Like many cities, Sacramento is dealing with an underfunded pension liability. Unlike most cities, Sacramento is using options to help plug the hole.
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.
Sacramento’s policy only permits the fund to sell calls or buy puts against existing positions. Only basic strategies. No call spreads. No put spreads. Nothing more complex.
The heart of Sacramento’s strategy is writing calls against its existing positions. Writing calls against stocks you hold brings in premium income on the contracts and reduces losses in declining markets. But it also truncates gains, when the prices of the covered securities move up past the strike price.
“Selling covered calls on the portfolio is another way to bring in income, and it fits in with our emphasis on principal preservation,” Colville said. “It’s a defensive hedge as well.”
The money manager, who joined the city in 1994 after a stint at CalSTRS, can only trade options against 30 percent of the portfolio and must restrict himself to contracts of 90 days or less.
Colville typically writes out-of-the-money calls that have no more than 30 to 40 days to go before expiration. To reduce the risk that a stock will be called away, Colville typically allows for about 5 percent appreciation in the stock. “How often is the market going to rise 5 percent in a given month?” he asked rhetorically.
Colville relies on TJM to manage the options program. That means TJM keeps track of his positions, any information that might impact their prices, and the trading. If TJM believes Sacramento should exit a position, it will advise Colville. He may or may not give them the green light.
“They advise me based on their metrics, and I apply my investment bias to that,” Colville explained. “I decide whether their advice fits with my investment strategy.”
The two don’t always see eye to eye. Given this year’s rally in the stock market, Colville’s options positions have been under stress. TJM advised Colville to exit some of those positions. He decided to hold off, believing the rally would quickly fade. On a recent Friday in March, he finally capitulated, liquidating some of his options positions.
“Sometimes I trip over myself and think I’m smarter than the market,” he admitted. The money manager pays TJM about 50 to 75 basis points in fees annually to manage the program and handle the trades.
Based on data provided by Colville, in the 18 months from July 2011 to December 2012, Sacramento’s options program proved successful. The yield in its large portfolio jumped 50 percent, from 2 percent to 3.2 percent, as a result. The yield on its international portfolio more than doubled to 4.8 percent.
Other metrics show the money manager’s use of options both reduced his portfolio’s risk and allowed him to outperform a similar portfolio that did not incorporate options.
“These are impressive numbers,” said Xerxes Bhote, the TJM executive responsible for the firm’s derivatives business. “Granted, it’s only about $100 million, but it’s still significant.”
Bhote is optimistic about the future use of options by pension plans. “We’re probably in the first or second inning of this,” he said. “But the pension fund world is starting to realize they need to add yield.”
