I earlier described some disturbing details about the assets held by the San Diego County Employees Retirement Association. Our separate pension fund for city employees, the San Diego City Employees’ Retirement System, is another tale of local woe that I worry may have global implications.
A full account of the sad history of SDCERS was provided by the Kroll Report, an investigation requested by the City of San Diego in February 2005. The Kroll team was headed by Arthur Levitt, former Chair of the Securities and Exchange Commission, and their report was released in August of 2006.
The Kroll Report traced the beginning of our current fiscal problems back to 1980. Determining whether the pension liabilities are adequately funded involves comparing the assets of the fund (whose current value should be straightforward to calculate) with the present value of required future payments. The interest rate used for that present value calculation would logically be based on the presumed future rate of return on the assets. This calculation had historically been made using an assumed rate of return of 8%, and there had been a number of years when the portfolio return had exceeded this. In 1980, the City Council passed a resolution designating any earnings of the portfolio in excess of 8% as “Surplus Earnings” which could be used among other things to provide a more generous retirement package without requiring any new contribution of funds from the city.
Of course, any investment portfolio is going to have good years and bad, and the assets would in reality only be sufficient to cover the liabilities for an 8% discount rate if the good years are in fact used to restore capital for the underperformance of the bad years rather than as an excuse to simply increase the liabilities even further. A strategy of always siphoning off all the “surplus” over 8% is in fact guaranteed over time to result in an underfunded system. I find it hard to believe that members of the City Council could have failed to understand this. In any case, they surely did comprehend that the designation meant more goodies they could hand out at the time, paying for which would be somebody else’s problem.
Thanks to a number of years of a strong stock market, the day of reckoning was put off for quite a while. However, by 1996, the city had acquired a very significant unfunded liability. A comparison of the fund’s assets and liabilities (still assuming the 8% return that city policies guaranteed would not be realized) implied a funded ratio at that time of only 93.5%. Nevertheless, the city in 1996 adopted an even more generous and retroactive increase in retiree benefits, which included an option for employees near retirement to “buy” additional retirement coverage at 50 cents on the dollar. All of this was to be paid for through a combination of promised future increases in the city’s contributions and of course from the future Surplus Earnings account. Increases in health benefits were also being paid from those same phantom funds.
Just in case those Surplus Earnings failed to materialize as hoped, the 1996 plan also included a stipulation that if the funded ratio were to fall a further 10% (to below 82.3%), the city would promise to make a balloon payment to restore 82.3% funding. The notion was apparently that the threat of such a potentially large fiscal shock would induce future city councils to take steps to gradually restore funding before that trigger threshold was breached.
Future city councils did not, and by 2002 the city was scrambling to find a series of short-run fixes. The deficit now appears to be on the order of several billion dollars, and no one today seems to have an adequate plan for how the city is actually going to pay for all it has promised to do.
I relate these seemingly very local details to what I know to be a global Econbrowser readership because I am afraid that San Diego is just one example, albeit a particularly egregious one, of forces that may be playing an important role in recent financial trends. I have been developing concerns (e.g., , , ) that investment dollars have been flowing into high-risk strategies that could yield above-market returns for a while but actually imply negative expected returns. An example would be providing the capital that gets loaned as a mortgage to a subprime borrower. One thing that has puzzled me about such a hypothesis is where the demand for such assets could be coming from– who would be so foolish as to place a short-sighted value on only the near-term gains?
It occurs to me that one possible answer might be found in the pension funds for local governments whose operating motif has been to worry only about the very near-term consequences of their actions. I noted last month that the San Diego County Employees Retirement Association (a separate entity from the city retirement fund discussed here) could have several billion dollars at risk in this kind of unsound gambling. We learned last week that the New York State Teachers Retirement System held $65 million in equity of New Century Financial Corporation. One finds at Pension Tsunami a half-dozen stories each day about communities grappling with severe problems in fulfilling the pension liabilities foisted on them by earlier local governments. Free Exchange advances the thesis thusly:
It’s a pretty common story: investors with big losses behave essentially like gamblers in a casino, trying to double down in order to recover their previous position. In this case, state and local pensions have enormous unfunded liabilities. This is due in part to unrealistic valuations of their asset base during the stock market bubble, which left them with an enormous hole when the bubble collapsed. It is also due to the massively overgenerous promises politicians made, in part because the bubble inflated tax revenues to unrealistic levels in many localities, and in part because until recently they didn’t have to account for their pension liabilities the way private companies do, which made big boosts for public sector pensions feel like a freebie for their supporters in the civil service unions.
So now you have these pension funds pouring into risky instruments that promise higher potential returns in order to close up the holes. Instruments that, from the quotation, they don’t understand too well, or keep track of too closely.
Who would want an asset with likely short-term above-average gains but whose expected return (including the outcome of the disastrous low-probability tail) is actually negative? That would seem to be a highly accurate description of the political bargain crafted by the San Diego City Council over the last two decades. One therefore wonders whether there might have been pressure on SDCERS in turn to invest in financial assets with a similar profile.
I intended to take a look at the assets of SDCERS to see what kinds of risks they might be taking in the current environment. Unfortunately, the most recent annual report available from the SDCERS webpage is for 2003. I phoned SDCERS to ask about this, and was told they’re currently working on the 2004 and 2005 reports, but haven’t released them yet.
We did, however, recently receive the following information:
City Attorney Michael Aguirre and the employee pension fund’s top administrator clashed yesterday before council members hearing an update on the retirement system’s improving prospects.
David Wescoe, the administrator, told the City Council’s Budget and Finance Committee that system assets have jumped to $4.8 billion, $1.4 billion more than two years ago, due to consistently strong investment returns.
Somehow that doesn’t reassure me.