A Bet Lost, with More on the Table

Wednesday, Sept. 20, 2006 | The story is a simple one: the county of San Diego literally bet $45 million – if not more – that the price of natural gas would be higher than it is right now.

Last week, it lost the bet.

How could this be possible? How does the county end up in a position where it’s putting such a large wager on such a volatile commodity?

Well, it needs money.

For a variety of reasons, and despite the fact that it has been infused with billions of dollars in loans and taxpayer funds, the county’s pension fund has never recovered from a decision in 2002 to give county employees a vast retroactive benefit.

Rather than ask taxpayers to help pay for that decision, the county’s supervisors have leaned on investors in the pension fund to make gold out of straw.

They are trying – perhaps too hard.

They began in recent years to invest more and more of the pension funds assets in risky hedge funds – ones like Amaranth Advisors, which just lost half of its assets in one week. The Amaranth collapse unleashed a flood of news this week and speculation about the state of the approximately 8,000 hedge funds operating today. The county’s pension was immediately identified as one of the largest investors in Amaranth.

To be sure, there may be a place for such investments in a portfolio like the county’s.

But the county’s pension system now has $1.5 billion invested in hedge funds – about one-fifth of its total assets. As a comparison, the California Public Employees’ Retirement System – a fund nearly 30 times bigger than the county’s – has only $2 billion invested in such funds.

The county holds 10 hedge funds in its portfolio – with plans for more. And its sizable investment in the unregulated and obviously volatile partnerships seems too risky.

“I would say that’s high. That’s one fiduciary’s opinion, but I would say that’s really high,” said Neil Hokanson, who runs the Solana Beach-based firm Hokanson Capital Management.

Hokanson said that there may be a place in a portfolio like the county’s for riskier “alternative” investments.

“This is money used to pay people’s retirements. I don’t think that if it was my retirement they were handling that I would want them investing so heavily in hedge funds,” Hokanson said.

The county’s officials must not feel as though they have much choice. The supervisors are unwilling to fully confront taxpayers with the massive obligations they’ve incurred. And, partly because the supervisors also have direct influence on the policies of the retirement board, the pension system has found itself obligated to earn at least 8.4 percent each year on its investments. Not only that, after good years – when earnings flow into the fund – they have the temerity to consider it “excess earnings” and send the money to fund extra benefits for retirees. Good years are never as good as the bad years are bad.

Such earnings expectations can be difficult to satisfy.

“A lot of actuaries I talk to think a more reasonable expected earnings would be around 6 percent,” Hokanson said. “If they’ve decided that they need to take more risk in order to make up for a shortfall, that should be a very public decision that everyone understands.”

This month, the county’s pension managers trumpeted this success with a news release claiming earnings of 15.6 percent over the previous year.

There are two points on this:

• The county’s pension system has had bad years.
• When I’ve asked them about those years they always say “You can’t judge us by the performance of one year.” Apparently the truth is you aren’t supposed to judge them after a bad year – just after a good one.

To make all these big investment returns happen, the county’s pension team invited a man named Nick Maounis and his partners to come to San Diego and talk to them about their hedge fund, Amaranth Advisors.

In July, the retirement system agreed to give Amaranth $175 million. The Amaranth investment became 3 percent of the county’s total portfolio. After this week, the county will be lucky to take away $130 million after it asked Amaranth for all its shares of the hedge fund back.

Amaranth was making a play on natural gas and it apparently fooled people like the county into thinking that if the natural gas thing didn’t work, they wouldn’t be that bad off.

Amaranth lost half of its assets in one fell swoop. The county has nine other hedge fund investments – supposedly set up in such a way to ensure they won’t all fail.

Hedge funds, however, as we learned this week, are secretive partnerships that may be doing something much different than what we think or hope they’re doing. The people who run them charge exorbitant fees and take a cut of the profits that are produced.

What’s to say the other nine hedge funds the county pension invests in aren’t ready to similarly surprise us?

And that gets to the final most aggravating part of this story. At issue here is the public’s tax dollars and the retirements of thousands of public employees – yet the county has recklessly turned over public funds to people who have no legal obligation to describe anything about what they’re doing. Their documents aren’t public. The partnerships aren’t regulated by the Securities and Exchange Commission. The public has little ability to analyze or challenge these investments. Even if they were safe and proven effective, this fact alone would make them unacceptable as a public investment.

Yet the county’s pension system has handed over $1.5 billion in public assets to these partnerships.

In 2002, the county’s pension fund had more money than it would need to make sure the employees it had could collect pensions for the rest of their lives. That year, the Board of Supervisors – made up entirely of professed fiscal conservatives – decided that its employees were not going to receive the pensions they deserved. The five supes decided not only to make pensions better from that point forward, but also to retroactively award a new level of benefits.

This was a giveaway. Pensions are meant to retain and attract quality employees. But after the 2002 move, hundreds of employees immediately retired to take advantage of the gift – more than had retired over the entire year previous. It was a vast giveaway worth more than $1 billion.

The supervisors have never wanted to confront taxpayers with these consequences of their decision. They’ve instead asked for more than $1 billion in loans.

Now those loan proceeds are invested in hedge funds.

This is a monumental bet that we must realize the county’s pension officials have made on our behalf.

If they lose the bet, they might be able to move on to different jobs. But taxpayers and employees will find themselves in a mess that would take decades to clean up.

Please contact Scott Lewis directly with your thoughts, ideas, personal stories or tips. Or send a letter to the editor.