A little-known ballot measure a quarter century ago, Proposition 21 in 1984, opened the door for much of the current controversy over California’s public employee pensions.
Pension funds had been required to put most of their money into bonds. The measure lifted the lid and pension funds, seeking higher yields, began shifting most of their money to stocks and other riskier investments.
Now it’s possible to look at the big problems facing public pensions and suspect that the difficulty would be smaller and more manageable, perhaps even avoided in some cases, if the funds had stayed with a conservative investment strategy based on bonds.
Here is an outline of the trouble facing public pensions, particularly the giant California Public Employees Retirement System that covers half of all non-federal government workers in the state.
Unaffordable benefits. When funds had surpluses from a booming stock market, pensions were increased to levels now said by some to be “unsustainable.” CalPERS famously told legislators a major increase for state workers, SB 400 in 1999, would leave state costs little changed for a decade. But expected investment earnings fell far short, causing a dramatic increase in state costs to $3.9 billion in the new fiscal year.
Investment losses. CalPERS investments valued at $260 billion in the fall of 2007 plunged to $160 billion in March of last year, before rebounding to about $200 billion. The losses must be covered by increased employer contributions from state and local governments. Now in an era of historic cuts in government budgets, big increases in pension costs are projected. Labor unions are being urged to agree to cut pension costs.
Hidden debt. Critics say pension funds understate the debt owed for future pensions by assuming costs will be covered by overly optimistic earnings, about 8 percent a year. CalPERS and CalSTRS may lower their earnings forecast. A proposed accounting rule change would use lower bond rates for part of the debt estimate. A Stanford study using bonds showed a state pension debt of $500 billion, not the reported $55 billion.
Scandal. A former CalPERS board member, Al Villalobos, sued by the state along with a former CalPERS chief executive, Fred Buenrostro, received more than $50 million in fees for helping private equity firms obtain CalPERS investments. CalPERS had a series of well-publicized real estate losses, including $1 billion in a failed 15,000-acre development north of Los Angeles.
The narrative would be that moving away from bonds led to surpluses, optimism that earnings could pay for higher benefits, little defense against a market crash, and a need for higher earnings that requires riskier investments.
An investment strategy based on bonds probably would provide lower benefits. That might have blunted some of the criticism of generous pensions — for example, the “$100,000 club” posted by a reform group.
But it’s the growing cost of pensions, crowding out funding for education and other basic government services, that has Gov. Arnold Schwarzenegger and others calling it a “crisis.”
The fear that costs can’t be controlled, and that the massive pension debt will continue to grow, fuels the move to switch new government hires from pensions to the 401(k)-style individual investment plans common in the private sector.
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Attorney General Jerry Brown, the Democratic candidate for governor, mentioned the change in CalPERS investment strategy twice as he announced a civil lawsuit filed in May against the former CalPERS officials, Villalobos and Buenrostro.
“CalPERS in former times operated on a more steady, slow-return, extremely safe investment,” he said, “and over the decades this has been changed to a more risk-tolerant environment. I think they are going to have to move it back to a more balanced portfolio.”
Brown attributed the change to the emergence of a “casino economy” and widespread pressure, not just on pension funds, to “earn more and more.” He later acknowledged that he had forgotten about the little-known ballot measure.
Proposition 21, approved in 1984 two years after Brown ended eight years as governor, lifted a lid that allowed only 25 percent of pension fund investments to be in blue-chip stocks.
Public pension funds like CalPERS, which began operating in 1932, were only allowed to invest in bonds in their early years. A ballot measure in 1966, Proposition 1, took the first step away from bonds.
The measure placed on the ballot, without a single “no” vote in the Legislature, was said to be needed to lift a 94-year-old prohibition against stock investments, which were being successfully used in 30 states.
Proposition 1, approved despite a ballot pamphlet argument urging voters to “stay off of this common stock bandwagon,” allowed up to 25 percent of pension fund investments to be in large-company stock that paid dividends and met other safety tests.
As the stock market began a decades-long boom, the Legislature placed a measure on the ballot, Proposition 6 in November 1982, allowing up to 60 percent of pension fund investments to be in stocks. It was rejected by 61 percent of the voters.
After a series of hearings the Legislature, with only two “no” votes, placed Proposition 21 on the June 1984 ballot to replace the 25 percent cap on stocks with a broader guide based on what a “prudent person” would do.
The “prudent person” rule was said to have worked well for private-sector pensions for a decade. Though less restrictive than the measure roundly rejected a year and a half earlier, the new version passed with 53 percent of the vote.
A joint legislative committee held five hearings on pension management leading up to Proposition 21. The legal counsel was Ian Lanoff, now fiduciary counsel for the California State Teachers Retirement System.
Lanoff had helped develop the “prudent person” rule for private-sector pensions in the Employee Retirement Income Security Act of 1974, enacted after problems in pension funds operated by the Teamsters union and others.
“I was very much in favor of what was done,” Lanoff said of Proposition 21, “and I think it has worked to the benefit of both PERS and STRS through the years.”
He said two of the most powerful legislators of that era, former Assembly Speaker Willie Brown, D-San Francisco, and the late Assembly Rules Chairman Lou Papan, D-Millbrae, pushed for Proposition 21.
In another change, the Proposition 21 campaign was chaired by Robert Carlson, the CalPERS board president, now retired. He said studies showed that investing in all asset classes yielded higher returns.
“Other funds across the U.S. had unlimited authority and some had limited authority,” he said.
Carlson said the CalPERS fund, about $32 billion in 1984, made big gains under the policy of letting laymen, acting as prudent fiduciaries with advice from experts, determine the asset classes.
He believed the change would be more successful than letting “politicians dictate” the amount that could be invested in stocks. In his view, Proposition 6 failed because it specified a percentage for stocks, rather than allowing flexibility.
The ballot pamphlet arguments for Propositions 21 and 6 were signed by former Assemblyman Larry Stirling, R-San Diego. The former city councilman said much of his motivation came from the San Diego retirement system.
He said the San Diego pension fund was getting minimal investment earnings, sometimes as little as one percent, from institutions that were loaning the money to others at a much higher rate, sometimes more than 5 percent.
Stirling said he wanted to end the profitable “arbitrage” by the lenders, get a better yield for the pension funds to aid retirees and taxpayers, and strengthen the “trust” status of pension funds to prevent raids by politicians seeking money to balance their budgets.
What he did not foresee, said Stirling, is that the financial health of the pension funds resulting from Proposition 21 would be used to approve “unsustainable” increases in pension benefits.
“You learn a lesson,” he said, “and the lesson is there is nobody enforcing the prudent man rule.”
The ballot pamphlet argument for Proposition 21 said pension trustees would be “personally liable” if they fail to exercise the care expected of a “prudent person” knowledgeable in investment matters.
“This approach recognizes that, when the duty to choose is linked to personal responsibility for the choice, the highest level of independent, professional judgment is exercised,” said the bipartisan argument signed by Stirling and Papan.
In practice, the personal liability is hedged by insurance provided by CalPERS and CalSTRS for their board members. Spokesmen for the two funds said there have been no lawsuits or legal claims alleging that board members made imprudent decisions.
The ballot pamphlet arguments against Propositions 21 and 6 were signed by Jake Petrosino, a former CalPERS board member. The opponents argued, among other things, that stocks are risky and taxpayers would have to pay for losses.
“I just know we took on Wall Street and, of course, got our brains beat out,” said Petrosino. “The whole idea was to allow them free rein to invest in anything they wanted to.”
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The use of bonds in pension funds is getting a new look in two ways — as a method for showing debt through “risk-free bonds” and as part of a strategy to manage risk and return through “liability-driven investing.”
A number of economists argue that since public pensions are guaranteed by law and virtually risk free, their debt owed for pensions promised current workers and retirees should be offset or “discounted” with the earning rate of risk-free government bonds.
Currently, public pension funds operate under accounting rules that allow the debt to be discounted with the assumed rate of earning from a diversified portfolio that includes stocks and other investments, now often about 8 percent.
What happens when the debt is calculated with the less risky and much lower earnings from government bonds, a little over 4 percent, was shown in a study done by Stanford graduate students in April.
The Stanford report said the shortfall or “unfunded liability” for the three state pension funds (CalPERS, CalSTRS and UC Retirement) was a “hidden debt” of $500 billion, not $55 billion as reported by the retirement systems.
The point of view of the economists may be getting some traction. The Governmental Accounting Standards Board asked for comment last month on a proposal to use the risk-free rate to discount public pension debt not covered by assets.
The change would increase any “unfunded liability,” presumably emphasizing the need to put more money into the pension fund. Some think the change would result in higher government pension payments, but how much is unclear.
Next week, the board of the California State Teachers Retirement System is scheduled to receive a background paper and hear a pro-and-con discussion by two experts on “liability-driven investing.”
One of the results of the flexible strategy is likely to be more investment in bonds. The CalSTRS paper notes that the strategy might “lock-in” a funding deficit and yield lower earnings.
The liability-driven strategy is said to be used by some corporate pension funds, which operate under tighter rules for valuing assets. The paper suggested the CalSTRS board might want to revisit the strategy when the system’s funding improves.
The CalSTRS funding level is 77 percent, below the 80 percent some regard as an acceptable minimum. The funding level of CalPERS also is near 80 percent, boosted by a $600 million contribution increase from the state in the new fiscal year.
Last September, CalPERS actuaries proposed a back-to-bonds pilot program in a small survivor benefit program that had a surplus. They wanted to test “immunizing” against big swings in funding levels.
The survivor program “could then be used as a model for immunization possibilities in the future should surpluses ever arise in other programs.” The CalPERS board rejected the proposal.
Reporter Ed Mendel covered the Capitol in Sacramento for nearly three decades, most recently for the San Diego Union-Tribune. More stories are at https://calpensions.com/ Posted 1 Jul 10