Essay WSJ 130814 Pension Leverage copy

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Markets
San Diego Pension Dials Up the Risk to Combat a Shortfall
San Diego County's Pension Manager Is Extreme Example of Those Using Leverage to
Boost Performance
By
Dan Fitzpatrick
Aug. 13, 2014 8:06 p.m. ET

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. "We think we'll see a lot more people look at risk the way we do in the not-too-distant future," said Lee Partridge, chief investment officer of Houston-based Salient Partners LP, the firm hired to manage the county's money. "Yes, we are an outlier, but that is not a bad thing."
Mr. Partridge said 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, it says. It gained
13.4% last year.
As a group, state pension funds across the U.S. have enough assets to cover just 75% of future benefits for their members, according to Wilshire Associates, an investment consultant in Santa Monica, Calif.
San Diego board members haven't yet set a limit on how much leverage would be used, but one estimate floated at an April board meeting is the bet could involve an amount equal to as much as 95% of the fund's assets. Simply put, it could have a market exposure of $20 billion despite only managing half that amount.
Wilshire Associates Managing Director Andrew Junkin said more pension funds are now
"examining leverage" as they seek to add balance to their portfolios, meet return targets and reduce their reliance on stocks.
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's plan was approved by the county in April but didn't receive much attention until this week, when a local newspaper columnist wrote criticizing the strategy. In response, the pension fund posted a letter on its website to answer questions on the issue.
Some local residents said they were wary.
"Larger [pension] systems are moving away from risk, and try to be a little more conservative.
We don't need to see our systems move in the opposite direction," said Chris Cate, a taxpayer advocate in San Diego, who is running for city council.

San Diego-area residents are well-acquainted with pension problems. A decade ago, the city's pension, which is separate from the county's,…