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Monday, September 26, 2005 | The administrator of the city of San Diego’s retirement system told me in an interview the other day that he just had something beaten into his brain.
Not literally, of course. Larry Grissom has gotten his fair share of knocks lately but we doubt that it has come to physical blows yet.
No, this was an intellectual beating ordered on Grissom by the IRS.
And if it weren’t for the fact that the retirement system is in the middle of an historic period of political turmoil in the city these days, an issue they are dealing with right now might normally register a little brighter on the “wow-that’s-interesting” radar screen.
To explain, it’s all about DROP. What is it? Why are members of the pension board who are also city employees running away from a potential decision about it? And why did the IRS come calling?
A quick review: DROP stands for Deferred Retirement Option Program. Enacted in 1997, the program allows city employees who reach retirement age to retire without really retiring.
Sound like a punishment instead of a privilege? Just wait.
When an employee enters DROP, the retirement system creates for him or her a DROP account. For up to five years, the retirement system deposits that employee’s pension into the DROP account. At the same time, the employee is still working for the city and still, of course, collecting a paycheck.
But there’s more than one river flowing into this DROP account. Not only are the pension checks making their way to it, but 3.05 percent of the employee’s biweekly paycheck – before taxes – also makes its way to the DROP account along with a matching 3.05 percent from the city.
That’s not all, the employee’s DROP account also collects the infamous 13th check to retirees – an extra bonus paid from so-called “surplus” investment earnings of the retirement system. We won’t even get into the mind-blowing paradox of how a retirement system estimated by some to be facing a deficit of $1.7 billion can give out a bonus every year because it earned a “surplus” on its investments.
Finally, the DROP account also earns 8 percent annually regardless of how well or how poorly the retirement system’s investments actually perform.
And that word “regardless” has become a bit of an issue. See, Grissom told me in an interview that up until about 10 days ago he would have told me that he thought DROP was sort of a hybrid retirement vehicle. In other words, it had aspects of both a “defined benefit” retirement program and a “defined contribution” system.
A defined benefit, is just that: Regardless of how much the city or worker puts into the pension fund, a retiree receives the exact amount of money when he retires that was promised to him. A defined contribution is just that: the employees and city decide exactly how much to put into a retirement system, but what the worker gets out of it when he or she retires is uncertain.
The basic city of San Diego employee pension is obviously a defined benefit. So what’s DROP? I mean, after all, for years, city retirees could just hold their DROP account as a sort of great fixed income investment account that earned 8 percent and take it out whenever they pleased. If you take it out whenever you please, then that means it’s not necessarily a “defined” benefit – because it’s bigger or smaller depending on when you take it out.
Who cares? Yep, the IRS.
So, on Sept. 16, the retirement system’s board of administration found itself obligated to change the rules. To protect retirees from taxes, the board had to force them to decide to either cash out their DROP accounts immediately or subscribe to a monthly predetermined withdrawal. In other words, to get what’s called an annuity.
But one board member dissented. His name is Richard Kipperman. He’s a bankruptcy consultant, and although he doesn’t necessarily have a problem with the IRS conformity plan, he refused to authorize anything that would validate a different part of DROP: this idea that the city can guarantee DROP participants they will earn 8 percent on their accounts every year.
Apparently he’s not alone on the board. For you investors out there, a quick quiz: Name the top five investment options out there through which you can get a guaranteed annual return of 8 percent. Stumped?
“For those funds with guaranteed returns or very low risk, I think the market is giving significantly less than 8 percent,” said Kipperman, one of the newest members of the city’s pension board.
Fellow pension Trustee Bill Sheffler agrees. What the city is offering its employees in DROP is “basically an infinitely renewable CD that earns 8 percent.”
The average interest rate that banks are giving right now on one-year certificates of deposit, or CDs, is 3.64 percent. The five-year Treasury note yields about 4 percent these days.
The retirement system staff promised Kipperman and his colleagues that it would produce a report by August that outlined options the board had to reevaluate that interest rate.
For whatever reason, the report hasn’t yet arrived – Sheffler says he suspects he and others supportive of changing the interest rate are being “stonewalled.”
Grissom explained the report’s delay by waxing sarcastically in third person.
“Larry is wonderful, Larry is knowledgeable, Larry is skilled and a pro in this business but there has been so ungodly many things swirling around these days and I have not had time to get it done,” Grissom said.
Regardless, it will be interesting to see what happens when the report does arrive.
Already two employee members of the retirement board have let it be known that they will not participate in any kind of decision relating to the DROP account interest rate adjustment.
Bill Lopez, who represents the city manager on the pension board, said he would support lowering the DROP interest rate but he will abstain totally from the debate.
“I would encourage board members who are employees to be very cautious when deciding whether to participate in that vote,” said Lopez, who is the director of the city’s risk management department.
The message is not lost on Lopez’s colleague, trustee John Torres, who is currently defending himself against felony charges that he and five others inappropriately voted on benefit increases that directly impacted their own pensions.
Torres, also, has indicated he will abstain from any votes regarding the interest rate credited to DROP accounts. Torres also has a DROP account of his own, you see.
But in addition to the conflict-of-interest worry (which, by the way, the Pension Reform Committee warned about last year) there’s another potentially problematic consequence of lowering the DROP interest rate.
See, if the board lowers the DROP interest rate, it will have basically shown that it can arbitrarily lower the DROP interest rate. And if the board can lower the DROP interest rate than the DROP system isn’t necessarily a defined benefit.
And you might remember how the IRS feels about that.
“The interest rate has been disguising the irregularity of the system by artificially linking it to the entire defined benefit program via the assumed rate of return,” said Diann Shipione, the former retirement board member who blew the whistle on the retirement system’s burgeoning debt.
If you didn’t understand her quote, let me get out my special copyright “San Diego City Employees’ Retirement System to English Dictionary” and try to explain.
Careful observers of the city’s retirement problems will remember that 8 percent also happens to be the assumed rate of investment return of the San Diego City Employees’ Retirement System. In other words, SDCERS believes it can earn what averages out to be 8 percent every year. Some years better, some years worse. But SDCERS claims it will average out to at least 8 percent. And we can count on it.
But there’s no city law that requires that DROP recipients receive the same 8 percent in their special accounts. They just do. Some of them claim that they were promised, through informational materials and such, that they would always receive the same interest rate as the assumed rate of investment return.
So Shipione is saying that if the system does lower the DROP interest rate to a more realistic return people can be guaranteed, it may unveil more problems than it solves.
Unless I’m reading my dictionary wrong.
E-mail Scott Lewis at