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Dude, Where’s My Investment?

After two years of relying exclusively on MUNI, BART, and my Bianchi, last year I broke down and purchased a car− my first new car in twenty years. Negotiating for a car has become much simpler. Immediate mobile phone price comparisons have squeezed dealers’ commissions and forced dealerships to rely more on volume and customer service.

Similarly, internet price comparisons have reduced fees on mutual funds investing.

When I purchased my car, I delivered a check and told the representative I would pick my car up the following week. The rep said he would register my car with DMV and it would be waiting for me in stall #1234. By happenstance, the next day I invested in a mutual fund. I wrote a check and the representative offered to send me the shares or the company would hold my shares in account number #1234. Pretty simple. Pretty similar transactions.

why has the San Francisco Employee Retirement System (SFERS) left public employees’ $3 billion deferred comp so convoluted that no one can define what type of investment it is?”

So with technological advances, it causes one to question why has the San Francisco Employee Retirement System (SFERS) left public employees’ $3 billion deferred comp so convoluted that no one can define what type of investment it is? Allow me to apply SFERS methodology to a hypothetical example of a car purchase, where the car is the metaphor for an investment in a mutual fund. If you find the complexity of my example discouraging, you should question whether your entire investment exists, and who is holding the shares that do exist.

Assume a San Francisco police officer, a fireman from Seattle, and an accountant from El Paso visited a car dealership to purchase cars for their children that were scheduled to graduate from college at the end of the semester. When the three public employees pulled out checkbooks, the dealer advised them, “Don’t write the check to us. Make your check payable to State National Life Insurance.” The fireman protested that he didn’t need life insurance, whereby the salesman responded, “By writing a check to the life insurance company, you will acquire the car for a cheaper price.” The police officer, obviously the smartest person, inquired, “Businesses all try to eliminate the middleman, but you are adding a middleman, and claiming that this will lower the cost? Is the life insurance company working for free?”

One month later, the accountant from El Paso visited the salesman to take a photograph of the car her son would receive upon graduation. She asked what stall her son’s car was parked in and the salesman responded: “Your car is actually registered to State National Life Insurance Company and parked in their lots. The insurance company has converted your ownership into three ‘units’ which act like a claim voucher.” The accountant pressed, “How do I know that State National Life actually purchased my car and that they aren’t just using the float on my money until my son’s June graduation?” The salesman’s answer: “Trust us.”

There are four primary problems with this scenario, and by extension SF’s deferred comp:

First, to accept that adding an extra insurance middleman-layer lowers costs requires a willing suspension of disbelief.

Second, if car buyers are not provided evidence of owning a specific car, and they don’t need the car right now, one can question whether State National Life is buying the car or substituting a cardboard replica until the buyer actually needs the car.

Similarly, Prudential’s contract with the city, (Item 5(a)) provides Prudential with the flexibility to replace derivatives, futures, and options for the mutual funds investors think they are buying. These esoteric instruments are leveraged, risky, and complex; and allow Prudential to mimic a mutual fund’s investment performance for a fraction of the investment outlay. This frees Prudential to use some of deferred comp investors’ money for other Prudential uses. In 2009, one of the SFERS’ deferred comp components lost over $100 million from derivatives− not a temporary fluctuation of price, but a permanent vaporization of the investment.

Third, because investors’ cars are not earmarked and they instead acquire a proportional interest in State National Life’s entire fleet, if the Seattle fireman’s check bounces, that has the effect of reducing the value of everyone else’s “claim vouchers.”

Likewise, Prudential’s marketing brochure describes how every public employee from Seattle to El Paso to San Francisco has his or her investment commingled into one big multi-employer account. Thus, even if SFERS claims that their members are pure of derivative diseases, the fact that SF employees are swimming in the same infected pool with other cities means that the financial health of SF’s assets are still subject to the contagious Prudential contracts with other cities.

Fourth, like FDIC insurance, SIPC insurance exists to protect mutual fund investors from transgressions up to $250,000. The security of that SIPC insurance is forfeited when Prudential alchemizes mutual funds into one large insurance account.

Prudential’s annual independent audit verifies the assets on Prudential’s books. However, that audit does not investigate the security, composition, or proportional value of San Francisco’s $3 billion stake in the great Prudential commingled account. The only way to confirm that a) Prudential actually invests 100% of San Francisco’s money, and b) San Francisco’s assets are segregated from the contractual whims of other municipalities; would be for SFERS to present the account statements from Vanguard and Fidelity. If the Vanguard and Fidelity statement values do not exactly match the values SFERS disclosed in their annual report, the annual report must have been based on conjecture.

As discussed above, embedded in SFERS’ 2008 annual report, were the spreading sparks of disparity between what SFERS reported as balances and an investment component that was evaporating. The end result: a $100 million firestorm that the next generation of city employees had to replenish. Without an independent audit, or SFERS providing the source documents for their annual reports, investors’ are doomed to repeat themselves.

I met with SFERS Executive Director Jay Huish on November 21st and presented him with the aforementioned issues.

Lou Barberini is a West Portal CPA. Feedback: Lou.barberini@gmail.com

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