PENSIONS - The Reeducation of CalSTRS

A little learning is a dangerous thing. But not when it comes to running the nation's second-biggest pension fund.

For years the California State Teachers' Retirement System was the epitome of a creaky, mismanaged bureaucracy, toiling in the shadow of its crosstown sibling, the California Public Employees' Retirement System. Its membership -- public school and community college teachers -- felt neglected. Its investment staff was underpaid. Its returns in most years were at best mediocre.

That has all changed. CalSTRS has awakened from its slumber, emerging as a powerful force on the local and national stage. Risking a political vendetta, it stood up to California's popular Republican governor, Arnold Schwarzenegger, and helped defeat his plan to terminate traditional pensions for newly hired public workers. Its board approved far-reaching ethics reforms last year. And CalSTRS has shaken up its asset allocation and adopted an aggressive plan to add some $20 billion into real estate and private equity by 2012, when it expects its portfolio to be worth $200 billion. It has also engineered an abrupt turnaround in its investment performance: Last year CalSTRS' portfolio -- worth $157.9 billion at the end of December -- gained 16.79 percent, ranking it in the top 4 percent of public funds with more than $1 billion, according to Wilshire Associates.

More than anything, CalSTRS has studied the lesson plans of its public fund peers, especially CalPERS, and dramatically stepped up its profile as a shareholder activist. Wielding an annual corporate governance budget of $1.6 million, it now outspends all but two pension plan providers, CalPERS and TIAA-CREF. With an investment of more than $1 billion, CalSTRS is also one of the largest backers of Relational Investors, the San Diego activist investing firm that turned up the heat on Home Depot, leading CEO Robert Nardelli to resign under pressure.

Taking a page from other pension funds' textbooks, CalSTRS is increasingly willing to go it alone in its legal maneuvers -- opting out of class-action lawsuits and pursuing its own claims to great effect. In December the pension fund extracted $46.5 million from Denver-based Qwest Communications International, roughly 30 times what it would have gotten as a member of the federal class-action suit that the telecommunications services provider settled for $400 million in 2005. And in February, CalSTRS recovered about 78 percent of its alleged $135 million in losses on Time Warner's stock.

"It's spectacular," says William Lerach, a leading securities lawyer who represented 66 other institutions that pursued separate claims against the New York­based media giant. "In a normal class action, the most they would have gotten is 4 to 5 percent."

CalSTRS owes much of its newfound assertiveness to CEO Jack Ehnes, who has emerged as a national spokesman on corporate governance issues as chairman of the Council of Institutional Investors, an association of public and private pension funds that together have more than $3 trillion in assets. But Ehnes, who took up his duties in early 2002, isn't just a lecturer. He led CalSTRS' countercharge against Governor Schwarzenegger's assault on traditional pensions and is championing an increase in CalSTRS' stake in activist money managers, from $1 billion to $2.5 billion.

"Before Ehnes, CalSTRS was like any other public system," says Dallas Salisbury, president and CEO of the Employee Benefits Research Institute in Washington, D.C. "Now CalSTRS is clearly cutting edge."

Ehnes, 55, says his zeal for shareholder activism is less about ideals than bolstering the bottom line. "The fact that we've put a billion dollars into corporate governance funds and are putting in more conveys that we're not just betting on a wish," he says.

All these efforts have helped CalSTRS stand tall as it emerges from CalPERS's shadow. Last year CalSTRS' investments outperformed those of its Sacramento rival by 139 basis points. And a recently introduced bonus plan for its investment personnel could narrow the pay gap with CalPERS's staff, which once managed its portfolio. In 2009, CalSTRS will move into a new, $186 million high-rise headquarters along the Sacramento River, a big step up from the drab office building on the outskirts of town that it once shared with a dental insurer.

"There has been a transformation," says Phil Angelides, the former California state treasurer whose eight-year tenure on the boards of CalSTRS and CalPERS ended in January and who lost the governor's race to Schwarzenegger last fall. "CalSTRS has come into its own and become in many respects an equal partner of CalPERS in leading the way to changes in the financial marketplace."

But for all its momentum, CalSTRS faces a pressing challenge: an unfunded actuarial liability of more than $20 billion -- in absolute dollar terms, among the biggest in the nation -- that threatens its ability to deliver the retirement, disability and survivor benefits it has promised to nearly 795,000 current and former state teachers.

At 86 percent, CalSTRS' funding ratio of assets to liabilities is only slightly above the median for large public funds, according to Standard & Poor's, and roughly equivalent to CalPERS's ratio of 87.3 percent. But unlike most retirement systems, including CalPERS, the contributions CalSTRS receives from the state government don't automatically increase when its funding ratio falls. That makes the sheer size of its shortfall, and the risk of its spiraling out of control, a potential disaster.

Even if CalSTRS achieves its assumed 8 percent annual return, its unfunded liability could double, to $40 billion, by 2014 unless it extracts more money from teachers, schools and the state alike.

CalSTRS' board approved the outline of a funding proposal in December that could add as much as $1.5 billion a year to the annual contributions it receives. But getting the state legislature and Governor Schwarzenegger on board will be a Herculean task. That same month, the governor set up a bipartisan commission to study the state's full range of pension and retiree health care obligations, a move that will postpone legislative debate beyond this year. The commission's report, due by January 2008, is sure to cast a harsh light on CalSTRS' proposal for extra funding: Together, CalPERS and CalSTRS have an unfunded liability of $47 billion -- the biggest dollar shortfall of any state. Worse still, state employees, including some teachers, have been promised as much as $70 billion in retiree health care benefits, but Sacramento has not been setting aside enough funds to meet these obligations.

CalSTRS could be in for a long political battle. With Schwarzenegger in office until 2011 -- he was reelected in November -- the pension fund must compete at the public trough with a series of bold and expensive policy initiatives, most notably the governor's plan to make California only the second U.S. state to offer health care to all residents, including the children of illegal immigrants.

In January the governor fired an opening shot that wasn't exactly friendly to CalSTRS: His proposed $143 billion state budget for the fiscal year ending June 30, 2008 would cut $75 million, or 12 percent, from a supplemental account that the pension fund uses to pay for cost-of-living adjustments to teachers' pensions.

Ehnes, who served for five years as Colorado's state insurance commissioner, knows that CalSTRS' finances are troubled -- and he isn't one to mince words. "We're at a true crossroads in our survival," he says.

ALSTRS' FINANCES HAVE BEEN A CHALlenge for much of its history. When the pension fund was created by the state legislature in 1913, the plan was already in the red, the result of teachers' having been granted credit but no funding for earlier work. Not until 1972, with the funding ratio at an alarming 25 percent, did CalSTRS switch from a pay-as-you-go system. In 1990 the legislature directed the state's general fund to hike its fixed contribution to 4.3 percent of teacher payroll, augmenting contributions from teachers and school districts. Although the rate would be negotiated down during the bull market of the late 1990s, California legislators have never granted CalSTRS the automatic funding provision that most pension systems enjoy.

Some of CalSTRS' early missteps were of its own making. In 1982, when the pension plan had nearly $10 billion in assets, the legislature decided it was big enough to manage its own portfolio, rather than relying on CalPERS's staff. But in September of that year, CalSTRS descended into scandal: Federal prosecutors indicted Gilbert Chilton, the chairman of the board and of its new, three-person investment committee, with taking a $1 million bribe in exchange for arranging a $50 million loan from the fund to a wildcat oil company in Texas run by Charles Raymond, a convicted swindler.

Chilton, appointed by then-governor Edmund (Jerry) Brown, was on the lam for more than four years before turning himself in. He was convicted of embezzlement -- not only for taking the kickback but also for stealing $487,000 from a Fresno savings and loan where he had worked -- and sentenced to 15 years in prison.

When CalSTRS finally took control of its portfolio the following year, it hired CalPERS's CIO, Melvin Peterson, as assistant CEO for investments. But he and his successor, Richard Lambourne, a retired investment adviser, were largely hands-off. CalSTRS' board had contracted with Manufacturers Hanover Trust Co., now part of JPMorgan Chase & Co., to run fixed-income investments. Alliance Capital Management Corp., now part of AllianceBernstein, and Trust Co. of the West, later acquired by French bank Société Générale, managed equities. Those arrangements became superfluous in 1984, however, after California voters passed Proposition 21, which replaced investment restrictions with a "prudent expert rule" that gave the state's pension funds free rein to invest in any asset class.

Realizing it needed more control, CalSTRS in 1985 hired a new CIO, Thomas Flanigan, to build an investment staff and asset allocation from scratch. Flanigan had been recommended by Arthur Levitt Sr., the New York comptroller who ran New York Common Fund -- then the nation's largest pension plan -- where Flanigan had worked for more than ten years, rising to head of fixed-income investments. By 1989, CalSTRS had $29 billion in assets and was 69 percent funded. That year, Flanigan made the pension plan an early public sector entrant into private equity, with a 5 percent allocation.

In governance issues, though, CalPERS moved to the vanguard under CEO Dale Hanson, who was hired in 1987 to raise the pension fund's profile and ratchet up public pressure on corporate America. CalSTRS had a governance staff and dutifully voted its proxies and held discussions with executives. But its activity under then-CEO James Mosman -- a former head of the state's Department of Personnel Administration who was hired in 1988 -- was far less muscular and barely visible.

This early divergence in style resulted from the systems' radically contrasting memberships and board composition -- differences that persist today. CalSTRS serves mostly women teachers, and the governor appoints five of its 12 board members, who must be confirmed by the State Senate. The governor selects the state's director of finance, who also sits on the board. CalPERS, which represents a diverse lot of white- and blue-collar public workers, including cops and firemen, has more elected members, resulting in greater union representation on its board. The governor appoints only three of it 13 trustees. (The state controller and treasurer, elected officials, sit on both boards.)

As the bull market of the 1990s took off, CalSTRS investment policy came under attack, ultimately leading to CIO Flanigan's downfall. In 1996, Federal Reserve chairman Alan Greenspan warned of "irrational exuberance," only to see equities continue to rise. Flanigan, too, thought stocks were overpriced and kept nearly half the portfolio in bonds. With returns suffering, a frustrated CalSTRS board, led by then­State Controller Kathleen Connell, pushed for his ouster.

"I spoke with [then-] governor Pete Wilson, and it was clear that we needed to rectify the allocation and the leadership," says Connell, now a business consultant and a lecturer at the Haas School of Business at the University of California, Berkeley.

The following year the board voted unanimously not to renew Flanigan's contract. (The former CIO, now a consultant, says the vote was about "political control of the board.") Flanigan was replaced by his deputy, Patrick Mitchell, who had been in charge of the fund's investments in equities and fixed income. He jumped on the bull market bandwagon, boosting equities and returns: The fund achieved full funding in 1998; at the end of 1999, it became the third U.S. pension plan to surpass $100 billion in assets. The following year, its funding ratio peaked at 110 percent.

As Mitchell shook up investment policy, CEO Mosman grappled with customer service problems. Mosman had installed CalSTRS' first call center in the early 1990s, dramatically shortening hold times for members. But after the transition to a new data processing system went awry in 2000, response times declined and the processing of beneficiaries' survivor and disability benefits slowed markedly, a problem that persisted for years. "It was close to a crisis," says Carolyn Widener, who now heads CalSTRS' board.

Then the market began to crash, a reversal that would erase some $30 billion from CalSTRS' portfolio. Mitchell left in April 2000 of his own volition for "a different opportunity set," as he says, at Metropolitan West Asset Management in Los Angeles. (In March 2006 he became a managing director at Airlie Opportunity Capital Management, a high-yield hedge fund in Greenwich, Connecticut.) Mitchell was replaced by Christopher Ailman, 48, who had run a large staff and overseen a diversified portfolio at the Washington State Investment Board, one of the first public investors in private equity. Mosman retired in June 2001, ending a 30-year career in state government. "It was time for a change," he says. (He is now the executive director of the National Council on Teacher Retirement, a trade association based in Sacramento.)

In December 2001, CalSTRS' board -- still deluged with customer service complaints -- decided to hire Ehnes, who had a mix of public and private sector experience and promised to stamp out what he calls "the DMV syndrome," the bureaucratic culture that often infects motor vehicle departments and other government agencies.

Ehnes arrived from Denver, where he had spent the two previous years as vice president of corporate affairs for Great-West Life & Annuity Insurance Co., the U.S. subsidiary of a Canadian company that provides health insurance and administers defined contribution retirement plans. Earlier in his career Ehnes had expanded guaranteed health coverage to autistic children and the self-employed as Colorado insurance commissioner and had also served for more than ten years on the board of the Colorado Public Employees' Retirement Association, the last five as chairman.

To set a new tone, one of Ehnes' first acts was to change CalSTRS' Web address from the bureaucratic "calstrs.ca.gov" to "calstrs.com." He invested in training and expanded call center hours for a staff that gets 1,000 calls a day and annually conducts 35,000 one-on-one consultations about retirement planning, beneficiary changes and death and disability benefits.

"He has increased the level of performance in just about every way -- administration, benefits, legislative relations. He knows the issues and facts, doesn't get in people's faces and works things out," says Gary Lynes, a Bay Area middle school math teacher who chairs CalSTRS' investment committee and is its longest-serving member, having been appointed in 1984 by then-governor George Deukmejian.

Though a consensus builder, Ehnes isn't afraid to go to battle. Shortly after arriving in Sacramento, he took on the powerful insurance industry. At issue was the insurers' ability to sell annuities to teachers investing in 403(b) accounts, the public sector equivalent of the 401(k). Although CalSTRS markets a 403(b) product to teachers, Ehnes supported state legislation, strongly backed by leading annuity provider TIAA-CREF, that would have allowed individual school districts to decide which financial firms could market products to their employees, instead of permitting a free market where any 403(b) product could be offered to any school. Proponents' unstated goal was to limit sales of variable and fixed annuities, which have much higher fees than traditional mutual funds, yet comprise as much as 80 percent of assets in 403(b)s.

Industry lobbyists pushed back hard. In a compromise, school districts did not become gatekeepers, but 403(b) vendors of variable annuities and other financial products in California were required to list fees and other details on a public Web site, 403bcompare.com, which CalSTRS manages. "It was difficult to get them to comply," Ehnes says, "but they've come a long way in recognizing the rules of engagement have changed."

CALSTRS' NEWLY ASSERTIVE PRESence in the markets is the result of the hit its portfolio took in the bear market and the revelations of corporate excess that emerged in its aftermath. "The scandals were too large to take the attitude that this was somebody else's battle to fight," says Angelides, who led the board's activist charge and was often the public face when CalSTRS joined other pension funds in the big battles of recent years, including the push for Sarbanes-Oxley, the separation of investment banking and research and improved disclosure of executive pay.

If these efforts are the aerial assault, the ground war is being waged by CalSTRS' six-person corporate governance staff, which prepares thousands of proxy votes, writes scores of letters to the Securities and Exchange Commission and other regulatory agencies and negotiates with corporate boards. In the 2006 proxy season, CalSTRS voted against two thirds of all compensation plans and corporate actions such as spin-offs and stock splits. And as attorneys for Qwest and Time Warner can attest, CalSTRS won't hesitate to go to court, often alone, when its staff and board believe that malfeasance has harmed shareholders.

"My only regret is that we were unable to get any personal contribution in the settlement from either [former Qwest CEO Joseph] Nacchio or [founder Philip] Anschutz," says Christopher Waddell, who served as CalSTRS' general counsel through November before taking a similar post at the San Diego City Employees' Retirement System. (Nacchio will pay $1.5 million, but it is be covered by insurance.)

CalSTRS' outcome in the Time Warner case was among the best in a wave of recent settlements. Although CalPERS sued and recouped a greater share of its alleged losses -- $117.7 million, or 91 percent of its claim -- the University of California and six Ohio state pension funds recouped about 44 percent and 36 percent, respectively, considerably less than CalSTRS' 78 percent.

Increasingly, CalSTRS and CalPERS are acting in concert to promote their governance agendas. In the wake of Hewlett-Packard Co.'s recent wiretapping scandal, the two funds pushed to enact a proposal at the company's annual meeting last month that would enable large shareholders to nominate directors, the first such bid in the U.S. in three decades. The effort failed but attracted plenty of attention: CalSTRS and CalPERS each paid close to $100,000 to cosponsor a full-page ad supporting the proposal in the Wall Street Journal two weeks before the vote. The funds have a combined stake of more than $1.1 billion in Hewlett-Packard stock.

Notwithstanding such tactics, CalSTRS CIO Ailman stresses that, as the owner of 2,800 domestic stocks, the fund's governance motives are constructive. "We own a huge exposure," he says. "We've bet our future on corporate America and always will."

The roughly half-dozen companies that CalSTRS targets each year for reform are a key focus of its corporate governance program. As a courtesy the pension fund doesn't disclose the names of the targeted companies until several months after it approaches management (the 2007 list won't be released until June).

CalSTRS says the program has improved governance. In December 2005, for instance, Sirius Satellite Radio's board approved a CalSTRS proposal calling for the creation of a nominating committee comprising independent directors. Last May, after CalSTRS met several times with Compuware Corp. executives, the company introduced, and its shareholders ratified, a watered-down poison pill plan. CalSTRS has been less successful, however, in pushing Exxon Mobil Corp. to align executive compensation more closely with performance and to do more to reduce carbon emissions and promote clean technologies.

Engaging companies in this way has led to a pop in their stock. In the 12 months ended April 2006, share prices of companies that had received their initial letter from CalSTRS in the previous year rose 26.33 percent, versus a 15.68 percent gain for the Russell 3000 Index. Over more than three years, CalSTRS says its engagement has added at least 5 percentage points to companies' stock prices.

Even when CalSTRS sues a company for securities fraud, its goals often go beyond extracting cash. A case in point is the 2002 class-action lawsuit that CalSTRS brought against Homestore.com, an online real estate outfit based in Westlake Village, California, that had inflated revenues in 2000 and 2001 by $160 million, or nearly 30 percent, according to its own disclosures. In a settlement reached in March 2004, CalSTRS and other parties to the suit recovered $93 million, most of it in stock.

More important than the money, says Ailman, was the slate of permanent governance changes that the settlement imposed: a requirement for an additional independent director to be nominated by shareholders, with input from CalSTRS; prohibitions on the use of stock options for director compensation; and a separation of the roles of CEO and chairman. "Our job was not to destroy the company but to make it better," says the CalSTRS CIO.

Joe Hanauer, chairman of Move, as Homestore is now known, says CalSTRS was "tough but responsible" in the settlement negotiations and in nearly a dozen subsequent meetings as well as countless conference calls that were focused on nominating the new independent director, Geraldine Laybourne, co-founder, chairwoman and CEO of Oxygen Media, who was appointed in June. "Other shareholders might have used it to put in a political appointee, but they were really interested in what would work best for the company and the shareholders in the long term," says Hanauer.

CalSTRS, which remains a shareholder in Move, is reaping rewards from its patient approach. After peaking at $148 in January 2000, the stock plummeted to just 53 cents a few months after news of the scandal broke in November 2001. But in 2006 the company earned a record $18.5 million on revenues of $290.4 million. At a recent price of $5.69, the shares have risen 44 percent since the settlement was concluded.

The most powerful tool in CalSTRS' arsenal, reckons Ailman, is the $1 billion that the fund has invested with Relational Investors. An additional $1.5 billion will be allocated to six other activist money managers, including Japan's Nissay Asset Management and Breeden Capital Management, a Greenwich, Connecticut­based hedge fund run by former SEC chairman Richard Breeden.

"About 75 percent of corporate governance is about investments, 15 percent is legal and 10 percent is federal and legislative stuff," says Ailman.

CalSTRS' investment in Relational has done well. For the two years ended December 31, 2006, the fund manager delivered an annualized 11.15 percent return net of fees, compared with 10.22 percent for the S&P 500 index. This performance figure includes some $300 million that CalSTRS invested directly in shares of two Relational holdings: diversified medical products maker Baxter International and financial services firm Prudential Financial.

In February, shortly before Relational co-founder David Batchelder took a seat on Home Depot's board, CalSTRS made a similar side bet on the home improvement retailer's shares -- after it gave in to a key demand from Relational and agreed to consider selling its wholesale supply business.

Lately, CalSTRS' status in the corporate governance world has gotten a boost from Ehnes's role as chairman of the Council of Institutional Investors. Ehnes has helped to revitalize the somewhat unwieldy group that was losing relevance in governance matters. He came on board in 2005 along with a new executive director, Ann Yerger, who had been head of the CII's research service.

"CII had been dead in the water for ten years," says Robert Monks, the author, investor and shareholder activist who founded Institutional Shareholder Services in 1985. "It has become rejuvenated and [is now] a fine representative of beneficiaries in America."

ITH CALSTRS' FUNDING ratio falling and its cash flow projected to turn negative in the next decade, Ehnes and the board began debating ways to address the system's deteriorating finances in late 2004. But they soon came face-to-face with the political reality of CalSTRS' own governance shortcomings.

In January 2005, Schwarzenegger proposed replacing traditional pension plans for new state employees with 401(k) accounts. When CalSTRS' board voted 10 to 2 to oppose the proposal, the governor reprised his cinematic role as the Terminator and ousted four of his appointees to the board who had opposed his plan. The purge -- possible only because the board members had not yet been confirmed by the State Senate -- grew worse when the Democratic-controlled Senate later declined to confirm a fifth Schwarzenegger appointee who had voted in favor of killing pensions, leaving five of 12 board seats vacant.

Though Schwarzenegger had fresh appointments by August, his effort was ultimately voted down in a statewide referendum. Still, Ehnes fretted that a new, inexperienced board would have trouble coalescing into a constructive body so soon after the turmoil. Moving into crisis mode, he flew around the state and met personally with every new board member in their home area.

"I had to start educating new members again on all these heavy issues and make sure there was a reasonable understanding of them," he says. Ehnes adds that his fiduciary orientation program drove home the point that "the board has to exercise independent thinking all the time."

CalSTRS' reconstituted board has done its best to loosen the gubernatorial ties that bind. Last November it sought to insulate itself from political pressure by voting unanimously in favor of rules that would restrict and force disclosure of political contributions and payments that are sometimes offered to board members and staff by money managers' placement agents in a bid to win investments. If approved by the state legislature, the restrictions would be among the nation's toughest and would apply to board members, the governor and gubernatorial candidates. (CalPERS sought similar restrictions in 1998, but its proposal was overturned in court on technicalities.)

The restrictions are a necessary step forward, but few believe they are sufficient. "If nonelected officials who aren't paid have authority over decisions that can make service providers hugely wealthy, you have a situation that is very pregnant for improper influence," says activist Monks. "Campaign contributions are simply one of the visible forms."

With the purge behind it, CalSTRS' board restarted talks about how best to increase funding and began the arduous task of forging a consensus. Through most of 2006, Ehnes and deputy CEO Ed Derman bargained with lobbyists for school districts, retired teachers and other constituent groups.

No one wanted the extra money to come out of their own pockets in the form of higher payroll contributions. Such groups as the California Retired Teachers Association and the Association of California School Administrators supported closing the gap by issuing pension obligation bonds and extending the amortization period from 30 to 40 years. Such a move, similar to stretching out a mortgage, would reduce the near-term cost while buying more time for narrowing the shortfall, they argued. The California Teachers' Association, among its other demands, wanted an increase in purchasing power protection for pensions and additional resources for supplemental Medicare insurance for the 62 percent of teachers whose districts provide no medical coverage for retirees older than 65.

"We've got haves and have-nots within the same segment of retirees, and that creates a lot of tension about how to solve the problem," says Ehnes. Adding to the challenge of finding a workable solution: State law requires any increase in member contributions to be offset by an increase in benefits.

Then there is Proposition 98, which amended California's constitution in 1988 and mandates a minimum level of state funding for K-12 schools and community colleges. As a result of this provision, teachers are worried that if school districts have to boost their pension contributions, the funds could come out of their paychecks. "Teacher's groups are afraid," says board chairwoman Widener, a junior college English professor in Los Angeles. "Districts may argue that it's deferred compensation, so they must take it away from salary."

CalSTRS' legal counsel contends that Prop 98 would not obligate the state to give more money to school districts to cover their higher pension contributions.

Despite such complexities the board approved the outline of a $1.5 billion-a-year funding strategy in December that would require teachers, school districts and the state to increase their contributions gradually until the plan achieves full funding; at that point contributions could decline to as low as current levels. The scheme would boost member contributions from 8.0 to 8.5 percent of teacher payroll, raise school district contributions from 8.25 percent to as much as 13 percent of payroll and boost state government contributions from 2.0 percent to as much as 3.25 percent. The CalSTRS plan calls for no increase in benefits, but the existing 2 percent annual cost-of-living adjustment would become guaranteed.

Now Ehnes has the tough job of explaining the proposal to 120 California state legislators, 46 of whom are freshmen. "We're going to have to take a few steps back before we just start talking numbers," he says. "We would like people to understand the actuarial science behind our plan -- but they don't for the most part."

Of course, nobody expects any plan calling for funding increases to be an easy sell to the governor -- nor even to land on his desk until well after his newly formed committee, officially known as the Public Employee Post-Employment Benefits Commission, issues its report on the broader plight of California pensions. Tensions were running high when the commission met for the first time in early March, with fiscal conservatives calling for increasing the state's retirement age from 55 to 65 and union representatives countering that the system is secure. Gerald Parsky, chairman of the commission, told a crowded hearing room that the group will find "a calm and reasonable way to educate the public" about the magnitude of the pension and health care crisis.

Parsky, a Republican who is chairman of money manager Aurora Capital Group in Los Angeles, is well versed in pension politics. He chaired George W. Bush's California presidential campaigns in 2000 and 2004 and served on the President's Commission to Strengthen Social Security. As a regent of the University of California in 2005, he spoke out against Schwarzenegger's plan to do away with defined benefit plans, saying they served as an important tool for recruiting teachers.

As Ehnes ramps up his lobbying efforts, his goal is to focus the debate on CalSTRS' needs and the state government's obligations to fund them. "We have this simple financial fact," he says, "which is, if I need a dollar or ten dollars or a hundred, the sooner I get those dollars into the system, the more cost-effective the solution is. No one is so naive as to think they're getting out of paying these guaranteed benefits."

A S EHNES MANAGES THE POLITICAL ASPECTS of CalSTRS' funding challenge, Ailman must contend with the complexities of its portfolio. The timing of his arrival in October 2000 couldn't have been worse. The CIO position had been vacant for four months and CalSTRS' investments hadn't been rebalanced during that period. "I took the helm of the ship right as it was getting bashed by a hurricane," says Ailman, who adds that he could have been "a poster boy for Tagamet."

He set out to correct the "unintended bets" he discovered in the portfolio. The allocation was conventional: About 65 percent was invested in equities, 25 percent in bonds and 10 percent in private equity and real estate, with 80 percent of the stock holdings indexed. But the portfolio was overexposed to hard-hit technology, media and telecommunications stocks relative to its benchmark, the Russell 3000 index. And CalSTRS' foreign equity holdings had a big tilt toward growth stocks. "That first year I noted some structural things to fix, and like a chiropractor I pushed them back into place," says Ailman.

The adjustments, though small, made a difference in a portfolio where 1 basis point was equal to about $10 million. In 2002 the CIO tweaked some of CalSTRS' benchmarks. He introduced the Lehman Brothers U.S. aggregate index (excluding tobacco) as its fixed-income benchmark instead of a custom index that was heavily weighted toward U.S. Treasury debt. The board also installed McKinsey & Co. and Cambridge Associates as CalSTRS' first consultants for alternative investments.

In 2004, as the portfolio recovered its losses, the board decided to increase the proportion of actively managed equity and fixed income to 30 percent of the portfolio; for the first time, it also expanded the potential range of CalSTRS' alternative investments beyond North America and Western Europe to include the entire world. Last fall the board introduced a currency overlay to hedge the exposure.

As the board gained confidence and came to grips with the sheer size of its long-term liabilities, it realized it had little choice but to increase risk to achieve its expected 8 percent annual return. CalSTRS' staff and its general consultant, Portland, Oregon­based Pension Consulting Alliance, added to the challenge by lowering their projected annual returns for various asset classes, particularly fixed income, which is now expected to return 4.75 percent annually over the next 20 years, down from a previous estimate of 5.25 percent.

In September, CalSTRS' board lowered its target allocation to fixed income from 26 to 20 percent and cut cash from 1 percent to zero. At the same time, the board agreed to raise CalSTRS' 6 percent allocations to real estate and alternatives to 11 percent and 9 percent, respectively. The combined 20 percent exposure to these asset classes will put CalSTRS far above today's average public fund exposure of 8.8 percent, according to the National Association of State Retirement Administrators -- as well as CalPERS's 14.0 percent combined target. Still, there's little margin for error: The expected annual return of the target portfolio is only 8.25 percent.

CalSTRS figures it will take another five years to shift the required $20 billion to real estate and private equity. The challenge will be particularly difficult in private equity, where CalSTRS is constrained by a policy, imposed by its board, of investing only in funds with top-quartile returns as determined by research firm Venture Economics. CalSTRS' plan implies a private equity portfolio worth $13 billion in 2009 and $18 billion in 2012. But McKinsey did a back-of-the-envelope estimate last summer and found that the system could expand its private equity investment, which stood at $8.2 billion at the end of June, by only $3.5 billion, or 43 percent, to $11.7 billion; beyond that level CalSTRS' money would make up more than 10 percent of the assets of its chosen funds -- a percentage that few general partners would countenance.

Ailman says CalSTRS is looking at lowering its threshold to permit investments in private equity firms that rank in the top three eighths of their peers but is quick to downplay the possibility. "I don't know that we're necessarily going to have to lower our quality," he says, pointing to the $15 billion-plus funds being raised by Kohlberg Kravis Roberts & Co. and Blackstone Group. "We're actually putting bigger chunks to work faster than expected," he says, noting that as fund sizes have ballooned, the percentage of these funds offered to CalSTRS has remained steady.

In 2006 -- a record year for private equity fundraising -- CalSTRS committed more than $4 billion to the asset class. Worldwide, private equity firms raked in $434 billion, including the money that flowed to real estate funds, versus the prior record of $311 billion set in 2005, according to Private Equity Intelligence, a London-based consulting firm.

Investors are often wise not to follow the crowd. But Erik Hirsch, the CIO of Hamilton Lane, which manages more than $9 billion and advises institutions worldwide on an additional $55 billion in private equity assets, thinks there's plenty of capacity and return potential. "Bigger funds are resulting in larger transactions with a whole different set of companies," he says. "The buyout market is proving itself to be scaleable."

Beyond these megafunds, Ailman says, new investment opportunities abound in nontraditional areas, such as infrastructure investment, both at home and abroad. The demand for capital is immense, particularly in Asia, which will require at least $200 billion annually in infrastructure spending over the next five years, the majority of which will need to be filled by private sector funding, according to Julie Kim, who studies Asia-Pacific infrastructure for the Rand Corp. in Santa Monica, California. On a visit to South Korea last September, Ailman met representatives of Australia's Macquarie Group and discussed a project to build a subway line in Seoul. CalSTRS board has held workshops on infrastructure investing but has yet to give the green light.

Expanding the real estate portfolio from $9.5 billion to $22 billion will be a less difficult challenge, Ailman says. Bigger real estate portfolios are coming on the market, and there are new opportunities in public-to-private real estate transactions and direct co-investment funds. In addition, there is a burgeoning range of "cross-over" opportunities that are a blend of real estate and private equity, including mezzanine finance, equity and foreign debt. "That's where we're going to look and see -- how big is that space?" says Ailman.

Although CalSTRS' senior leadership is optimistic about boosting returns and contributions, it's highly likely that both efforts will have to succeed to close the pension plan's massive funding shortfall. Ehnes, ever the optimist, believes that the challenge of translating hope into reality amid a tendentious debate in California will only make CalSTRS stronger in the long run. Meanwhile, underperforming CEOs and compliant boards would do well to cast a more watchful eye on Sacramento. When it comes to shareholder activism, there's a new taskmaster in town -- and many lessons have yet to be taught.