Wednesday, July 5, 2006 | In order to fall back into the good graces of the Internal Revenue Service, the city’s troubled pension system will likely be asking the City Council sometime soon to do two things: pay a surprise $33.8 million bill and figure out a different way to pay for those retirees whose pension checks top $13,000 a month.
The probable requests surfaced after attorneys and consultants for the pension system identified five separate potential violations of IRS tax code stemming from the way in which the San Diego City Employees’ Retirement System receives and dispenses of the cash in its $4 billion fund.
The violations, the practical impact of an era in which the pension system became a focus of the Justice Department and the Securities and Exchange Commission, are a reminder that the pension system has another master to serve: the IRS. And, if left unaddressed, they would damage the very tax-exempt status that spurs the existence of a separate pension system altogether.
“It would really cease the function (of the fund) as a saving institution for retirements,” said Mark Sullivan, a pension board member who oversees a committee evaluating concerns raised by a January internal investigation.
On Friday, tax attorneys for the pensions system were scheduled to file a bundle of corrective actions in the hopes of rectifying the five tax violations it has self-reported to the IRS. The violations range from the obscure to the infamous – from pension nuances to the special union president benefit at the heart of five corruption indictments brought by the U.S. Attorney’s Office.
Sullivan believes the system will be able to rectify its issues with the IRS and doesn’t believe its tax-qualified status will be threatened.
The move is one of a laundry list of items the pension system and the City Council must undertake to sort out the numerous legal and accounting irregularities that sprout from the pension crisis.
“There are easily two dozen issues or more that are recommended remediation or changes, all of which are being closely tracked by the mayor’s administration,” said Fred Sainz, spokesman for Mayor Jerry Sanders.
The filing also will likely result in the presentation of a $33 million bill to the cash-strapped city of San Diego in order to make up for past violations related to the retiree health care benefit.
In 1982, the city began granting a health care allowance to retirees. But rather than set up a separate fund and cover the cost from the city’s annual budget, officials instead began siphoning off the retirement fund’s investment earnings and using them to pay for a portion of the retiree health care benefit, among other things.
Investigators found that, for tax purposes, the city should have set up a separate trust to handle the distribution of the benefit, and that it should have been paid for from a source other than investment earnings. Investment earnings, which are supposed to be squirreled away to make up for bad investment years, were used in part to pay the benefit from 1985 until 1992 and then again from 1997 until 2005.
“Where the money came from and how it was given to retirees was illegal,” Sullivan said.
Administrators set up a trust in 1997, which provided the fund with the proper structure to administer the benefit under the tax code, Sullivan said.
But attorneys for the pension system have opined that the city owes $8.2 million in backlogged costs because the pension system – not the city – paid for the benefit. In addition, the pension system should also bill the city $1.5 million for the administrative costs of handling the city’s work, attorneys said.
Then there’s interest. Because the costs were incurred beginning in 1982, the price tag for interest: $24.1 million.
The pension system submitted to the IRS this calculation for its approval. Sullivan said the city could be asked pay off the $33.8 million sum over a five-year period.
“Either the IRS buys off on that or they don’t. If they don’t, I suspect it will be because it’s not big enough,” said trustee Bill Sheffler of the payment.
Although the $33.8 million payment is likely to be spread out over a number of years, any additional cost to the city comes at a time when city officials are trying to scratch out any extra bucks in order to fund admittedly neglected areas: depleted emergency reserves, backlogged maintenance repairs, the pension system and a newly created fund to cover the retiree health care benefit.
“It’s at a very, very, very, preliminary stage. So we haven’t got the point to determine if we agree with the finding or how we would pay for it if we did agree,” Sainz said.
The bill is one in a long line of clean-ups facing the pension system that, if enacted by the pension system or City Council, are likely to further strain the city’s tight general fund – the account that covers basic, day-to-day expenses such as public safety, street repairs and parks.
Throughout the last two decades, many decisions were made by city and pension officials that alleviated the pension system’s costs to the city in the short-term. A number of benefits are held off of the system’s books and paid for by investment earnings, something that, on the books, lowers the pension system’s liabilities and the city’s annual payment into the pension system. Likewise, the amortization period used by the city to pay off the deficit allows the burden to be pushed off into the future.
Pension and city officials have signaled their intent to alter a number of these practices, moves that would shift a greater size of the pension burden off of future generations and back to today’s taxpayers.
“We’re trying to assess the implications, because at the end of the day many of them will have general fund implications,” Sainz said.
Having tax-exempt status is important to the retirement system so the IRS determination plays an important role. A pension is treated differently than annual salary under tax code. Typically, both employers and employees are taxed in the distribution of income. However, with the IRS’ blessing, any income taxes on contributions into the pension fund are deferred from the time the contribution is made until it is actually paid out.
“We need to comply with the IRS,” Sheffler said. “The plan would be disqualified if we didn’t go after the money.”
Other self-reported IRS violations include technical aspects of administering the pension system. One also touches on the presidential leave benefits, which was thought to have violated the IRS code because it allowed unions to pay contributions into the pension fund. Typically, only the city would pay such employer contributions.
Another IRS code forbids pension systems from paying out pension benefits above a certain level, which Sullivan calculated at about $13,000 a month – or $156,000 a year.
Sheffler, an actuary by trade, said the law was put into place to “keep fat cats from exploiting these pension systems.”
However, with employees sometimes making six-figure salaries and spending three decades at the city, reaching such a level is hardly unheard of. As such, officials said they will likely have to ask the city to either set up a separate fund to pay any benefits above and beyond this level or simply pay the annual sum from the appropriate city budget.
Pension officials weren’t certain as of press time how many retirees earn above the $13,000-a-month threshold. David Arce, the system’s operations manager, said he imagines the number will be somewhere between five and 25 pensioners.
Attempts to determine who met that threshold were unsuccessful as of press time.