How hard would it be to steal millions from CalPERS, the nation’s largest public pension with $320 billion in assets? Easy-peasy.Ted Siedle, the pension proctologist, is at it again, and this time he's setting his sights on CalPERS, the largest and best-known US public pension.
Yesterday the Wall Street Journal reported a disturbing fact—a fact well known to pension insiders for years. That is, officials at CalPERS do not know the full extent of the fees the pension’s private equity managers take out of the pension.
At a 2015 meeting, the chief operating investment officer openly acknowledged that no one knew the performance fees paid.
Let’s clarify what’s going on here. Presumably the mega-pension knows, or can readily establish, all the fees—asset-based and performance—it pays its money managers pursuant to fee invoices. (A breakdown of other operational fees—which can be significant—can either be gleaned from investment fund financial statements or specifically requested from managers.)
What CalPERS doesn’t know is the performance and other fees its managers take directly from the funds they manage for CalPERS without asking, disclosing or invoicing.
At the same 2015 meeting, the chief operating investment officer admitted, “We can’t track it today.”
CalPERS claims to have turned to “big data” computer models—algorithms—to understand private equity costs. Supposedly, a software program developed by outside firms determined at the end of 2015 that the pension paid $3.4 billion in performance fees over the past quarter-century to private-equity firms. In 2016, that number was said to be $490 million. Don’t believe these figures for a second.
For those who are impressed by opaque algorithms no one understands and that lack effective feedback loops to highlight deficiencies and errors, I suggest reading Cathy O’Neil’s new book, Weapons of Math Destruction.
As an expert in ferreting-out hidden, excessive and illegal investment fees, I would never recommend any pension fiduciary (and certainly not a fiduciary overseeing hundreds of billions in government workers retirement savings) rely upon an ill-defined computer model to catch criminals.
So, to re-cap the problem facing CalPERS: Private equity managers are taking billions from the pension but the pension has no idea how much. How comforting is that to pension stakeholders? You’d think that California’s largest state employee union, SEIU Local 1000 and AFSCME would be concerned about protecting the retirement assets of their members that are participants in the state pension.
Of course, if CalPERS doesn’t know how much money these private equity managers are taking out of the pension, it cannot possibly know whether the amounts taken are legitimate or wrongful—i.e., theft.
In my opinion (and based upon my experience conducting over $1 trillion of pension investigations), it is almost certain some CalPERS private equity managers are, shall we say, misappropriating assets from the retirement system. Recent SEC staff findings confirm my views.
In 2014, SEC staff found that more than half of about 400 private-equity firms it examined had charged unjustified fees and expenses without notifying investors. To be sure, CalPERS conceivably could have adroitly avoided the hoards of private equity wrongdoers but, based upon my knowledge of longstanding CalPERS due diligence lapses and monitoring weaknesses, don’t count on it. As I wrote in 2011, CalPERS involvement in an investment scheme is no assurance of integrity or a “Good Housekeeping Seal of Approval.”
CalPERS board member JJ Jelincic, who raised the issue of undisclosed fees in the 2015 board meeting mentioned earlier agrees. “We don’t know what fees our private equity managers are taking out of the pension and so we can’t possibly know whether all the fees are legitimate. When I’ve raised the issue, I’ve been told the managers are our “partners” in the funds and we should just trust them.”
I posed the following question to CalPERS today in an email: If CalPERS does not know precisely how much money private equity managers are receiving related to fund assets, how can stakeholders be assured that these managers are not wrongfully taking from the pension?
In response CalPERS said, “Our Private Equity fees are fully disclosed in our Comprehensive Annual Financial Report and in the Private Equity Annual Program Review.”
In my experience dealing with CalPERS, the board regularly claims certainty as to matters which it barely grasps. How long has CalPERS known about potential theft by its managers? At least four years.
On March 22, 2013, I sent a letter to the CalPERS board reciting my credentials (for those board members who did not already know me) and emphatically stating, “It is apparent to me, even from a distance that the fund continues to lack many of the safeguards I would recommend to improve management and performance.” I received no response to the letter.
A few months later, on May 13, 2013, I sent a second letter to board member Jelencic, as requested, providing further detail regarding issues which in my expert opinion should be investigated fully by the pension. Included in these issues were specifically “undisclosed fees related to investment providers/vendors,” and “private equity and hedge fund conflicts of interest, fee abuses and malfeasance.”
I am told that when Mr. Jelencic brought my second letter to the attention of the board at a closed meeting, the Board President responded, “How is this letter different from any of the thousands of others we receive? The suggestion to meet with me was rejected, I am told by Jelencic. CalPERS today stated, “We cannot comment on issues that are discussed in closed session.”
If it’s true that the CalPERS board regularly receives thousands of letters from forensic experts and other credible whistleblowers alleging potential wrongdoing regarding pension investments—allegations of wrongdoing which the board routinely ignores—that’s really scary. Unions protecting government workers should be alarmed that such warnings go unheeded and demand to see all such correspondence.
My advice to would-be criminals: If you want to steal millions, escape detection and prosecution, then set your sights on the mother of all pension honey-pots, CalPERS.
I agree with Ted, it's unacceptable that any large public pension investing billions in private equity can't track all fees and other costs very closely (to the penny). This is a matter of basic accounting, no need for sophisticated algorithms to track these fees (that's just ridiculous).
But CalPERS does fully disclose its private equity fees in its Comprehensive Annual Financial Report and in the Private Equity Annual Program Review.” It has to by law or else its board and senior staff can be convicted of fraud and misappropriation of funds.
What about GPs? I doubt they're doing anything remotely shady in terms of fees. It's simply not worth it for them to risk their relationship with CalPERS or a SEC fine of millions of dollars.
I believe that Ted Siedle is trying to drum up business for himself. He wants to be able to conduct a comprehensive audit on CalPERS, above and beyond the standard financial statements. If so, he should be very upfront of his intentions when writing these articles.
Siedle isn't the only one criticizing CalPERS. In her latest comment, Yves Smith (aka Susan Webber of Aurora Advisors) also attacks CalPERS for keeping its board in the dark on how private equity "subscription line financing" gooses staff and GP pay and systemic risk:
It’s remarkable to see that some private equity general partners, who above all are experts at increasing their own net worths, are concerned about a gimmick that boosts reported private equity fund returns. By contrast, limited partners like CalPERS are in “Nothing to see here” mode on the increase risks and costs, which include being forced to liquidate investments at the worst possible time to pay down these extra private equity borrowings.I will let you read the rest of Yves' comment here as it's long, self-indulgent, somewhat nauseating and very poorly researched and relies on outside experts who frankly don't have a clue of what they're talking about.
The gimmick is subscription lines of credit. They allow private equity fund managers to borrow at the level of the investment fund, in addition to the debt they heap onto the portfolio companies they buy. We had heard of them over two years ago, but didn’t write them up then because they weren’t being used all that much back then.
Yves does raise good points on transparency and the board's fiduciary duty, but there are some things she claims which are just ridiculous or plain wrong. For example, she ends her comment by stating (added emphasis is mine):
Can Costigan really be completely ignorant, say, the conflict of interest resulting from the consultants being hired by staff and therefore having incentives to keep them happy? Did he miss the entire financial crisis, in which ratings agencies gave overly rosy grades to subprime related credit vehicles because the structures were their clients? Or that ratings agencies are famously slow to issue downgrades because they want to stay on a good footing with their clients? Or that compensation consultants have managed to devise norms that result in ever-escalating pay irrespective of performance?So where did Yves go wrong in her flimsy and overly critical analysis? Well, just from the points I underlined, I can tell you she and the professor she cites are wrong.
More specifically, Professor Ludovic Phallippou of Oxford, who specializes in private equity, has pointed out how consultants and academics had been comparing private returns to that of the S&P 500 from the mid 2000s to mid 2010. In the last two years, MSCI World has become the preferred point of reference. Why? Because the S&P 500 has been doing very well over the last three years, unlike the MSCI World index. And Sam Sutton, a private equity reporter at Buyouts Magazine, told me it was intriguing to see that CalPERS’ consultant CEM Benchmarking has wound up scoring every public pension fund client he’s written about as having above average performance, which would seem to be mathematically impossible until you allow for artful selection of peer groups.
As we reported in 2015, we caught CalPERS’ private equity consultant PCA trying to implement an absolute return for CalPERS and CalSTRS, which essentially meant ignoring the risks of private equity in looking at its returns. As we explained at the time on this site and at Bloomberg, this was not completely bogus analytically and intellectually, but would also throw the idea of risk measurement out the window. No finance academic would back this approach.
The only thing that stopped this scheme from being implemented on a stealth basis was an op ed in Sacramento Bee by private equity expert Eileen Appelbaum.
Costigan is either so clueless or so inattentive that he missed this sorry episode. There was no benefit whatsoever to retirees or system health to this proposed change. The benefits would accrue solely to staff, in terms of much more favorable bonus targets and greater ability to spin CalPERS performance as adequate. Mind you, there are other examples of staff playing fast and loose with numbers, like the one we wrote up yesterday, but this one was outrageous.
Moreover, Costigan admits staff has motive to seek more pay…they make less than their peers! And then he argues that because consultants back staff recommendations, that there is nothing to worry about.
Of course, since the board sat pat when CEO Anne Stausboll gave Chief Investment Officer Ted Eliopoulos a $135,000 gift via a bonus that violated his bonus formula by paying for non-performance, perhaps Costigan has a point. Senior staff gets paid for performance whether they deliver or not, so why would they need to play games?
The switch from using the S&P 500 to using MSCI World is a reflection of the global shift in the private equity portfolio, not because the latter is easier to beat.
Second, some consultants claim that having an absolute return benchmark is in line with meeting the actuarial target rate of return. In other words, there is a logic to using absolute return benchmarks in private markets but there are risks too.
What risks? In any given year, you can substantially underperform an absolute return benchmark if markets are getting clobbered and you need to value down your PE holdings (I've seen this plenty of times). Conversely, you can significantly outperform this benchmark when markets are soaring (seen this plenty of times too).
This is why many experts prefer a public market index and spread (to reflect illiquidity risk and leverage) when trying to benchmark private equity.
In the good old days when private equity funds were killing it in terms of performance, they would easily beat the S&P 500 + 300 basis points benchmark over a very long period.
But as more and more investors shift assets into private equity, the opportunity set is much smaller, so the spread has been reduced to 150 basis point or even less over the appropriate public market stock index.
Importantly, benchmarking private market assets isn't as easy as Yves and her professors think and I'm surprised they haven't taken the time to look at the value-added these programs have created at CalPERS and elsewhere over a 10 or 20-year period.
If you read Yves' comments, you will think that CalPERS board is totally incompetent and the senior executives are pulling wool over their eyes to "goose their pay."
This is total nonsense but I blame the governance structure at these large funds. Where is California's state Treasurer? Why isn't some auditor general performing a comprehensive risk, investment, operational, and performance due diligence of CalPERS and making the findings public?
Admittedly, such a comprehensive audit requires expertise and very few firms have the resources and knowledge to complete such a huge undertaking but as long as CalPERS stays quiet, people like Yves and Ted Siedle will be all over them, claiming incompetence, negligence, and even outright fraud.
[Note: CalPERS should hire my friends over at Phocion Investments, fly them over to Sacramento for three months and let them conduct an intense audit, especially performance audit. CalPERS will never do it but trust me, it will be the best bang for their buck ever as my friends have all worked at large pensions and they really know their stuff.]
But the problems at CalPERS keep mounting and it has become a PR nightmare. J.J Jelincic, an outspoken member of the CalPERS Board of Administration is not seeking re-election, setting up a wide-open race to succeed him:
Jelincic, an eight-year incumbent and CalPERS investment officer, told the pension fund in late March that he planned to run for another term.I must say, I'm sorry to see J.J. Jelincic leave the Board as he has investment experience and asked a lot of important questions (which fell on deaf ears). More worrisome, he posted a very critical message on his website, basically saying CalPERS Board is incompetent:
But, he did not file paperwork to run by this week’s deadline. He posted a message on his website saying he would not be on the ballot.
Jelincic’s message further urged voters to press candidates for more information about CalPERS’ investment strategies. He did not return a phone call from The Bee by deadline.
“I originally ran for the CalPERS board because I thought the board was not doing its job and was too often being manipulated by staff. After eight years on the board, I can tell you it was even worse than I realized,” he wrote.
Three candidates have filed paperwork to run for Jelincic’s seat. They are State Personnel Board member Richard Costigan, state scientist David Miller, and Long Beach Unified School District member Felton Williams.
Costigan sits on the CalPERS board as an appointee from the State Personnel Board. He’s was a legislative affairs secretary and deputy chief of staff to Gov. Arnold Schwarzenegger.
He said he wanted to run for a four-year term on the CalPERS board because it would give him “more certainty” in his role on the board. His appointment from the Personnel Board must be approved every year.
Because Jelincic is not running for re-election, CalPERS is extending the candidate filing deadline for his seat. It is scheduled to close on May 30.
Michael Bilbrey, another incumbent, is seeking re-election. He’s facing challenges from Margaret Brown, the director of facilities at the Garden Grove Unified School District; Bruce Jennings, a retired legislative consultant in the Capitol; and Wisam Altowaiji, a retired city engineer for Redondo Beach.
CalPERS members will start receiving ballots for the election in September. Ballots will be counted in October.
The CalPERS board has 13 members. Some are elected by public employees and retirees, others are appointed by the governor and two are statewide elected officials.
My term ends in January 2018. I have decided not to run for re-election.After reading this, it raised my concerns that CalPERS Board isn't fulfilling its fiduciary duty. It also demonstrates why the governance at Canada's large public pensions is infinitely better than that of US public pensions. Board members at large Canadian public pensions are independent and highly qualified, they are nominated for a term and they are held accountable for these pensions.
I originally ran for the CalPERS Board because I thought the Board was not doing its job and was too often being manipulated by staff. After eight years on the Board, I can tell you it was even worse than I realized.
I have tried my best to improve the situation, and I think I have helped do that. But in the process, I have angered some senior management and fellow Board members who are invested in the status quo. It is clear to me that this Board has abdicated its responsibilities to challenge, monitor and supervise the staff.
The CalPERS Board is responsible for managing trust funds--other people’s money--but has allowed staff to fail to properly track costs. We have given staff permission to withhold information from the Board and allowed them to have exclusive control of the information given to the Board. The Board routinely rubber-stamps staff’s recommendations without examining alternatives or the implications of those decisions.
The Board recently changed asset allocations. Why? Secret! What factors were considered? Secret! What costs were evaluated? Secret! Was the impact on beneficiaries and employers considered? Secret!
Why should Board members know or care? Because they are fiduciaries who have an obligation to act “with the care, skill, prudence, and diligence under the circumstances then prevailing that a prudent person acting in a like capacity and familiar with these matters would use in the conduct of an enterprise of a like character and with like aims.” (from the California State Constitution) Would you hire someone to manage your money if they couldn’t tell you what they are doing or why? I invite you to ask any Board member to identify the investment strategy within any asset class.
A new election is coming up. Please look closely at the candidates. I encourage all of you to hold the Board to a higher standard. Demand real engagement. Demand real transparency. Demand real accountability.
I thank all of you for your support over the years.
I guarantee you that this nonsense would never fly at a board meeting at Canada's large pensions. How do I know? I've sat in on board meetings at PSP Investments when I worked there and every single board member asked good questions and was highly engaged in every aspect of that pension.
The same goes for other large Canadian pensions. The Board meetings at CalPERS are public (most, not all) and I'll give them that much, but sometimes I cringe listening to these board members and I was particularly appalled at how they treated J.J. Jelincic (see this article for more of a background).
Now, I don't know J.J. from a hole in the wall, have only exchanged one brief email with him, so I don't know everything that is going on with him and his interactions with other board members.
Dave Hart wrote a particularly nasty comment about him at the end of this article above:
It is not a sad day for Californians. J.J. went out of his way to create a wall between himself and the rest of the Board. His comments referred to in the article are assertions that are impossible to verify and are very much "Trumpian": bombastic without any backup and do nobody any good. As a CalPERS employee, he was off work at full pay for the last 8 years and very much enjoyed being the bomb-thrower. He failed to use his time in office to develop an articulate position of specifically what needed to be changed and made no attempt to find allies in or outside the CalPERS Board to make such changes. I wonder if his decision to not seek reelection coincides with his decision to retire from state service. In any case, his departure will not hurt CalPERS. J.J. had the capacity to do a lot of good, but his ego took the front row. How do I know this? I worked along side him as the chair of an allied bargaining unit for five years and got to know his good side as well as the not so good. If the the BEE is going to print an article and repeat allegations they need to do more investigation to see if there is any there.Obviously, J.J. has few friends on CalPERS's board and investment staff but I think he did his job as best as possible given the circumstances (when you're one against the rest of the board, you're basically a dead man walking).
Anyway, enough on that. In other interesting news, aiCIO reports that California Gov. Jerry Brown’s recently revised state budget proposes a $6 billion supplemental payment to CalPERS, which he says will save the state $11 billion over the next two decades:
The supplemental payment effectively doubles the state’s annual payment. It is intended to ease the effect of increasing pension contributions due to the state’s unfunded liabilities and the CalPERS Board’s recent decision to lower its assumed investment rate of return to 7% from 7.5%.Lastly, John Moorlach, a state senator, wrote a comment that was republished on USA Today, Here's why Brown's plan to prepay CalPERS is smart:
California currently has $282 billion in long‑term costs, debts, and liabilities; $279 billion are related to retirement costs of state and University of California employees, according to the revised budget.
“These retirement liabilities have grown by $51 billion in the last year alone due to poor investment returns, and the adoption of more realistic assumptions about future earnings,” said Brown in his budget.
As of June 30, 2016, CalPERS was only 65% funded, and reported unfunded liabilities of $59.5 billion. According to the revised budget, without the supplemental pension payment, the state’s contributions to CalPERS are on pace to nearly double by fiscal year 2023‑24. However, the additional $6 billion will reduce the unfunded liability, and help lower and stabilize the state’s annual contributions through 2037‑2038, assuming there are no changes to CalPERS’ actuarial assumptions.
According to the budget, contribution rates as a percent of payroll will be approximately 2.1 percentage points lower on average than the currently scheduled rates. For example, peak rates would drop from 38.4% to 35.7% for state miscellaneous (non‑safety) workers, and peak rates would drop from 69 percent to 63.9 percent for CHP officers.
The funding for the supplemental payment will be paid through a loan from the Surplus Money Investment Fund. Although the loan will incur interest costs of approximately $1 billion over the life of the loan, actuarial calculations indicate that the additional pension payment will lead to net savings of $11 billion over the next 20 years.
For 2017‑18, the state’s contribution to CalPERS is estimated at $5.8 billion ($3.4 billion General Fund). Without the supplemental payment, Brown says that the state’s contribution is estimated to reach $9.2 billion by 2023‑24, due to anticipated payroll growth, and the lower assumed rate of return. However, with the supplemental payment, the state’s 2023‑24 pension costs are projected to be $8.6 billion.
Gov. Brown wants to prepay the California Public Employees Retirement System with $6 billion beyond what most had expected.Excellent comment and I agree with his views on the contribution prepayment but fear markets will tank in the near future and this will throw a wrench in this proposal.
The source of the funds is the Surplus Money Investment Fund. Don’t ask me why a state with a $169 billion unrestricted net deficit has some $50 billion in a low interest bearing account with such an odd title. Perhaps the University of California Chancellor can explain how her system and the state can better pull these things off?
Also, don’t ask me why the timing is so odd. The Legislature just approved an annual $5.2 billion gas and auto tax increase, and now the governor has $6 billion for non-road repair expenditures?
Despite these concerns and anxieties, I like the proposal. It’s about time that the governor got serious about the state’s spiraling unfunded defined benefit liabilities, but, I would postulate that this proposal needs a little more sizzle to make it an even more interesting opportunity.
Let’s address the cash flow components of this idea. The state currently has funds that are earning less than 1 percent per year. Paying down a 7.5 percent loan would provide a bigger bang for the buck. The spread of more than 6.5 percent will provide significant savings to the state’s general fund.
It’s true that whatever is deposited into a defined benefit pension plan by a plan sponsor is irretrievable. That is, it’s not a loan to CalPERS, it’s a payment. Once it goes in, the state cannot ask for it back. But, this will be a prepayment. Consequently, should the state have a cash flow emergency, it could simply stop making the regularly scheduled payments into CalPERS and slowly accumulate back this advancement.
The upside? The state gets to pay down its liabilities sooner, which will have the potential of reducing the annual required contributions in future years. The state obtains the 6.5 percent spread in savings. CalPERS can allocate the funding to meet its own cash flow needs and reduce transaction costs by doing it in bulk. The state wins. The taxpayers will win. And CalPERS wins.
What could go wrong? Ask former New Jersey Gov. Christine Todd Whitman. In 1997, she issued $3.4 billion in pension obligation bonds. This is a risky technique that converts a soft debt to the pension system into a hard debt to bondholders.
The idea is similar to Brown’s proposal, in that the cost of the money is cheaper than the current 7.5 percent investment assumption rate of the plan. In the late 1990s, this may have been a brilliant move. But, when the “dot.com” boom turned to bust, pension plans lost a significant amount of plan funds invested in the internet-related industries.
The big risk the governor will have to face is the possibility that the investment markets may tank after making the contribution prepayment. Remember, if you lose 50 percent on your investments this year, you have to earn 100 percent next year just to break even on your principal.
It’s not a good idea to time the market. It’s better to dollar-cost average, which means investing the same amount at regular intervals over time.
We cannot see the future. It’s obvious that CalPERS cannot, based on its recent repositioning out of certain equity markets last September, which has cost it more than $900 million in lost appreciation.
Had Brown recommended this prepayment move last year, he would be a hero right now.
To make the proposal more interesting, Brown should ask the Board of CalPERS what type of incentive it will give the state for the prepayment. CalPERS will benefit from the large influx and should provide at least a 3.75 percent reduction on the actuarially calculated required contribution. This would provide a $225 million savings to the state, using the $6 billion figure, thus providing some sizzle.
Investing is not difficult, but it is also not for the faint of heart. You have to live with your decisions. Trust me, I managed a $7 billion portfolio and sat on the board of one of the nation’s largest public employee pension systems.
While serving as the Treasurer of Orange County, I assisted in constructing a prepayment vehicle for the pension system. Instead of 26 regular payments during the year on biweekly pay days, the county paid the full amount up front, less the negotiated incentive. The county borrowed the funds, at an interest rate lower than the investment assumption rate of the retirement system and has realized some $100 million in net present value savings over the last 11 years.
How did the county do with its investments over this time period, with the change in the regular payment intervals? It actually out-performed what would have occurred under the normal protocol.
We should always remember that past performance is not an assurance that future performance will be the same or better. But, prepaying CalPERS’s massive obligations is something that should be strongly encouraged. Pension plan debt is an expensive liability in the current low-interest rate environment. Consequently, public employee retirement stakeholders should enter into a good debate on this proposal.
Below, I embedded Part 1 of CalPERS's recent Investment Committee. You can view all five parts here. As always, if you have anything to add, feel free to reach me at LKolivakis@gmail.com.