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April 1, 2013

Bridging the Gap

The City of Sacramento uses a Covered Call Strategy to Narrow the Difference Between its Pension Assets and Liabilities

By Peter Chapman

Like many cities, Sacramento is dealing with an underfunded pension liability. Unlike most cities, Sacramento is using options to help plug the hole.

City of Sacramento

For the past 18 months, the City of Sacramento has been writing covered calls and buying the occasional put. It trades options primarily to enhance its yield, but also to preserve principal.

John Colville is the city's portfolio manager. "A big objective of our portfolio is fixed-income interest and dividend payments," Colville explained. "We needed to augment that. And you can't do it in bonds or the stock market."

Colville manages about $300 million of the city's $2 billion in pension assets. Of that, about $135 million is invested in equities. The rest is comprised of fixed-income securities.

Of that $135 million in equities, Colville writes calls against $70 million to $90 million during any given month. He uses a mixture of options on indexes, exchange-traded funds, and individual stocks.

The decision to incorporate options into his investment strategy was not taken lightly. Most pension plans abhor options because they are not well understood and conjure up images of gambling. But a yawning gap between the plan's assets and liabilities gave Colville's investment board the courage it needed to take the plunge.

According to a recent report by Sacramento's treasurer, the Sacramento Employees' Retirement System, the plan managed by Colville, had assets of $294 million and liabilities of $389 million. That gives it a gap of $95 million, or funded ratio of 75.5 percent.

That's not bad, but it's not great either. Pensions are considered healthy if they are 80 percent funded. Many U.S. cities and states saw their gaps widen sharply in the aftermath of the financial crisis of 2008.

According to a recent study by the Pew Charitable Trusts, the aggregate funding level of pension plans serving the 61 largest U.S. cities fell from 79 percent to 74 percent between 2007 and 2009.

Overall, the financial obligations of the municipalities exceeded their assets by a combined $99 billion in 2009, the most recent year for which complete data is available.

The financial crisis of 2008 was largely to blame, Pew reported, and some cities were in worse shape than others. Charleston, W. Va., for instance, had only 24 percent of the assets needed to meet the town's future obligations. Sacramento didn't make the list, because it is too small, with an estimated population of 472,178.

There are only about 50 city employees still contributing to the fund, which was closed to new employees in 1978, and about 1,200 annuitants. In dollar terms, those 50 employees contribute $300,000 per year, while the fund pays out $34 million to the annuitants. Sacramento needs to make up the difference.

But with both U.S. Treasury bonds and blue chips yielding only about 2 percent a year, Colville knew he had to look elsewhere. In 2011, he won approval from his investment board and contracted with Chicago-based brokerage TJM Investments to design an options strategy.