Arnold Schwarzenegger should only hope that Paul Wachter has better luck managing the California governor's money than he is having with the University of California's.
Wachter, who controls Schwarzenegger's multimillion-dollar blind trust, chairs the investment committee of UC's retirement and endowment funds. By the time he came on board in 2004, UC's plan, once among the nation's best-performing and best-funded, found itself caught in a downward spiral that has spooked the system's managers and beneficiaries alike, and thrown the always fractious university community into an uproar. Now irate labor and academic critics, joined by some state politicians, are lambasting some of the prominent regents who oversee the system.
It's an extraordinary turn of events for the proud institution, whose faculty has won 50 Nobel prizes, including five in economics in the past seven years. UC's coffers had been filled to overflowing for so long that in 1990 the regents -- the academic equivalent of a corporate board of directors -- decided to eliminate annual employee and university contributions to the retirement fund. Even so, by the end of June 2000, the plan's assets had a market value of $41.9 billion, compared with liabilities of $24.1 billion -- for a funding ratio of 174 percent. On an actuarial basis, with asset values smoothed over five years -- the method UC uses when reporting its numbers -- the plan's funding ratio of assets to liabilities was a stunning 154 percent. Today, however, the university system, with $48.1 billion in assets, is 104 percent funded and is predicting that it could slip below 100 percent and into shortfall as early as next year.
Why the rapid deterioration? Partly, it's the result of poor performance. The bear market after 2000 cost UC more than $11 billion, or 26 percent, of its assets. Last year's returns were solid -- the retirement fund earned 18.83 percent to rank in the top quartile among its peers for its fiscal year ended June 30, 2007 -- but longer-term numbers tell a markedly different story. Annualized returns of 11.93 percent for three years and 11.14 percent for five years ranked in the mid-to-low end of the third quartile. (The $6.7 billion endowment has fared even worse, substantially underperforming its peer group for the five- and ten-year periods through 2006.)
Another big culprit is soaring liabilities. These leaped to $42 billion in 2006, a stunning increase of 74 percent, triggered by a rise in active plan participants from 104,000 in 2000 to 122,000 in 2006 as well as an ill-timed increase in benefits in 2001.
Still, most of the country's retirement plans would happily switch places with the UC system: The average funding ratio for the 126 biggest plans is 86 percent. But the deterioration at UC has been steep and swift enough to make the regents jittery. Early last year they called for a resumption this July 1 of contributions from employees and the university system, unleashing howls of protest on campuses and in the hallways of the capitol in Sacramento, where the legislature and governor were locked in battle over the state's budget.
"Over the years the workers have benefited from a rather stable pension system, but all of a sudden, it's a little shaky and they have to contribute," says State Senator Leland Yee, a Democrat who represents parts of San Francisco and San Mateo counties. "Any person in their right mind would start asking questions."
Employees decried the proposed annual levy of 4 percent of payroll -- split between workers and UC -- as the start of what they fear could be a jump to as much as 16 percent in the next few years. The legislature, which will pump $3.3 billion, or 3.3 percent, of the state's general budget into the university system this year, rejected UC's request for an additional $60 million to help fund part of its contributions.
Irate unions are pinning much of the blame for the mess on Gerald Parsky, founder and partner of Aurora Capital Group, a private equity firm based in Los Angeles. In 2000, as chairman of the UC Board of Regents' committee on investments, Parsky, a Republican activist and confidant of President George W. Bush, led the overhaul of an investment policy that, he says, relied on a risky and concentrated mix of mostly domestic stocks and bonds, all managed in-house. Results had been strong -- compound annual returns of 15.6 percent over the ten years ended June 30, 2000, easily beat the 13.5 percent balanced fund median, according to Capital Resource Advisors (now CRA Rogers Casey), placing UC well above its peers -- but the portfolio was dangerously unbalanced. Just three stocks, General Electric Co., Hewlett-Packard Co. and Telefon AB L.M. Ericsson, made up 14.4 percent of the equity holdings -- and they suffered badly when the tech-stock bubble popped.
So the committee decided to diversify the portfolio by boosting foreign equities, indexing one third of U.S. stocks and reducing the duration of the bond portfolio. It brought in Wilshire Associates to devise a more appropriate mix of assets and begin the process of finding outside managers. The recommended allocation shifted from a simple 75 percent/25 percent stocks-and-bonds mix (albeit with wide latitude that permitted foreign holdings and a highly successful venture capital program) to a more diversified and controlled blend of 53 percent domestic equities, 7 percent foreign stocks, 35 percent domestic bonds and 5 percent private equity.
Today the results are being assailed from nearly all sides. Wachter, on the board since 2004, chides his fellow regents for having adopted an overly cautious strategy and for implementing it with painful slowness. Seven years after targeting a 5 percent allocation to private equity, for instance, the retirement plan had reached 2.6 percent at the end of June; real estate makes up just 1 percent of the portfolio, compared with a 5 percent goal set in 2003.
"I can't say they've moved as fast as humanly possible," concedes Wachter as he sips a Starbucks coffee in his sun-drenched office near the beach in Santa Monica. "It frustrates me constantly."
UC treasurer and CIO Marie Berggren says it's prudent to move cautiously and that the first fruits of diversification flowered in last year's strong returns. "We've evolved into a well-managed institutional fund, the results of which are evident in the performance this year," she says. "We're going to build the alternatives, but that takes time. You can't invest in an asset class when you don't have an expert."
Charles Schwartz, a retired professor of physics at UC Berkeley and a relentless critic of UC's overseers, says the strategy overhaul reflected "a private agenda on the part of a small handful of people on the Board of Regents to raid this big pot of public money through stealth and dishonesty." He and others allege that Parsky's push to hire Wilshire and outsource investment management was partly an effort to solicit funds for thenTexas governor George W. Bush, whose California presidential campaign Parsky chaired. Parsky and Dennis Tito, Wilshire's chairman and CEO, both deny the charge. But critics add that the Wilshire report was badly flawed and that money managers with personal and business ties to members of an investment advisory committee set up in 1999 to counsel the regents are now managing hundreds of millions of dollars for UC. The university denies any conflicts of interest, noting that members of the advisory committee have no involvement in fund manager selection.
Supporting the system's unions, Yee introduced a resolution calling for a new retirement plan board that, like most such bodies, but unlike UC's, would include worker and faculty representatives. The resolution, which has passed the Senate and was expected to pass the Assembly by mid-September, is nonbinding and does not require the governor's signature; Yee says he will seek to change the state constitution if the regents fail to act by early next year.
The resolution gives leverage to the unions as they bargain with UC over pay raises and health care coverage. The unions and the faculty (which is not unionized) do not oppose a resumption of pension contributions per se, but they do not want contributions to take away from any salary increases.
Yee's resolution threatens to open up one of the state's most elite and powerful institutions. By statute, the 26-member Board of Regents has 18 gubernatorial appointees. They now include such notables as its chairman, Richard Blum, a wealthy real estate investor married to U.S. Senator Dianne Feinstein; Sherry Lansing, former chairman and CEO of Paramount Pictures' motion picture group; and John Moores, owner of the San Diego Padres and founder of BMC Software and JMI Services, a real estate developer.
The other members comprise one student appointed annually by the regents and seven ex officio members, including the governor, lieutenant governor and UC president Robert Dynes. Together they oversee an operation with $17 billion in annual revenues; if it were a corporation, Oakland-based UC would rank alongside the likes of Delta Air Lines and Rite Aid Corp. in the Fortune 200. The system educates more than 214,000 students at ten campuses, employs 170,000 faculty and staff, and, in addition to operating five medical centers, 16 health professionals' schools and three law schools, helps manage three U.S. Department of Energy laboratories. It awards more Ph.D.s than any university in the U.S.
"This is a public institution, not someone's private country club," says Yee, "We're going to open it up incrementally, so it's more transparent and more accountable."
With 122,000 active members and 45,000 retirees and other beneficiaries, UC is a young plan and should be in fine health -- pension plans typically have a ratio of one active employee to one retiree. But it is hobbled by the lack of employee and UC contributions and climbing liabilities that even top-tier returns can't overcome.
Performance, although improved, lags peers' because UC's asset allocation has had comparatively minimal exposure to such recently hot asset classes as private equity, real estate and, until the past year, foreign stocks. The challenge of building a staff to select and oversee external managers and the pressures of operating in a politically charged atmosphere have led the regents to err on the side of caution and created turmoil in the treasurer's office, slowing implementation. UC has had four chief investment officers since 2000.
"There's personal risk because the treasurer's office is effectively accountable to the president of the university, the regents, the beneficiaries of the funds, the students, the faculty, the staff and the public, and so they are very circumspect, as they should be," explains investment committee chairman Wachter. "We're certainly going in the right direction, but the process is slow." By contrast, Wachter, unencumbered by these constituencies, has racked up strong returns for the governor's blind trust, knowledgeable sources say.
In the meantime, the squeeze on the UC budget is intense -- and growing. The university says it needs an additional $500 million this year to achieve its top priorities, which include restoring competitive salaries, improving student-faculty ratios and updating technology and buildings. Yet UC's liabilities are escalating. To fully fund the cost of future benefits accrued by retirement plan members each year, UC and its employees would have to pay about 16 percent of payroll, or $1.3 billion for the fiscal year ended June 30. Plus, UC has unfunded liabilities of $11 billion to $12 billion for retiree health care costs. Funding these on a pay-as-you-go basis, including annual normal costs and an amortization of the unfunded liability, would require almost 19 percent of payroll, or more than $1.5 billion for the past year, UC says.
Because the state has rejected additional money for pension contributions, UC is faced with diverting money from other priorities if it chooses to resume these payments on its own. "Sometimes a budget crisis helps you bring about institutional change," says regent Parsky, adding that more money will be needed from the state and private individuals and that the university will have to run more efficiently.
THE REGENTS AND THE TREASURER MAKE NO APOLOGIES about the transformation of the investment guidelines. Although the previous scheme, proposed in 1991 by then-treasurer Herbert Gordon and approved by the regents, called for a 75 percent/25 percent mix of equities and fixed income, the permissible ranges -- 15 percent for both -- were so large that "in effect, the treasurer's office was itself setting asset allocation," says Parsky, a former chairman of both the investment committee and the regents who remains highly influential. The parameters of subasset classes were equally ill-defined: UC ran an extraordinarily successful venture capital program as part of its equity allocation.
In Parsky's view risk abounded. At the end of 1999, only 16 stocks, including soon-to-plummet Cisco Systems, Lucent Technologies and Time Warner, made up more than half the portfolio. Its average bond duration of 12 years, meanwhile, far exceeded the five years of the Lehman aggregate bond index and the ten years of the Lehman long Treasury index. What's more, there was limited use of benchmarks and no independent evaluation and verification of performance. In short, it was a fiduciary nightmare.
Echoing other critics, Patricia Small, who resigned as CIO under pressure in August 2000, tells Institutional Investor that the Wilshire review process was based on "inaccurate data, weak and unprofessional." Small, now a partner and portfolio manager at KCM Investment Advisors in San Rafael, California, says the review did not, for example, examine prior returns on a risk-adjusted basis. It proposed identical allocations for the retirement plan and the endowment despite their different liabilities.
She and others question Parsky's motives in hiring Wilshire and revamping the investment strategy. "The fix was in," says Ward Connerly, a member of the investment committee in 2000 who is best known for leading the 1996 drive to end affirmative action at California's public universities. One week before UC awarded Wilshire a follow-up contract worth $350,000, Wilshire CEO Tito made an $80,000 soft-money donation to the Republican Party's state elections committee.
Tito and Parsky have denied any connection between the contract and the donation. Stephen Nesbitt, the main Wilshire consultant to UC, says that his firm "didn't make any money on the UC relationship at all. We did it because Parsky was driving it, and we had confidence that we wouldn't get into a quagmire." (Nesbitt is now CEO of Cliffwater, an institutional investment consulting firm specializing in alternatives that is based in Marina del Rey, California.)
Regents today acknowledge that the asset allocation adopted in 2000 was conservative. But they argue that it was prudent given the highly overfunded status of the plan and the limited personnel resources of the treasurer's office. "We asked, 'Is the staff prepared and capable of helping to implement the move?'" says Parsky. "There was a real desire on my part and others' to protect capital. I believe the regents acted prudently and well within the norm in terms of pension plans."
Still, outsiders remained skeptical about the regents' motives because the board's investment committee had debated and adopted the new strategy in secret meetings in January and March 2000 and in later deliberations in 2002. In April 2003, retired professor Schwartz, the UC clerical workers' union and the San Jose Mercury News successfully sued to gain access to transcripts and minutes of the meetings as well as data on the internal rates of return of individual venture capital investments. Critics also say that two members of an investment advisory group set up in 1999 to provide outside advice to the investment committee have conflicts of interest. John Hotchkis, a member since 2000, retains a 1.1 percent stake in Hotchkis and Wiley Capital Management, which began managing UC funds in 2004; the next year Causeway Capital Management, run by Sarah Ketterer, Hotchkis's daughter, began managing assets in a non-U.S.-stock strategy. Another advisory committee member, David Fisher, chairman of Capital Guardian Trust Co., became an adviser in 2004; in the same month Capital won a new investment mandate.
The university denies any conflict of interest, saying that its first investment in Capital Guardian was in 1992, long before Fisher joined the advisory board. Hotchkis, they note, was retired and had no active decision-making role at his old firm or his daughter's. What's more, investment advisory group members do not vote and are not involved in selecting outside firms.
Nonetheless, the regents have become increasingly sensitive to criticism. In a July meeting in Santa Barbara, they discussed tightening their disclosure policy for investment advisory group members. Although no decision was reached, Wachter says that this month the board will likely vote to require members of the investment advisory group to disclose any and all interests in money management firms.
Still, Wachter and other UC officials take offense at the conflict-of-interest charges. "Take Fisher," says Wachter. "He's a legendary guy. He and others do this as volunteers. The first thing we should say to these people is 'thank you,' and not terrorize them."
ALTHOUGH THE ASSET ALLOCATION CHOSEN BY THE regents was extremely cautious, it could have been even more so. Initially, some regents wanted to switch the entire retirement fund into bonds and immunize liabilities for decades to come. Ultimately, says former Wilshire consultant Nesbitt, the chancellors of the various campuses dissuaded regents from this option, noting that because the number of covered employees would continue to grow and salaries would increase, an all-bond strategy wouldn't work. Foreign stocks were also a tough sell. Real estate "didn't feel like a natural diversifier," Nesbitt adds, because UC owned large amounts of property under its facilities and would gain exposure to real estate investment trusts through its new, more diversified public equity portfolio.
The regents adopted Wilshire's recommendations in 2000 and added gradually to alternatives -- beginning with the endowment in 2002, establishing a 5 percent target for an absolute-return allocation. But turnover in the treasurer's office and the need to build a new staff slowed progress, Parsky says. Small was forced out after five years, ending a 28-year career at the university, and received a $550,000 severance. Since then three different people have held the job, beginning with DeWitt Bowman, former CIO of the California Public Employees' Retirement System, who served on an interim basis.
In June 2001 the regents hired David Russ, who had been managing director of public markets for University of Texas Investment Management Co., giving him a mandate for change. A numbers guy whom Parsky calls "one of the best investment managers in the country," Russ determined that the staff actively managing equities had not been adding value and lacked the skills to vet and monitor external stock pickers. In the two years ended June 30, 2002, UC's internally managed equities had lost an annualized 17.95 percent, 153 basis points worse than the Standard & Poor's 500 index. Over ten years the stock portfolio had returned an annualized 10.34 percent, compared with 11.43 percent for the S&P 500. By contrast, in the ten years through June 2002, bonds had returned an annualized 10.43 percent, far above the 7.34 percent return of the Lehman aggregate bond index. Russ acted deliberately but decisively. One year after coming on board, in August 2002, he eliminated 11 equity analysts and traders.
In November 2002, State Street Global Advisors, in one of the biggest transitions ever, moved the remaining $15.8 billion of actively managed equities into index funds. UC's bond portfolio remained in-house.
Russ, eager to rebuild the portfolio, began hiring specialist staff to oversee external managers of equities, bonds and absolute-return funds. In 2003, after the regents again revised their targets, he moved the endowment into hedge funds; he added direct real estate investments to both funds in 2004. He began ramping up exposure to international equities in the endowment in 2005. The regents diversified earlier and faster in the endowment because it is smaller and because they believed there would be fewer repercussions if investments went south, Wachter says.
By June 2005, 19 percent of the endowment had been invested in non-U.S. equities and 8.6 percent in hedge funds. But in the retirement fund, only 8.6 percent was in non-U.S. stocks, slightly above the 7 percent target; the regents had not yet authorized investments in hedge funds.
UC's highly successful venture capital strategy was torpedoed by the disclosure policies that resulted from the 2003 lawsuit. The university had one of the earliest venture investment strategies in the nation, beginning with a 1978 commitment of $3 million to Brentwood Associates. Helped by its proximity to Silicon Valley, UC invested with such top-tier venture firms as Kleiner Perkins Caufield & Byers in 1980 and Mayfield Fund and Sequoia Capital in 1981. Over the ten years ended June 30, 2003, UC's private equity portfolio had an annualized return of 26.5 percent, with most of the gains deriving from venture capital. The $229 million invested in Kleiner Perkins and Sequoia has generated more than $1.5 billion, a multiple of 6.5 times, net of fees.
"We were in negotiations with Sequoia, Kleiner Perkins -- easily 20 firms altogether," says one person with knowledge of the venture program. "But they dropped us. They said, 'If you have any Freedom of Information Act issues, you can't be one of our investors.'" Although Sequoia was the only venture firm to publicly ask UC to withdraw its capital (it refused), since the lawsuit the pension plan has not made new commitments to Kleiner Perkins, Sequoia or other well-known funds.
The venture capital setback also wore down Russ, who quit in June 2005 to take the CIO job at Dartmouth College's endowment. Eager to preserve UC's venture program, he successfully lobbied for legislation that requires public pension funds in California to disclose internal rates of return on investments in private equity and venture capital funds but not information on companies in those firms' portfolios. (The law applies to CalPERS as well, which the San Jose Mercury News had also sued.) Russ grew weary of the numerous requests for information under public-records laws, meetings with unions and public accusations from Schwartz (who has a section on his Web site titled "Russ' Whoppers"). A UC Berkeley graduate and native San Franciscan, Russ had planned to spend his career as treasurer and CIO of UC. "Now I focus 100 percent on investment management," he says.
"Losing David was definitely a blow," says Wachter. After Russ left, Berggren, who had overseen venture capital investments for Bank One Corp. before joining UC in 2002 to manage alternatives, stepped in to serve as acting treasurer; she was named CIO in 2006.
Berggren, a detail- and process-oriented manager, defends the slow pace of diversification. "I've been told consistently, 'Don't push to get the allocation; make sure you do it in a measured, thoughtful way.'" Nonetheless, Berggren says the strong performance in the fiscal year ended June 30 is evidence of the progress being made.
At the end of June, foreign equities represented 23 percent of the retirement plan -- including 4 percent in emerging markets -- slightly above the 21 percent target established in 2006. Foreign stocks returned 30.48 percent during the year, the largest percentage gain of any category. The endowment is further diversified into alternatives, with 5 percent in private equity, 16 percent in hedge funds and 3 percent in real estate. It had net returns of 20.01 percent in the fiscal year ended June 30.
The regents have pushed to become more aggressive. In May they introduced in the retirement plan an allocation for absolute-return funds with an initial target of 0.5 percent and a long-term target of 5 percent. This month they will consider an allocation to real assets such as natural resources and infrastructure, beginning with 0.5 percent and a long-term target of 5 percent. The retirement plan's long-term targets, including 5 percent for both real estate and private equity, are similar to the median allocation of large pension funds, which, according to Wilshire, include 6.9 percent for both real estate and private equity. Berggren predicts that it will take 24 to 36 months to realize these targets.
As for the declining funding ratio, Berggren says the blame lies less with performance than with rising liabilities and the lack of contributions. The contribution holiday deprived the retirement plan of $11.4 billion (in current dollars) it would otherwise have received between 1992 and 2006. Had those contributions been made, the funding ratio would be roughly 116 percent, not the 104 percent reported for June 2006. What's more, liabilities have nearly doubled since 2000 because they compound annually by the 7.5 percent discount rate; benefit increases granted in 2001 boosted liabilities by 3.3 percent; and the number of covered active employees jumped 20 percent, to 122,000.
Strong returns alone won't make the difference for UC. The fund needs to outperform its 7.5 percent assumed rate of return by about 3 percentage points to make up for the lack of contributions, according to UC's consulting actuaries, the Segal Co. In the ten fiscal years ended June 30, the retirement plan returned an annual 9.04 percent -- 154 basis points above the 7.5 percent rate.
And whether contributions will resume is uncertain. The university will have to coax additional funds out of the tight state budget to fund its share of contributions. Most UC unions accept the principle of making pension contributions but want pay hikes to cover increased costs -- as well as an across-the-board 10 to 15 percent improvement in salaries.
Wachter is likely to accelerate the advance into alternatives. He frets, though, that UC may be coming to the party a bit late. "You can say in retrospect that the pension fund portfolio has been too conservative for the market of the past few years," says Wachter. "But it's changing, and I hope we're not sitting here in three years with you saying, 'You were a jerk for moving so much into alternatives, absolute return, international and all those less traditional asset classes.'"