CalPERS mulls ending tobacco investment ban

CalPERS has missed out on as much as $3 billion in investment gains since the nation's largest defined benefit plan shed its tobacco holdings, as that industry powered ahead, a recent report from its consultant states.

That has the California Public Employees' Retirement System weighing whether to take up the habit again. Members of its investment committee on April 18 are expected to consider a plan that could allow the $291.2 billion system to reinvest in tobacco company stocks and other sectors that had been culled from its portfolio.

The potential reinvestment plan follows a report by CalPERS' general consultant, Wilshire Associates, Santa Monica, Calif., that said excluding tobacco stocks has cost the retirement system as much as $3.037 billion in combined investment gains between 2001, when the stocks were first removed from the portfolio, and the end of 2014. Like retirement systems nationwide, CalPERS is under growing pressure to capture investment gains as low interest rates bite into returns and an aging population increases demands for benefits.

Reinvesting in tobacco stocks, however, could touch off a firestorm, particularly because Sacramento-based CalPERS also is a major provider of health-care benefits. That could open the retirement system to criticism it is attempting to enhance investment gains while supporting products that endanger its participants.

“It would be like one part of the state throwing gasoline on a fire, while the rest of the state is trying to put it out,” said Stanton A. Glantz, a medical school professor who is director of the Center for Tobacco Control Research and Education at the University of California, San Francisco.

Mr. Glantz said reinvesting in tobacco stocks would fly in the face of California state policy to reduce tobacco consumption.

In explaining their thinking, CalPERS officials said the pension trust is separate from the system's role in buying or administering health insurance, and that they need to ensure they can pay retirement benefits.

“In my mind, in our belief statement and in our California Constitution, our obligation as the investment office is to consider what is in the best fiduciary interests of our beneficiaries,” CalPERS Chief Investment Officer Theodore “Ted” Eliopoulos said.

CalPERS' funding ratio is 76.3%, and in the fiscal year ended June 30, the retirement system posted a 2.4% return, 510 basis points below its assumed 7.5% rate of return.

Top officials of the pension plan are aware of the potential for controversy. At a March meeting, they discussed implementing a media plan to address criticism if the investment committee were to approve a tobacco reinvestment plan.

Henry Jones, chairman of CalPERS' investment committee, said in an interview that the system's investment staff is drafting a resolution for presentation at the committee's April 18 meeting that would offer several choices as to how to proceed with reinvestment of excluded sectors.

One approach would allow the investment committee to review individual divestments separately, including tobacco, companies that invest in Iran or Sudan, or firearm manufacturers. The committee would then vote to reinvest or continue excluding those stocks. (While excluding companies that invest in Iran and Sudan was mandated by the Legislature, CalPERS can reinvest if it shows that such divestments are not in its fiduciary interest.)

Another option discussed at the investment committee's March meeting would require reinvestment in tobacco stocks should CalPERS miss out on investment gains of at least $750 million over 12 consecutive quarters.

In another approach, if cumulative missed investment gains reached $2.5 billion for all divested stock categories, even if it were for only one quarter, that also would trigger reinvestments in every excluded category.

The $750 million provision also would apply to other exclusions, such as firearms manufacturers and companies that invest in Iran/Sudan. But lost investment gains from those sectors are less than $65 million since 2011, making reinvestment unlikely in the near future.

Past investment opportunity losses, however, wouldn't be counted under the proposal; the clock would be reset to July 1, 2016.

Tobacco stocks have performed well over the last two decades.

In the 20-year period ended Dec. 31, U.S. tobacco companies returned an annualized 15.31% vs. 8.09% for the S&P 500 index, according to Pensions & Investments research.

At the time of CalPERS' tobacco divestment decision, in October 2000, the tobacco industry faced legal settlements that were expected to harm profitability. Despite settlements that cost the industry billions of dollars, it has prospered.

Gross margins of tobacco companies are in the 50% to 60% range and investors view the stocks as safe bets, said Jack Kelly, an analyst with Edward D. Jones & Co. in St. Louis. “The companies have unlimited pricing power because the addicted consumer wants their product,” he said.

Mr. Jones said the reinvestment provisions are surfacing as part of a multiyear review of CalPERS' investment guidelines and policies.

He added that excluding such stocks from the CalPERS portfolio means the retirement system can't engage with the companies, contrary to its environmental, social and governance policy.

“We believe strongly we need to have a place at the table to influence those companies to act responsibly,” he said.

The CalPERS board appears split on the issue of reinvesting in tobacco stocks.

Board member J.J. Jelincic said he wants to reinvest in tobacco stocks, but having a threshold requiring CalPERS to wait longer to show it is missing out on major investment gains makes little sense because the retirement system would continue to lose money.

“We ought to just deal with this,” he said, advocating for the investment committee to reintroduce tobacco stocks into CalPERS' investment portfolio as soon as possible.

California State Controller Betty Yee, also a CalPERS board member, said she is concerned about the missed investment gains, but “it's incongruent to put our money back into tobacco,” she said. “It runs counter to the health and welfare of CalPERS members.”

Mr. Eliopoulos declined to say which reinvestment approach he favors, but said, “it's a good idea to review the various divestments and to make a determination on a regular basis as to whether it is appropriate and good for the fund.”

If CalPERS were to reinvest in tobacco stocks or other excluded stock categories, “it would be highly unique,” said Keith Brainard, research director of the National Association of State Retirement Administrators, based in Austin, Texas.

Mr. Brainard said divestment of tobacco stocks among public plans has not been widespread.

Institutional investors that have divested from tobacco stocks include Harvard Management Co., Stanford Management Co., the New York City Retirement Systems, the University of California Regents and the California State Teachers' Retirement System, according to a Pensions & Investments review.

California State Teachers' Retirement System Chief Investment Officer Christopher J. Ailman, in an interview, said he continues to oppose divestment of tobacco stocks and other sectors, because it cuts into investment gains.

But he said the system's investment committee is not expected to revisit the tobacco exclusion issue. He said the investment committee had determined that owning tobacco stocks violate the fund's risk factors, given that tobacco is harmful to humans.

CalSTRS divested tobacco stocks from its index strategies in 2000. External equity managers were allowed to invest in tobacco stocks until the end of 2009.

A November 2014 CalSTRS report estimated that since the $178.7 billion retirement system fully divested from tobacco, and firearms in 2013, the pension fund has underperformed its custom benchmark by about $772 million compared with an index that included those stocks.

Harvard University was one of the first institutional investors to divest of tobacco in 1990. In a statement, Harvard spokesman Jeff Neal said the decision was motivated by the inability of the university to address the ethical responsibilities associated with tobacco sales and “the desire not to be associated as a shareholder with companies engaged in significant sales of products that create a substantial and unjustified risk of harm to human health.”

Harvard's ban on investing in tobacco stocks remains in effect.