Can CalPERS Afford to Throw Stones?

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

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?

Corrections and Clarifications "Can CalPERS afford to throw stones?" (Finance, June 24) stated that all California Public Employees' Retirement System board members voted on investments involving money managers Ronald Burkle and Richard Wollack, except for Kathleen Connell, who abstained, and Sidney L. Abrams, who was absent. In fact, other board members were absent for one or more of the three votes. However, at least 10 of the board's 13 members participated in each vote. All three votes passed without opposition.

By Christopher Palmeri in Los Angeles

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