It’s a basic form of storytelling, used in countless books and movies: Two people, in similar circumstances, confronted by difficult choices. One does what is right, even if it seems like the harder choice. He fights through the many challenges, has moments of self-doubt and worry, before ultimately being rewarded. The other takes the easy way out. For a brief time, he appears to be ahead, before the shortcut is discovered, and ultimately receives the deserved comeuppance.
It’s a narrative technique as old as the Bible. It’s a staple of rom-coms, sci-fi flicks and adventure movies.
The investment version of this is playing out today in California in two different pension funds for public employees. There is little doubt how this movie is going to end.
The first is from investing behemoth California Public Employees' Retirement System, or Calpers. As the Wall Street Journal reported this week:
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.
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.
The antihero in this story are the gamblers who run the retirement portfolio for the San Diego County public-pension system. Why gamblers? Because of this, as reported by San Diego Union-Tribune:
In April, pension board members unanimously approved a new investment strategy that dramatically increases use of “leverage,” a form of borrowing.... The county’s remarkably transparent goal is to raise the risk of losses in hopes of lifting returns, because the government and its workers haven’t saved enough to fully fund checks promised to retirees in the future.
You might wonder where the county got the idea that leverage was its best bet. As it turns out, it comes from the county’s high-priced chief investment strategist. “We’re trying to bring up the risk, not keep the return and dial down the risk,” Lee Partridge of Salient Partners told the San Diego Union-Tribune. Leverage has increased from 35 percent to 100 percent of the assets in the pension fund.
Salient Partners is going to be paid $10 million a year in fees for helping to conceive and execute this strategy. San Diego County’s pension-fund returns ranked in the lowest quintile, at 84 out of 100, over the past three- and five-year periods, according to Wurts Associates.
What makes this approach so surprising is a simple comparison of San Diego County to the local competition, the City of San Diego (not to mention Calpers). The city pension board bars the use of leverage for pensions. Instead, it favors a low-risk asset allocation approach. The city’s fund is outperforming the county’s. Salient Partners has generated returns of 9.7 percent a year. 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.
To review: A pension plan is failing to save enough to meet its retirement obligations, and rather than save more, it ramps up leverage.
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.
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Barry L Ritholtz at firstname.lastname@example.org
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James Greiff at email@example.com