat down, relieved and warm at last, Dear and his investment team filed up to the table and took their turns explaining the portfolio’s performance in 2011. There was partial sunshine by then; I could see all the way out to the tip of the Monterey Peninsula.

Articulate, precise and personable, Dear had the board’s complete attention and, it seemed to me, respect. The news wasn’t that great. When all the reports were in, the total portfolio return for 2011 was 1.1 percent. Although disappointing, this was in line with the portfolio’s benchmarks because 2011 had been a tough year for anyone with Cal-PERS’s portfolio profile. And Dear had done better for the CalPERS portfolio than I had done for the Shinn portfolio in 2011, which still depressed me.

Looking further back, the annualized return on the CalPERS total asset portfolio had been 6.48 percent for the previous decade and 1.47 percent for the previous three years. It then kicked up to 15.69 percent as of midyear 2011 before falling back to 1.1 percent for the full calendar year. By the same token, the portfolio’s volatility — defined as the standard deviation of the portfolio returns on an annualized basis — over the ten-, three- and one-year horizons was 13.78, 13.01 and 6.82 percent, respectively. As the official statement later summarized: “Due to the high volatility of global equity markets in 2011 (caused in large part by the ongoing Euro debt crisis and the slowing of global economic growth), the fund experienced a 7.9 percent loss in its public equity asset classes. CalPERS U.S. equity portfolio lost .03 percent, while its international equity assets declined 13.9 percent.”

Dear had lots of experience with the whipsaw of market reversals when he was executive director of the Washington State Investment Board. According to several people I’ve spoken with, he successfully grappled with what WSIB’s current executive director, Theresa Whitmarsh, describes as “skewed investment decision processes, deficient manager monitoring and careless internal controls.”

In 2009, CalPERS hired Dear and charged him with improving the portfolio’s risk management while also delivering on the targeted 7.75 percent return — a tall order on both counts in a crisis atmosphere and increasingly chaotic markets. “It was a gutsy move for Joe and a loss to WSIB but a big gain for Cal-PERS,” says D3 Family Funds’ Nierenberg.

Dear was familiar with the debate over the right analytic approach to running the CalPERS portfolio, and he was convinced that the system needed to manage its assets and liabilities in an integrated fashion. He was skeptical of the LDI approach, not least because of the additional expense and complexity it would impose, but he was also intensely aware that the traditional approach of betting on different combinations of asset portfolios had its own shortcomings. In fact, he began his Monterey panel discussion by pointing out that he, the CIO, was appearing together with Alan Milligan, the chief actuary, thereby presenting both sides of the CalPERS ledger in an integrated fashion.

I linked up with Dear at a Pacific Pension Institute conference in Malaysia late last year, and we discussed different approaches to pension asset and liability management. I knew him from ICGN meetings and also from some sessions at attorney Millstein’s corporate governance institute at Yale, where I had made presentations over the years. Dear was cautious about LDI.

“LDI may be right for some private pension plans but not for CalPERS,” he explained. “I’m not sure what the optimum solution for CalPERS is, but we have an obligation to our members to get it right. We are in a position where we have to chuck out the old asset allocation model without having a fully finished solution to replace it. This is going to be an iterative process.”

All big institutional investors have some variant of the problem facing CalPERS. State governments want to minimize payments into the system at the same time that benefits promised in the past automatically swell. So all look to high portfolio returns even as the flood of global liquidity and quantitative easing are driving absolute returns lower and lower.

Paul Ryan, a Republican U.S. representative from Wisconsin, challenged my former Princeton University professor Ben Bernanke on the effects of QE on pensioners during some tense House Budget Committee hearings on February 2. “Do you measure the effects of these sorts of policies on savers?” asked Ryan. “Are you concerned at all about the very, very low interest payments that these savers are getting from these kinds of fixed-income assets, which are hitting our savings and investment side of the economy in exchange for helping the borrowing and consumption side of the economy?”

“We think about that a lot,” replied the Federal Reserve Board chairman. “I recognize that for people on a fixed income or whose main income is interest on a CD, it imposes a hardship.”

Journalist Michael Mackenzie rather acidly observed in the Financial Times in January, “As we have seen with QE1 and QE2, the administration of such medicine warps investing fundamentals as it delivers a brief sugar high for markets. . . . But the biggest cost is how low rates are crushing retirees, money market funds, pension funds and insurers managing long-term liabilities that require much higher returns than are on offer. . . . It leaves insurers and pension funds with a choice of either underfunding their future obligations or taking the risk of moving into dicier investments in search of higher returns.”

AS EVERY INVESTMENT PROFESSIONAL knows, there are only three ways to square this portfolio circle: Accept more volatility and get higher returns, get higher returns at the same volatility (the investor’s equivalent of pure Hogwartian magic), or achieve current returns and volatility at a lower operating cost.

The first way to try to fill the gap is more of the same, by climbing out further on the risk frontier into higher-yielding assets, repeating the Yale model. This is precisely the strategy that set up CalPERS for its big losses in 2007–’08. But with the Federal Reserve clearly intent on driving the risk-free rate into the ground, pension funds and endowments with real commitments to meet in the future are left with nowhere to go but further out on the frontier.

During 2011, Cal­PERS had about 20 percent of its portfolio in fixed income; 50 percent in public equity; almost 15 percent in private equity; 10 percent in relatively illiquid holdings of real estate, infrastructure and absolute-return hedge funds; and 5 percent in cash and cash equivalents. The equities and long-dated assets are inherently more volatile than fixed income, increasing the probability that the CalPERS funding ratio could fall below the 60 percent level, according to LDI accounting methods.

So LDI is an unpleasant cocktail any way you drink it. A lower risk-free rate increases the net present value of the stream of future pension liabilities, thus driving down the starting point of your funding ratio. Investing in higher-yielding assets to grow out of the underfunding hole exposes you to volatility that can drive your funding ratio even lower, possibly into the danger zone where state authorities or the beneficiaries may clamor to shut you down.

CalPERS is not alone in this fix. As UBS strategist Thomas Doerflinger warns: “Pension funds have been hit by a nasty combination of declining interest rates (which increase the present value of the Project Benefit Obligation) and poor global stock market performance (which reduces plan assets). As a result, the ‘solvency rate’ of pension funds, which was already low at the start of 2011, has declined to worrisome levels that put plan sponsors in a bind.”

This nasty twist isn’t limited to public pension funds. According to some analysts, the pension funding gap of the Standard & Poor’s 500 Index companies doubled from 2010 to 2011 because of the plunge in the risk-free rate and the resulting swelling of the net present value of their liabilities. When a private pension plan’s funding ratio falls below 80 percent, ERISA rules raise a red flag and impose several restrictions; if the ratio falls below 60 percent, the plan must freeze benefits. For the S&P 500, the accounting rules are strict and the disclosure is comprehensive.

The second way for CalPERS to fill the gap is by obtaining higher returns at the same level of volatility for any given segment of the portfolio. This means squeezing out additional alpha without swallowing additional beta volatility at the same time — the portfolio manager’s Holy Grail. The hope here is that CalPERS can use its size to attract the best and the brightest to manage its portfolio, to fundamentally outperform their peers in areas that aren’t correlated with other asset markets. CalPERS has about 8 percent of its portfolio in hedge funds, an asset class sometimes referred to as absolute return.

The hunt for true alpha forces pension funds even closer into the arms of those talented traders and managers who can deliver excess returns year after year without blowing up. These traders are employed (and well compensated if successful) at hedge funds, private equity houses, real estate developers and other specialized intermediaries. About 60 percent of global hedge fund assets today come from pension funds, endowments and foundations.

The third way of filling the gap is for the pension fund to obtain these returns at lower costs. This means either getting the money managers to cut their fees or taking much of the management task in-house and benefiting from economies of scale.

CalPERS spent $1 billion in fees for external money managers in 2010, but squeezing this is a tall order for Dear and his colleagues in the investment office. Hedge fund fees have shown only marginal downward pressure despite the shellacking many of the funds, and their investors, took in 2007–’08. For example, 2 percent management fees and 20 percent (or higher) performance fees remain the rule for the best-performing hedge funds.

That’s no surprise given that the bulk of excess returns comes from a relatively small number of hedge funds. By one estimate, the top 100 funds account for a staggering 90 percent of the excess returns. These high performers are not eager to bargain down; a lot of institutional money is chasing the same talent pool, after all. Moreover, the hedge fund world itself is going through slow but constant consolidation as a result of the shakeout of 2007–’08, expanding regulatory overhead and a higher level of due diligence by institutional investors.

The private equity world is even more concentrated, and the fees reflect this, at least for those funds that manage to return high margins to their institutional investors. That said, the big private equity firms have shown some recent willingness to negotiate management fees. News reports have suggested that Carlyle has had to cut fees and offer other unusual incentives to lure investors to its new, $2.3 billion real estate fund.

The alternative path to cost reduction is to bring more money management tasks in-house — and, of course, to do a good job of it. CalPERS manages twice the amount of funds internally as its pension fund peers do: 62 percent versus an average of 33 percent. The California plan also has adopted a passive investment approach with one third of its assets, compared with 22 percent for its peers. Passive management is more cost-effective than active management and, for a fund of Cal­PERS’s scale, makes a lot of sense.

KEITH AMBACHTSHEER, A UNIVERSITY of Toronto finance professor and an expert on pension fund management, makes a convincing case that large pension funds like CalPERS can, with the right incentives and governance structure, consistently bring in good portfolio returns at a lower cost by managing money internally rather than outsourcing it to professional managers, especially in the high-cost private market asset categories. He points to the outstanding 20-year performance of the Ontario Teachers’ Pension Plan (which he had a hand in designing) as a real-world example.

Generating lower fees through in-house management isn’t easy from a governance standpoint. The pension fund’s board needs to approve a compensation structure for its managers that is competitive with the private sector. This can give a trustee sticker shock. Says James McRitchie, a CalPERS beneficiary and corporate governance expert: “The CalPERS trustees have to worry about public perception of what public employees are paid. Although the public sector often pays clerical staff, firefighters and police officers relatively well compared to what employees with similar educational levels might be paid in the private sector, the reverse is true of professionals with advanced degrees, such as executives, scientists, attorneys, doctors and money managers.”

Ambachtsheer cautions that “trustees must accept the reality that people with the requisite skills to generate good top-line performance in private markets are expensive. They must be willing to make the case to their plan members that these higher internal compensation costs are a small price to pay to end-run the external 2-and-20 tolls still prevalent in today’s financial services market.”

CalPERS board president Feckner argues that the plan has already bitten that bullet. “CalPERS has saved $156 million annually using internal management, according to a cost-­effectiveness measurement,” he points out. “Our investment staff compensation is reviewed and examined regularly with an independent consultant to ensure that we find ways to compete in the marketplace but also maintain prudent levels of compensation. These can often be difficult decisions, but it’s something that needs to be considered when operating in the public sector.”

Operating in the public sector means that CalPERS’s operations, including board meetings, are conducted with a degree of transparency that would astonish private sector boards. A small team carefully recorded most of the Monterey session for subsequent posting on the fund’s website.

I’d spent quite a few uncomfortable hours under public scrutiny in 2007–’08 as an assistant secretary of Defense, fielding questions interspersed with criticism from congressional overseers as the TV cameras rolled. The glare of the klieg lights can enlighten the public but also mislead when the subject is governance, particularly the governance of money.

“CalPERS’s governance scandals led many to the mistaken belief that the system’s funding shortfall was due to corruption and incompetence at the top,” says McRitchie. “Although devastating to the system’s reputation, the financial impact of the board’s ethical lapses was probably minimal.”

But as the drumbeat of negative publicity continued through 2011, CalPERS’s board and management saw the corrosive effects of governance problems on the fund’s political power and performance. They observed the reputational hit the retirement system was taking on almost a daily basis in the press and in its dealings with the state.

Although few were finance experts, the CalPERS trustees were aware of the well-established positive correlation between pension fund governance and portfolio returns. Ambachtsheer and his colleagues at the University of Toronto tested this relationship in a study conducted in the late 1990s and repeated in the mid-2000s. Their basic finding: Pension funds with good governance ratings outperformed those with poor ratings by an average of 100 to 200 basis points per annum on a risk-adjusted basis.

Although the Toronto group’s methods have some inevitable shortcomings — for one thing, governance is inherently difficult to measure objectively — its statistical conclusions jibe with common sense. Cautions Weil Gotshal’s Millstein: “The relationship between governance and performance is probably positive but hard to prove. At the end of the day, good portfolio performance comes from choosing good managers, inside and out, and that requires good governance.”

Dear and his colleagues in the Cal-PERS investment operation came up with an innovation that effectively combines good external and internal management through what they call the multi-asset-class portfolio, or “MAC Partners,” program. According to Dear: “The idea is to select three or four external managers to handle around $1 billion each, within a given risk budget and return targets, with a compensation structure based on their performance. It’s one way to attack our dynamic asset allocation problem; rather than make all the allocation calls inside CalPERS, we provide the risk parameters consistent with our investment committee’s guidelines and let the managers figure it out — and pay them accordingly.”

In terms of top-level governance of investment strategy, Dear concurs with the best practices put forward by the World Bank. According to the formula concisely summarized by Sudhir Rajkumar, head of the Bank’s pension investment advisory group, “The board should focus on just three things: defining the pension plan’s financial objectives, agreeing on the investment horizon and setting the investment policy and active risk budget. Once they decide on these strategic decisions, they should delegate execution to the plan’s staff, with metrics to ensure accountability.”

Dear agrees with this approach. He wants to have the CalPERS board as a whole clearly define the asset and liability management strategy. “Asset allocation isn’t a technical problem that can be solved by financial professionals,” he says. “It is a strategic decision set by the board as a whole.” Much to the members’ credit, and thanks to Dear’s persistence, that’s exactly what they were all doing at the Monterey Best Western on January 23.

As part of getting their heads around this strategic decision, in 2010 CalPERS’s board members turned to a former head of Deloitte’s governance and risk management practice to help structure the position of a chief risk officer. Frederick Funston, the prime author of Surviving and Thriving in Uncertainty: Creating the Risk Intelligent Enterprise, had made a specialty of dealing with firms under stress when he worked in Deloitte’s global risk practice.

Funston and his team spent several months in late 2010 and early 2011 in Sacramento, interviewing up and down Cal-PERS’s ranks. They kept running into the residual effects of organizational tensions during the high-stress period when the portfolio was cratering in 2007–’08 — tensions that ran deeper than the overhaul of the risk manager’s job.

For example, the board had four direct reports in senior management and dealt with other senior managers on a daily or weekly basis. There were multiple board committees that met frequently, with sometimes overlapping mandates. In addition to putting newly appointed CEO Stausboll in an awkward position, these multiple reporting channels diffused authority at CalPERS and obscured accountability.

In its report to the board, Funston’s team wrote: “Accountability is a two-way street — in holding management accountable, the board must also be prepared to hold itself and each board member accountable as co-fiduciaries. The board must rely heavily on the moral compass and motivations of the individual trustee to do the right thing and improve their own effectiveness.”

But what is “doing the right thing,” for a public pension fund trustee? To whom is the trustee primarily responsible: current beneficiaries, future beneficiaries (who are paying into the system on the promise of future benefits), the government of California or its citizen voters? There is no bright-letter template for trade-offs among the pension trustee’s multiple potential obligations. As Millstein observes: “The concept of fiduciary responsibility for a nonprofit board is extremely underdeveloped — in fact, almost nonexistent. But these pension boards do have a firm legal basis for choosing their priority of fiduciary responsibility, providing they think it through carefully and consistently.”

Funston and his colleagues reviewed the academic literature to glean a set of best-practice principles of governance and fiduciary responsibility for public pension funds. They surveyed 16 of CalPERS’s closest peers to construct a group of governance benchmarks with which to compare the fund’s current practices. Then they translated these principles and the benchmark data into a set of operational recommendations for Cal­PERS. Funston and his team presented the board with the benchmark results and with a list of governance reform suggestions at its August 16, 2011, meeting. “It was a lively debate,” recalls Feckner.

Stausboll agrees. “The debate and discussions about the board governance reforms were the most valuable part of the process,” she says. “Hearing the viewpoints of board members and colleagues firsthand helped us reinforce and refine our delegations to staff, the roles and responsibilities between the board and staff, and ultimately expectations.”

With Feckner’s support, the board ultimately voted to adopt both the principles and the operational changes recommended by Funston’s team. The board agreed to several major changes in reporting procedures and mandates, to rebalance the four elements of the governance relationship that Funston had flagged early on: to improve trust and confidence with the staff, to focus on the important and tough strategic questions, to enhance decision-making insight and to clarify organizational accountability.

To remedy the problem of diffused authority, board members streamlined CalPERS’s reporting structure, reducing the number of direct reports to the board to just two: Stausboll and Dear. They improved trust by tightening even further the ethical rules and disclosure guidelines for all managers and board members at CalPERS. “As board members, we have a sacred trust to protect, and the hard lessons we learned over the past few years taught us that we can’t take that for granted,” said Feckner in an e-mail to me. “We needed to move quickly to assure our members and all Californians that our decisions are transparent and above reproach. We wanted to make sure that everyone understood that the bar was very high — that we act according to the highest ethical standards.”

WHAT I WITNESSED AT MONTEREY struck me as a clear example of focus on an important and tough strategic question — arguably, the toughest question facing any public pension board, and certainly the one with the biggest public policy consequences.

As I drove my rental car along the Pacific coast back up to San Francisco, the sun gloriously lighting up the green California foothills, it struck me again: Who would want this job, much less campaign for it? I empathized with the CalPERS board members. If they stuck with a 7.75 percent return target and stretched for yield and then the portfolio got hammered by the volatility that comes with that riskier territory, they’d be blamed by beneficiaries and voters alike, no matter how many consultants told them it was okay. If they backed off to a lower, safer number in expectation that the world was likely to be less benign for investors, they’d be vilified by Sacramento for sending much bigger bills to government employer units throughout the state, which was already in a pitched budget battle over scarce resources.

As they grapple with this harsh dilemma, the board members endure long hours and a lot of tedious math. They don’t get paid very much to do this, and they certainly aren’t getting lavishly entertained. Last year they voluntarily adopted organizational and governance reforms that made them operate in a transparent fishbowl. The critical scrutiny must be excruciating.

But so far, the reaction of Sacramento politicians and of CalPERS’s peers to the governance reforms has been positive. WSIB board member Nierenberg says: “Those of us who serve on pension boards as fiduciaries really do carry a sacred trust to current state employees and their families, to former employees and their families, and to the taxpayers, who are always at risk of making up shortfalls. I’m glad to see CalPERS affirming the gravity of these obligations and committing to govern itself accordingly.”

The Sacramento fund’s reform efforts are also applauded by Peter Clapman, former senior vice president of asset management firm TIAA-CREF, a well-known advocate of corporate governance reform and the principal author of the widely respected “Clapman Report” on best practices for managing pensions, endowments and charitable funds. “The CalPERS governance recommendations meet the highest standards of good governance,” Clapman says. “When CalPERS implements its report, it will serve as a model for all public pension funds.”

So all eyes are now on CalPERS’s implementation, particularly on the tough question of portfolio strategy. “Good governance is linked to positive portfolio performance and robust funding levels by states,” observed governance guru Millstein as we sipped coffee in his airy office overlooking New York City’s Central Park in December. “But it cuts both ways. Poor governance causes mediocre portfolio performance and erodes the support of politicians and citizens alike.”

He turned and looked out the window at the bright winter sky. “I have high expectations for CalPERS,” he said. “Their turnaround matters to a lot of people besides the Californians. All state public pension funds face this same set of problems, and it’s a major public policy challenge on a national scale. We all have a stake in this.”  •  •

James Shinn ( ) is a lecturer at Princeton University’s School of Engineering and Applied Science. After careers on Wall Street and in Silicon Valley, he served as the national intelligence officer for East Asia at the Central Intelligence Agency and then as assistant secretary of Defense for Asia at the Pentagon. He serves on the advisory boards of GSA, a New York–based financial advisory firm, Oxford Analytica and CQS, a London-based hedge fund.

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