Although it rarely comes up in mainstream financial media there is an enormous problem in the US with underfunded public pension funds. Unless this problem is addressed, it will have a serious impact on millions of pensioners and on the overall economy. Politicians will inevitably cut benefits which they will perceive is the only avenue open to them.

The California Public Employees Retirement System (CalPERS) is by far the largest pension fund at $326 billion. CalPERS provides pension and medical benefits for approximately 1.9 million state and municipal employees and retired employees in California.

CalPERS’ investment record can be described as lousy. By January 2009 before the financial markets had even bottomed out, its assets had declined in value by almost 30% from the preceding year and a half.  A lot of people saw the bubble rising before 2008. What was CalPERS thinking?

At that time the fund had about 65% of the dollars needed to pay the benefits it was obligated to pay. By June 2016 it was funded at almost 77%.  The fund posted an 11.2% return for 2016-2017 and is projecting an 8.7% return for its fiscal year 2017-2018.  Still, today it estimates that it is back to having $70 for every $100 it will eventually pay out. This is in the midst of a raging bull market when the DJIA more than doubled.

The fund needs to do a lot better if it is going to keep up with the pension demands of an increasing number of retirees who are living longer and increased medical and pharmaceutical costs for its aging population. Understanding why this happened is the first step to fixing it.

I do not want to mince words. The problem is that CalPERS is managed by a bloated bureaucracy of state employees and overseen by a board made up of largely incompetent political hacks.  In many ways just hiring professional managers would go a long way to solving the problems.  (No I do not expect this article will lead to a lucrative consulting contract. Telling the truth rarely does.)

Part of the problem can be attributed to the diversification policy being used. You cannot invest over $300 billion in just a handful of stocks but diversification for the sake of diversification is not the answer either.

In its last annual report, the fund reported that it held more than 1 million shares each of Chevron and Disney. Both are solid, blue chip, dividend paying California based companies.  No one would suggest either is a bad long term investment.

At the same time the fund owns hundreds of other equities, some well know and many not so well known.  Most pay no dividends. In more than a few cases the fund held only a few thousand shares of some of these companies. For a fund this size to own 5000 shares of small companies hoping that their price will increase $5 or $10 it is not worth the cost of a cadre of analysts to follow them.

CalPERS employs about 400 analysts all of whom are state employees and most will get a pension when they retire.  While they are not the most expensive analysts in the world (and they do not have to be) neither are they Wall Street’s best and brightest.

The portfolio also contains bonds issued by foreign companies and foreign governments.  There is nothing wrong with that, per se, but do we really need CalPERS to employ analysts to follow the economies of Chile, Germany and France?

Suggestion No. 1:  CalPERS could consolidate its portfolio a little, do away with smaller positions and foreign offerings and lay off a few analysts. There are individuals teaching economics and finance on the faculties of UCLA, Berkley and other state schools who are already employed by the state and who already get a state pension.  A blue ribbon panel composed of some of these individuals to help CalPERS see where the economy and the markets are going might help CalPERS avoid a substantial loss when the markets get ready to correct again (like now).

But that is just a start.

CalPERS seems to have a love /hate relationship with hedge funds and private equity managers.  In 2014 it announced that was going to begin severing relationships with its private equity and hedge funds, citing the high cost associated with these private managers. At the time these funds represented about 10% of its total portfolio — including $4 billion of hedge funds and $31 billion of private equity.

A year later, CalPERS disclosed that it still paid $700 million in performance fees to private equity firms and that it had paid a whopping $3.4 billion in fees since 1990. CalPERS justified the fees by pointing to the $34 billion in profits it made from these funds in the same period. Despite its promise to cut down on private equity funds, the fund was still invested in more than 280 funds at the end June 2015. In its most recent annual report, CalPERS cites the private equity funds as the most profitable segment of its portfolio.

Suggestion No.2 If CalPERS is considering investing a few hundred million dollars in a private equity fund, shouldn’t the fees be negotiable? Perhaps the legislature should step in and cap the fees that can be paid to a hedge fund or private equity manager.  No one can suggest that any private equity firm is going to say no to an investment of that size and the savings would go right to CalPERS’ bottom line.

Perhaps nothing points to the foolish way in which CalPERS invests its money than its history of real estate blunders. CalPERS invested almost $1 billion with home developer Lennar and lost most of it when Lennar went bankrupt. It invested and lost $500 million in Stuyvesant Town, a complex of 56 buildings with 11,000 rental units near the East River in Manhattan.  CalPERS response to this loss was to get back into the NYC real estate market and invest more than $300 million in 787 Fifth Avenue, reported to be the most expensive office building in Manhattan at the time.  Does CalPERS really need to invest in NYC real estate?

Suggestion No, 3.  There is a significant shortage of affordable housing in California. In Silicon Valley there are stories of police and firefighters living in RVs and trailers and school teachers living in their cars. Many of those people pay into CalPERS. CalPERS should consider funding at least 100,000 units (and perhaps a lot more) of affordable housing around the state. That will not really put a dent in the problem but it would be an excellent start.

In addition to the benefit from the construction jobs and the housing for people who need it, it should be obvious that people without a permanent place to live do not buy furniture and appliances.  Creating these permanent communities would certainly boost the sales tax revenue that the counties and municipalities are collecting. A population boost of 5-10,000 people in some smaller counties might create the need to hire more teachers and police who would pay into the CalPERS fund for decades.

More importantly, CalPERS could hold the mortgages on these properties and collect 5% and possibly more on its investment for 25-30 years.  I would think this is a more attractive investment than a bond issued by a foreign corporation even if the bond is rated triple AAA.  It certainly makes more sense than investing in high end office buildings whose tenants will move out when the market tanks.  Low end affordable housing is not sexy but the tenants tend to pay the rent in good markets and bad.

CalPERS also provides medical benefits for about 1.6 million current and retired state and municipal employees.  CalPERS does not break out the costs but it is obvious the skyrocketing costs for prescription drugs must be substantial and probably growing faster than the any other outlay.

Suggestion No.4. Instead of buying generic drugs for plan members, buy a generic drug manufacturer. CalPERS certainly has the money to own or joint venture with an FDA approved manufacturer to produce a lot of the pills it doles out every month.  One or two manufacturing facilities could make 10 or more of the top 20 generic prescriptions and mail them directly to plan beneficiaries who need them. This cuts out the manufacturer’s profit and the profit of at least one middleman. If one half of its plan participants get one prescription per month at a savings of $10 it could bring close to $100 million per year to CalPERS’ bottom line and that is probably conservative. I suspect that Kaiser or one of the other healthcare plans might be willing to take excess production or jump on the chance to invest as well.

People are always telling me that my blog articles expose problems and scams but that I rarely offer solutions or suggestions. At least when I expose a scam some people might not invest and thus not get hurt. The odds of anyone at CalPERS actually reading this are very slim, but who knows, it might actually resonate with someone who matters.