Stung by Losses, Pension Fund Invests With Borrowed Money

In the conservative world of pension investing, San Diego County’s retirement fund has long stood out like a Formula One racecar in a fleet of grey four-door sedans.

In recent years, the pension gunned an aggressive and complex mix of investments that backfired during the financial crisis. Now, the fund’s managers are retooling and launching a novel investment strategy that seeks to boost returns by using borrowed money.

Under the guidance of a new outside consultant, the $7.2 billion San Diego County Employees Retirement Association has decided to borrow an amount equivalent to up to 35 percent of its assets.

Using borrowed money — leverage — can be dangerous. Financial leverage is often viewed as a double-edged sword that can amplify both gains and losses. But the pension’s investment consultant, Lee Partridge, says the goal is to protect the fund if the economy stagnates or grows slowly.

It’s part of a new strategy the pension board approved March 18 to lower the fund’s overall risk while generating an additional $1.2 billion in returns over the next decade.

But to do that, the pension will essentially be investing more money than it has. The fund will set aside about $350 million to borrow $2.5 billion worth of 10-year U.S. Treasury futures.

The idea behind leveraging Treasuries is that too much of the pension’s money is linked to global stock markets. The market crash of 2008-2009 made that painfully clear. Devastating losses wiped out a quarter of the fund’s value — $2.1 billion — as of June 30, 2009. Treasuries were among the only investments that held up.

The pension intends to shed risk by shifting money into areas that aren’t so closely linked to stock markets. The fund will also buy debt in fast-growing economies like China, Russia and Brazil, and shift money into real estate, oil, gas and other natural resources.

While the pension is gaining the right to purchase Treasuries in the future, it has no intention of actually taking on all $2.5 billion in notes. The pension will instead buy futures contracts, not the Treasuries themselves. (Futures are a financial tool that allows them to buy U.S. government bonds at some future date at a price set today.)

Futures have been around since the days of Aristotle, but the use of large-scale financial leverage is a new approach for pension funds. Partridge has never done this before either.

While Treasuries are considered safe, Partridge acknowledged that leveraging them has risks.

The biggest is that interest rates rise sharply over the next few years. That would drive down the price of Treasury notes. If that happens — and many analysts think it will — Partridge said the pension would lose money. Because it’s using leverage, the pension would have to cover the loss.

The loss gets deducted from the $350 million in the pension’s brokerage account. If the losses become too steep, SDCERA could be required to put more cash in its dwindling account. That could force the pension to sell other profitable investments that it doesn’t want to.

If the pension owned the actual Treasuries, it wouldn’t actually be stuck with a loss. They would decline in value, much the same way a stock declines in value, but no money would change hands and the bonds would continue to pay interest.

That’s a chance Partridge and the board say they’re willing to take with the future nest eggs of thousands of San Diego County workers. If interest rates are rising, it likely means that the economy is picking up steam. The rest of the fund’s portfolio will do fairly well, they say.

Overall, Partridge said the pension’s new strategy has less risk than its former, more traditional mix of investments. “The probability that you get into a painful scenario with this [leveraged] portfolio is far less,” he said.

Dan McAllister, the county treasurer-tax collector and a member of the SDCERA board, says the pension can’t afford to take chances. He said he supported the new investment strategy because the fund’s consultants assured the board it will mean less risk and bigger returns. “We do not need to take on added risk,” he said.

On the surface, the fund appears healthy and able to meet its obligations to the more than 13,000 county retirees who receive an average check of about $2,500 a month. Scratch a bit, however, and things don’t look so great.

A key barometer of a pension’s health is the funding ratio — the ratio of assets to liabilities. SDCERA’s funding ratio stands officially at 91.5 percent, but that’s only because of an accounting practice that defers losses over several years.

If last year’s $2.1 billion loss were to be recognized right away, San Diego County’s pension fund would only be 65 percent funded, according to a report by an independent consultant. That’s well below the 80 percent that pension experts regard as healthy.

San Diego County’s pension expects its investments to yield 8.25 percent annually.

That expectation is likely behind the county’s strategy, said Herb Morgan, a member of the city of San Diego’s retirement fund, which expects slightly lower returns.

Morgan, a veteran money manager, said he’s skeptical of the idea of adding leverage to a pension fund.

“Treasuries is a more conservative way to do it,” he said. “So it’s not like it’s super crazy, but I wouldn’t do it with my own money, so I’d vote against it as a pension trustee.”

If the new investment strategy backfires, San Diego County could have to ask taxpayers to contribute more. Taxpayers made a $314 million annual contribution to the pension in the most recent year. County employees contributed another $50 million.

Susan Mangerio, president and CEO of Investment Governance and an expert on pension risk management, said underfunded pensions could be tempted to take on more leverage to improve their financial positions.

“Unless they have a solid risk management structure in place to properly measure and monitor leverage, this is a dangerous strategy,” Mangerio said. “Absence of a disciplined approach to leverage could result in even more problems for pensioners, taxpayers and fiduciaries.”

Partridge was hired last year as SDCERA’s private investment consultant, with a salary that could pay him $4.5 million over three years. The association initially planned to outsource its in-house investment staff to Partridge, too, but the board is reconsidering that plan after a voiceofsandiego.org story raised questions about whether it was illegal and SDCERA’s attorney agreed.

Partridge replaced former Chief Investment Officer David Deutsch, who was forced to resign last year amid mounting losses.

Deutsch responded to questions about the use of leverage by public pension funds in an e-mail interview. In general, Deutsch said, leverage can be used to improve the mix of assets in the portfolio. When a fund bets more than all its assets, however, it is simply speculating in the capital markets. “Banks and thrifts may have business uses for such excess bets, but public investment funds are not banks,” he said.

The $78 billion State of Wisconsin Investment Board was one of the first to adopt the strategy of leveraging bonds in January. CalPERS, the state employees’ pension fund that’s the largest in the country, posted a memo in February on the use of leveraged bonds, prompting speculation that it was considering following suit. The memo warned that leveraging Treasuries carries its own set of risks.

Some investors see more risk in Treasuries with the U.S. government running massive deficits and flooding the financial system with money on a scale unimaginable a few years ago. If those fears play out and interest rates become volatile, that could spell trouble for the pension fund’s Treasury bets.

This isn’t the first time that San Diego County’s has dabbled with borrowed money. Deutsch’s “alpha engine” strategy — named for the Greek letter representing above-market returns — leveraged the widely held Standard & Poor’s Index of the 500 leading publicly traded companies. That freed up cash that SDCERA invested heavily in hedge funds, which often use leverage to improve returns.

The result was an extremely sophisticated and complex portfolio that defied basic understanding — and brought unforeseen risks.

One of the pension’s hedge funds, Amaranth Advisors, proved to be a classic example of the destructive powers of excessive leverage. The hedge fund lost $6 billion in a few weeks in 2006 in a bad bet on natural gas futures. SDCERA is suing Amaranth to recover its $150 million investment.

McAllister has confidence that the new strategy will be easier to understand and monitor than in the past. “Warren Buffett has done extremely well over the years by adhering to a base philosophy of keeping things simple and easily understandable,” he said. “As long as we can meet our liabilities and minimize portfolio risk, then we will have accomplished a lot.”

Rob Davis contributed to this story.

Seth Hettena is a San Diego-based freelance writer. Please contact him directly at shettena@gmail.com.