Thursday, August 18, 2005 | This is part two in a four-part series.
The county of San Diego’s pension system positioned itself quite well for the investment boom of the late 1990s.
With proceeds from pension obligation bonds it issued in 1994, the county’s pension system rode the boom to its highest heights, generating surpluses every year. The surplus in 2000 reached $320 million.
Just two years later, that fund faced a deficit of $1.25 billion. Red ink on the balance sheet meant the fund needed a boost. It needed assets. A deficit in a public pension fund grows for every year it continues without sufficient assets to cover the promises the government has made to its employees.
The trustees who oversee the San Diego County Employees’ Retirement Association are in charge of paying down that deficit – in effect, it is their job to send taxpayers a bill for what has been earned by county employees.
But before the SDCERA sent the county and its taxpayers the big bill from a massive benefit enhancement in 2002 that had sent the fund into a deficit, the trustees made some changes to how they calculate the bill.
First, they changed the deadline by which the deficit would need to be paid off. In 2002, the system had a mandatory five-year amortization period on such pension deficits. Meaning, that like a home mortgage, the county could finance the deficit for five years, paying off a portion of it each year until the county owed nothing more to retirees than it had invested. With the pension benefits the county awarded in 2002, however, that short of a time frame would have meant an enormous taxpayer payment into the pension fund the next year that could have stretched as high as $450 million, according to some calculations.
So the trustees pushed the deadline out to a little farther than eight years.
It proved to be a habit-forming initiative.
The next year, the board of retirement again made a change – switching this time to a 15-year rolling amortization schedule. And again, in 2004, the county’s pension board lowered the payment the supervisors would have to make by replacing the amortization period with a 20-year fixed timetable.
In four years, the county’s pension board pushed back the deadline by which they would require a balance in the pension fund three times.
That helped ease the sticker shock, but not as much as an initiative the county’s administration undertook in 2002: They went to Wall Street and asked for a loan.
Given the county’s excellent credit ratings, Wall Street welcomed the officials and agreed to give them more than $737 million. It is a loan county taxpayers will be paying off until 2032. Given the success the county had experienced in the 1990s putting the borrowed assets to work, the county’s pension fund welcomed the new investment possibilities.
A large portion of the new proceeds went to pay off the older pension obligation bond debts. After those liabilities were put to rest, the county took the proceeds from the loan and invested $550 million into the pension system.
The money made it possible for the Board of Supervisors, even though they had given the benefits to their employees in 2002, to skip a proportionately higher payment to their pension system in 2003.
But over the next year, even with the $550 million boost, the pension fund’s shortfall worsened again. By June 30, 2003, the pension fund had a deficit of $1.435 billion. In spite of the big loan from investors, the fund’s deficit had grown again. It dropped to a 75 percent funded ratio, meaning that it had 75 percent of the assets it needed to pay off all the liabilities it would eventually owe county retirees. And the deficit was projected to top $1.6 billion.
The county called up Wall Street investors again and by the end of the fiscal year, in June 2004, they secured the sale of another $450 million in pension obligation bonds – leaving the taxpayers with yet another loan to pay off.
Better to pay off the loan than to watch the pension system’s health worsen, county officials said in interviews.
“When you have the ability to and good interest rates to work with, pension obligation bonds are a good option. From what I’ve seen, they’ve provided us a significant economic savings,” said Don Steuer, the chief financial officer of the county.
Where do the savings come?
The county issued its bonds during attractive borrowing times. County administrators were able to secure interest rates for the bonds lower than what the pension fund expects to receive from the investment market each year.
The maneuver, to refinance debt in the pension system to “hard” debt owed to Wall Street investors in order to invest it at a higher rate in the pension fund’s portfolio, is known as arbitrage.
The county may be borrowing $1.2 billion from investors right now, but it is putting that money to work in the stock market. The pension fund’s managers believe they can earn 8.25 percent. If they do earn that much with the bond proceeds, Steuer said the county will have saved itself more than $130 million by issuing the bonds.
“It has to do with your overall portfolio management,” Steuer said. “If you’ve put yourself in the position to have good credit, you can take advantage of low rates and save money.”
Stephen D’Arcy, a professor of risk management at the University of Illinois, agrees.
“In general if you can borrow at an effective rate then you’re likely to do better than if you just didn’t put money in at all,” D’Arcy said. “But it is somewhat worrisome – there are no guarantees you’re going to get a higher rate of return on investments than the interest rate you borrowed at.”
And it’s still a $1.27 billion debt – separate from the $1.2 billion pension deficit.
No pension fund in California has issued as many pension obligation bonds as the county.
To pay off Wall Street investors, county taxpayers will pay $63 million this year. The annual payment will rise to more than a $100 million by 2020.
All to pay off benefit enhancements given to county employees in 2002.
“In the future, county taxpayers are going to wake up and ask the county supervisors why they’re still paying off pension debt the county incurred 15, or maybe 20, years before,” said Michael Conger, a lawyer who has sued the county on behalf of retirees in the past.
The 2002 deal effectively elevated the cost structure of the county’s labor and that can be a problem, said Emily Kessler, an actuary and staff fellow at the Society of Actuaries.
Like the county, she said, many businesses and governments watched the funded ratios of their pension plans rise and stay in very healthy positions in the late ’90s. But it’s precisely during those types of “good times” that businesses and governments should avoid giving pension benefit enhancements to their employees, she said.
“If you always improve benefits during an up cycle, when the cycle comes down you’ve shot yourself in the foot and you’re in trouble,” Kessler said. “When you do that, you escalate your cost structure and then you attempt to maintain that cost structure when times aren’t so good.”
The county’s most recent payment to its pension system – which included an agreement to pay part of what the employees would normally be required to pay themselves – was $271 million.
Add the debt payments on the pension obligation bonds and that’s a one-year total payment of $334 million in pension debt costs.
The county has 17,717 employees. That means that for each employee, the county made an average additional payment of $18,851 to support his or her retirement in one year.
From the perspective of the pension board, which will be responsible for paying retiree benefits, another round of pension obligation bonds may be necessary to shore up its funding level, said Dan McAllister, the county’s treasurer and tax collector and a member of the retirement board.
“Because the interest rate environment market right now is primed and ready, we are in as good a position as ever to issue more bonds,” McAllister said. “The issue, of course, is whether the county is willing to take on more debt to fund up its pension promises.”
It doesn’t sound like county administrators are.
“At the present time, we are not preparing any recommendations to issue any additional pension obligation bonds,” the county’s CFO Steuer said.
With pension obligation bonds off the table for now, only direct taxpayer payments will be available to offset the remaining deficit in the retirement fund. And because of the 20-year financing plan being employed to pay down the debt, those taxpayer payments aren’t projected to grow as fast as the deficit is for the next two years.
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Part Three: Retirees prepare for fight to save health care.