California Pension Plan: Betting the house

Kurt Brouwer July 25th, 2009

From the New York Times [registration may be required] we get this report on the California Public Employees Retirement System (CalPERS), which is the largest pension plan in the nation.  CalPERS has struggled of late due to investment losses and funding issues.  It also has a credibility problem after helping bring about the current crisis in California public pensions.

Now, the investment chief for CalPERS is doing something that is quite unusual in that he is calling for the system to essentially bet billions on risky assets in the hopes of making a big gain [emphasis added below]:

CalPers Hopes Riskier Bet Will Restore Its Health (New York Times, July 23, 2009, Leslie Wayne)

Big as California’s budget woes are today, so are the problems lurking in its biggest pension fund.

The fund, known as Calpers, lost nearly $60 billion in the financial markets last year. Though it has more than enough money to make its payments to retirees for many years, it has a serious long-term shortfall. Meanwhile, local governments in the state are pleading poverty and saying they cannot make the contributions that would be needed to shore it up.

California’s public pension funding problem is one of the thorniest financial issues facing the state. The state made an unwise and almost certainly unsustainable deal to substantially raise public pension payouts approximately 10 years ago.  CalPERS played an important role in that disastrous decision (see Budget Busting Pensions).

The New York Times continues:

Those problems now rest largely on the slim shoulders of Joseph A. Dear, the fund’s new head of investments. He is not an investment seer by training, but he thinks he has the cure for what ails Calpers, or the California Public Employees’ Retirement System, the largest in the nation with $180 billion in assets.

Mr. Dear wants to embrace some potentially high-risk investments in hopes of higher returns. He aims to pour billions more into beaten-down private equity and hedge funds. Junk bonds and California real estate also ride high on his list. And then there are timber, commodities and infrastructure.

That’s right, he wants to load up on many of the very assets that have been responsible for the fund’s recent plunge. Calpers’s real estate portfolio has tumbled 35 percent, and its private equity holdings are down 31 percent. What is more, under Mr. Dear’s predecessor, Calpers had to sell stocks in a falling market last year to fulfill calls for cash from its private equity and real estate partnerships. That led to bigger losses in its stock portfolio.

CalPERS has made very significant investments in illiquid real estate and private equity partnerships.  Selling stocks last Fall to help keep those partnerships going may or may not have been a huge mistake, but it is certainly unusual behavior.

From the Sacramento Bee, here is a report on a billion dollar bust in CalPERS’ real estate portfolio.  The details do not sound encouraging:

…CalPERS made aggressive investments in real estate at the worst possible time, when inflated property values had peaked and were already beginning to decline.

As The Sacramento Bee’s Dale Kasler detailed in a recent article, one CalPERS real estate misstep stands out in particular. In February 2007, CalPERS invested $922 million in a deal with LandSource Communities Development LLC that involved thousands of homes and lots in seven states including Florida, Arizona and California.

A month before the investment was finalized, Lennar Homes, a principal partner in the LandSource deal, announced it was writing off $500 million in real estate assets because of deteriorating market conditions. That should have served as a clear warning to CalPERS, but it did not.

Sixteen months later, LandSource filed for Chapter 11 bankruptcy. Depending on what assets the partnership sells to pay off creditors, CalPERS could lose its entire investment, nearly $1 billion...

In fairness, CalPERS made lots of money from its real estate investments over the years, so a billion dollar writeoff won’t break the bank.  However, the bankruptcy of a private real estate deal like this one should be a warning light that the partnership investments the plan already holds may have other unwelcome surprises.

Joseph Dear, CalPERS’ new investment head seems to be a smart guy and he is certainly well connected in a political sense.  He also seems to be a gutsy guy in that he is definitely making a bet — in effect, betting the retirement future of many Californians  — that the private partnerships he likes will outperform more traditional investments.

…He [Joseph A. Dear] was hired in large part for his management skills and political savvy – honed in Washington, where headed the Occupational Safety and Health Administration in the Clinton years. He does not have an M.B.A. or any other advanced degree in finance. Harvard, Yale or Wharton is not on his résumé. Instead, his lone degree, in political economy, is from Evergreen State College in Olympia, Wash.

Most recently, Mr. Dear headed the Washington State public pension fund, which gained a reputation as a daring investor under his oversight. It risked more of its portfolio – 25 percent – on private equity than any other public fund. The bet pushed the Washington State Investment Board, which now has $67 billion in assets, into the top 1 percent of its peer group in performance during the boom years, according to Wilshire Associates. But in the fiscal year that ended last month, the fund lost 27 percent of its value, or $18 billion.

Calpers has a lot riding on Mr. Dear’s effort to achieve above-market performance. The fund just posted a loss of 23 percent, the worst in its history. That leaves it 66 percent funded, the lowest level in two decades, meaning it has only $66 on hand for every $100 in benefits promised to 1.6 million California public employees and their families.

… “Calpers is significantly underfunded, and they have decided that they will roll the dice,” said Edward A. H. Siedle, president of Benchmark Financial Services, which audits pension plans. “Is that appropriate if you have just lost 25 percent of your portfolio? These are high-risk, illiquid, unregistered products where there is tremendous valuation uncertainty. I would bet you any amount that five years from now, this plan will not have outperformed the market.”…

On one hand, I applaud CalPERS and its new head of investments for taking a bold and contrarian stand.  It may work and, if so, I will be very happy.  On the other hand, I question the motivation behind this move.  Is it the desire to follow a sound investment principle of adding to solid holdings when they have fallen in value? Or, is it a move like that of a gambler who suddenly decides to double down in order to erase a series of losing hands?

Via: Calculated Risk

See also:

Budget Busting Pensions

10 Rules for Investing

Oakland ‘Mulls’ Bankruptcy

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4 Responses to “California Pension Plan: Betting the house”

  1. [...] a rest here:  California Pension Plan: Betting a house This entry was posted in Posts about Health & Beauty, Uncategorized and tagged california, [...]

  2. Carol Wardon 27 Jul 2009 at 5:52 am

    Seems to me this is a text book example of moral hazard, or Heads I Win, Tails You Lose. Mr. Dear, and by extension Calpers, is risking nothing, because if his strategy fails, the California taxpayer is on the hook to make up the excess. If it succeeds, he is lauded as a genius. I think game theory would predict this as a dominant strategy regardless of market conditions.

    For your sake as a California taxpayer, and mine as a US taxpayer, I hope it works. Somehow, though, it reminds me of Lake Woebegon where all the children – or in this case, investment returns – are “above average.” It just can’t be so.

  3. Kurt Brouweron 27 Jul 2009 at 9:48 am

    Carol — you raise a very important point. The CalPERS investment approach appears to have an incentive to take on more risk. Unfortunately, we have seen a lot of textbook examples of moral hazard lately.

  4. [...] Double Down? – California Pension Plan: Betting the house – Kurt Brouwer – … Now, the investment chief for CalPERS is doing something that is quite unusual in that he is calling for the system to essentially bet billions on risky assets in the hopes of making a big gain [emphasis added below]: … – Fundmastry Blog [...]

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