Understanding San Diego's $1,700,000,000 pain in the ass

By Daniel Strumpf

Chaos rules in San Diego. The city is in deep financial and political doo-doo, and city officials are either resigning, being forced to resign or being charged with crimes one after the other. But ask your average urban dweller how our city-once touted as a paragon of financial virtue-fell from grace into the municipal manure pile, and you'll either get a blank stare or a mumbled explanation that has something to do with a pension system. At the same time, talking to an “expert” can be a lot like drinking from a fire hose.

That's why CityBeat decided to boil down the inherently complex tale of how our city ended up $1,700,000,000 in the hole and what led to multiple civil and criminal investigations.

We've removed all of the advanced mathematical mumbo-jumbo, enough acronyms to cause a cerebral hemorrhage and whittled three decades worth of history down to the bare essentials. What's left is a hopefully digestible tale of how San Diego ended up in the dire situation in which it finds itself these days. We offer it to our readers with the hope that knowing how we got into this mess will help us find our way out.

How a pension fund works

Employees of the city of San Diego get money from city's pension plan from the time they retire until the day they die. To provide that, the system depends on three sources of funding:

1. City employees contribute a portion of their annual pay.

2. The employee contribution is matched by their employer, the city.

3. The money collected from these two sources is then invested in hopes of generating profits, which are funneled back into the system.

How exactly that money is invested is controlled by a board of 13 trustees who, under state law, must act prudently and diligently to protect the integrity of the fund-a duty that takes precedence over any other.

To determine how much the city and its employees have to chip in, these trustees rely on a type of accountant called an actuary. That person determines how much money the system needs to pay its current retirees, as well as how much money it needs to invest that year to eventually support current employees when they retire.

To do that, the actuary uses a series of complex calculations taking into account factors like the number of recent retirees who will start withdrawing money from the system, the number of retirees who've recently died who no longer draw a monthly check, anticipated pay raises and potential investment earnings.

That cost is then evenly spread out over a given period of time, just like a car payment or mortgage, to determine how much money the system needs to operate this year. Subtract the assumed investment income, and the remaining total represents the amount the city and its employees owe the system. If both groups contribute half, then the system is fully funded according to the actuary's projections, or, is said by those in the biz to have achieved “full actuarial funding.”

Fast fact

Unlike the not-so-secure federal Social Security program-which takes money from a current worker and gives it to a current retiree (leading to big problems when retirees eventually outnumber workers)-the city's pension system puts the employee's money away for safekeeping, investing it so that small sum grows over time into enough money to support that same employee at retirement.

How it all began

In a prelude to a series of deals that led to the intentional under-funding of the pension plan, city officials and pension trustees developed a number of bad habits and policies that would eventually add to the retirement system's problems.

In the early 1980s, the City Council began counting the profits from the system's investments that were over and above those anticipated by the actuary as extra earnings-or, free money!-and using them to pay for additional employee benefits. That prevented those profits from being reinvested, undermining the actuary's assumptions and leaving no cushion for years when investments performed below expectation.

In the early 1990s, a faltering national economy and the first Gulf War hit San Diego hard in the ol' wallet. In 1992, City Auditor Ed Ryan, who also served as a retirement trustee, convinced his fellow trustees and their actuary to play a few accounting tricks in hopes of reducing the amount of money the city was supposed to kick down to the pension plan. Ryan succeeded in reducing the dollar figure the city owed to the pension fund by using a less conservative method of calculating that contribution, but ensuing increases in retirement benefits and low employee turnover would actually increase the city's contribution. Oops!

Where's ed?

When Ryan's name was not among those who received federal subpoenas in 2004 and 2005, some observers privately mused that he was probably in a back room at FBI headquarters singing like a bird.

Despite Ryan's accounting tricks, the city's tab for the pension bill jumped by nearly $10 million in 1995. Added to state raids of city property-tax coffers and a national recession, the increase left city officials-who were busy planning expensive special projects like hosting the 1996 Republican National Convention-short of funds.

No doubt envious of the city's impressive investment returns, in 1995 Ryan persuaded his fellow trustees to make an exception to the rule requiring the city to make the full payment recommended by the actuary. Instead, he suggested using some of the system's extra investment income to cover what the city was supposed to pay into the fund. The trustees approved the plan with a 7-6 vote, hoping to prevent what Ryan said were otherwise necessary city employee layoffs, but the pension system's lawyers jumped in front of the oncoming train.

The city would have to stick to the rules and make its full contribution this year, they said-but the seed of things to come had been successfully sown.

Big Fat Mistake No. 1

The following year City Manager Jack McGrory, the top municipal employee accountable directly to the City Council, came up with a plan that would finally sway the trustees and their attorneys. He offered to increase employee and retiree benefits-including those of a majority of the pension trustees, because they're city employees-but only if the trustees agreed to let the city pay less than what the actuary said it owed.

Fateful decision

That stipulation raised at least one trustee's eyebrows about an apparent conflict of interest, but the pension system's lawyers ultimately approved the deal. No one bothered to mention that both the City Charter (which is like a constitution) and the Municipal Code (a book of laws) required the city to make the full payments recommended by the actuary.

As an alternative, the city would switch to a rigid payment plan designed to immediately save the city money by lowering its 1996 bill. Over time, the payments would gradually increase to the level recommended by the actuary, with the largest payments coming in later years to be paid by future taxpayers, a favored trick of politicians hoping to avoid tough decisions.

The plan also envisioned transferring the burden of providing healthcare for city retirees from the city to the retirement system, a move that later won voter approval, but the city has since neglected to provide funding for that benefit. Instead, more of the system's excess investment earnings were to be used to cover the cost.

In exchange, the scheme established several new employee benefits, such as the drowsy-sounding “deferred retirement option program” (DROP), which allowed senior employees to start drawing pension checks up to five years before they actually retired. Woo-hoo!

But because the plan raised the system's expenses-increasing benefits and adding the cost of retiree healthcare-while simultaneously reducing the city's payments, the pension fund took a double hit. Knowing that there'd be some impact to the bottom line, McGrory poked two safeguards into the agreement: a provision that the deal would expire by 2009 and the city would return to kicking down its full share of funding, and something called the “trigger.”

The trigger

If for any reason the system's funding level-basically, the how much money the system has versus what it owes-fell below 82.3 percent, the city would have to make an immediate “balloon” payment to the retirement system, enough to raise the funding level back to 82.3 percent, and from that day forward the city would have to resume making the full actuarially recommended contribution.

McGrory's plan initially proved effective, lowering the city's annual payment to the system and, had everyone stuck to the plan, it just might have worked in the long run.

If that weren't enough...

During the next five years, several factors further undermined the pension fund, although their full effect was masked by the booming stock market.

* Post-retirement pay was allowed to exceed an employee's annual salary.

* Employees were allowed to purchase up to five years of employment credit at prices lower than what they normally would have contributed to the system, increasing their annual retirement pay.

* In 2000, the city settled a lawsuit filed by employees correcting an error in the way benefits had been calculated in the past, resulting in a large increase in benefits for employees and retirees.

* The DROP program was made permanent.

But, all the while, the city didn't increase its contribution to the pension fund as it was raising benefits, and its continued reliance on surplus stock-market earnings to fund those benefits put a stranglehold on the retirement system. As extra earnings were removed from the pension fund, system trustees had less and less money to invest, creating a negative spiral. The annual assessment of the system's finances in 2000 showed that, despite a substantial hit from the settlement of the lawsuit, the funding level had increased to 97.3 percent, the retirement system's highest mark in a decade. But in the coming year, the stock market took a nosedive, causing the funding level to plummet, and declining investment returns were only a small part of a much larger problem.

McGrory's payment schedule hadn't assumed a stock-market bust, and with each passing year the gap between the amount the city was paying and the amount the city really should have contributed to keep the system sound began to widen dramatically, silently driving the retirement system deeper and deeper into debt.

A Blue Ribbon Cover-up

By October 2001, Terri Webster, the city's assistant auditor and a pension trustee, could see that the pension fund's investment earnings had dropped dramatically, and she sent an e-mail alerting Cathy Lexin, the city's personnel director and fellow retirement trustee. It has become known as the “EEEK memo.”

EEEK! A memo!

The “EEEK memo” is one of the most referenced pieces of evidence in the City Hall investigation. In it, Terri Webster tells Cathy Lexin that, as of Aug. 31, 2001, stock-market earnings in the pension trust fund amounted to “about $15 [million] compared to $53 [million] same time 2000... a 71% drop! BEFORE 9-11-01!”

After 9/11, Webster had sent similar warnings of increasingly bad news to Ryan, her boss, and other officials, but she never shared her concern with the so-called Blue Ribbon Committee, a group of local business leaders selected by newly elected Mayor Dick Murphy earlier in the year to make an independent assessment of San Diego's fiscal health. Instead, she and Ryan fed the committee stale information about the pension system while simultaneously trying to influence the findings of Richard Vortmann, the Blue Ribbon Committee guy tasked with evaluating the pension system.

Cassandra complex

In memos from 2001 and 2002, Richard Vortmann, president of National Steel and Shipbuilding Co., comes off as somewhat of truth teller, albeit in private. Vortmann repeatedly argued to city staff, Mayor Murphy and fellow pension trustees that cutting deals to push the cost of benefits into the future was a recipe for financial disaster. But he never blew his whistle publicly.

From their perspective, Webster and Ryan could see that the pension fund was in big trouble, and it was only a matter of time before the funding level fell below the 82.3-percent trigger, forcing the city to make a payment of approximately $150 million, which the city couldn't afford-no way, no how.

And they had another good reason to keep the information under wraps.

By the end of 2001, the city was scrambling to complete the financing for the construction of the beleaguered Petco Park, and news of the city's financial troubles could have, perhaps, scuttled the already-tenuous deal.

The Blue Ribbon Committee would work for nearly a year before finally presenting its report to the City Council in April 2002, but by then the City Council had already been informed of the threat posed by the impending trigger payment.

With the burst of the tech bubble contributing to yet more budget woes, and with the results of six years of pension under-funding coming to a head, city officials once again faced the possibility of laying off workers. The City Council and City Manager Michael Uberuaga, who succeeded McGrory, decided to borrow a trick from McGrory and appeal to the labor unions for help.

Big Fat Mistake No. 2

In April 2002, the city finished its annual negotiations with the unions and offered to grant large increases in employee benefits-as well as special benefits for three union presidents-so long as the pension trustees agreed to absolve the city of having to make the $150-million trigger payment.

In June 2002, Lexin privately delivered some bad news to the City Council, informing them that the retirement board's actuary and lawyers had opposed a scheme, floated in May by City Manager Uberuaga, to lower the funding trigger from 82.3 to 75 percent. They rightly noted that it could jeopardize the system's long-term financial stability. Remember, the trustees' prime responsibility is to the system and its members, regardless of the city's ability to pay its bills.

The City Council voted to send Lexin to the pension board's July meeting armed with an approved fallback plan should the trustees reject the scheme to lower the trigger to 75 percent. It's likely that Lexin coordinated with Ron Saathoff, president of the firefighters union and a pension trustee, on the backup plan because when it began to look like the City Council's desired proposal would probably fail, Saathoff recommended something that looked a lot like Lexin's Plan B.

Ron Clams up

Ron Saathoff is a central figure in the pension fund crisis. In a May 21 e-mail to labor negotiator Dan Kelley, Terri Webster said Saathoff's approval of balloon-payment relief was crucial: “... especially need Ron behind releasing the trigger since he runs the show” at the retirement system. Saathoff benefited handsomely when, under the deal, his union-president job time was counted as city employment when it came time to dole out pension pay. Interesting side note: When CityBeat editor David Rolland recently overheard Saathoff and some of his firefighter colleagues complaining about media coverage of the pension crisis at a Mission Valley bar, Rolland offered to publish Saathoff's side of the story. Saathoff at that time agreed to sit down with CityBeat, but he has yet to return Rolland's call to set up an appointment.

The trustees approved Saathoff's idea, which left the 82.3-percent trigger but rendered it pointless because the trustees gave the city a five-year grace period to pay a balloon payment of what some thought was as low as $25 million but others said was more like $150 million. Four months later, on Nov. 15, 2002, before finally signing off on the deal, the trustees took the unusual step of requiring the city to take responsibility for any resulting legal actions against them.

On Nov. 18, the City Council was scheduled to vote on the plan-without public discussion-but Diann Shipione, a pension trustee who had previously written to the mayor expressing concern about the city's efforts to under-fund the retirement system. She appealed to Murphy and the City Council to look beneath the surface, warning that the benefits-for-payment-relief deal might be “corrupt.”

Notable & quotable

“What concerns me is that the benefit enhancements were conditioned upon the retirement board approving this agreement, and that is, in my opinion, ethically troubling.... I'll be quite frank with you, it almost appears to be corrupt.”
-Diann Shipione's comments to the City Council, Nov. 18, 2002

After hearing from Shipione, as well as plan supporters Saathoff, Lexin and Ann Smith-a lawyer representing the Municipal Employee's Association, the city's largest labor union-only visibly disturbed City Councilmember Donna Frye voiced concerns. In a fateful 8-1 vote, the City Council approved the deal. Frye voted no. That same day, the City Council also voted unanimously to approve the benefit enhancements.

The pension trustees and the city responded to Shipione's allegations by circling the wagons and taking aim. Newly hired Deputy City Manager Lamont Ewell wrote a memo to the City Council, charging that Shipione had “omitted, slanted and misrepresented the facts” and her fellow trustees went a step further to discredit her warning, taking out an ad in the Union-Tribune announcing, “Chicken Little would be proud.”

The Retirees Strike Back

Shortly after the 2002 deal was inked, Jim Gleason, a former city employee and pension trustee, filed a class-action lawsuit against the city and the retirement system on behalf of his fellow retirees, claiming that city officials violated local law by making less than the actuarially recommended contributions and that the pension trustees who profited from the deal violated state conflict-of-interest laws. After more than a year of litigation, the city settled in August 2004, agreeing to make a $130-million payment to the system in 2004-05 budget, start paying the full actuarial payment every year as of July 1, 2005 (and never under-fund again) and put up $550 million of city real estate as collateral just in case.

The agreement effectively repealed the under-funding schemes created under City Managers McGrory and Uberuaga, although the expensive benefits given to employees and labor leaders under the 1996 and 2002 deals remain in place. And there was another downside-the settlement froze the actuary's calculation until 2009, meaning that the city's contribution wouldn't change along with the system. As a result, the current payments aren't as large as they should be to keep the system sound.

The Disclosure Dilemma

In September of 2003, after Gleason filed suit, Shipione discovered that outdated and incorrect information about the city's funding of the retirement system had been included in a city bond document. Designed to provide potential investors with an assessment of city finances, the document was subject to federal government regulations, and the errors probably amounted to securities fraud.

Shipione blew her whistle again, causing upheaval at City Hall and prompting a review of the city's previous financial statements to investors. That review uncovered additional errors, some unrelated to the pension system. The city then hired KPMG, an outside auditing firm, to re-audit its 2003 statements.

In mid-January, City Auditor Ryan, who was ultimately responsible for the accuracy of the city's financial reports, announced his early retirement. His assistant, Terri Webster (the one who kept the Blue Ribbon Committee in the dark) would eventually be named acting city auditor, and on Jan. 27, the city voluntarily filed an official mea culpa, submitting changes to its annual financial report. In doing so, the city admitted to making errors and omissions. And federal regulators with the Securities and Exchange Commission (SEC) thought to themselves, Hmmm... very interesting.

Did you know?

Dozens of other faulty disclosures have since been found in documents dating back as far as 1996.

Eight days after the filing, a Wall Street firm lowered the city's credit rating, curtailing its ability to borrow money at reasonable interest rates. On Feb. 13-Ryan's last day with the city-the Securities and Exchange Commission officially requested documents related to Ryan's error-laden disclosures, and the U.S. Attorney's office announced that it had launched an investigation into possible fraud and public corruption. That's pretty much when all hell broke loose.

That news sparked additional downgrades to the city's credit rating, City Manager Uberuaga announced his resignation, Deputy City Manager Ewell was tapped to replace him in April and, as the new top dude, Ewell quickly learned that the SEC's inquiry had blossomed into an official investigation of possible securities fraud when subpoenas started arriving at City Hall.

By the end of June, the retirement system's debt had swelled to $1.3 billion.

Descent into Madness

The city's settlement with its retirees in August meant it would soon be forced to make record contributions, taking a huge bite out of its annual budget. With that prospect looming on the not-to-distant horizon, attention turned toward two reports issued in mid-September 2004.

The first, authored by the Pension Reform Committee, a group of nine professionals recruited by Mayor Murphy in 2003, presented the City Council with 17 recommendations-only five of which have since been implemented-to help bailout the retirement system.

The second, an exhaustive exploration of the policies that led to the pension under-funding and the city's related disclosure practices, came from Paul Maco. A partner in the Washington, D.C., firm of Vinson & Elkins and a former SEC official whose clients include failed energy titan Enron, Maco was also recruited by the City Council to represent the city in its dealings with the SEC. Critics decried Maco's dual roles as investigator and defense attorney as an obvious conflict of interest and, while his report did paint an ugly picture of city bureaucracy, it stopped short of saying city officials broke laws.

Days after the reports were released, the city's credit rating was suspended, making it impossible to borrow money. Amid persistent chatter, Murphy and Ewell tried to assure the citizens and the media that San Diego was not in danger of going bankrupt.

In October, auditors from KPMG expressed concern about Maco's report and the city's failure to conduct “an adequate investigation in order to conclude that likely illegal acts have not occurred....”

In an attempt to satisfy KPMG-and perhaps help the U.S. Attorney and the SEC pick off white-collar criminals in City Hall-newly elected City Attorney Mike Aguirre began his own investigation in January of 2005, publishing the first of five reports to date. Among other things, Aguirre has opined that Murphy and the entire City Council-excluding Michael Zucchet and Tony Young, who had yet to be elected at the time of the 2002 deal-could all be liable for violating securities laws. He also claims some of the benefits granted in return for pension-payment relief were illegal. The City Council eventually formed an audit committee, comprising former SEC Chairman Arthur Levitt and two other high-priced consultants, to reconcile Aguirre and Maco's reports in hopes of satisfying KPMG.

During his investigation, Aguirre confiscated more than 20 boxes containing what he said were previously subpoenaed, yet unreleased, documents in the offices of Webster, Lexin and City Treasurer Mary Vattimo, who, like Lexin and Webster, was also a pension trustee. The City Attorney accused them of obstructing justice, but Lexin claimed some of the documents belonged to the retirement board and were protected under attorney-client privilege.

Let me get this straight

The retirement system wants the city to pay its debt, the city wants to issue bonds to pay its debt but needs a better credit rating to borrow money, the rating agencies want to see the city's audits first, the auditors want to see a credible investigation, and the investigators want to see documents that the retirement board won't turn over.

Pension trustees also invoked the attorney-client privilege for certain documents subpoenaed by the U.S. Attorney. Mayor Murphy and others unsuccessfully appealed to the board in February to waive that right in hopes of facilitating the ongoing investigations but were rebuffed.

Under a successful ballot proposition, the pension board of trustees was restructured in late February so that a majority of its members were not financially tied to the system. Under the previous arrangement, nine of the 13 trustees had such ties. Murphy appointed seven new trustees but made the controversial decision not to precondition their appointments on a willingness to waive the attorney-client privilege. In April, the new board declined to waive that privilege.

With lots of stinky rotten egg on his face and prior supporters now expressing zero confidence in his ability to lead the city out of this mess, Murphy announced his resignation in April-prompting a special election in July-but indicated he would stay on to complete ongoing labor negotiations and an especially painful budget process.

Going Nowhere Fast

Different approaches to the impending labor negotiations helped pit Aguirre against Murphy and members of the City Council in the soap opera that continues to play out at City Hall.

Shortly after taking office, Aguirre proposed a plan to reduce the pension debt by rolling back some of the benefits granted since 1996. He cited bankruptcy as the other alternative. The mayor, a majority of City Council members and union leaders vehemently opposed the roll-back option, noting that once the benefits had been granted, they became the vested property of the employees.

Once again rejecting the possibility of bankruptcy, the mayor offered another proposal, approved by the City Council, that included a two-year freeze of benefit and salary increases, some benefit reductions for new employees and retirees and the issuance of $400 million in bonds to help pay the city's debt, now estimated at $1.7 billion on the low end.

Ultimately, the city and the unions settled on a watered-down version of Murphy's plan, which critics claim wouldn't put a significant dent in the city's pension debt.

When Ewell presented his budget for the coming year to the City Council in May, he made it clear that despite an influx in revenues the city's required $163 million payment to the pension fund would take a significant bite out of its $857 million general-fund budget. Ewell proposed cuts to virtually every department-with exceptions for police and fire-eliminating positions and increasing fees charged to businesses and citizens. (Please see side story on Page 12.)

Hammer Time

On May 17, 2005, District Attorney Bonnie Dumanis filed charges against six pension trustees, alleging they violated state conflict-of-interest laws because they personally profited from their 2002 vote (please see graph above).

The accused include Saathoff, Lexin, Webster and Vattimo as well as Sharon Wilkinson, elected to the board in 1992 by city workers, and John Torres, vice president of the Municipal Employees Association, who was elected by the union's members in 2000. Of the six people charged, Torres is the only remaining pension trustee. Additional charges from the DA are expected, and many believe the mayor and some City Council members may be next.

The U.S. Attorney and SEC are also continuing to investigate, and last week the plot thickened when the U.S. Attorney subpoenaed all documents dating back to 2000 related to compensation paid by the city to Lexin, Ryan, Saathoff, Webster and Deputy City Manager Bruce Herring, who served as a point man for both city managers McGrory and Uberuaga during the 1996 and 2002 negotiations. Similar documents pertaining to Webster's husband, Russell Webster, and Lexin's husband, Madison Wiggins, who both work for the city, were also subpoenaed.

(Hardly) The End.

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Published: 06/15/2005


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