23 July 2019

San Diego Pension Dials Up the Risk

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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. 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.

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 and it gained 13.4% last year.

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-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.

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's fund has remained among the healthiest public pensions in the country and currently has enough assets to meet all future obligations to retirees. The current amount at risk on Wisconsin's strategy is roughly 6% of the fund's $90.8 billion in assets.

Click here to access the full article on The Wall Street Journal. 

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