Russell Read, the former chief investment officer of Calpers, the largest pension fund in the United States, knows his trees.

Read owned a 500-acre Maine forest landscaped with the same mix of maples and oaks the colonists would have seen when they first arrived on the shores of America.

Bob Carlson, who was a board member at the California Public Employees' Retirement System for nearly half its history, recalls asking about commodities like timber during Read's interview for the position at Calpers.

His eyes lit up, said Carlson. That's what I wanted.

Read got the job in June 2006 at the age of 42 and quickly set out to turn Calpers into a modern, aggressive investor.

At the time, esoteric new markets were racking up huge, almost unimaginable gains. He and the board were in agreement -- Calpers should be part of it.

I think the push for commodities and infrastructure and forestry and some of those other things was kind of a movement afoot, said Tony Oliveira, Supervisor of California's Kings County and one of the Calpers board members who helped choose the new investment chief.

A former senior executive at Deutsche Bank, who had once taught risk management, Read seemed to be the right person for the times.

Despite Read's background and the ever riskier bets he was making, Calpers still struggled with risk management. Carlson, who describes Read's risk management plans as brilliant, said that Read left the fund before he could put them in place.

Red flags about the growing riskiness of Calpers' portfolio also went unheeded. A consultant warned Read in December 2007 about the size of the fund's commitment to private equity, but the push went on.

For a while, Calpers looked smart under Read, hitting a peak value of $260 billion in October 2007 as it borrowed money to boost returns and moved into sophisticated collateralized debt obligations, land for residential real estate, as well as commodities.

But as the financial crisis unfolded last year, Calpers lost $100 billion, more than a third of its value, tumbling to $160 billion a year and a half after the high. The other thing it lost was its gold plated reputation, founded on steady returns, pioneering new investments and policing public companies as an activist shareholder. Smaller rivals who were more conservative lost much less.

Calpers has not retreated, though -- just the opposite, in fact. As the entire pension industry questions what level of risk it should be taking in the aftermath of last year's financial meltdown, Calpers in June increased its target for venture capital and private equity -- what the fund's advisor itself called the highest risk, highest reward bet -- to 14 percent of overall investments, up from 10 percent.

Chief Investment Officer Joseph Dear, who declined to comment for this story, in a published internal interview called the changes relatively minor. We looked at the long term return assumption and basically said we don't see a significant reason to change, he said.

Calpers has the reputation of being the gold standard of pension investing, largely by the virtue of its size. But the reality is very different, said Edward Siedle of Benchmark Financial Services, a pension fund investigator and investment consultant.

The new strategy by the board was nothing more than a high-stakes attempt to dig itself out of a hole, he said, reflecting the view of many critics. Since their liabilities have grown and their assets have shrunk, they have concluded that they need to take more risk to close the gap, he added.

Voters in California are beginning to understand that they will have to make up any shortfalls. Rating agencies are reviewing municipal debt with an eye to what billions of unexpected liabilities could do to fragile budgets.

And in the past weeks, a scandal about how former Calpers officials lobbied to place investments has drawn renewed attention to the obscure world of managing pensions.

In all likelihood this risky gamble will not end well, Siedle said.

CALPERS MODEL

Big as Calpers is, its influence is even bigger. It takes on countries, refusing to invest where labor practices don't meet its standards, for instance.

Olivia Mitchell, Chair of Wharton business school's Insurance and Risk Management Department, remembers traveling to Thailand, where the primary question from officials was what were Calpers' plans for investment there.

Every year the fund, which serves about 1.6 million members including former state and city workers, from janitors to judges, challenges what it feels are corporate governance laggards with a Focus List that commands considerable attention. Targets have ranged from drug company Eli Lilly & Co to chairmaker La-Z-Boy. Calpers argues that singling out corporate inadequacies leads to better stock performance -- and higher returns for the fund.

Over the past quarter century, Calpers also has transformed how the entire pension industry is run.

Former director Carlson chaired a 1984 voter initiative to lift a cap on stock investments for the fund, whose solvency is guaranteed by the state.

The goal was to break free from political dictates of state capital Sacramento, whose investment ideas gave Calpers directors pause. They wanted us to invest in government buildings, that's what they wanted. We did away with it, Carlson said.

The measure squeaked by, stock investments rose, and the fund got more aggressive. Shortly after 2000 it made its first investment in hedge funds -- a shot heard around the pension fund world.

It was their investment more than anything else that basically allowed every other pension fund to invest in the hedge fund space, said NYU Stern School of Business Professor Stephen Brown. Nobody could be fired for doing what Calpers did.

SIZE MATTERS

One reason Calpers invests so much is that it has to: $200 billion, roughly twice the state of California's annual budget, is a lot to invest, and Read had his hands full getting such a big ship to turn.

Failures that would cripple other ventures merely put a dent in Calpers. Read closed a $2.5 billion venture known as LandSource in the summer of 2007, the beginning of the end of the American housing boom. LandSource filed for bankruptcy protection in early 2008, though Read still got a $208,000 bonus for the fiscal year.

In 2001, before Read joined Calpers, board members said they wanted to get into agriculture. The board members didn't care what the product was, recalled Michael McCook, the former head of the real estate division. The only caveat was that the money could not go into an area with price supports, he said.

Word of the interest spread through the grapevine. Richard Wollack, a real estate tycoon, soon pitched McCook a plan to buy prime vineyard land in Northern California, Oregon and Washington.

By April 2002, Calpers struck a $100 million deal with the politically-connected Wollack to run Premier Pacific Vineyards, to buy and plant land with grapes, then sell to established vineyards within seven years.

The vineyards are losing money, and the investment is up to $200 million, but in a fund roughly a thousand times bigger, it is a rounding error.

It doesn't take Calpers a long time to make up a bad decision, because it is diversified and so large, McCook said.

But bad decisions can pile up.

THE YALE MODEL

While Calpers led public pension funds into alternative investments, arguably they were far behind Yale University Chief Investment Officer David Swensen, father of the Yale Model of investing, which produced double-digit returns for years from diversification into poorly understood and illiquid markets, where sophisticated investors saw an edge.

With Yale showing the way, Calpers and other endowments began private equity, real estate and foreign companies.

Mark Anson, Read's predecessor and now president of Nuveen Investments, made many of the early alternative investments and also started the risk management system in 2001. Calpers bought a computer program for equities and fixed income, then added on real estate and other parts of the portfolio.

The result of the computer model is a starting point to talk about risk, Anson said, arguing that the risk management system, which was upgraded in 2007 under Read, didn't fail in 2008. When you say, 'My gosh what should be the risk management policy?' or 'Why didn't Yale or Calpers or anyone else see this coming?', well, not even the Fed saw this coming, he said.

But at least one board consultant saw something amiss. Michael Schlachter, managing director and principal at Wilshire Associates, by email said he warned Read in a December 4, 2007 memo that Calpers' then-proposed increased allocation to private equities seemed large. The fund had already outspent its target of 6 percent, he pointed out in the memo.

Critics say the board lacked more than fancy computer models. It lacked common sense.

Boards of funds like Calpers could have and should have seen the big picture -- starting in the 1990s when fat stock market returns could have been reaped and rolled into bonds.

Where would they be if they had captured the returns? They would be fully funded, said Thomas Flanigan, founding chief investment officer of the California State Teachers' Retirement System, the smaller sister fund to Calpers.

It was too obvious ... Even my sister called up and said, 'The market is at 30 times earnings and I'm going to sell.' I said, 'That's a good idea.'

Had public pension funds locked in profits then, pension fund boards years later would have thought twice about buying into opaque investments and Wall Street may not have been so inventive, Flanigan added.

It would not have been necessary to create these overly risky products with the intent to recover from what they missed, he said.

Flanigan sees history repeating itself as Wall Street accommodates the appetite at public pension funds for more risk in the search of home-run profits to make up for losses over the last two years.

Calpers is looking at its own relations with consultants, probing more than $50 million in fees paid by private equity firm Apollo Management and others to a firm headed by a former Calpers board member.

State Attorney General Jerry Brown has also launched a Calpers probe into the so-called placement agents who lobby for pension fund business.

At the same time, board member Oliveira is leading the Calpers push to reassess risk management, and he looks at it from a very broad perspective, from studying the political risk of laws governing Calpers to understanding how health costs could affect its massive programs for beneficiaries.

There is a lot to do: an assessment report to kick off the drive concluded there is no comprehensive risk policy within the organization and management of risk appears to be more reactive than proactive, among 18 observations.

Like other funds, Calpers is keeping more cash on hand. It also is changing rules for private equity funds that want to work with it, requiring more disclosures and overhauling how they are paid. And it is turning to lawyers for help.

Faced with huge losses on subprime loans, Calpers is suing the rating agencies which it said misled them by giving top ratings to mortgage bond funds which later turned out to be a house of cards. Calpers also was overcharged for foreign exchange transactions, says state Attorney General Brown, who is suing bank State Street.

The market rally this year also has helped. The recovery now is showing our asset strategy is doing pretty well, Oliveira said. Calpers' losses have been cut by about half from the market low, taking the fund to around $200 billion.

The recovery, however, remains wobbly, and California, the nation's largest economy, is in dire straits. The state resorted to IOUs when it nearly ran out of cash, a third year of drought has left farms fallow, and layoffs have even reached into Silicon Valley and Hollywood.

CHANGE IS UNPOPULAR

If Calpers falls short on its pension commitments, taxpayers will pay. But there is growing pressure from Governor Arnold Schwarzenegger and others to cut future pensions or do away with them altogether in favor of 401(k)-style programs where individuals manage their own money and both reap the rewards and suffer when risks don't pay off.

Most Californians support pension changes for new hires including an upper limit on benefits, replacing pensions with 401(k) plans and changing pension calculations to cut benefits, according to a Field Poll in October.

Meanwhile Calpers is aiming for an annual investment return target of 7.75 percent, in line with returns in recent go-go decades. Lawrence Fink, chief of gargantuan asset manager BlackRock told the Calpers board in July he didn't think the fund would hit its target. I think it's going to be subpar for many years, he said, suggesting that cuts in benefits be considered.

Shortfalls add up fast. Taxpayers are on the hook for about $2 billion for each percentage point investments are behind target, said Rick Roeder, an actuary who has consulted for public pension funds. And the targets are high, he added.

Calpers has relatively optimistic assumptions about investment returns compared to other public funds in the state, Roeder added.

Politics only adds to the risk at Calpers.

The state guarantees state pensions and elected officials hold many board seats, a potentially dangerous mix. Wall Street banks waited to find out if they were too big to fail but California has a legal obligation to rescue Calpers if it founders.

In any instance where you know you have a (safety) net, your behavior is likely to be riskier. The net here is taxpayer dollars, said Jessica Levinson, director of political reform at the Center for Governmental Studies in Los Angeles.

There's no downside to losing money, said Orange County Supervisor John Moorlach, who was a board member of the county employees' fund from 1995 to 2006. Calpers could have put aside money in the late 1990s, when they were fully funded against liabilities, but instead it backed raising benefits.

Stacking the board with political representatives of beneficiaries only makes things worse, argued Keith Richman, a former Republican state lawmaker and critic of the state's public pension funds. Politicians are encouraged to make promises and are gone by the time promises come due.

In Calpers the conflict of interest is built into the state Constitution. It says the majority of board members need to be recipients, he said.

Wharton's Mitchell said studies showed that political boards tended to be more aggressive investors.

WHO'S THE BOSS

Calpers' mission statement is to do well by pensioners, but if the payer of last resort is the state, perhaps the mission should be to avoid catastrophe for taxpayers, would-be reformers say.

Calpers' responsibility, broadly speaking, is to the taxpayers, said Steven Frates, senior fellow at the Rose Institute of State and Local Government. When the check comes due, those are the people who pay it.

Common wisdom holds that if pension funds act more like trustees than aggressive investors, returns will be lower.

We can't have it both ways, said pioneering shareholder advocate Robert Monks.

But a March presentation to the Calpers board by Wilshire Consulting showed a different picture. The most conservative investments, such as treasury bills, had had the best returns over the previous 10 years, in complete opposition to the presentation's theory of efficient markets, which says riskier rewards like private equity have higher payouts.

Even holding funds in cash proved more lucrative than most investments, including stocks and private equity.

Calpers is fine, board President Rob Feckner, a union representative and glazier, said in a recent defense of the fund in a Sacramento Bee opinion piece. The fund is fine-tuning its investment strategy, negotiating for reduced fees from outside managers and aimed to keep contribution increases to a minimum. Meanwhile the board is 'smoothing' recent returns, an accounting device which lets the fund take the 2008 hit over many years rather than at once.

The alternative is to cut city and state salaries, jobs or both.

Everyone has learned there was too much optimism and too much leveraging and so on, State Treasurer Bill Lockyer, an ex-officio Calpers board member, told Reuters.

But now is a good time to buy, he said. It's an opportunity for those of us who have more money to go and make more, he said.

Read did not respond to interview requests.

He and his wife have a non-profit forest foundation in Maine, where Pensions & Investments described his property in a 2006 interview. Calpers says it has made a more than 9 percent return in its Forestland portfolio since 2007, and is considering distressed Australian timberland.

Perhaps Read's legacy will live on.

(Additional reporting by Paritosh Bansal in San Francisco, additional research by Courtney Hoffman in San Francisco, editing by Jim Impoco and Claudia Parsons)

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