General Motors by the Sea?

Wednesday, April 29, 2009 | Anyone who thought that the DeLorean had dropped them off back in 2002 after reading about potential tinkering with the city’s pension system would not have been far off. The practical effect of changing how the pension system calculates San Diego’s annual pension obligation would be nearly identical to the city’s infamous pension underfunding known as Manager’s Proposal 2: To delay higher pension payments due to a recession in the hopes — really, prayers — that higher investment earnings down the road will make up the difference.

I admit there are many technical details and jargon like “corridors” underlying the latest idea that, according to Rani Gupta, is being mulled by Mayor Jerry Sanders’ staff. At the heart of the matter, however, is a pretty simple question: Should the value of the pension system’s portfolio, and thus the assets pledged to make future retirees pension payments, be based on what those assets can fetch on the market today? Or should their value be based on something else, like their past value or how much we think they’ll be worth in the future? This is important because the amount our cash-strapped city has to pay into the pension system each year depends on how much the system’s existing assets are worth.

For the most part, public pension systems do not use the current market value to figure out how much in assets they have in the bank. Instead, nearly all “smooth” fluctuations in the market to keep annual contributions from changing unpredictably due to natural volatility in the stock market. In other words, most public pension systems assume that their Microsoft stock is worth not only what it sells for on the market today, but also what it has sold for over the past four or five years.

What this means in practice is that sudden changes in the value of the assets are not felt fully until a few years down the road.

The danger with this approach, however, is that you’ll “smooth” over not only normal volatility but big structural changes in the price of assets. Things like, say, the worst recession since the Great Depression. That’s why the San Diego City Employees’ Retirement System currently limits smoothing to relatively small fluctuations. The idea described by Gupta is to scrap this limit, and smooth everything, giant recessions and all.

To understand the implications of such a change, you have to understand the underlying assumption behind smoothing: That recent changes in the value of your assets represent only short-term fluctuations and, over the course of many years, will cancel each other out. In other words, the current recession is not the result of global imbalances, overpriced housing, and sketchy financial instruments. It’s just a statistical artifact — really, just random noise — that will go away on its own.

If you believe this assumption, you have a lot in common with former City Manager Michael Uberuaga and the City Council that approved his proposed pension underfunding in 2002. When the value of the city pension system’s assets fell during the 2001 recession, the city was on the hook to make a giant lump-sum payment promised by yet another pension underfunding scheme approved in 1996.

But Uberuaga and the council did not believe that the recession was anything more than a temporary blip, confident that the sharp losses would be cancelled out by future gains. Given the city’s pension-induced fiscal stress over the past four years, we now know what a bad strategy that was.

Jay Goldstone, the city’s chief operating officer, recently asked the City Council to refrain from making up its mind until a committee of “experts” can consider the matter. Fortunately for San Diego, we do not have to wait for July, as Goldstone proposes, for the verdict; an international committee of experts known as International Accounting Standards Board has been thinking about this very subject for many years.

And their conclusion is that this is a bad idea. Indeed, though the IASB had once endorsed both the idea of smoothing and the use of corridors, it now believes that “(e)ntities should recognize all changes in the value of plan assets and in the defined benefit obligations in the financial statements in the period in which they occur.” This is a view that has been echoed by the head of America’s own Financial Accounting Standards Board, an organization that develops generally accepted accounting principles within the United States.

We don’t have to agree with IASB and FASB that smoothing is bad to acknowledge that getting rid of “corridors” — limits on the smoothing — would move the city’s retirement system in exactly the opposite direction from where the world’s experts think retirement system accounting practices should go.

The fallout from our last attempt to relieve stress on the city budget by shorting the pension system earned San Diego the title of Enron by the Sea, after the largest bankruptcy in American history. Since the American car companies may soon take over that title from Enron, perhaps the mayor’s staff wants San Diego to keep up?

Vladimir Kogan is a doctoral student at UCSD’s Department of Political Science. He is a co-author of a forthcoming book about San Diego politics and its pension crisis. His e-mail address is vkogan@ucsd.edu.