The $225bn (€177bn) California Public Employees’ Retirement System (CalPERS) used to be considered a leader in setting new trends, such as investing to improve companies’ corporate governance or to achieve environmental and social goals. But today it is in the line of fire, with critics pointing to its disappointing results and pushing for big changes.

So 2012 could be a turning point for the fund. In November there may be a referendum about a pension reform that will put newly hired state and local government workers into defined contribution (DC) plans similar to a 401(k) account or into hybrid plans that blend smaller guaranteed pensions with DC savings accounts. If the reform is approved, CalPERS - which is a defined benefit plan - will suffer a setback in its political status and power and it will also receive less in contributions. Under the plans, California would become the largest of nine states adopting a hybrid formula.

Since last December, two of the most vocal critics of CalPERS have both been Democrats: a departing member of the board, Louis Moret, and the former assemblyman Joe Nation, professor at the Stanford Institute for Economic Policy Research (SIEPR).

Moret had been appointed to a four-year term on CalPERS’ board in February 2008, after serving for many years on the Los Angeles Fire and Police Pension Board. He left CalPERS just as its quarterly earnings report was released by Wilshire consultants, revealing below-median results (as of 30 September 2011), an annual 5.4% over the last 10 years, below the Wilshire median for large funds of 5.7% and a broader Wilshire median for institutional investors of 5.5%. “It looks horrible,” said Moret, remarking that during his previous service on the LA Fire and Police Pensions board money managers with earnings below the median for three or four quarters were terminated.

The problem is not failing to achieve the 7.75% rate, says Nation, but in insisting on assumed returns that are too high. “Had [Cal-PERS] assumed lower, more realistic returns in the past, increased contributions would have improved their funded positions today,” Nation wrote in The Sacramento Bee. “They insisted on absurdly high assumptions, underfunding our pension systems for decades and, because of compounding, creating a much bigger problem.”

SIEPR estimated the scale of the problem in a new study. It found that, as of June 2011, CalPERS’ funded ratio was only 74% (with an unfunded liability of $85bn-90bn), using the 7.75% rate of return on its investments; at a more realistic 6.2% rate of return, its funded ratio falls to 58%. CalPERS would need to earn an average annual rate of more than 12% for 16 years to be certain that assets exceed liabilities. “That level of long-term return is Bernie Madoff territory,” observed Nation, stressing that the magnitude of the problem is sufficiently large that prospective benefit reductions for current employees should be examined, despite legal hurdles, and that the additional cost of not fixing California’s pension problem is $1.2bn per year.

CalPERS has officially replied with a statement, claiming that the SIEPR study was based on low discount rates to artificially magnify unfunded liabilities, and that over the past 20 years, CalPERS has earned an average annual investment return of 8.4%. Moreover, CalPERS CIO Joe Dear said he is comfortable with his long-term (20 years) return target of 7.75%.

From the conservative side, the sharpest criticism of CalPERS came from Barron’s in a December 2011 editorial, which accused the fund’s administrators of not having the taxpayers’ interests at heart, and focusing on the wrong objectives - “It was no coincidence that some of its strategies resembled the platforms of California politicians” - and making investment mistakes similar to those of the average individual investor, such as buying high into the real estate bubble from 2005-08, and selling stocks at the bottom during the panic of 2008 to raise necessary cash.