San Diego County citizens disgusted with massive potholes, deficient sewer and water systems, library closings, ad nauseam should scoff at politicians’ promises that things will get better. They won’t. Already-ruinous pension payments will eat up much more of future budgets — and actually, if the books were honest, those annual pension contributions would be larger still. That’s because both the County (San Diego County Employees Retirement Association) and the City (San Diego City Employees’ Retirement System) grossly overestimate their expected annual pension portfolio returns, thereby lowering governments’ annual contributions and passing the bill to future generations.
Since June 30, the County’s pension fund portfolio has plunged from $8.4 billion to below $6 billion. On February 11, San Diego County Board of Supervisors chairwoman Dianne Jacob declared in a speech that “even if the [stock] market bounces back, the required contribution by the County is expected to triple over the next five years.” And if the market doesn’t bounce back? She didn’t go into that.
During the last week of February, the city council was meeting on the topic of pension-payment obligations. Councilmember Carl DeMaio asked the City’s actuary how many bucks the City would be plunking in the pot “if the market does not suddenly recover.” Answer: the City would set its future annual payment at $100 million more than it is currently plunking in. What does $100 million mean? It’s equivalent to “shutting down every library in the city and closing 37 percent of the park and recreation programs,” says DeMaio.
The County estimates that it will make 8.25 percent per year on its pension portfolio. The City looks for 7.75 percent. Domestic and foreign stocks have been roughly cut in half since peaking in 2007. Common stocks (domestic and foreign) make up more than half of the portfolios of both the County and City. Stocks would have to go up about 20 percent a year for five years just to get back to normal rates of return, says Joe Esuchanko, consulting actuary for the City.
The County, in particular, has been gambling with employees’ retirements. Often-volatile commodities make up 4 percent of its target asset allocation. Alternative equity investments — which could include speculative things like venture capital, buyout funds, and green investments — make up 5 percent. There is actually a slightly higher weighting of international stocks (24 percent) than domestic stocks (23 percent). For a long time, the County had 20 percent of its portfolio in hedge funds but got slaughtered in two of them, and that weighting is now down to 14 percent. Early this month, the County’s chief investment officer, who had championed aggressive investments, abruptly resigned, “but I don’t think the board is looking for radical changes to the portfolio,” says chief executive Brian White. The hedge funds may stay.
The City claims it doesn’t have hedge funds in its portfolio, but it has so-called market-neutral money managers that bet that some stocks will go up and some go down, similar to the hedge-fund strategy. The market-neutral portfolios did poorly in the most recent quarter.
As of September 30, the County’s one-year record was a negative 13.8 percent. For the past three years, it has been up only 4 percent a year — a long way from the 8.25 percent bogey. The City’s pension fund has nothing to brag about: as of September 30, it was down 15.62 percent over the past year and up only 2.47 percent annually over the past three years, both a long way from the 7.75 percent annual target. Those County and City numbers would be down considerably now.
In November, actuarial consultant Esuchanko told the council that as of October 31, the City’s unfunded liability had grown to $2.8 billion and that the pension fund was only 58 percent funded. The council, with the exception of Donna Frye, paid no attention. But early this year, Mayor Jerry Sanders’s bean counters announced that the unfunded liability was $2 billion and the funded ratio 66.3 percent. The difference between 58 percent and 66.3 percent is explained by the “smoothing” process; the City evens out results by factoring in several years of market gains and losses. Today’s funded ratio might well be below Esuchanko’s 58 percent without the smoothing techniques, which, incidentally, are another manipulation by which pension funds paper over big losses. The County uses smoothing too.
William Sheffler, a boardmember of the City fund, thinks the 7.75 percent target is acceptable because about half of it represents inflationary expectations. The County’s White says the board talked about the 8.25 percent expectation in January and will revisit the topic in June.
Market pros overwhelmingly think both the City and County are overestimating future returns. “It’s painfully obvious that public and private pensions are not going to make their long-term goals,” says E. James Welsh of Carlsbad’s Welsh Money Management. “I would say 5 to 6 percent is more realistic,” but political pressure pushes the bogey higher.
Over hundreds of years, stocks have gone up around 9 to 10 percent yearly and bonds around 4 percent. Right now, stocks are in a horrendous bear market and Treasury bonds are returning less than they have for decades. “I would say it should be 7 percent,” says Mike Stolper of Stolper & Company. “Every time the market gets ugly, it becomes politicized and the policy is assaulted, and every time it does well, these morons increase benefits. The problem is corrupt politicians and reactionary responses to stressed markets.”
“I would not go any higher than 5 or 6 percent,” says Neil Hokanson of Solana Beach’s Hokanson Associates. He adds an interesting point: “Studies show that retirees can count on withdrawing 4.2 percent [of their nest eggs] a year and not have to tap their capital, not allowing for fraud or incredibly bad investment outcomes. This is the kind of number investors should be focusing on. With Treasury bond rates so low, how can a pension manager forecast a rate of return much higher than that of corporate bonds?” (Quality corporate bonds of 9 to 14 years’ maturity yield 5 to 6 percent.)
Councilmember Donna Frye has a very practical reason why she believes target rates should be reduced: “If they had more reasonable expectations for returns, they would want to invest in something more stable and consistent,” she says of City fund managers.
Jim Gleason, who was on the City pension board for a dozen years until 1972 and was the major plaintiff in a successful suit against the retirement board, says, “They are still overly optimistic. They should scale back from 7.75 percent,” although he doesn’t recommend a specific figure. Reason: “It’s a different world we are playing in.”
Amen to that. Stocks have rallied recently, but few think another bull market is at hand. There is a 20 percent chance of depression and continued deflation and a strong possibility that it will be many years before stocks get back to their 2007 levels. It’s no time to roll the dice.