by John Lawrence from San Diego Free Press
According to the Wall Street Journal, San Diego County's pension fund manager is using an extreme amount of risky leverage to make up for a shortfall in funding. This is equivalent to the gambler who makes riskier bets to make up for the bad bets he's made in the past. Wall Street Journal reporter Dan Fitzpatrick called San Diego County's investment methods "one of the most extreme examples yet of a public pension using leverage - including instruments such as derivatives - to boost performance." We have seen this kind of risky behavior before. Some jurisdictions like Orange County, CA and Jefferson County, Alabama along with the cities of Detroit, San Bernardino and Stockton, CA have gone bankrupt. The strategy being used by San Diego County Employees Retirement Association ("SDCERA") is drawing a lot of criticism. The pension fund manages about $10 billion on behalf of more than 39,000 active or former public employees.
All this additional leverage comes not that long after many pension funds lost billions in the financial crisis of 2008. The problem is that San Diego County's fund doesn't currently have enough assets to meet its future obligations. The plan is about 79% funded. It gained 13.4% last year. It seems that they can't wait to get back into the game which has turned into a disaster for so many others. Short memories.
Their solution to the fact that they are underfunded is to take on an extremely risky investment strategy to make up for the shortfall. Leverage has increased from 35% to 100% of pension fund assets. That means that, if anything goes wrong, the entire investment fund could go bust leaving retirees with absolutely nothing. The group that is managing the fund, however, Salient Partners, will probably walk away with no consequences having deposited its $10 million yearly management fees in a secure lockbox.
The County's risky approach contrasts with the City of San Diego's which favors low-risk asset allocation. In contrast to San Diego County, many pension funds are getting out of the risky Wall Street gambling casino business. Take California Public Employees' Retirement System (CalPERS), for example. It is taking its money out of hedge funds after other pension funds lost big trying to make up for pension fund shortfalls. As the country's biggest pension fund, it is making changes to its investment portfolio designed to reduce risk. It said on September 15, 2014 that it will pull all $4 billion it has invested in hedge funds because it finds them too costly and complicated.
Also officials at Los Angeles’s fire and police employees pension fund decided last year to get out of hedge funds altogether after an investment of $500 million produced a return of less than 2% over seven years. The hedge-fund investment was just 4% of the pension’s total portfolio and yet $15 million a year in fees went to hedge-fund managers, 17% of all fees paid by the fund.
As of July 1, 2014, Lee Partridge of Salient Partners is authorized to use the county’s $10 billion fund to put at least $20 billion at risk, mostly with options, derivatives and other arcane financial instruments. What could possibly go wrong with that? Lee will be betting on foreign junk bonds, emerging-market stocks, options on the future value of zinc and other speculative financial instruments. Nothing is off the table.
Salient Partners has generated returns of 9.7 percent a year for SDCERA. Meanwhile, the city’s fund has earned 13.6 percent a year and at lower cost. In 2013, San Diego County spent $103.7 million in investment and administrative fees. It is one of the highest-cost pension funds in the entire country.
Barry Ritholtz has reported:
I am not fond of forecasts, so instead, I will offer one of two likely outcomes: Eventually, San Diego County’s pension fund blows up. The losses are spectacular, and the county taxpayers are saddled with billions in new tax obligations. Alternatively, the townsfolk figure out how much risk is being put on their shoulders, and fires everyone involved, from the pension board to the advisers to anyone who voted for these shenanigans.
I have seen this movie before. I know how it ends.
It's the age old story of lack of prudence and fiscal responsibility leading to gambling the farm in order to save the farm. If you win, you stay on the farm; if you lose, the farm's gone and you're out on the street. The retirees and/or taxpayers will be out on the street while Salient Partners will make sure their management fees are highly protected from lawsuits.
The pension fund's dilemma is brought on partially by the US Federal Reserve's policy of low interest rates. Pension fund managers can't get any kind of a return in conservative investments which basically pay 0% interest. Therefore, they have to go to the Wall Street casino and gamble.
The City of San Diego has skated on thin ice before. After generously upping benefits to current and former employees in 2001, it suddenly found itself short of the money necessary to live up to its promises. So it borrowed $1 billion and gambled it on Wall Street. To its chagrin it lost most of the money. Taxpayers had to make up the difference.
Once burned, twice shy, or you would think. Now it seems like deja vu all over again as Yogi Berra would say.
Pension fund shananigans are nothing new. Back in 1996, Mayor Susan Golding tapped the city pension fund to help pay for the Republican convention. As a reward for tolerating the theft, city employees were given further pension benefits. Susan Golding bragged about the fact that she was a big time player while former Mayor Maureen O'Conner just lost a few piddling millions at the gambling tables:
"Poor Maureen," began Golding. "Public humiliation, and for what? A couple million? That's what she gets for playing small ball. She didn't even have the sense to use public funds, the way I did when I started playing the stock market with all those millions from the city's pension funds. That's where the real action is. God, when we hit, we hit big. There is nothing in the world that can top that feeling - not good governance, not keeping the Chargers in San Diego through ticket guarantees - not even ditching your money-laundering husband. And when we lost - well, it wasn't our money to begin with, so no big whoop."
The hapless treasurer of Orange County, Robert Citron, caused his County to enter bankruptcy in 1994 after he lost billions gambling on Wall Street. Orange County was the largest county to have declared bankruptcy at that time. Gambling on Wall Street in fancy derivatives led to Citron's downfall, and the taxpayers didn't want to make up the difference. Municipal bankruptcy was the only alternative. Citron later pleaded guilty to six felonies regarding the matter. Whether or not a city or a county can get out of its pension obligations by declaring bankruptcy at this time is open to debate.
The San Diego County pension fund is playing with fire according to many knowledgable sources.
Voice of San Diego has reported:
Wealth managers like Luis Maizel of LM Capital Group said the strategy is “a little bit more boom-or-bust than is traditional.”
To prove his point, Maizel printed out a copy of the asset allocations of CalSTRS, the state teachers’ retirement investment fund and pushed it in front of me.
CalSTRS’s targets, according to a Sept. 10, 2013, news release, are to have 51 percent of their money in global equity, 16 percent in fixed income, 6 percent in an “inflation sensitive” category, one percent in cash and maybe one-half to one-third of their real estate investments as “traditional.” That leaves the 13 percent they are putting in private equity and maybe four or five percent more from real estate as non-traditional investments.
That means CalSTRS has roughly 17 percent of its money in risky, non-traditional investments. Compare that to SDCERA, which has about 25 percent of its money in these risky investments.
Pension Pulse says:
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.
The question is what risk does Salient Partners have if the pension fund goes bust. Do they just walk away without paying any price? It seems that way. They get $10 million per year as long as everything goes well. So they probably have everything to gain and nothing to lose. San Diego County retirees and taxpayers are the ones who will be left holding the bag.
This just in from U-T, September 18:
After hours of hand-wringing from trustees and pleadings from retirees to safeguard their livelihoods, the county pension board voted Thursday to formally consider firing their Texas investment consultant.
The decision on the future employment of Salient Partners of Houston was set for Oct. 2, one day after the last of the county’s in-house investment staff was scheduled to go to work for the investment firm as part of a years-long outsourcing push.
In the meantime, Chief Investment Officer Lee Partridge of Salient will no longer be permitted to risk up to five times the amount of San Diego County’s pension money invested under his “risk-parity” strategy.