It is no secret that pension economics is becoming the topic du jour in public finance land. On August 11, 2014, the U.S. Securities and Exchange Commission (“SEC”) made known its allegations of securities fraud against the State of Kansas. According to the official cease-and-desist order, information made available to municipal bond investors “failed to disclose that the state’s pension system was significantly underfunded, and the unfunded pension liability created a repayment risk for investors in those bonds.” Although the matter is being settled due to disclosure improvements made by the Sunflower State, it is clear that the SEC examiners considered both the liabilities and investments of the Kansas Public Employees Retirement System (“KPERS”). Specifically, concern was raised that KPER’s 2008 investment losses were a big factor in causing a rise in the Unfunded Actuarial Accrued Liability (“UAAL”) from $5.6 billion in 2007 to $8.3 billion in 2008.
A key takeaway from this recent SEC action is that a pension plan’s asset-liability reality, its investment management style and how much gets shared with investors are individually and collectively important. Prospective and existing bondholders need to be knowledgeable about any or all of the risks that could lower the probability of repayment.
It is not surprising then that the reaction to news accounts about what sounds like a material use of leverage by the San Diego County Employees Retirement Association (“SDCERA”) is drawing criticism. In “San Diego Pension Dials Up the Risk to Combat a Shortfall” (August 13, 2014), Wall Street Journal reporter Dan Fitzpatrick refers to their approach as “one of the most extreme examples yet of a public pension using leverage – including instruments such as derivatives – to boost performance.” Comments from readers range from intimations of gambling to imprudence. Bloomberg commentator Barry Ritholtz predicts that “San Diego County’s pension fund blows up” or “…the townsfolk figure out how much risk is being put on their shoulders, and fires everyone involved…” Click to read “Doing the Right Thing” (August 12, 2014).
My reaction to the announcement about this newly approved strategy is objective. I am interested in learning more about (a) what exactly SDCERA intends to do (b) how they will carry out their plan and the (c) basis for monitoring the third parties that are tasked with implementing levered actions, including the purchase of financial futures contracts. Although not an ERISA plan, SDCERA trustees are tasked with a duty to “act with skill, care and diligence” and “follow the prudent person rule” and to “act in good faith and in the best interest of members, beneficiaries and the fund as a whole.” It is therefore critical to know whether the intention to add more investment risk, in anticipation of greater returns, is something that SDCERA is allowed to do and whether a structural foundation has been created to support procedural prudence.
As I wrote in Risk Management for Pensions, Endowments and Foundations, leverage, when used effectively, “can improve returns. Improperly used, the leverage inherent in certain derivative transactions spells disaster. Margin calls, cash flow problems, bond rating downgrades, damage to reputation, and litigation are just a few of the possible consequences of excess leverage.” Using other people’s money to lever a portfolio is a two-way street and controls must be established and then followed to avoid runaway losses.
According to an August 8, 2013 memo from Mr. Lee Partridge, one of SDCERA’s outside consultants, the Investment Policy Statement that was in the process of being revised for this California-based pension plan would allow for the use of leverage as long as doing so “does not materially alter the risk level of the investment program given the current asset allocation as approved by the Board. Risk constraints established by the Board (for the total portfolio, the individual asset classes, and individual managers) control the use of leverage.” The text further states that “Under no circumstances may derivatives or leverage be used to circumvent the intent or limits otherwise prescribed by this policy.” (My researcher has asked SDCERA for a final version of the current Investment Policy Statement)
Some of the many questions that need to be answered are listed below:
- What types of futures contracts will be purchased to gain exposure to stocks, bonds and commodities?
- Will these positions help to hedge any asset class exposures or instead serve as “substitutes,” recognizing that derivative contracts are not the same thing as securities?
- How will the performance of this derivatives-heavy strategy be evaluated in terms of quantifying tracking error, operational and financial risks and opportunity costs of doing something else?
- How often will the size of positions be altered and on what basis?
- How will the strategic and tactical asset allocation percentages change, and on what basis, as the result of implementing this levered approach?
- Why was it decided that this significant use of futures would be superior to either investing directly or allocating monies to asset managers that employ futures as part of their strategy?
- Did the trustees examine the use of indirect leverage already in place by virtue of asset managers to which SDCERA has allocated monies?
- How does SDCERA plan to keep its total portfolio adequately diversified, once this futures program has commenced?
- Which outside asset managers will be terminated, if any, to make room for the direct use of futures? Is there an early termination cost that SDCERA will incur with any or all of the asset managers to be terminated by SDCERA?
- On what basis could this new strategy lead to a violation of the SDCERA Investment Policy Statement? Should that occur, how would SDCERA correct its breach of asset class limits and risk tolerance threshold?
- How will the SDCERA risk management infrastructure change? Will someone be hired as a Chief Risk Officer? Who will establish and monitor a risk budget framework that takes into account this newly approved active futures strategy?
The list goes on with multiple questions to be asked and answered by SDCERA. Given the public outcry about underfunded pension plans that could potentially trigger a bailout, any organization that seeks to add investment risk to close its funding gap needs to thoroughly communicate more than basic information to beneficiaries, taxpayers, municipal bond underwriters, rating agencies and muni bond portfolio managers.