Real estate decline hits pension system

Getting a handle on real estate investments has to be one of the first orders of business for Anne Stausboll, the new chief executive officer of the California Public Employee Retirement System.

Already reeling from stock market losses, CalPERS also has experienced steep declines in the value of its real estate holdings. As a recent front- page article in The Wall Street Journal detailed, CalPERS made aggressive investments in real estate at the worst possible time, when inflated property values were at their height. CalPERS officials have said they expect to report paper losses of 103 percent on the pension fund's housing investments in the fiscal year that ended June 30. The losses could be even higher.

Pension fund officials blame the losses on an unprecedented slide in housing values that caught them, other big institutional investors and ordinary home buyers by surprise. But CalPERS continued making heavy investments in housing as late as mid-2007, when the market already had begun to soften.

Unlike most pension funds, it invested not just its own capital, but large amounts of borrowed funds, too. Borrowed money increases returns in an up market, but magnifies losses when the market falls.

CalPERS officials say they have conducted a thorough reassessment of their real estate investment strategy and have taken steps to improve oversight. According to The Journal, fund officials are considering reducing the amount of borrowed money that can be used in housing deals and cutting back on loan guarantees.

Real estate represents only 11.2 percent of CalPERS' portfolio. The housing portion of the pension fund's real estate holdings is a fraction of that. But the real estate losses have come on top of a precipitous stock market decline: CalPERS stock holdings have lost 41 percent of their value this year.

The overall value of the pension fund has dropped $54 billion, down from its peak of $260 billion in October 2007 to $186 billion last week.

The size of the losses almost ensures CalPERS will raise employer contribution rates. Fund officials have already warned state and local governments that if markets don't recover by June, they may be hit with pension-fee increases of 2 percent to 5 percent of payroll beginning as early as 2010. That will be a heavy burden for government to bear.

While CalPERS can be faulted for what, in hindsight, appears to be imprudent real estate investment decisions, state and local elected officials must assume some part of the responsibility for the fund's predicament.

In recent years, as we have frequently noted, cities, counties, special districts and the state have approved lavish retirement benefits. While markets were hot, that worked out fine. But with investment returns faltering, the burden of paying for those benefits is shifting to government employers and ultimately to taxpayers. With revenues falling, it will be very difficult for governments to pay those higher pension contributions without cutting services or laying off workers.

In the short term, governments have no choice but to pay increased pension contributions. In the long run, the state and cities and counties will have to reduce retirement benefits for new workers.