September 17, 2004

Budget Use of Pensions Sows Trouble in San Diego


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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