Thursday, Feb. 19, 2009 | Pension board members are slated to vote Friday morning on a move that could slash the costs of a controversial retirement program by reducing the guaranteed return paid to employees that participate.

Lowering rate of return would make the Deferred Retirement Option Program, known as DROP, less attractive for city employees. Whether it would cause most city employees to work longer or retire earlier isn’t quite clear, but city officials believe they would save millions by not having to pay the 7.75 percent annual rate, regardless of how the market is performing, an issue that has become especially contentious given the recent market losses.

“I think in totality, DROP is a very expensive program for the city and at least lowering the rate would begin a savings,” city Chief Operating Officer Jay Goldstone said. “Exactly how much in the long term is somewhat hard to predict today.”

The DROP program was first approved in 1997 as a way to retain experienced city employees who might otherwise retire.

It has come under fire as a plush pension perk that is unsustainable, given the city’s budget shortfall and the pension fund’s losses in the recession. The city ended the program for new employees in 2005. Mayor Jerry Sanders and ex-City Attorney Mike Aguirre have tried unsuccessfully to eliminate the program entirely, and City Councilwoman Donna Frye has sought to introduce an ordinance requiring the program to be cost-neutral to the city.

DROP is open only to employees who are eligible to start drawing a pension because they have 20 years of service. Police and fire employees must be 50 years old, and other city workers 55 years old, to participate.

Employees who enter the program continue to work for the city for up to five years. During that time, the monthly pension payments they would’ve received if they retired are instead deposited into an account paying a guaranteed rate of 7.75 percent. The employee’s salary and years of service are also frozen so employees’ annual pension payments can’t grow.

When employees retire, they can withdraw the money in their DROP accounts as a lump sum, in addition to receiving their regular pension payments. Alternatively, they can use their DROP account balances to form an annuity controlled by the San Diego City Employees’ Retirement System, which makes regular payments assuming the same 7.75 percent interest rate.

The rate for DROP accounts has been pegged to the official rate that SDCERS uses to predict its investment gains. It was recently lowered from 8 percent.

But there has long been talk about further lowering the rate, which officials say is too generous given the risk-free nature of the DROP program.

For one thing, officials point out, the official SDCERS rate is based on average long-term performance, while the DROP accounts span, at most, five years. Much like a short-term Treasury bill generally carries a lower interest rate than a long-term security, officials say DROP should also pay a lower interest rate.

Those who support dropping the rate, including Sanders, say a DROP interest rate should reflect the fact that the employee bears no risk. The mayor wants to tie the DROP rate to the rates paid on five-year Treasury securities, also a low-risk investment with the same time frame.

Five-year Treasury bills now pay 1.36 percent, SDCERS actuary Gene Kalwarski told the board last month. Pension board members have also talked about lowering the rates on DROP annuities but keeping them at a somewhat higher rate than the normal DROP accounts because they are longer-term in nature. They could, for instance, tie the annuity rates to 30-year Treasury securities, which now have a 2.86 percent interest rate. Kalwarski is expected present options for measuring new rates at Friday’s meeting.

A lower interest rate would have a significant effect on a DROP employee’s payments. For instance, an employee who qualified for a $40,000 annual pension payment when he entered DROP would have $286,000 in his DROP account after five years under today’s interest rate. If the rate were lowered to 4 percent, he would have $262,000 after five years, according to Kalwarski’s calculations.

Those effects are compounded if the annuity rate is lowered as well. For instance, if the same employee converts his DROP account into an annuity, he would take home $27,636 a year under the 7.75 percent rate. If the interest rates for both the DROP account and the annuity were lowered to 4 percent, he would receive $18,958 a year.

SDCERS board President Tom Hebrank said the program was meant to be a program that wouldn’t cost the city money, but clearly hasn’t met that promise.

Frank DeClercq, firefighters union president, insists that the program saves the city money, pointing to 2005 analysis that found the program saved about $45 million through 2004. But the report considered only a small fraction of the program’s costs.

Other reports have found that DROP costs the city money, and Kalwarski has said it isn’t “cost-neutral” to the pension system. However, since Sanders took office, Goldstone said there hasn’t been a comprehensive study that considers DROP’s costs to the city and the pension system. Union officials have pushed for such a study, which Goldstone said the city will likely have to perform one day.

“The dialogue, the discussions, are clearly ramping up now, and at some point we may have to demonstrate why DROP is not cost-neutral and why it’s costing the city,” Goldstone said.

DeClercq said the city’s delay in conducting a study is evidence that the push against DROP is about appearances. He noted that in flush years, when the pension system’s investments are making more than 8 percent, the city earns money on the difference.

“The years the system made 12, 13, 14 percent, I didn’t see anyone calling the city employees and saying, ‘Hey, we’re making a lot off your money,’” DeClercq said.

Rebecca Wilson, the SDCERS chief of staff, said while pension officials and board members are keeping in mind the recent economic losses, they aren’t the driving factor behind the change.

“The decision has to be a decision that’s appropriate for the long term, and not just appropriate for the short term,” she said.

There are still many questions about the ultimate effects of a decision to lower the interest rate.

It would clearly make the program less attractive for city employees. So many of those now enrolled in DROP could decide to retire before their five years are up.

Goldstone believes that, in the long run, a lower DROP rate will lead employees to work longer by giving them less of an incentive to retire early. He said that would decrease the city’s retirement costs because their pension payments would start later.

A lower rate of return could have myriad impacts that could affect the city’s bottom line. For instance, if a lower rate led workers to delay retirement, would they stay in positions that otherwise might have been left vacant or filled with cheaper employees, thus costing the city money?

Also, once employees enter DROP, their salary increases don’t factor into their pension calculations. If those employees were to keep working without joining DROP, how much would their retirement payments increase?

Goldstone acknowledged that the many factors involved make determining the cost savings of a lower DROP rate difficult, but said the evidence suggests a lower rate would save significant cash nonetheless.

“When we’re giving them 7.75 percent in good times and bad times. … I think that more than offsets any additional costs because somebody got a 3 or 4 percent salary increase that could bump up their retirement,” Goldstone said.

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