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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.”

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