More Leverage to Combat Pension Shortfalls?
A large California pension manager is using complex derivatives to supercharge its bets as it looks to cover a funding shortfall and diversify its holdings.You can visit the San Diego County Employees Retirement Association (SDCERA) website by clicking here. This is not to be confused with the San Diego County Employees Retirement Systems (SDCERS), which is a different pension plan.
The new strategy employed by the San Diego County Employees Retirement Association is complicated and potentially risky, but officials close to the system say it is designed to balance out the fund's holdings and protect it against big losses in the event of a stock-market meltdown.
San Diego's approach is one of the most extreme examples yet of a public pension using leverage—including instruments such as derivatives—to boost performance.
The strategy involves buying futures contracts tied to the performance of stocks, bonds and commodities. That approach allows the fund to experience higher gains—and potentially bigger losses—than it would by owning the assets themselves. The strategy would also reduce the pension's overall exposure to equities and hedge funds.
The pension fund manages about $10 billion on behalf of more than 39,000 active or former public employees.
San Diego County's embrace of leverage comes as many pensions across the U.S. wrestle with how much risk to take as they look to fulfill mounting obligations to retirees. Many remain leery of leverage, which helped magnify losses for pensions and many other investors in the financial crisis. But others see it as an effective way to boost returns and better balance their holdings.
"We think we'll see a lot more people look at risk the way we do in the not-too-distant future," said Lee Partridge, chief investment officer of Houston-based Salient Partners LP, the firm hired to manage the county's money. "Yes, we are an outlier, but that is not a bad thing."
Mr. Partridge said one of the main goals is to avoid an overreliance on the stock market for returns.
Like many public plans around the country, San Diego County's fund doesn't currently have enough assets to meet its future obligations. The plan is about 79% funded, it says. It gained 13.4% last year.
As a group, state pension funds across the U.S. have enough assets to cover just 75% of future benefits for their members, according to Wilshire Associates, an investment consultant in Santa Monica, Calif.
San Diego board members haven't yet set a limit on how much leverage would be used, but one estimate floated at an April board meeting is the bet could involve an amount equal to as much as 95% of the fund's assets. Simply put, it could have a market exposure of $20 billion despite only managing half that amount.
Wilshire Associates Managing Director Andrew Junkin said more pension funds are now "examining leverage" as they seek to add balance to their portfolios, meet return targets and reduce their reliance on stocks.
San Diego's new approach is comparatively complex at a time when some big pension plans are moving in the opposite direction. The country's biggest pension, California Public Employees' Retirement System, is weighing a number of changes to its investment strategy designed in part to simplify the portfolio, The Wall Street Journal reported this week.
San Diego's plan was approved by the county in April but didn't receive much attention until this week, when a local newspaper columnist wrote criticizing the strategy. In response, the pension fund posted a letter on its website to answer questions on the issue.
Some local residents said they were wary.
"Larger [pension] systems are moving away from risk, and try to be a little more conservative. We don't need to see our systems move in the opposite direction," said Chris Cate, a taxpayer advocate in San Diego, who is running for city council.
San Diego-area residents are well-acquainted with pension problems. A decade ago, the city's pension, which is separate from the county's, endured a scandal after its accounts were found riddled with errors, though the matter didn't involve sizable investment losses.
Then, in 2006, the collapse of Connecticut hedge fund Amaranth Partners LLC created tens of millions in losses for the county's fund. Amaranth made a series of risky bets on natural-gas futures.
"Leverage is a tool, and it can be used improperly. And if it's used improperly, you could suffer large losses, as shown in Amaranth," said Brian White, chief executive of the retirement system in San Diego County.
The CEO said there is a "huge difference" between Amaranth's approach and the one being employed by Salient. The investments being made by Salient, Mr. White said, are "highly liquid" and diverse, as compared with the illiquid, very concentrated bets made by Amaranth.
Salient is being paid $10 million annually for managing San Diego County's pension fund.
Public funds still have most of their assets in stocks, but many funds that were burned by the tech-stock bust and the 2008 financial crisis have turned to private equity, real estate and hedge funds as alternatives.
Public pensions for years have had indirect exposure to borrowed money through property or buyout funds, but most have steered clear of putting more money at risk than they have in their portfolios.
The State of Wisconsin Investment Board was one of the first to embrace the leveraged approach. Trustees in 2010 approved borrowing an amount equivalent to 20% of assets for purchases of futures contracts and other derivatives tied to bonds.
Wisconsin staff members initially thought putting 100% of assets at risk might protect the fund against a variety of economic scenarios, but they concluded that such an amount "could be considered to be a substantial amount of explicit leverage for a pension fund," according to a December 2009 report.
Wisconsin's fund has remained among the healthiest public pensions in the country and currently has enough assets to meet all future obligations to retirees.
A spokeswoman said the Wisconsin system is moving slowly on its strategy because of concerns about adding leverage at a time when economists expect interest rates to rise as the U.S. economy strengthens. That would cause bond prices to fall, and leverage could magnify the impact of those declines on the fund's assets. The current amount at risk on Wisconsin's strategy is roughly 6% of the fund's $90.8 billion in assets.
I note the following in SDCERA’s investment section (emphasis mine):
At the core of SDCERA’s operations is its acclaimed investment program. SDCERA is entrusted to prudently manage the multi-billion dollar pension fund that provides retirement benefits to members. An accomplished team of investment professionals and money managers, in conjunction with the Board of Retirement, prudently manages the investment of the pension fund.Wow, I'm speechless! The "award-winning" money managers at SDCERA sure know how to talk up their game. The problem is I never heard of these guys and if they're so great, why aren't others embracing their investment approach, prudently leveraging up their investment portfolio by 95%?!?
SDCERA’s investment program has earned industry accolades and awards as one of the top performing retirement funds in the country. The program’s success is largely due to a well-diversified portfolio and progressive investment strategies that put it in the same league as some of the country’s most sophisticated investors. SDCERA is a long-term investor with a gross 10-year annualized investment return of 7.26% and a gross 25-year annualized investment return of 9.46% as of March 31, 2014.
Of course, using derivatives to leverage up pension assets is nothing new. Ontario Teachers and HOOPP have been doing this for a very long time. But they aren't going crazy with leverage and I trust their portfolio managers know what they're doing when it comes to using derivatives to efficiently gain exposure to an asset class (it's not just about leverage).
SDCERA is using an outside money manager, Houston-based Salient Partners, to leverage up their investments. The firm manages $20 billion in assets but I never heard of them. They might be good at what they do but I'm wondering who are these guys and what advantages do they offer relative to bigger players like Bridgewater or others who have experience using leverage across various asset classes.
And the problem with leverage is that it can come back to bite them in the ass. Gains and losses are amplified when leveraging your portfolio 2 to 1. This exposes them to serious drawdowns in the future which will make their pension shortfall worse, not better. Where is the governance in this process? What is the funding and investment policy of this fund? It looks like they've got it all figured out but I expect them to get clobbered in the future.
Chris Tobe, a public pension consultant and author of Kentucky Fried Pensions, sent me an email telling me "San Diego County Employees Retirement Association is one of the most corrupt," adding this:
First 13.4% when the average large Public Plan did 17.4% is hundreds of millions in underperformance.And what is interesting is earlier this week, Dan Fitzpatrick of the Wall Street Journal reported, Calpers Rethinks Its Risky Investments:
Partridge makes over $10 million a year. A whistleblower exposed Partridge etc. There are dozens of articles of shady dealings at San Diego County.
The largest U.S. public pension plan is considering a dramatic retreat from some riskier investments, as it tries to simplify its $295 billion in holdings and better protect against losses during the next market downturn, according to people familiar with the matter.I've already covered the revolt against hedge funds. If you ask me, CalPERS is asking the right questions and taking the right approach. They also have a better governance than these county pension funds, which will help them in tough times.
California Public Employees' Retirement System is weighing whether to exit or substantially reduce bets on commodities, actively managed company stocks and hedge funds, the people said.
The pension, which manages investments and benefits for 1.6 million current and retired teachers, firefighters and other public employees, is a bellwether for investment trends at other public plans. Any shift it makes will likely influence others because of its size and history as an early adopter of alternatives to stocks and bonds.
"When Calpers makes a decision, it has a ripple effect through the state and local pension community," said Jean-Pierre Aubry of the Center for Retirement Research at Boston College.
The discussions are taking place between the fund's interim Chief Investment Officer Ted Eliopoulos and Calpers's other top investment executives. The Calpers board hasn't yet been informed about any possible changes and no final decisions have been made, the people said.
The potential moves would constitute a major strategy change for a pioneer of public investments in so-called alternative assets. It isn't clear where Calpers would shift money pulled from these investments.
The retrenchments also could mean a reduction in external managers who are paid millions of dollars to make these bets for Calpers, these people said.
Many state and local pension funds were badly battered during the financial crisis and haven't yet recovered, leaving them struggling to meet obligations to 19 million workers and retirees nationwide. A run-up in the stock market has allowed Calpers to partially recover from the crisis, but it only had enough assets to cover 76% of guaranteed benefits to retirees as of June 30.
Calpers also is putting some new investment ideas on hold. Executives recently shelved internal discussions about whether to make a deeper push into securities backed by risky debt.
The Sacramento-based retirement system is wrestling with how much risk it should take as it follows one of its best performances since the financial crisis. The fund reported investment gains of 18.4% for the fiscal year ended June 30. That exceeded internal goals as domestic and international equities rose nearly 25%, real estate was up 14% and private equity increased 20%.
A top Calpers executive declined to discuss specific areas under review but acknowledged that a number of big questions are up for discussion, including whether the pension's most-complex investments are too small to make an impact on the fund's overall returns. Another issue is whether the fund can rely on individual trading bets to beat the overall market.
"What you have to ask yourself is, can you trade your way to success with $300 billion?" said Eric Baggesen, the fund's senior investment officer for asset allocation and risk management.
Until somewhat recently, pension funds invested almost exclusively in stocks and bonds. Calpers was among the first to invest heavily in real estate in the 1990s and then hedge funds and private equity in the early 2000s.
By October 2007, Calpers's assets hit a precrisis high of $260 billion. During the financial crisis of 2008-2009, they dropped to $165 billion as some of those alternative investments didn't perform as expected, particularly real estate and private equity.
Just one bad year can have serious consequences, since Calpers relies on its returns and contributions from local governments to fund pensions. Calpers has to request more money from municipalities if its investments decline in value, and cash-strapped cities then are forced to cut services or raise taxes to cover the bill.
Calpers hinted at a shift away from complex investments last fall when it released a set of investment principles that included a warning that the fund "will take risk only where we have a strong belief we will be rewarded for it." In February, it approved a new set of investment goals that reduced future exposure to equities and private equity while increasing allocations to bonds and real estate.
One of the more-dramatic moves under consideration is a complete pullback from tradable indexes tied to energy, food, metals and other commodities, according to people familiar with the discussions. Calpers began making such investments in 2007 as a way of diversifying its portfolio and it currently has $2.4 billion in such derivatives, or less than 1% of total holdings.
Executives on Calpers's investment staff also are debating whether it would be better to shift $55 billion it currently invests in individual company stocks and link those investments to broader market targets such as industries or countries, said people familiar with the discussions.
Another topic of discussion is what to do with Calpers's $4.5 billion hedge-fund portfolio, which amounted to 1.5% of the pension plan's total holdings as of June 30. Calpers in 2002 became one of the first public pensions to invest in such funds, which charge higher fees and typically bet on stocks, bonds or other securities using borrowed money. But over the past year, staff members have clashed over whether the investments are too complicated, can truly act as a buffer during a crisis or are large enough to affect Calpers's overall returns. The Wall Street Journal reported last month that Calpers already is reducing its hedge-fund stake and expects to take it as low as $3 billion as compared with $5 billion earlier in the year.
Former chief investment officer Joseph Dear was in favor of increasing Calpers's hedge-fund stake, but he died in February. In March, the board asked Mr. Eliopoulos to review the program, and he gave that task to fixed-income chief Curtis Ishii, said people familiar with the moves. Mr. Ishii's recommendations to the board are due in the fall.
Below, CalPERS dealt a blow to hedge funds by announcing it's considering scaling back hedge fund holdings. CNBC's Kate Kelly reports the details.
Postscript: See my follow-up comment on why leverage spells headline risk for SDCERA.
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