As the nation’s largest state-based pension fund, the California Public Employees’ Retirement System is known for using its massive investment muscle to promote various social-investment causes. So-called ESGs – environmental, social and governance issues – are a major theme for CalPERS, as it promotes broader board diversity, moves away from global-warming-creating carbon-intensive industries and invests more in women-owned and minority-owned businesses, among many other values-oriented priorities.

Advocates for these types of investments often argue that it’s good business to focus more on “socially responsible” companies or to divest from others, but an ongoing debate at CalPERS suggests that isn’t always necessarily true. For months, CalPERS’ top investment officials have been setting the stage for a vote in the investment committee Monday. They proposed ending CalPERS’ 16-year policy of divesting from tobacco stocks – a decision that analysts say has cost the underfunded system as much as $3 billion over the years, as tobacco stocks have soared.

But in a 9-3 vote, the investment committee decided not only to maintain its current ban on tobacco investments, but to expand it further. As the Sacramento Bee reported, the committee’s vote is final because it includes all members of the governing board.

CalPERS depicted its original divestment decision as a financial, rather than social, one and committee members made the same point Monday.

In 2000, tobacco companies were facing lawsuits. But as the Wall Street Journal reported in April: “The MSCI World Tobacco index returned more than 309 percent in total returns over the decade from 2005 to 2015, compared with 172 percent total returns for the broader MSCI World consumer staples index, according to FactSet.” And Monday, the committee also argued that tobacco investments still have long-term risks, despite the recent tobacco-stock performance.

Yet despite the financial justifications, there’s always been a strong social element about the divestment strategy. The latest remarks from top state officials and editorial boards make clear that the tobacco-divestment issue is a social matter as much as a financial-performance-related one.

“Not only is this a predatory out-of-state industry whose child-baiting marketing tactics are disgraceful, but its product is responsible for more than $13 billion in annual health care costs,” Lt. Gov. Gavin Newsom said in a statement after CalPERS announced a reconsideration of its policy. “Taxpayers will be forced to pick up part of that tab, including CalPERS’ own retiree health benefits. We cannot sell our soul for profit. Investing in death for a return is inexcusable.”

Treasurer John Chiang argued that CalPERS never totally divested from tobacco stocks anyway. “It is time to end the charade that somehow CalPERS stopped investing in tobacco companies more than a decade ago. Our external managers currently have plowed a sizable $547 million in tobacco-related funds, according to the latest CalPERS staff estimates,” he said. Chiang called for CalPERS to divest from its indirect tobacco-related investments, too.

And the Los Angeles Times editorial board Monday made clear just how much this fight is about social issues, rather than financial ones: “Divestment is a difficult call for governmental pension funds. They have a clear fiduciary duty to maximize the returns on their members’ investments. But in our view, these public agencies also have a responsibility not to support evil, corrupt or destructive forces whose ill effects far outweigh any good they may do. That can take the form of products, like tobacco and firearms, or regimes.”

Those who testified at the committee also made similar social-oriented points. They won the day, as the committee voted to divest of its remaining $547 million in tobacco-related investments – ones invested by outside managers.

Not surprisingly, it’s been CalPERS’ investment staff that has focused more on financial returns. The committee’s investment agenda for its Monday meeting detailed three options. It could have removed all tobacco-investment restrictions. It could have expanded the divestment beyond the current restrictions – i.e., also restrict tobacco investments from externally managed portfolios. Or it could have left the current approach of divestment from internally managed portfolios. It chose option two.

“Divestment, as an active investment decision, represents a form of active risk taking that must be considered, first and foremost, within the context of the CalPERS Board of Administration’s fiduciary duty,” according to the staff report’s executive summary. “As a mature, cash-flow negative system, CalPERS is obligated to seek out and implement the portfolio construction methods that best serve our mission – the sustainable delivery of promised benefits. In efficient markets, however, limiting the opportunity set for investments has generally been shown to have a detrimental effect on performance, and CalPERS’ experience with its tobacco investment restrictions over the past 15 years has been no exception to the general rule.”

As CalPERS investment officials explained in public presentations to its board last month, as a public pension fund managing the assets of the state’s government employees, the agency’s prime responsibility to assure that it makes the best-possible investments to assure that it fulfills its pension promises to current and future retirees.

It’s worth reviewing the basics of how these pension funds operate. Typically, in the private sector, employees receive defined-contribution plans, such as 401(k)s. The employee has some money deducted from the paycheck and invested in mutual funds. Sometimes the employer also contributes a portion. If the investments do well, the employee retires with more money. If they don’t, the employee has to make do with less.

By contrast, government employees at the state and municipal level typically receive a defined-benefit plan, in which the government agency promises a set pension benefit based on a formula. The government employer pays a large share, with the employee also typically having money deducted from wages to go toward the benefit. The pension fund invests those dollars. No matter what, the employee still receives the promised amount. If investments go sour, the size of the unfunded liabilities, or debt, grows and taxpayers are required to pick up the slack.

Given the potential impact on government budgets, these investment issues take on a highly political tone. CalPERS’ investment returns have been dismal in the past year, which creates pressure to reduce pension benefits or hike investment returns. With the former a non-starter in the current political environment, the latter becomes the subject of intense scrutiny. That’s what we’re seeing with the current debate in the CalPERS investment committee.

CalPERS staff had been leading the charge to a) further lower expected rates of return based on those disappointing recent results and predictions of a continued tough road ahead; and b) try to boost return rates by allowing staff to reinvest in soaring tobacco stocks. But the state Legislature apparently hasn’t gotten this message.

New legislation would call for CalPERS and the California State Teachers’ Retirement System to divest any holdings from a North Dakota oil pipeline that has been the source of protest by Native Americans and environmental activists. Certainly, any such divestments would mean little in an investment portfolio (in both funds) valued at $450 billion. But the Legislature is showing its desire to continue a push for more investment decisions based on social concerns, rather than strictly financial ones.

That’s always a risk in publicly controlled systems. That’s a tension that will continue, although Monday’s vote shows that CalPERS isn’t likely to soon abandon its current approach even in the face of mounting fiscal problems.


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