September 17, 2004
Budget Use of Pensions Sows Trouble in San Diego
By MARY WILLIAMS WALSH
San Diego is caught in a financial bind, facing the
possibility of a bankruptcy filing, largely because of a $1.2 billion
shortfall in its pension fund for municipal workers. For years the city
has spent money from illusory pension fund earnings, according to the
authors of a new report released yesterday.
Yet the practice, which the authors called dangerous, is sanctioned by
law in California and other places and is commonplace among cities that
offer pensions to their workers. The findings raise the possibility
that other communities will face similar financial disasters.
At the core of San Diego's troubles, according to the report, is its
use, year after year, of pension fund earnings that exceeded
projections to pay for a variety of local projects, including expenses
associated with playing host to the 1996 Republican National Convention
and paying health insurance premiums for retired teachers and
firefighters.
But actuarial projections are long-term averages, and when the
above-average earnings are used in a good year, that does not leave any
money to offset the inevitable bad year.
The idea that a pension fund provides "free money" that a city can
spend is "dangerous and widely misused," said the report, which was
commissioned in February by the mayor of San Diego in an effort to
identify flaws in the city's financial reporting procedures and to
recommend corrections. Many local governments harness illusory pension
money as San Diego did, the authors said.
"This was not something done by stealth. This was not unique to San
Diego," said Richard Carl Sauer, a former official of the Securities
and Exchange Commission and now a partner in the Washington office of
the law firm of Vinson & Elkins. "Any number of municipalities have
used surplus earnings to cover budget items."
Mr. Sauer and the new report's other author, Paul S. Maco, said they
were not aware of any single source of detailed information on the
handling of state and local pension funds. Therefore, they said, it was
impossible to predict how many other localities might end up in San
Diego's situation.
"One thing that is fair to say is that part of the story in San Diego
is that people were not taking a very close look," said Mr. Maco, a
former S.E.C. lawyer who oversaw the agency's work on Orange County,
which declared bankruptcy in 1994. He, too, is now a partner with
Vinson & Elkins in Washington, specializing in securities law and
public finance.
"If there's one message that comes from this," he said, "it's that
cities should take a very close look at the status of their obligation
to fund their pension system."
Though San Diego's troubles are thought to have been brewing for more
than two decades, their severity was not widely understood until
recently. For many of the years when the city was setting the stage for
its current problems, it was winning awards for the quality of its
financial reports and being given high ratings by credit agencies.
These days, San Diego is unable to issue bonds because of errors in its
2003 annual report, which is being redone. In addition, the S.E.C. and
the Justice Department are investigating its financial management and
legal disclosures.
The awareness of a problem started with the appointment in 1997 of a
registered investment adviser, Diann Shipione, as a trustee of the city
retirement system. Ms. Shipione said in an interview that she was
increasingly troubled by the way the city was handling the pension
fund, but other trustees rebuffed her questions and challenges. She
went public with her concerns when she read the prospectus for a
municipal sewer bond issue and realized that the city was not
disclosing the magnitude of its pension debt, raising the possibility
that one day the bondholders and the pensioners would be competing for
the same money.
Cities are not held to the same standards of disclosure that
corporations are when they issue stocks and bonds. The only relevant
provisions of the federal securities laws are broad prohibitions of
significant omissions and misstatements. Until now, the S.E.C. has
never brought an enforcement action over a city's pension disclosures,
Mr. Maco said.
The basic cause of San Diego's troubles is the tension between the
obligations of its pension fund, which come due over many decades, and
its annual budget, which has to be balanced. When actuaries calculate
the value of a pension fund, they project the rate of return the fund
will achieve on its investments, generally basing that on the kind of
investments in the fund. The projected returns are used to calculate
the amount the city will have to pay into the fund every year to keep
it sound.
In reality, the pension fund is unlikely to return exactly what the
actuary said it would in any single year. But over the long term, the
excess returns in the good years are supposed to offset poor returns or
losses in the bad years.
"When above-average returns are defined as 'surplus' and siphoned off
for other uses," the report said, "the result may be the depletion of
the system's financial strength" because there is no financial cushion
for the bad years.
That appears to be what happened in San Diego. In 1980, city officials
noticed that the pension fund was producing what came to be known as
"surplus earnings." They withdrew this hypothetical surplus and used it
to finance a cost-of-living adjustment for the city's retirees.
Soon after that, the city found more "surplus" pension money, and used
it to pay the premiums for its retirees' health insurance.
"We call that concept 'shaving off the mountaintops,' " said Rick
Roeder, the actuary for the retirement board. He said that because he
worked for the pension fund, and not the city, he had been unaware of
the extent of the problems that were brewing.
Years ago, corporations also withdrew actuarial surpluses from their
pension funds, and put the money to work in the business. But the
practice became fiercely controversial in the 1980's, when disputed
surpluses became a factor in corporate takeovers. Congress eventually
imposed steep excise taxes on these withdrawals, making the "free
money" suddenly look very costly. Today, companies rarely withdraw
pension money for business purposes. Publicly traded companies, though,
are still able to factor their illusory pension earnings into their
bottom lines.
San Diego authorities continued to rely on the pension fund's "surplus
earnings" until 1996. The routine was thrown off that year by a number
of increases in promised employee benefits. The city and its labor
unions reached a temporary agreement that the pension fund could make
do with smaller contributions for a time. That gravely weakened the
pension fund, but a roaring stock market concealed the problem. The
temporary underfunding became permanent.
It was at this point, according to the new report, that the city's
financial disclosures "began to exhibit significant inaccuracies and
omissions."
The authors do not cite individuals for particular blame, but instead
describe "a failure of city personnel to understand the increasing
complexities" building up in the pension fund and "poor communications
with outside professionals," like the actuary, who could have advised
them of the risks they were taking on.
They recommend that the city adopt higher disclosure standards, similar
to those set in the Sarbanes-Oxley Act in the wake of the Enron
scandal.
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