The corporate form of business organization is critical to continued economic development and job creation throughout the world.¹ To be successful in an increasingly competitive economy, stay abreast of technological change and accomplish normal growth, corporations need reliable and affordable sources of capital funds. This paper will discuss the increasing importance of pension funds as a source of this capital, and the way in which one US fund – the California Public Employees' Retirement System (CalPERS) – makes decisions regarding allocation of its capital to markets around the globe.

Today, US pension funds control financial assets of more than $6.7 trillion, an increase of almost 45% since 1994.² Retirement systems that provide benefits to state and local government employees (known as "public pension funds") control over one-third of these assets, or $2.4 trillion.³

US investors hold over $432 billion in non-US equities, with the largest twenty-five US pension funds holding $181.1 billion of that amount.⁴ While general US investments in foreign markets has increased a relatively modest 10% since 1996, the US pension fund share of these foreign investments is increasing more dramatically (from 28% of the total US held foreign equity in 1996 to 42% by the third quarter of 1998).⁵ Experts project that US pension fund assets will grow by 6% over the next five years, contributing to probable continued increases in cross-border capital commitments.⁶

Pension fund trustees and professional administrators must stay focused on the long term. Funded retirement systems exist as multi-generational entities with liabilities that extend 40, 50 and even more years into the future. Pension fund investment strategies tend to reflect this very long-term viewpoint. For example, as measured by turnover rates⁷, pension funds – and most particularly public pension funds – generally hold their equity investments significantly longer than other types of US investors.⁸

These data indicate the growing importance of US public funds as a reliable source of patient capital, now and into the future. As discussed below, the CalPERS Board of Administration and the System's professional administrators are fully aware of the relationship between the long-term liabilities of the fund they administer and the importance of the capital funds they provide to a competitive global economy.

With assets valued at over $150 billion, CalPERS is the largest pension fund in the United States.⁹ CalPERS has achieved double-digit returns for six of the last seven years. For the past three-year period (ending 5/31/99), CalPERS earned 16.3% on its investments; for the five-year period (also ending 5/31/99), the fund earned 15.8%.¹⁰

CalPERS mission is to ensure the retirement and health security of its over one million members.¹¹ As a defined benefits system, CalPERS' assets are directly tied to the benefits that must be paid to these members, and their survivors, over their lifetimes. Based on the expected aging of the population, and the impact of this global issue on CalPERS in particular, the current $150 billion in assets approximates the amount, as measured and forecast at this moment, that is needed to meet CalPERS' future benefit liabilities.¹²

One of the responsibilities of the CalPERS Board of Administration is to determine how the trust fund is to be allocated for investment among various possible asset classes.¹³ Asset allocation is the most important element of CalPERS investment strategy, and is never made in isolation. This critical decision must be made – and periodically revisited – with full view of the System's future stream of liabilities, employer and employee contributions to the fund, and estimated future operating costs. The Board's goal is to maximize returns at a prudent level of risk – an ever-changing balancing act between market volatility and long-term goals.¹⁴

CalPERS follows a strategic asset allocation policy that identifies the percentage of the System's funds to be invested in each asset class. Policy targets are typically implemented over a period of several years on market declines and through dollar cost averaging.¹⁵ CalPERS current asset allocation mix¹⁶ by market value and policy target percentages is shown below:

CalPERS commitment to non-US markets began in 1986 with a 10% allocation (to both international equities and fixed income). This commitment has steadily increased so that, as demonstrated above, 20% of CalPERS fund is currently targeted for allocation to non-US equity markets and 4% to non-US debt markets.¹⁷ In the Board's view, investments outside of the US are critical to obtain both diversification and increased returns.¹⁸

To date, all of CalPERS international investments have been managed by outside firms hired by CalPERS for this purpose. These managers are selected based upon their style (e.g., passive vs. active, growth vs. value) and regions of expertise (e.g., Europe vs. Asia). Once selected, the firms are delegated discretion for the assets under their control. This discretion is limited, however, by two factors. First, in the usual fashion the managers' compensation is directly linked to specified performance benchmarks. To the extent a particular country's market is excluded from the benchmark index, the manager may be less inclined to invest CalPERS assets in it. Second, the CalPERS Board has affirmatively determined that certain country's markets are outside the scope of the managers' discretion; that is, they may not make equity and/or debt investments in them. Further, the Board has also determined that certain other markets pose a sufficient degree of relatively higher risk to justify limiting the managers' discretion to invest in them; in other words, the manager may invest in such markets, but only to an expressly limited degree. CalPERS is the only known US pension fund that specifically controls its non-US investments to this extent.¹⁹ This policy of control within CalPERS is implemented through its "Permissible Country Program," which is the topic of the remainder of this article.

CalPERS' Permissible Country Program does not seek to determine the relative attractiveness of specific markets. CalPERS delegates this determination to its external asset managers. Rather, the Program seeks to identify those markets that, in the opinion of the CalPERS Board, are "safe" enough to support institutional investment practices by a very large defined benefit public pension fund.

CalPERS retains and outside consultant (Wilshire Associates Inc.) to assist in the evaluative process that leads to identification of the "permissible countries." With respect specifically to equity investments, Wilshire suggests that eight broad categories capture each market's opportunity and risk factors.²¹ Wilshire weights the relative importance of each category, and the sum of the weighted categories represents Wilshire's overall evaluation of each market/country. (The following chart depicts all eight categories, with their weightings; the discussion following the chart describes each factor more specifically.)

(Source: Wilshire Associates Inc., Permissible Country Equity Investment – Analysis and Recommendations (April 1999).)

Within each of these eight macro categories is a series of micro factors:

1. The political risk category analyzes the risk to foreign investors resulting from political changes in a country that can negatively impact market openness, liquidity, or performance. Markets with apparently stable and democratic political systems, and those committed to supporting foreign investment, are ranked high. Markets with political systems judged to be unstable are ranked lower. Each country's sovereign credit rating is also analyzed, as a reflection of a country's stability, and its willingness and ability to repay its debt.

2. When analyzing market liquidity and volatility, Wilshire seeks to measure the ability of an investor to sell assets in a country in a manner that is timely and does not adversely affect security prices. Other factors indicative of stock market return volatility are also evaluated.²²

3. Country development is a very broad category. First, GDP per capita is used to measure the economic strength of a country, and is a general measure of wealth. Wealthier countries tend to have better developed financial infrastructure and, generally, present less overall risk to foreign investors. GDP per capita is assigned the highest micro factor weight within this category. Other lower weighted micro factors are average annual GDP percentage growth; the health of the country's banks; level of education in the labor force; labor force productivity; and population literacy rates.

4. Market regulation/legal system/investor protection is assigned the heaviest weighting because, under the current CalPERS Permissible Country Program, it represents the key to a country's investment climate. The micro factors within this category seek to measure the degree to which foreign investors are legally protected in each market, through regulations and the existence of shareowner and creditors' rights. The role of a dedicated market regulatory agency, as well as each country's laws, are reviewed to assess the following equally-weighted factors:

• Adequacy of financial regulation: Higher scores reflect a strong agreement to the statement, "Regulation and supervision of financial institutions is adequate for financial stability."²³
• Bankruptcy/creditors' rights: This factor seeks to measure the adequacy of creditors' rights in each market, in the case of bankruptcy or reorganization proceedings.²⁴
• Shareowners' rights: Higher scores reflect stronger regulations regarding the legal rights of equity holders to protect their ownership interests (through proxy, judicial and other avenues).

5. The degree of market openness to US investment is a critical barometer of a government's commitment to free market policies. Countries with higher restrictions on foreign investment receive a lower score.

6. Country's with automated trading and settlement procedures, through which transactions are settled in a timely and efficient manner, receive a higher score.

7. The transaction costs factor measures the costs associated with trading and includes stamp taxes and duties, amount of dividends and income taxed, capital gains taxes and commission rates.

8. Year 2000 compliance and technological growth looks primarily at the degree to which a country's companies are expected to suffer mission-critical systems failure²⁵, and secondarily at its ability to absorb new technology.²⁶

Using the scores derived through this process, the CalPERS Board makes three critical decisions. First, the Board identifies those countries/markets in which it is appropriate for CalPERS managers to exercise unlimited investment discretion. Second, the Board identifies those countries/markets that represent a relatively higher degree of risk for institutional investment, thereby limiting investment managers in their ability to make investments.²⁷ Finally, the Board identifies those countries/markets that are, at the time of the list compilation, inappropriate for any CalPERS manager to invest. By default, every country not on one of the two earlier lists is considered to be in this last category. Moreover, each of these policy determinations are, of course, made effective on the date the final Permissible Country Program "list" is adopted, and subject to change as conditions in the various country markets change.²⁸

CalPERS Permissible Country Program probably is unique among US public pension funds. However, as US investment in non-US markets continues to expand, other large institutional investors may adopt similar programs.

When any country's laws, regulations, political stability, business culture or market practices impose relatively greater risk on foreign investors than is the case in other available markets, it will become increasingly difficult for the more risky market to attract new capital funds. Better, more rapid communication, improved company and market transparency, and the increasingly global nature of competition for capital funds will promote more thorough analytical approaches to evaluating foreign investment opportunities. There is no longer any capital market that can exist as an island in the new sea of global competition, and no institutional investor that can afford to avoid at least considering the risk-adjusted investment opportunities that may be found in every corner of the world.

* CalPERS instructs managers to limit exposure to group B in total to 20% of the aggregate portfolio of broad non-US equity mandates that permit exposure to the emerging markets. In addition, specific countries in this category should not exceed two times their market capitalization weight or 5% of the portfolio, whichever is lower.

** Note: Malaysia currently has capital controls in place and is not permitted for investment until these controls are lifted.

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