San Jose’s pension woes: Are bad investments to blame?

The city has invested nearly half of its employees’ retirement in high-risk investments like hedge funds

San Jose Mayor Chuck Reed, who championed a ballot initiative to cut pensions for public employees
Paul Sakuma/AP

Andy Paul, 32, works as a library assistant at the Dr. Martin Luther King Jr. library in San Jose, Calif. In 2013, he earned $48,000.

If a measure to cut pensions for city workers is ultimately upheld in court, Paul and San Jose’s 6,868 other employees will either have to pay an additional share of their salaries toward their pensions (up to 16 percent) or receive less-generous benefits upon retirement. “I feel disrespected,” Paul says. “Many of my co-workers have decided to stop working for the city.”

The city’s political leaders say the pension cuts are a necessary step to save San Jose from bankruptcy. The Silicon Valley city spends one-fourth of its $1.1 billion budget on pensions and retiree health care. To help meet those costs, say officials, San Jose has cut more than 20 percent of its staff since 2009. Many libraries that used to be open six days a week are now open four, while fire and police departments have shrunk, pushing up response times.

But experts and an Al Jazeera examination of the city’s two pension funds suggest that the San Jose’s investment strategy — shifting money from stocks and bonds to high-risk, low-transparency “alternative investments” such as private equity, hedge funds and real estate — may be a bigger factor in the financial crunch.

“The missing link in debates about pension reform is poor investment performance,” says Edward Siedle, president of Benchmark Financial Services and a former attorney with the Securities and Exchange Commission. “San Jose’s officially reported 2012 and 2013 performance was absolutely atrocious. Any discussion about the unsustainability of benefits must come after discussion of radical market underperformance.”  

In the aftermath of the 2008 financial crisis, 48 states have passed legislation to reduce benefits for new workers. A handful of state and city governments, with Rhode Island and San Jose the most prominent examples, have cut benefits for current employees. Rhode Island has also come under fire for its foray into alternatives. Those investments, meanwhile, make up a growing proportion of public pension-fund portfolios nationwide.

Poor performance

In 2012, San Jose Mayor Chuck Reed, a Democrat, championed a ballot initiative to overhaul pensions, which was later approved by 70 percent of voters. Donors from outside the city limits contributed nearly all — 97 percent — of the money in support of the referendum.

Unions that represent city workers challenged the measure in court. In December, a California Superior Court judge ruled that portions of the measure — in particular, cuts to benefits already promised to current employees — violated the state’s constitution. But the city is likely to appeal.

The San Jose case could be precedent-setting. It is the first attempt by a municipal body to cut pensions on this scale while not in bankruptcy. And unlike in Detroit, taxpayers in the San Jose metro area aren’t struggling financially: It has the highest per-capita income in the nation, according to the Census Bureau.

City officials say pension costs, not investment strategy, precipitated the cuts. “Mayor Reed’s primary concern has been the exorbitant cost of our generous benefits,” said Michelle McGurk, a spokeswoman for the mayor. “While investment performance can certainly impact overall costs and unfunded liabilities, to my knowledge our retirement plan’s performance has historically been on par with retirement systems and the market at large.”

But the investment performance of the city’s two pension funds — which in total have about $4.7 billion in assets — suggests otherwise. Federated City Employees Retirement System, one of the two funds, returned -3.2 percent at the end of fiscal year 2012, compared with an average of 1 percent among public funds nationwide. This was the worst of the statewide pension funds surveyed by Al Jazeera, and the worst of any public pension fund in California. The S&P 500, meanwhile, returned 5 percent during that same period.

Similar results held for 2013. Nationwide, only one major statewide public pension fund, the Indiana Public Retirement System, underperformed the San Jose Federated City Employees’ 8 percent return. (The stock market rallied that year, with the S&P returning more than 20 percent.)

The Police and Fire Department Retirement Plan, the other San Jose public pension fund, also underperformed funds in other states and cities, returning -0.5 percent in 2012 and 9.6 percent in 2013. The average public pension-fund return in 2013 was 12 percent.

Perhaps more than other types of investments, the city’s holdings in alternatives contributed to poor performance. The San Jose Federated City Employees Retirement System’s investments in “real assets” — indirect investments in real estate, including securities and derivatives — returned -10.9 percent in 2012 and -10.1 percent in 2013. No data is yet available on the performance of San Jose’s hedge-fund investments, but as a whole, public pension funds’ investments in hedge funds have performed poorly.

The amount of money in question is significant. Reed says that his pension-reform proposal would save $68 million per year. But if the Federated City Employees Retirement System alone had performed in conjunction with the S&P 500, the city would have saved more than twice that amount in 2012.

A 2010 report by the city, which many say prompted the pension-overhaul effort, did not include an analysis of the funds’ investment performance, only the costs of the benefits they pay out.

Public pension funds need to ask themselves
why they are upping the ante with alternative
investments at the same time that private pension funds
are selling them off.

Jeremy Gold

Former head of Morgan Stanley's pension division

Campaign workers at an election party in San Jose in 2012 for people voting no on Measure B, which supported the state in attempting to cut pensions of public workers.
Paul Sakuma/AP

The city began ramping up its investments in hedge funds, real estate and private equity three years ago. In 2007, the San Jose Federated City Employees fund held just 5.11 percent of its portfolio in alternatives — almost exclusively in real estate, and none in hedge funds. As of Sept. 30, 2013 (the most recent report available), it had 48.7 percent, higher than any pension fund tracked by Pensions & Investments, the trade publication for the pensions community. The Police and Fire pension held 44.1 percent.

As San Jose and other cities turn to alternatives, many private pension funds are divesting from them because of poor performance. “Public pension funds need to ask themselves why they are upping the ante with alternative investments at the same time that private pension funds are selling them off,” said Jeremy Gold, an independent actuary who formerly headed Morgan Stanley’s pension division.

Meanwhile, it’s more costly for investors to own alternatives than stocks and bonds because of the higher fees charged by money managers.  

Reed’s office declined to comment on whether he believes hedge funds are an effective investment strategy for pensions. The San Jose Department of Retirement, which administers the city’s two pension plans, said it was investing more heavily in alternative investments in order to reduce “volatility” in its portfolio. As the stock market rises and falls, alternative investments can help reduce day-to-day fluctuations that characterize stock exchanges, said Harvey Leiderman, an attorney who works as the outside counsel and spokesperson for the Federated City Employees pension fund.

But Gold disagrees with that kind of assessment. Pension funds and other investors, he said, often cling to the belief that the value of alternatives fluctuates less frequently simply because reports on their performance are issued less often. “Just because the value of alternative investments are reported monthly instead of in real time like the stock market doesn’t mean that they are somehow less volatile,” said Gold.

Changing leadership

San Jose’s massive increase in alternative investments came at the same time as changes in the funds' management. In 2010, Reed championed an effort to replace elected officials, who made up half the boards that oversee the funds' investments, with people who work in the financial sector. (The other half, composed of public employees elected by their peers, remains.)

Reed said the new boards would prevent conflicts of interest, as elected officials often depend on the support of public employee unions.

But critics of the move say the financial industry has routinely profited from public pension funds. The Government Accountability Office found in a 2007 report that conflicts of interest among investment consultants at public pension funds were rampant.

Siedle said that Meketa, the consulting firm that advises the San Jose Federated City Employees fund, has a conflict of interest because the company “both recommended money managers to its clients and was itself a money manager.”

And although California has tougher disclosure laws than other states, people overseeing pension investment decisions are required to disclose only their personal financial holdings, not the financial holdings of the businesses they own or oversee.

“The financial sector has far more conflicts of interest than your average public employee ever could,” said Siedle. “If trustees fail to disclose substantive information about their business interests, there’s no telling if they are materially benefiting from their position as a trustee.”

The board composition backed by Reed is atypical: No other major public pension fund in the United States has a similar requirement that they have a significant composition of people from the financial industry. 

I took a pay cut in comparison to similar work in the private sector. Now, with my retirement up for grabs, I may look somewhere else.

Andy Paul

San Jose library employee

California, meanwhile, has made it easier for officials to withhold information on how they are investing public employees’ retirement money. In September 2013, the state adopted a law that allows pension-fund boards to withhold from the public documents related to alternative investments. Previously, documents provided by money managers during open meetings to people who oversee public pension funds were subject to disclosure. Now many types of documents are exempted.

The bill’s sole sponsor was Assemblyman Kevin Mullin, whose largest donors since his election in 2012 are private equity manager Ken Fisher and his wife, Sherrilyn. Mullin’s office argued that money managers would shy away from doing business with the state’s public pension funds if they were forced to disclose certain types of investment information.

But critics say the law is bad policy. “Because of the sheer amounts at stake, public investment funds have been the source of pay-to-play scandals across the nation,” said Craig Holman, the governmental affairs lobbyist for Public Citizen, a consumer advocacy group in Washington. The law “is a throwback to the troublesome days of cloaking government decisions on investment of public funds.”

Paul, the library worker, said the morale of public employees has cratered since the passage of the pension referendum. At least 15 of his co-workers have left the library since that time, he said. “They left because they want a retirement that is secure.

“I chose to work for the city because of the promise of a secure retirement and health care,” said Paul. “I took a pay cut in comparison to similar work in the private sector. Now, with my retirement up for grabs, I may look somewhere else.

“Measure B [the pension overhaul proposal] is a clear sign that the mayor and the City Council care very little about us,” he said.

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