The pension fund is rife with potential
conflicts of interest
The California Public Employees' Retirement System
(CalPERS) earns its reputation as the world's corporate governance bulldog. With
the annual meeting season in full swing, the nation's largest pension fund has
been using its market clout to press for change at such poor performers as
Lucent Technologies, Qwest Communications International, and Gateway. CalPERS'
brand of activism has such a powerful impact on stock prices that finance
professors have dubbed it "the CalPERS effect."
Now, the $149 billion
fund may need a dose of its own medicine. CalPERS, which has 1.3 million
beneficiaries among current or former state employees, has developed a rash of
governance problems. Revelations that the fund knew about--but never blew the
whistle on--Enron Corp. Chief Financial Officer Andrew S. Fastow's self-dealing
partnerships were a big embarrassment. The board is increasingly pushing social
and political criteria in investment decisions. And there has been a spate of
high-level resignations. All this caps a more-than-two-year period when CalPERS'
investment performance has trailed that of other large pension
funds.
Just as troubling, CalPERS' board seems to have developed a blind
spot for potential conflicts of interest. In March, CalPERS put $100 million
into Premier Pacific Vineyards Inc., which buys land for growing grapes. The
co-CEO of that firm, Richard Wollack, is a major fund-raiser for California
Governor Gray Davis, a Democrat, who names three CalPERS' board
members.
CalPERS also committed more than $760 million in the past year
to two funds created by Los Angeles billionaire Ronald Burkle, who, with his
wife, has contributed to the campaigns for state office of two CalPERS board
members, Treasurer Philip Angelides and Controller Kathleen Connell, according
to the California Secretary of State's office. He previously employed two other
board members, San Francisco Mayor Willie Brown and actuary Sidney L. Abrams,
both have confirmed. Burkle is also a big contributor to Davis, whose wife,
Sharon, earned $37,500 last year as a board member at a Burkle company,
according to Jordan Rasmussen, her spokeswoman.
Davis spokesman Roger
Salazar says that neither Davis nor his wife have a role in CalPERS' investments
beyond the governor's board appointments. Wollack says his campaign
contributions and CalPERS' choice to invest with him are unconnected. "I've
supported the governor for 10 years," Wollack says. And Burkle's spokesman Ari
Swiller says CalPERS staff and McKinsey & Co. vetted Burkle's firm: "We have
a 16-year track record of 46% annual returns."
While giving CalPERS'
business to board supporters isn't illegal under state law, it certainly creates
the appearance of political influence in CalPERS' investment choices. CalPERS'
investment staff of more than 100 makes recommendations. But the board decides
where the money goes. It consists of the state treasurer and controller, the
three gubernatorial appointees, one legislative appointee, and a civil service
representative, plus six members elected by the fund's
constituencies.
CalPERS spokeswoman Patricia K. Macht says board members
can't vote on proposals from companies that have paid them significant income in
the past 12 months. The rule doesn't apply to campaign contributions. "It's
legal, but it's alarming," says Jim Knox, executive director of government
watchdog California Common Cause. All members voted on the Burkle and Wollack
investments except Abrams, who was absent, and Connell, who abstained, Macht
says.
CalPERS maintains that it's entirely coincidental that some
investment managers are campaign contributors. Burkle, for example, got his
first $200 million because his track record outshone that of 66 managers who
responded to a CalPERS talent call. CalPERS staff chose Burkle's next fund and
the Premier Pacific investment after months of analysis, Macht says. CalPERS,
she adds, discloses all dealings between board members and
contractors.
The issue has come up before. Macht says that CalPERS tried
to ban outside fund managers who contributed to board members' campaigns from
doing business with the fund in 1998, but a Sacramento County Superior Court
ruled it illegal. The judge's decision was based on a procedural point,
Sacramento attorney Charles H. Bell Jr., who argued the case for CalPERS. The
state legislature could still outlaw such conflicts, he says.
In any
case, say longtime fund watchers, CalPERS' investment strategy has become
increasingly influenced by the political priorities--notably of its
union-affiliated members. "There is an old guard who wants to invest in anything
that makes money and a new guard that wants to pursue a social agenda," notes
James McRitchie, an official of the state Toxic Substances Control Dept. who
operates an independent Web site with information about CalPERS called
perswatch.net.
Critics say the board members are getting in way over
their heads, and should rely on the professional investment staff. Few board
members have finance backgrounds, and none is an experienced investment manager.
"There's just too much temptation for politicians to meddle," says Terry
Sutherland, a state business tax assessor and plan member who watches the fund
closely. "None of these board members is Warren Buffett."
A driving force
behind the social investing trend is Treasurer Angelides, a Democrat who joined
the board after the 1998 elections. One of his first moves, in October, 2000,
was to divest the fund of tobacco stocks. Angelides has also pushed the fund to
invest heavily in the state. Over the past two years, CalPERS has put more than
$1.7 billion into local venture capital, biotech, real estate, and private
businesses in poorer parts of the state. The vineyard deal wasn't made under
this program, but wine is a big local industry. Some 16% of CalPERS' assets are
now invested in California, up from 13% last year.
Few state funds, say
pension experts, have such programs. Wisconsin puts just 3% of its money in the
state. Gary Bruebaker, chief investment officer at the Washington State
Investment Board, says state pension funds often get pressure to invest locally:
"Our response was always, `We are fiduciaries, and we'll do whatever makes the
most money."'
Another Angelides initiative is a program to screen
developing countries for such criteria as a free press, an independent
judiciary, and an active labor movement. Art Pulaski, executive secretary and
treasurer of the California Labor Federation, a coalition of union groups, says
his organization helped Angelides develop his screens and lobbied the CalPERs
board to support them. Pulaski insists that the goal is to improve
returns.
After the board passed a preliminary version of the screening
program in November, 2000, Pulaski's group called the vote a "historic union
victory at CalPERs." Angelides received more than $430,000 in campaign
contributions from unions while the plan was being developed.
Angelides,
who didn't respond to requests for comment for this article, has told
BusinessWeek in the past that his primary goal is superior returns. He
also said he wanted to dump tobacco stocks because the companies faced big
lawsuits. He said investment returns from developing countries with better
social conditions should exceed those of other emerging markets. Investing in
California boosts the state economy, he noted.
So far Angelides'
initiatives don't appear to have done much for the fund's returns or goodwill.
The tobacco divestiture proved ill-timed. After languishing for years, tobacco
stocks soared. The social screening caused an uproar in blacklisted countries,
and CalPERs had to reinstate the Philippines after the data used to exclude it
proved flawed.
CalPERS' returns could use a boost. In 2000 and 2001, the
fund lagged its peers by an average of one percentage point, according to
Wilshire Associates Inc.--a big gap, since 45% of CalPERS money is in
market-tracking index funds. Assets have shrunk from $172 billion to $149
billion. CalPERS isn't in financial danger--assets more than cover projected
liabilities. But it still has underperformed its peers by about a third of a
point this year.
CalPERS' new chief investment officer, Mark Anson,
blames demographics and market conditions--not socially responsible
investing--for the fund's underperformance. CalPERS has a riskier strategy than
many of its peers, he says, because it has a relatively young mix of
beneficiaries. That explains its bigger share of stocks--62%, vs. 59% for the
median large fund. CalPERS also puts much more of its portfolio abroad than its
peers--22%, vs. 11%.
This asset mix paid off in the 1990s. Over the past
10 years, CalPERS returned an average 9.97% a year, vs. 9.8% for its peers. But
lately its investments have been losers. Anson says the board reevaluates asset
allocation every other year--the next occasion is August. Anson won't tip his
hand, but he does say projected returns on stocks will likely come down, and so
may CalPERS' percentage of assets in stocks.
It's too soon to say how
social investing affects performance long-term. Even so, CalPERS is likely to
embrace it more strongly. Two top CalPERS board members--both moderating
influences--are leaving at yearend: Board President William D. Crist and Michael
Flaherman, who chairs the investment committee. Crist, 63, is retiring.
Flaherman says he's seeking "new challenges." The three candidates gunning to
replace Crist say they support the direction the fund is heading on social
issues. It's unclear whether there will be much balance from the executive side.
On May 15, CalPERs Chief Executive James E. Burton said that he, too, was
looking for a new job. Burton is considering an undisclosed post in the private
sector.
At a time like this, investors desperately need to see a few role
models among the major financial players. The champion of corporate governance
should smell like a rose. Instead, there's an unpleasant whiff of pork-barrel
politics rising from the board. Can anyone produce a CalPERS effect on CalPERS?