Lee Partridge, the investment consultant for the $7.2 billion San Diego County retirement fund, responded at yesterday’s board meeting to my story that appeared April 4 in the Voice of San Diego about the fund’s $2.5 billion bet on leveraged Treasuries.
Lee and I spoke this morning and he sent along the written response that he presented to the board, which appears below. You can also watch his presentation at yesterday’s board meeting by clicking here.
From: Lee Partridge
Sent: Thursday, April 08, 2010 12:41 AM
To: Brian White
Cc: Collins, Jeff_CoSD; Lisa Needle
Subject: RE: Fwd: voice story
I read through the Voice of San Diego article again and have a few comments. I’ve also copied Jeff for your convenience (hi Jeff). There are a couple of misleading or false statements but generally I thought most of what Seth said was true. Nonetheless, he’s overemphasized the negatives. My former boss used to say that if there’s a one percent chance that something could go wrong and you spend 50% of a presentation talking about it, you haven’t represented the truth accurately, you’ve distorted it. I think Seth’s point was that if Treasuries go down a lot in price, we’ll lose money on them. That’s tautological and not very helpful.The reality is that Treasuries will likely fall only if the rest of the portfolio is doing well. Treasuries have very stable, negative correlations to the risky assets in the portfolio and they exhibit relatively low price volatility. We’re trying to increase the price volatility of Treasuries sufficiently to offset losses that we’ll take on stocks, credit, private equity, emerging markets, real estate and natural resources in a bear market. My fear is that we still don’t have enough Treasuries to protect the downside of the plan—not that we have too many. Investors are generally way too complacent about risky assets. This is not a risk seeking strategy or a speculative bet, it’s a way to control downside risk that emanates from economic deterioration.
No matter what my asset allocation is it would be easy to paint a bleak picture if a reporter said something like, “Partridge says that if market conditions force each of these markets to fall the fund could lose billions of retiree dollars forcing taxpayers to foot the bill.” Technically that would be true there is no true information contained in the statement. If we want to be certain that we won’t lose money than we either need to increase contributions dramatically or lower benefits. This is less risky than the portfolio you had.
Taking into account the whole balance sheet it’s even a stronger argument. I took the benefit cash flows that Paul Angelo sent me and discounted them back at various discount rates. Those discount rates are pretty good proxies for the relative riskiness of the asset allocation strategy. I believe the red line is what you generally focus on the most. Note that the liabilities move from around $9 billion at an 8.25% discount rate to approximately $17 billion if discounted at 4%. That is the risk free rate of return with which we could match our liabilities with perfect certainty. It’s what Paul refers to as the settlement value of the liabilities.
The settlement value of the liabilities rises and falls by about 15% for every 1% change in interest rates. Using the fair value of our liabilities at a 7% assumed rate of return that would translate to a $1.6 billion market movement for every 1% change in interest rates. Also, I believe part of the pension was funded with fixed rate pension obligation bonds, which further exacerbates this picture. To place the Treasury futures position in context. The value of the Treasury futures position will rise and fall by approximately $200 million for every 1% change in interest rates. So, in addition to offsetting the risky assets, the Treasury position also offsets approximately 13% of the interest rate risk of the liabilities (not including any pension obligation bonds that were issued to fund the plan). The county and the plan has already taken a huge bet on interest rates but it’s not through the Treasuries it’s in the overall mismatch of assets and liabilities. We can save that for another discussion but it’s very important to keep in mind since this helps offset some of the problem embedded in the plan.
This strategy is about fundamentally diversifying the portfolio so that it does well during periods of both inflation and deflation, high growth and low growth, and during periods of still waters or crisis. This strategy isn’t rolling the dice, everyone else is rolling the dice and we look different because we’re being prudent. Why would 65% in public equities make sense to anyone managing public money? 2008 proved how painful that exposure could be. This strategy hardly ever underperforms and when it does it’s during periods of rapid equity growth that is generally accompanied by inflation. Again, I go back to the question, would you be willing to underperform your peers in the one scenario where you will be most likely to meet the plan obligations with no problem if you could outperform your peers in almost any other scenario?
I’ve taken a few of the comments from the article and commented on them.
(Click image below to enlarge:)