CalPERS' Continued Setbacks Might Lead to Greener Pastures – For Everyone!

According to Investment News, CalPERS is considering dropping its current active approach to embrace a more passive investment strategy.

Public pension plans have become a focal point in the investment industry over the last few years. Coupled with underperformance and imprudent fiduciary practices, many of these plans have problems that mirror the issues faced by other retirement plans – problems such as excessive risk taking, high costs, and limited transparency. This comes at a time when many citizens of this country are poorly funded for their own retirement. California may be looking to become the vanguard for better things to come for public pension plans.

According to Investment News, CalPERS is considering dropping its current active approach to embrace a more passive investment strategy. It reports, "the California Public Employees Retirement System's investment committee is evaluating whether the fees it pays its active managers are worth it or if paying less fees for passive management will lead to better long-term results." Reducing cost will in fact lead to better long-term results, even if CalPERS doesn't adopt a completely passive investment strategy. By adopting a low cost and passive investment strategy, CalPERS will double their efforts in increasing long-term expected returns.

Index Funds Advisors started following State pension plans in 2011 to see how some of the biggest institutional money managers fared against a simple buy-and-hold portfolio of passively managed index funds. What we found was astonishing. Over the 24-year period ending June 30, 2011, not a single State pension plan outperformed the passive portfolio. In fact, they weren't even remotely close. You can see more details about the IFA study here.

One of the biggest underperformers was the state of California's Public Employee Retirement System (CalPERS) plan, which underperformed a passive strategy with a similar risk exposure by approximately 2% per year. But underperformance isn't the only thing plaguing the largest State pension fund. Former executives of CalPERS are currently facing legal scrutiny over compensation practices.

Criminal charges were announced on March 18th against former CalPERS CEO Federico R. Buenrostro, Jr. and Mr. Alfred J. Villalobos, a private placement agent for the pension fund, in connection with a "pay-to-play" scheme. These schemes can be thought of as "lobbying" efforts from money managers in order to secure access to certain assets. In this case, Messrs. Buenrostro and Villalobos forged compliance documents in order to receive fees from one of the private equity firms they were placing assets with —somewhere in the range of $14 million. Pay-to-play schemes are illegal in the United States, although they are hard to identify given the opacity of the many revenue-sharing arrangements among all parties involved and the conflicts of interest that arise.

These "agent problems" and practices are not new in the institutional world, nor are they a surprise to IFA. We released an article in 2009 highlighting this behavior among CalPERS executives receiving excessive amounts of kickbacks from private equity firms who were lining their pockets—sometimes up to $65 million. How have these private placements done for the pension plan?

As mentioned previously, the performance of CalPERS has been one of the lowest in the nation. IFA recently produced an episode on IFA.tv, which dissected its performance and compared it to that of a simple passive strategy utilizing index funds. Based on simulated results, we concluded that CalPERS had left $117 billion on the table in possible return – not a small number considering that the entire pension fund is worth approximately $255 billion. Further, CalPERS' asset allocation was heavily invested in alternative investments, which includes private equity firms and hedge funds that are unregulated, nontransparent, highly risky, and expensive. It would seem that a lot of money is exchanging hands for excessive risk taking that is providing little to no benefit to public employees. And CalPERS isn't the only recipient of these imprudent practices.

Citigroup recently settled a lawsuit for $730 million for misleading investors about the credit quality and loss reserves for 48 bond and preferred stock offerings over a two-year period. Victims included the Arkansas Teacher Retirement Systems and the Louisiana Sheriff's Pension and Relief fund. Why were teacher and sheriff retirement plans participating in a preferred stock offering in the first place? One could assume that the consultant that was hired may have been paid handsomely. Even if no money exchanged hands, the fiduciary duty to prudently invest participant assets was completely ignored. Conflicting interests between what is best for plan participants and high compensation among agents acting on their behalf will always leave the participants in the dust – with less money.

But there may be light at the end of the tunnel.

California has the opportunity to take a giant step forward in aligning the best interests of its employees with its investment strategy, as well as becoming a beacon for the many public employees around the country who have suffered from malpractice with their retirement nest egg. Removing the incentive to create agency problems is crucial, if not necessary, to fix one of the biggest issues that is currently facing our nation.

It's time to make a change.

 

Works Cited:

Bray, Chad, Suzanne Kapner & Matthias Rieker. "Citi Settles Case for $730 Million." The Wall Street Journal. Tuesday March 19, 2013.

Brunson, Mary. "Paying for Pay to Play." IFA's Quote of the Week. Issue 6, November 20, 2009

Corkery, Michael & John R. Emshwiller. "Calpers Ex-Ceo Faces U.S. Charges." The Wall Street Journal. Tuesday March 19, 2013.

Kephart, Jason. "Largest Pension Fund Considers Dumping Active Management." Investment News. March 19, 2013.

 

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