A cloud over CalPERS

A long-awaited report on corruption within the California Public Employees’ Retirement System provided new details last week on how a handful of former officials were showered with gifts by a “placement agent” representing private equity firms and a health benefits contractor. CalPERS has already tried to put the scandal behind it, and state officials have instituted numerous reforms to guard against similar abuses. Yet the report will no doubt embolden critics of public employee pensions, who have been pushing to reduce or even end them. We don’t see much connection between the alleged malfeasance of a few CalPERS officials and the financial troubles afflicting most public pension funds. But the retirement system can and should do more to make sure that the contributions by workers and taxpayers aren’t squandered.

CalPERS is the largest public pension fund in the United States, with roughly $230 billion in assets. It manages retirement plans covering more than 1.6 million current and former employees of state and local agencies and their families. As a result of the subprime mortgage meltdown, CalPERS is also underfunded by tens of billions of dollars, or about 30%. State and local governments will have to fill that hole by making larger contributions to the fund, a burden that is projected to continue for the next 30 years.

The financial situation at CalPERS improved considerably after the stock market plunge, with double-digit returns on investments bringing in more than $70 billion in gains. Over the same period, however, the retirement system has been dogged by questions about the role that placement agents — middlemen who try to raise capital for private equity firms and the like — may have played in its investments. The controversy erupted in October 2009 when CalPERS said it was investigating the fees that some firms paid agents to win business with the fund.

The main figure in the probe was a former CalPERS board member, Alfred J.R. Villalobos, who had also served briefly as deputy mayor of Los Angeles in 1993. The law firm conducting the review couldn’t compel anyone to cooperate, so it gleaned nothing from Villalobos and several other former CalPERS officials to whom he was close. Yet the investigators’ report is full of damning details about undisclosed gifts Villalobos allegedly gave to CalPERS insiders and the millions of dollars in fees they helped him collect from clients.

Significantly, the report concludes that the CalPERS investment managers weren’t swayed by the ministrations of Villalobos and his allies within CalPERS, including then-Chief Executive Federico Buenrostro Jr. and then-board member Charles Valdes. On the contrary, the investigators say the companies that used placement agents appeared to have paid them large sums for doing nothing — except, perhaps, refraining from undermining the relationships the companies already had with CalPERS.

Nevertheless, another troubling implication is that private equity funds were passing the cost of placement agents on to CalPERS in the form of higher fees or reduced earnings. The report scolds CalPERS for not using its substantial clout to extract better terms in exchange for its dollars, and for not pushing harder to base the fees it pays to investment managers on their performance. That’s an important rebuke. As with any investor, the fees CalPERS pays trim the returns its investments generate. Even small fractions of a percentage in excess fees can add up to sizable reductions in returns over time.

Civil and criminal probes into the activities of placement agents are ongoing, and a lawsuit that then-Atty. Gen. Jerry Brown filed against Villalobos last year is awaiting trial. Meanwhile, CalPERS and state lawmakers have adopted numerous safeguards in response to the scandal. These include requirements that placement agents register as lobbyists and not receive commissions for investments made by state agencies, tougher restrictions for staff members on gifts and travel, and better protections against conflicts of interest among the consultants that evaluate and manage investments for the fund. CalPERS has also persuaded some of the firms that used placement agents to reduce their fees by more than $300 million and to refrain from using agents in any future dealings with the fund.

These are laudable steps, yet the authors of the new report have rightfully called on CalPERS to do more. Tough restrictions on gifts and travel should apply to CalPERS staff and board members alike, with penalties for the gift givers. Departing CalPERS officials should be barred from moving quickly into jobs at companies that do a significant amount of business with the retirement system. (The board recently endorsed bills to impose both of these restrictions.) The fund should minimize any fees paid to investment managers that aren’t tied to the performance of those investments. It should stop doing business with firms that make it pay, directly or indirectly, for placement agents. And it should adopt policies that address the risks posed when key executives or board members sink into financial trouble personally.

With placement agents common in the financial industry, these steps might seem like an overreaction to the problems caused by a few players. But it’s essential that CalPERS be above reproach. Taxpayers have grown increasingly skeptical of public employee pensions, despite the fact that most retirees’ benefits aren’t extravagant — three-quarters receive $36,000 a year or less. If taxpayers can’t trust CalPERS’ integrity, they can’t trust its accounting either.

Just days ago, the CalPERS board rejected a recommendation by its staff to adopt slightly more modest projections of future earnings. The decision spared cash-strapped state and local governments from having to pay about $300 million more into the fund, but it could prove costly in future years if CalPERS’ investments don’t perform as well as hoped.

Sticking with the higher projections also makes the fund appear healthier than it would if lower returns were expected. That’s another reason CalPERS’ credibility matters. If lawmakers come to believe that CalPERS is in worse shape financially than it lets on, pressure will build for the kind of sweeping reductions to public employee pensions that the Little Hoover Commission recommended last month. Although underfunded state and local pension funds need to be shored up, the way forward shouldn’t be clouded by questions about CalPERS’ reliability. The retirement system has gone a long way toward fixing the problems highlighted in last week’s report, but nothing will help its credibility more than finishing the job.