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MYSAK: SAN DIEGO...PUBLIC PENSION MELTDOWN

Joe Mysak is a columnist for Bloomberg News. The opinions expressed are his own.

San Diego Report Depicts Public Pension Meltdown: Joe Mysak

Sept. 22 (Bloomberg) -- Combine equal parts of accounting fiction, political games with budgets and optimistic assumed investment returns, and you get a multibillion dollar public pension headache for states and localities over the next decade.

Consider, for example, what's going on in the city of San Diego.

Back in January, the city sent out a special disclosure notice saying that its Employees' Retirement System (SDCERS) was only 67.2 percent funded. There was more than $1 billion between what the system needed, and what it had on hand.

The announcement set off alarms at the rating companies, which lowered the city's credit rating, as well as at the Securities and Exchange Commission and the U.S. Attorney's office, both of which began investigating what happened and why.

The city hired the law firm of Vinson & Elkins to review its disclosure practices from January 1996 to February 2004, and to represent it before the SEC. Attorneys Paul Maco and Richard Sauer, who wrote the report, both used to work at the SEC, Maco as the head of the Office of Municipal Securities.

The firm last week released a 276-page report on its investigation, which makes for the most compelling municipal market reading since the U.S. Attorney's lawsuit against the ex- treasurer of Philadelphia and his friends back in June.

Cut Contributions

That lawsuit depicted a pay to play culture in operation in Philadelphia. The Vinson & Elkins report isn't quite so lurid, yet it describes a much bigger and more widespread problem than municipal corruption.

The report said there was no evidence the city meant to deceive investors, but said its disclosure was prepared ``in a routine and occasionally careless manner that focused on current issues while regarding long-term concerns as speculative and inappropriate for disclosure.''

The report also provides context.

``The history of the relationship between the City of San Diego and SDCERS plays out as a series of initiatives by the City to reduce (at least in the short term) its contributions to the System, typically in response either to economic conditions that caused budgetary strain or to concessions made to the City's labor organizations,'' says the report.

``Many of these initiatives have been supported by the labor representatives on the Board. The result in each case was the postponement of difficult budgetary decisions into the future, often exacerbating the problems through the delay in confronting them,'' the report continues.

Surplus Earnings

Sound familiar? Let's not put as much money in the pension system as we should; let's increase benefits in the future instead. Let's not put in as much money in the pension system as we should; let's increase how much we think we'll make on the system's investments.

San Diego is not alone.

There are so many excellent parts to this report, which takes you right inside city government, that it's hard to know where to begin. Perhaps the one section every municipal official should read, though, is the one dealing with the concept of ``surplus earnings.'' This is where the city's troubles began.

In 1980, San Diego's city council decided to allocate 50 percent of the excess over the pension system's assumed rate of return to retirees, in the form of a ``13th check.''

``It looked very much as if this measure did no more than distribute investment windfalls to needy retirees,'' says the report. ``This view, unfortunately, was based on a fundamental misunderstanding of the actuarial concepts that underlie the funding of pension systems, public and private.''

Which is that above-average returns are supposed to offset years of below-average returns over the long haul.

Think Long Term

``The surplus earnings concept ignores this long-term dynamic of actuarial projections. It evaluates returns on a year- by-year basis and treats all cash generated by system assets (beyond assumed rates of return) as free money,'' says the report.

``This, of course, flies in the face of the basic premise of actuarially assumed returns: they are rarely met for any individual year, but are expected to average out over time to approximate the projections. Therefore the concept of `surplus earnings' is a misnomer. Unless and until it can be demonstrated that the actuary's projections are unrealistically conservative, all earnings are necessary to support the long-term viability of the system -- none are truly `surplus' or `excess.' ''

This will come as news to the public officials who cast a covetous eye on the outsized earnings pension plans wracked up in the late 1990s. As the report notes, ``San Diego is far from unique in its embrace of the view of surplus earnings as a budgetary free lunch. Many other municipalities nationwide have used surplus earnings to fund benefits that otherwise would come out of their general budgets (or not be granted).''

Nobody talks about surplus earnings today, of course.

But because states and municipalities reduced their contributions, the money's not there. The obligation is. So are all those little goodies they gave away as enhancements, in both good times and bad. There's a mismatch here. The mismatch is that politicians think short-term, and pension plans are long-term. Big problem.

To contact the writer of this column:
Joe Mysak in New York jmysakjr@bloomberg.net.

To contact the editor responsible for this column:
Bill Ahearn at bahearn@bloomberg.net.