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Push and Pull

A prudent benefits policy and an innovative investment approach have made the San Francisco retirement system one of the few public pension plans that is overfunded.

During the winter break of her freshman year at the University of San Francisco in 1968, Clare Murphy took a part-time job at the San Francisco Employees' Retirement System. It wasn't a casual choice. Her father had worked for the city as a data processor, and her grandfather had driven a trolley on Geary Street: Murphy had civil service in her blood. For $3.13 an hour the 19-year-old supervised seven other college students in a six-week project to alphabetize some 30,000 member files that had been organized by number.

The following summer she returned and received a new assignment. The task: Put the member files back in numerical order.

Despite that lesson in bureaucratic capriciousness, Murphy decided to follow in the family footsteps and work for the city. After earning her master's degree in 1973, she rejoined the pension fund; since then she has worked nowhere else. Three decades later Murphy is the executive director of the

$12.7 billion San Francisco retirement system.

For Murphy, constancy has been well rewarded. Head of the pension fund since 1985, she has helped transform a woefully underfunded plan into one of the few public retirement systems that is overfunded. A Wilshire Associates survey of 64 state retirement systems found that just 16 percent, or ten plans, were fully funded or overfunded on a market-value basis as of June 30, 2004. The funding ratio of the San Francisco plan, which provides retirement benefits to 51,000 police officers, firefighters and city and county employees, stood at 109 percent on a market-value basis, far above the median ratio of 83 percent for state plans, according to Wilshire.

What accounts for the plan's success? Credit restrained benefits, a savvy, hands-on board and a history of innovative investment strategies that have enabled the fund to return an average annual 10.27 percent for the ten years ended March 31, 2005. That compares with a 9.49 percent median for public funds with assets greater than $1 billion according to Wilshire data, placing SFERS in the top quartile of the Wilshire ranking. Over the past three years, SFERS has done even better against its peers, returning an average annual 8.45 percent, versus the 6.83 percent median.

"San Francisco has been near the top of the heap for a long time," says Keith Brainard, research director of the National Association of State Retirement Administrators.

Though a relatively small, low-profile player in the universe of public plans, San Francisco has repeatedly led its peers into new asset classes, jumping into real estate in 1978, venture capital in 1987 and emerging-markets debt in 1996. "We're receptive to innovative ideas," Murphy says.

"The executive director and the trustees of the San Francisco plan have open minds," says Jerome Booth, head of research at Ashmore Investment Management in London, a SFERS money manager. "It's very refreshing."

A straight shooter who engages her opponents in spirited debate, Murphy, 55, oversees all SFERS operations, including investment strategy, benefits administration and personnel matters. Leading a staff of 77, she works closely with David Kushner, the deputy director of investments, who functions as CIO. Murphy also represents the system before the San Francisco city council, known as the board of supervisors, and reports to the seven-person SFERS board, which has final authority over asset allocation and investment strategies. The board president, Joseph Driscoll, a lieutenant in the San Francisco Fire Department who holds an MBA and a CFA, has been a driving force behind the plan's investment innovations since he became a trustee in 1986.

San Francisco's pension success has been helped by the fund's rare governance structure. For the vast majority of public plans, city councils or state legislatures determine retiree benefits. Since 1889, when fines and pawnshop fees funded benefits for policemen, the San Francisco plan charter has stipulated that voters must approve retiree benefit levels. Proposals to boost benefits for public employees must undergo a lengthy and public process before getting the go-ahead. First, San Francisco's 11-person board of supervisors must vet any proposal, examining its costs as determined by the SFERS actuary. Then the supervisors vote on whether to put the measure before the public. The entire process usually takes six to nine months.

Between 1976 and 1996 cautious voters kept benefit levels frozen at levels roughly 10 percent lower than the California median. On two occasions during that period, voters rejected efforts by police officers and firefighters to boost benefits; they also turned down two attempts to change the charter so that plan provisions would be determined by collective bargaining rather than at the ballot box. Later, with markets soaring, voters loosened the purse strings a bit. In 1996, 1998 and 2000, they authorized hikes for firefighters, police officers and general employees, respectively, that increased benefits by some 20 percent on average. SFERS benefit levels are now near the state average for firefighters and policemen but remain about 10 to 15 percent below median levels in California for general employees, who represent 87 percent of all SFERS members.

Thanks to SFERS' strong funding ratio, the city of San Francisco, whose budget is perennially in deficit, enjoyed a contribution holiday from 1998 to mid-2004. For the fiscal year ended June 30, 2005, the city's contribution rose to $94 million, or 4.48 percent of payroll; it increased to about $138 million, or 6.58 percent of payroll for fiscal 2006. The increases reflect enhanced wages and benefits and the lowering of investment earnings assumptions in 2003.

SFERS' commitment to fiscal prudence puts it in sharp contrast to troubled public pension plans throughout the country. An extreme case in point: the San Diego City Employees' Retirement System. Unlike San Francisco, which stuck to a prudent benefits policy even in the heat of the bull market, San Diego made a name for itself as a model of profligacy and, possibly, self-dealing. In 1996 and 2002 the San Diego plan trustees voted to allow the city to underfund the pension system and boost retirement benefits at the same time. The result: a 66 percent funding ratio and a $1.4 billion shortfall for the San Diego plan and a downgraded bond rating for the city that has prevented San Diego from borrowing at reasonable rates. In May the district attorney for San Diego County filed felony conflict-of-interest charges against six former and current members of the system; the Federal Bureau of Investigation and U.S. Attorney's Office are investigating possible federal fraud and public corruption; and the Securities and Exchange Commission is probing whether city officials violated securities laws by failing to disclose San Diego's financial plight to bond investors (Institutional Investor, March 2005). Last month, in the wake of the ongoing scandal, the city's mayor, Dick Murphy, resigned.

For its part, the San Francisco retirement system has been well served by its seven-person board -- there are three mayoral appointees, three representatives elected by active and retired employees and one member of the city board of supervisors -- which has strongly supported the fund's innovative investment approach. Most important, SFERS has made a substantial and largely successful bet on alternative assets. The portfolio, which dates to 1987, includes venture capital, private equity and distressed debt but notably does not embrace hedge funds. The plan has also scored major gains from an outsize stake in real estate.

The fund's overall returns have been consistently strong. The ultimate beneficiaries, Murphy notes, are the city's workers and retirees. "Every month we write 19,500 retiree checks worth just under $40 million," she says. "It's wonderful to be paying people what they earned, with real money."

AT THE HELM OF THE SAN FRANCISCO PENSION fund, Clare Murphy radiates the confidence of the hometown girl that she is. Born in San Francisco in 1949, she grew up the eldest of 11 children in a crowded house in the working-class neighborhood of Glen Park. Everyone in the family had a strong sense of public service; Murphy's mother was a community activist focused on crime. Today five of Murphy's brothers and sisters work for the city and county of San Francisco, while two others work for the states of California and Oregon.

Sharing a bedroom with three sisters and eating dinner in a family of 13 inculcated both civics and civility, Murphy says. "We'd discuss all sides of an issue, but in a civil fashion," she says. "I learned when to listen and when to hold firm to a viewpoint. We all learned not to have fat heads."

Murphy attended Catholic schools, earning scholarships to the University of San Francisco, where she earned a BA in political science in 1971, and to Georgetown University, where she took a master's degree in government in 1973.

That year Murphy signed on with SFERS full-time, landing a management job. She began a four-year project to transfer the accounts and assets of 5,500 teachers from SFERS to the California State Teachers' Retirement System. "I was managing a team, educating members, doing calculations and learning about investments," she recalls. "I was completely hooked."

In 1976, Murphy became an assistant to the executive director, a position that allowed her to work with her father, Cornelius, who was leading a project to establish a new city payroll system. "He was an exceptionally patient man," says Murphy. Her father worked for the city for 33 years and

enjoyed a retiree's pension for 15 years before he died in 1996.

Murphy moved steadily through the ranks. In 1982 she became the staff actuary, gathering data for the consulting actuary to crunch. In 1985 the board of supervisors named her executive director, a civil service position. Over the years she has won the admiration of plan trustees and her colleagues in the state, who praise her straightforward style and common sense.

"She's a strong administrator who can say, 'Here's how things work,' and she has the respect among the political leadership to make those ideas prevail," says Rich Goss, administrator of the California Association of Public Retirement Systems.

"Clare can rub people the wrong way when she tells them things they don't want to hear," notes William Breall, a cardiologist who served as an SFERS trustee for 15 years before stepping down in 2004. "But I say, good for her."

Last year, for instance, Murphy urged caution when board members tried to create a program that would allow retiring workers to bank unpaid sick pay and comp time -- payments that can total as much as $100,000 for a firefighter or a police officer -- in tax-deferred accounts. "I was telling them that this was complex and it would need to meet Internal Revenue Service regulations, which hadn't been defined," Murphy says. Fire and police unions persuaded the board of supervisors to put the proposal before city voters in March 2004. It passed. But within a week the IRS issued new regulations that conflicted with the plan, which has not been implemented.

Murphy's managerial skills have been tested in SFERS' investment division as well. Herb Meiberger, a midlevel employee, works on cash flow and compliance issues, but since 1992 he has also served as a trustee, elected by plan members. It's an inherently awkward situation. As an employee, Meiberger is subordinate to deputy director of investments Kushner and ultimately to Murphy; yet as a board member, he is part of a group with authority over investment decisions. "It's been a touchy situation," concludes Meiberger, adding that he has voluntarily recused himself from participating in the annual evaluation of the executive director.

Nonetheless, tensions have flared. In an unusual move Meiberger in 1992 filed suit against Murphy and the board, alleging that they were withholding information from him. The parties settled when the board strengthened its open-records policies and agreed to provide information in a more timely manner. Meiberger also chides Murphy for a 2001 consultant's study that suggested changing the city charter to allow SFERS to use an outside actuary instead of employing one in-house. "It was a bought-and-paid-for study," says Meiberger. "It was a power grab by the executive director." Murphy says the board of trustees ordered the study.

"Mr. Meiberger is expressing his own opinion, which is not consistent with the board's view to date," she asserts. Murphy has acted as the plan's actuary since July 2002, six months after the previous staff actuary, Kieran Murphy (no relation), disappeared at sea.

Despite the occasional controversy, Murphy has enjoyed especially smooth relations with San Francisco's board of supervisors -- not surprising, given that the system's strong funding levels meant that no contributions were required from the city for six years.

"If you add costs to a budget, that causes everybody's red flags to go up," says Murphy. "But if you don't impose new costs, you become to a degree invisible."

It wasn't such a rosy picture back when Murphy joined SFERS. Inflation sparked by the oil shock of 1973 was triggering wage increases and boosting employer pension contributions that for firefighters and police officers would peak in excess of 100 percent of salaries in the early 1980s.

In 1976, John Barbagelata, a supervisor who had run a close second to George Moscone in the race for mayor the year before, tried to repair the system. He proposed that benefits for new employees be cut by about 20 percent, back to the levels of the late 1960s and below statewide averages. Voters supported Barbagelata's proposal; benefit levels held steady for the next 20 years.

In another act of fiscal prudence, voters agreed in 1980 to amortize future benefit increases over 20 years instead of the 30-year period used by most public pension funds. Under the previous method the plan would have approached but never achieved full funding.

During the past two decades, bolstered by San Francisco's judicious benefit policies, SFERS investment staffers, working with board members, have developed the plan's top-performing investment portfolio.

Aside from its outsize bets on alternatives (10.3 percent of total assets, versus an average of 4.2 percent for public plans surveyed by Nasra) and real estate (8.2 percent of assets, almost double the level of its peers), SFERS' asset allocation is generally in line with most public plans'. As of March 31 the fund kept 32.7 percent of assets in U.S. equities and 17.3 percent in international equities, 30.2 percent in fixed income and 1.3 percent in cash. Roughly 80 percent of SFERS' assets are actively managed and outsourced; about 20 percent are indexed in-house.

The bond mix is a spicy one, and it has been a major driver of performance. At the end of March nearly 10 percent of the bond portfolio was in emerging-markets debt, 10 percent was in high-yield corporates, and 10 percent was in high-yield commercial-mortgage-backed securities. Over the past five years, San Francisco's fixed-income investments have returned an annualized 9.1 percent, nearly 200 basis points more than their policy benchmark, an 80-20 blend of Lehman Brothers' universal and global aggregate bond indexes. The San Francisco plan's ace bond managers include Ashmore and Grantham, Mayo, Van Otterloo & Co.

Less impressive is the plan's stock-picking prowess. Equities have slightly underperformed, mostly because of SFERS' international investments, all actively managed. In the 12 months through March, the fund's stock portfolio returned 9.52 percent, compared with 9.85 percent for its benchmark, which is a blend of roughly two thirds the Russell 3000 index and one third its international equity benchmark. Over the past five years, stocks lost an annualized 2.04 percent, while the benchmark lost 1.77 percent.

SFERS has benefited handsomely, however, from its relatively big bet on real estate. Beginning with a $40 million investment in the closed-end Coldwell Banker Institutional Fund III in 1978, SFERS has steadily deepened its exposure to the sector and now includes co-investments in apartments and industrial properties. Over the past five years, the plan's real estate portfolio has returned an average annual 9.92 percent, about even with the National Council of Real Estate Investment Fiduciaries property index and well above the annualized ­3.16 percent return of the Standard & Poor's 500 index.

One of San Francisco's boldest investment moves seemed at first terribly ill-timed: In September 1987, just a month before Black Monday, SFERS became one of the first public plans to invest in venture capital. It committed $30 million, or about 1 percent of its assets, to Crossroads Group, a Dallas-based fund of funds. Callan Associates, then the plan's general consultant, endorsed the move, and Cambridge Associates, which took over as chief consultant in 1989, encouraged further alternative investments.

San Francisco's stakes in such top flight private equity funds as Battery Ventures, Knightsbridge Advisors and Polaris Venture Partners helped the plan's venture capital portfolio deliver an average annual 22.6 percent return between its 1987 inception and year-end 2004. That is well above the 15.96 percent posted by the portfolio's benchmark, the S&P 500 index plus 5 percentage points.

But, like many investors in the bubble years, Murphy & Co. made the mistake of overinvesting in venture capital, more than doubling the plan's commitment to the asset class just as valuations were reaching their peak in 1999 and early 2000. Many start-ups backed by venture funds suffered significant write-offs or write-downs after the bubble burst.

As a result, for the five years ended December 31, 2004, SFERS' venture capital portfolio returned ­12.5 percent, compared with a 2.7 percent gain for its benchmark. During the same period the plan's private equity portfolio did considerably better, returning an average annual 3.6 percent.

Interestingly, while other public plans have moved into hedge funds, San Francisco, the established innovator, has steered clear. Says Kushner, "We're concerned about the lack of transparency, high fees and the inability to benchmark-manage hedge fund managers and strategies." Adds trustee E. David Ellington, a lawyer and entrepreneur, "Now we'd be late to the game."

Through booms and busts the SFERS board has remained unusually receptive to new investment approaches. "The trustees are more willing than a standard public fund board to embrace new ideas and think ahead of the curve," says Kushner, who joined the system in 2001 after stints at ING Investment Management in Atlanta and ICC Capital Management in Orlando, Florida.

Leading the way is board president Driscoll, a San Francisco firefighter who estimates that he spends an average of 20 hours a week on board matters, reading journals and reports and meeting regularly with fund managers, often at his fire station at 7:00 a.m.

"Joe's one of the brightest guys I've ever met," says Ellington. "Before he proposes an idea, he makes sure that senior people in the system know where he's coming from, and he invites them to poke holes in his reasoning."

In 1996, Driscoll pushed SFERS to become one of the first public pension plans to invest in emerging-markets debt, beginning with a $100 million commitment to a fund run by Boston-based Grantham Mayo. The fund, which invests mainly in sovereign debt instruments, including defaulted loans, trade receivables and Paris Club obligations, isn't for the squeamish. It plunged 40 percent in August 1998 after the collapse of the Russian ruble and the meltdown of Long-Term Capital Management.

"A lot of people got scared, and a lot of people got nailed," recalls William Nemerever, who co-manages Grantham Mayo's fixed-income group.

Not the San Francisco retirement system: It persevered. The Grantham Mayo fund recovered and by the end of the year had lost only about 25 percent. Since 1996 it has returned an impressive 19 percent a year, compared with 12 percent for its benchmark, the J.P. Morgan emerging markets bond index. Other U.S. public pension plans have invested in the fund, but none has invested an amount even close to that of SFERS, says Nemerever. At the end of March, SFERS' investment in the fund was valued at $260 million, representing 2 percent of plan assets.

With Murphy's administrative support, Driscoll also helped lead the board into sovereign debt investing. In 2002, SFERS allocated $75 million to an emerging-markets local-currency debt fund run by Ashmore. The fund holds positions in bonds, interest rate swaps and other derivatives in about 20 countries. "The use of derivatives is problematic for some investors, but these investments are not particularly high risk," says Ashmore's Booth. "San Francisco was ahead of the curve."

Over the three years ended in March, the fund's stake in the Ashmore fund, now worth $109 million, has returned an average annual 15.57 percent, about 240 basis points higher than its benchmark, the J.P. Morgan emerging local markets index.

Driscoll also pushed for the plan's new currency-overlay program, which began on July 1. The managers of the program, San Francisco­based Barclays Global Investors, London-based Pareto Partners and Bridgewater Associates of Westport, Connecticut, will make targeted currency bets to reduce volatility and, it is hoped, add alpha to 80 percent of the plan's $2.2 billion international equities portfolio.

"Compared with other public pension plans, it looks like the risk and diversity of our portfolio is at the edge of the envelope," says Driscoll. "But maybe the other plans are in the wrong place."

The fund's general consultant, Angeles Investment Advisors of Santa Monica, California, is expected to complete an asset allocation study in September. In July the board agreed to accept Angeles Investment's recommendation to adjust its current targets. The target for international equities would rise by 5 percentage points, to 20 percent; U.S. equities would be trimmed by 3 points to 28 percent and real estate by 2 points to 10 percent, reflecting a dearth of good investment prospects. Still, SFERS is set to make its first investment in international real estate with a $50 million commitment to AMB Property Corp.'s AMB Japan Fund I. No other significant allocation shifts are likely, Kushner says.

Despite the plan's investment successes, the city's pension outlays are rising, to 4.48 percent of employee payroll in fiscal 2005 and 6.58 percent for fiscal 2006. And the San Francisco employee union is pressuring the city to boost benefits for the 87 percent of active members who are not police officers or firefighters.

"The city's contributions are going to keep growing and will create a budgetary burden that the city had been relieved of for a while," says Angeles consultant Leslie Kautz.

Political pressures would inevitably redound on Murphy, especially if the city laid off workers or raised taxes to pay for the benefit increase. But in San Francisco, it is the citizens who determine the retirement benefits of city workers. "It's the voters who make the commitment," Murphy says. "It's our job to make good on the pension promise."