The Morning Report
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Monday, August 31, 2009 | In this tough economy, we all know friends and colleagues facing financial problems. Some are making tough decisions and plotting a course for recovery. Others are making only cosmetic changes — living in ignorance or outright denial of their mounting liabilities.
Suppose a friend, Louise, is facing severe financial problems and asks for advice on handling her household budget. She lays out a list of her liabilities — from mortgage payments to multiple credit card balances.
Louise goes on to provide her forecasted monthly payments for each of these liabilities — $25 per month for Credit Card A, $50 per month for Credit Card B, $2,500 per month for a mortgage payment, and so on.
While Louise should be credited with outlining a spending plan, her approach is ultimately inadequate. Her forecast lacks any indication of whether her monthly payments will result in eliminating or even reducing the sizeable debt she faces.
A closer look at Louise’s financial condition over a five-year span from a liability standpoint reveals her dire predicament. Her mortgage is an interest-only loan, and her payment is expected to double in the coming years. Worse, she is planning to only make minimum payments on each credit card — meaning she will end the five year period in deeper credit card debt than when she started.
After constructing a true financial forecast showing all of Louise’s liabilities and incorporating her intended efforts to pay them off, a clear conclusion emerges. Louise has to find a way to cut expenses and renegotiate her liabilities. Anything short of such decisive action will perpetuate, or even make worse, Louise’s financial quandary.
Like Louise, the city of San Diego faces its own financial crisis stemming from not one, but several growing financial obligations and liabilities. Although unlike the case of Louise, the taxpayer is ultimately responsible for paying off the city’s liabilities.
To his credit, the mayor created a Five-Year Financial Forecast at the beginning of his tenure to guide his initial fiscal reform efforts in eight key areas. However, like Louise’s original approach, this initial forecast needs to provide a rolling look at the net liability facing the city in each of the eight areas. Moreover, as recently noted by the Independent Budget Analyst, the forecast must be updated to reflect new economic realities and worsening financial obligations.
To this end, I recently issued a memo asking that the city’s financial forecast be updated and enhanced to reflect a number of liabilities and issues.
Pension Obligation: The city faces over $2 billion of debt in its pension system — and this obligation and associated annual debt service is skyrocketing. The city’s pension payment will increase by about $70 million, to approximately $225 million in FY 2011. Worse, the bad news does not end there — as recent actuarial forecasts have revealed the city’s annual pension payments will hit an unsustainable value of 50 percent of the city’s payroll.
In reaction to this mounting liability, the city and the San Diego City Employees’ Retirement System have been exploring accounting gimmicks (such as the Corridor adjustment) to temporarily delay payments to the system. If such changes are indeed implemented, the Five Year Financial Forecast should at the very least reflect the short and long term impact to the city’s total pension liability and debt service from those changes.
Retiree Healthcare: On top of the pension liability is another severely unfunded liability for retiree health care — last valued at $1.2 billion of debt. The city continues to underfund this liability, paying a fraction of the true debt service. This approach is analogous to Louise paying the minimum payment on her credit cards.
While the recently-approved labor contracts temporarily freeze the city’s health care liability for two years, if an agreement to restructure this liability is not reached, the city’s liability for retiree healthcare will increase dramatically — retroactively to July 1 of this year — and continue to increase as far as the eye can see.
Labor Contracts: Much has been said about the important 6 percent reduction in city employee benefits in this year’s labor contracts. However, the public should know that some of the benefit reductions are temporary — and will be restored on the last day of the contract term. The five-year forecast should accurately reflect the temporary nature of the benefit reductions taken by city employees.
Pending Litigation: While a city will periodically face a number of lawsuits, there are several current lawsuits that carry high financial risk to the city. For example, the city’s own pension board has filed a lawsuit against the city, demanding the payment of $259 million as a result of previous decisions to underfund the pension system. Clearly, a loss in court on this and other evolving claims would represent a severe blow to city finances, and the potential impact should be adequately modeled in any forecast.
Debt Payments for Existing Public Facilities: The city’s debt obligations associated with Petco Park and the Convention Center expansion are scheduled to increase in coming years, as debt service shifts back to the General Fund from CCDC and the Port of San Diego. The city also faces an additional debt obligation of $21 million for Qualcomm Stadium in the event the Chargers exercise their contractual right to relocate from the venue. These shifts should be reflected in the five year forecast.
Costly Public Works Projects: Even while facing all of these liabilities, the city is considering two massive construction proposals: a new Downtown Library and a new City Hall building. Despite repeated requests from the City Council and the IBA, the impact to the Five Year Financial Forecast of moving these projects forward has never been provided. Imagine Louise planning to add on to her house or build a pool amidst all her debts, but not examining how these plans would impact her overall ability to pay down her credit card balances.
Decision-makers, as well as the public, must be made aware of how these projects will impact the city’s ability to pay down its other liabilities and/or fund its ongoing operational expenses.
Environmental Compliance: The forthcoming costs associated with maintaining the city’s municipal storm water permit and other similar requirements (e.g. wastewater treatment) are expected to increase significantly in the future. The forecast should reflect a range of scenarios for these liabilities.
Deferred Maintenance: The city has fallen behind on maintaining neighborhood infrastructure like roads and sewer systems. The city needs to adequately maintain its infrastructure in order to prevent further growth of an expensive backlog of maintenance needs — which end up costing taxpayers more than if assets are properly maintained in the first place.
Even the above liabilities do not tell the entire story, as other liabilities like ADA compliance, Workers Compensation Insurance, and the impact of new facilities must be acknowledged and dealt with by the city.
Another fatal flaw should also be corrected. Taking the case of Louise again, we see she only examined her monthly cash outlay, but omitted looking at the impact that the outlay had on her outstanding level of debt. In order to establish a path to financial solvency, she must allocate her income so that liabilities periodically decrease. The City of San Diego is no different.
In order to establish an effective plan to dig out of its financial hole, the city’s forthcoming Five Year Financial Forecast must acknowledge all its liabilities and formulate a plan to reduce its equivalent of credit card balances. Failing to do so will only continue, and potentially worsen, the city’s financial woes.
Put simply, the forthcoming Five Year Financial Forecast provides a tremendous opportunity to comprehensively recognize the scope of the city’s liabilities. Examining these liabilities together reveals that a financial “perfect storm” has formed, meaning that piecemeal approaches to fixing the structural issues facing the city will no longer suffice.
Recognizing the magnitude of each liability — as well as the rate at which each obligation is growing or declining — represents a first, but necessary step in developing an integrated approach for implementing sorely needed financial reforms and organizational restructuring.
Carl DeMaio represents San Diego’s 5th District on the City Council. You can e-mail him at: email@example.com.