Teachers’ Fund Chief Making No Apologies

A poor relative 1996 performance by the $68-billion California State Teachers’ Retirement System fund has sparked a war of words between the fund’s chief investment officer and state Controller Kathleen Connell.

The CalSTRS fund’s return last year was 9.9%, versus a 12.9% return earned by its sister fund, the California Public Employees’ Retirement System, or CalPERS, and sharply below the 19.5% return of the average U.S. stock mutual fund.

Although returns for both CalSTRS and CalPERS always lag stock funds in bullish years because the pension funds own diversified portfolios that include bonds and other assets, CalSTRS’ returns have trailed key pension fund benchmarks in recent years for one major reason: CalSTRS’ investment chief, Tom Flanigan, believes that the U.S. stock market has become dangerously overvalued.

So within the leeway given him by CalSTRS’ trustees, which include Connell, Flanigan has lowered the fund’s holdings of U.S. stocks to 32.9% of total assets now, from 41.3% three years ago.

Given the spectacular returns earned in the U.S. market over the last two years, Flanigan looks like Wrong-Way Corrigan. But he is unrepentant.

“We are erring on the side of caution,” Flanigan said Tuesday. Managing a pension fund, he said, “is not a performance race,” but rather a systematic process of earning returns needed to pay current and future beneficiaries--in this case, the state’s teachers--without putting their nest egg at significant risk. “I am following a long-term, risk-averse investment policy,” he said.

That’s not how Connell sees it. “I certainly think there’s a problem when a fund underperforms as much as CalSTRS has,” the controller said Tuesday.

While lowering the giant’s investment stake in U.S. stocks, Flanigan has boosted the fund’s investment in foreign stocks, a strategy that has been followed by many other public funds in recent years, including the $108-billion CalPERS, which is the pension fund for non-teacher public employees in California.

Much more controversial is that Flanigan has maintained a heavy investment in bonds, while many other large pension funds have lowered their bond stakes in the 1990s. CalSTRS now holds 37.5% of assets in bonds, compared with 41.2% three years ago.

In contrast, the average public pension fund’s bond stake has tumbled from 39.6% in 1993 to 33.4% now, according to pension consultant Greenwich Associates.

In this decade, bonds have been been a poor investment relative to stocks, as the bull market has barreled ahead at a rate few experts foresaw in 1990.

Flanigan, who was called in to restructure CalSTRS in the mid-1980s after a scandal and has directed the fund’s investments ever since, for the most part must maintain the fund’s investments within broad ranges set by the trustees. But he also has discretion over 10% of the fund’s assets--and he has used that discretion in recent years to continue buying bonds, while shunning U.S. stocks.

That has irked Connell, who maintains that CalSTRS’ consultants have recommended an “increased exposure to equities” in their regular reviews of the fund’s investment policies, as a way to boost long-term returns. “Why didn’t we listen?” Connell asked.

But in fact, CalSTRS does have more in stocks today--50.7% of assets--than it did three years ago, when stocks accounted for 47.8% of assets. The growth, however, has been in foreign stocks, which overall have returned less than the streaking U.S. market.

Flanigan insists that lowering the U.S. stock portion of the fund’s assets has been the prudent thing to do, because he believes the U.S. market may be at “its most overvalued [level] ever.”

Connell is focusing on the money CalSTRS--and, by proxy, its beneficiaries and the state--have left on the table because of Flanigan’s conservatism. But if the U.S. market declines sharply any time soon, Flanigan will, of course, look like a hero.

If the market continues to soar, however, Flanigan’s policy will probably become impossible to defend. In any case, he may not get the chance: Connell and other CalSTRS trustees decided last year to invite other applicants for Flanigan’s job.

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Tale of Two Funds

The California State Teachers’ Retirement System, or CalSTRS, holds far less in stocks than its sister fund, the California Public Employees’ Retirement System, or CalPERS. Mainly for that reason, CalSTRS’ returns have lagged in recent years.

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Asset CalPER SCalSTRS U.S. stocks 41.8% 32.9% Foreign stocks 18.4% 17.8% Private equity 2.6% 4.5% Bonds 30.5% 37.5% Cash 1.4% 3.4% Other 5.3% 3.9%

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Data as of Dec. 31, 1996

Source: CalPERS, CalSTRS