Few state governments are as in as much fiscal trouble as California’s, so it’s not surprising that few state pension funds have been as mismanaged as the California Public Employee Retirement System (CalPERS). But worse than that, CalPERS — along with its sister fund, the California State Teachers’ Retirement System — has led the nation in implementing shoddy investment and management practices that have exacerbated led to billions of dollars in losses and foregone revenue.
Now, as policy makers in other states consider ways to address their own pension deficits, CalPERS — the nation’s largest pension fund, with about $230 billion in assets under management — offers an example of exactly what not to do. They would do well to read “The Pension Fund that Ate California,” Steven Malanga’s article on the fund in the current issue of City Journal. Malanga, a senior fellow at the Manhattan Institute, recounts CalPERS’ history — which can be characterized as a fall from fiscal rectitude that only seems to get worse.
Even worse yet, CalPERS actively lobbied state lawmakers to implement many of the risky practices that have spelled so much trouble for it.
“When California’s government-employee pension system was established in 1932, it was a model of restraint,” writes Malanga. “With the 1929 stock-market crash in mind, California opted for a cautious investment approach, allowing the fund to buy only safe federal Treasury bonds and state municipal bonds.” That strategy worked while it lasted, but it began to unravel with the rise of unionization among government workers.
Then came the late sixties, a time of rapidly growing public-sector union power. In 1968, the California state legislature added one of the most expensive of all retirement perks, annual cost-of-living adjustments, to CalPERS pensions. Other enhancements followed quickly, including, in 1970, a far more generous pension formula: a worker’s pension was calculated from 2 percent, not 1.43 percent, of his average final salary, and he could start getting his pension at 60, rather than 65.
More generous benefits in turn led to riskier investment strategies.
As benefits increased, so did pressure to pay for them by boosting CalPERS’s investment returns. The shift started in 1966 when voters approved Proposition 1, a measure, promoted by CalPERS, that let it invest up to 25 percent of its portfolio in stocks. The timing wasn’t ideal, since the long economic stagnation of the late sixties and seventies had left equity markets struggling for gains. But by the early eighties, markets were roaring again, and CalPERS asked for permission to invest up to 60 percent of its portfolio in stocks. Voters rejected that ballot initiative but approved another, Proposition 21, in 1984, which likewise let CalPERS expand its investments —and didn’t specify a percentage limit.
Things got even worse in the 1990s. A 1991 reform that closed the pension fund to new employees was undone by the legislature only eight years later.
In 1999, the fund’s board concocted an astonishing proposal that would take all the post-1991 state employees and retroactively put them in the older, more expensive pension system. The initiative went still further, lowering the retirement age for all state workers and sweetening the pension formula for police and firefighters even more. Public-safety workers could potentially retire at 50 with 90 percent of their salaries, and other government workers at 55 with 60 percent of their salaries.
CalPERS wrote the legislation for these changes and then persuaded lawmakers to pass it.
Then there are the accounting gimmicks so brazen that they border on insane.
Typically, to protect governments from violent swings in contributions every year, pension funds like CalPERS average their investment returns over three years, hoping that good years offset bad years. In 2005, CalPERS extended the performance average to 15 years, an extraordinarily long period that blended the fund’s losses in the 2000s with its gains way back in the 1990s—thus reducing state and local governments’ immediate costs, which remained overwhelming nevertheless.
CalPERS’ desperate search for yield led to riskier investments, which led to cash flow problems, which in turn led to the sale of assets that could have yielded gains if they hadn’t needed to be shed due to lack of liquidity. An egregious example is CalPERS’ sale of Apple shares following huge losses in real estate.
The decline in property values also squeezed CalPERS’s cash flow, forcing the fund to sell off weakened stocks “at exactly the wrong time,” concludes a study by Andrew Ang, a professor at Columbia University’s business school, and Knut Kjaer, an investment manager. Their paper on CalPERS’s panic selling in 2008 notes that the cash-hungry fund sold 2.3 million shares of Apple Inc. for $370 million; those shares would be worth nearly $1.5 billion today.
What can other states learn from all this? Plenty.
States that wish to continue providing defined benefit pensions should make the costs of such plans clear to taxpayers by focusing on low-risk conservative investments that reflect the obligatory nature of pension obligations. In many cases, that would require states to increase their contributions. Given politicians’ proclivity to spend public resources on the present rather than on future obligations, that would be difficult to achieve.
Another common politically-driven temptation is to use surpluses, which usually result from higher tax collections during economic boom times, to increase benefits, rather than to build up reserves. When economic growth stalls, those increased benefits mean greater liabilities.
A better solution would be to move — gradually, if necessary — government employees to defined contribution systems like 401(k) accounts, which today are commonplace in the private sector.
For more on labor policy, see workplacechoice.org.