Pension Reform in San Diego. Reform BY JAY M. GOLDSTONE

Transcription

1 Pension Reform in San Diego Reform BY JAY M. GOLDSTONE

2 During the dot-com boom,the stock market was mushrooming and there was no end in sight.the euphoria was so great that people forgot about market cycles and corrections. As a result of rising stock prices and strong real estate growth, public pension plan assets grew, often to a point where plan assets exceeded plan liabilities,creating the misconception that employers could increase retirement benefits with no budgetary impact. Some employers increased retirement benefits to attract workers and other employers followed just to keep pace.it was a cycle that was doomed from the beginning. One of the mistakes made at this time was the widespread practice of increasing the pension multiplier to give an employee a greater retirement benefit while at the same time lowering the retirement eligibility age. This provided a greater opportunity to retire earlier at a time when people are living longer. Instead of providing the incentive for early retirement, employers should have been encouraging employees to work longer. During the frenzy in California, the state was eager to give employers the option of increasing benefits, and employers were eager to provide better benefits at no or low cost to the employees. Sometimes these improved retirement benefits were awarded in lieu of salary increases, and typically no one at the local level fully understood how the costs of these benefits are calculated and how much added financial risk they were assuming and passing on to future generations. Decision makers were probably told at the time that their pension plans were super funded and that they could use their surplus funds (assets in excess of liabilities) to pay for these added benefits far out into the future. And since plan assets were theoretically paying for the benefits,unlike salary increases,there would be no budgetary impact. It looked like a win-win situation: a great perk for employees and a freebie for the city. Now the euphoria is over. Fiscal year 2009 has closed, and officials at many jurisdictions are going to be surprised by their upcoming pension bills. While many governments are still feeling the budget stress caused by lower tax revenues in The decisions made by the City of San Diego in the mid 1990s regarding employee retirement benefits were probably not much different from those made at many other public agencies. The steps taken recently to start addressing San Diego s burgeoning pension costs will be steps public employers across the country will have to consider. the past year, their annual required contributions (ARC) could increase by up to 25 percent over the ARC for fiscal 2010,in some cases,or even more.for many jurisdictions,that will mean millions of dollars going toward the pension payment instead of police, fire, libraries, park and recreation, and other vital services. SAN DIEGO S STORY The decisions made by the City of San Diego in the mid 1990s regarding employee retirement benefits were probably not much different from those made at many other public agencies. The steps taken recently to start addressing San Diego s burgeoning pension costs will be steps public employers across the country will have to consider. The problem actually began when the city faced a budget shortfall and elected to underfund its pension obligation as a means to balance the budget. This did not happen once; it happened twice.the results were disastrous. In the long term, these decisions led to a securities fraud investigation by the Securities and Exchange Commission, numerous lawsuits, and necessary corrective actions taken by the city to ensure this situation will never happen again. It ended up costing the city tens of millions of dollars, and San Diego became the poster child for bad pension decisions and inadequate pension disclosure. It all started as a simple way of balancing the city s budget without making the tough budget decisions. The city sought approval from its pension board to pay less than the full ARC. The board was dominated by organized labor, and to secure their support, the city agreed to increase pension benefits a deadly combination. To exacerbate the problem, the city never properly disclosed its pension deals and its true pension liability to credit rating agencies,issued debt that included faulty disclosure,and ended up with an SEC investigation. A NEW WAY OF DOING BUSINESS The bad pension decisions and inadequate pension disclosure, along with their unintended consequences to the city, August 2009 Government Finance Review 27

3 eroded public trust. In 2004, the voters approved an amendment to the city s charter and created a form of government with a strong mayor to establish a system of checks and balances in the decision-making process.to provide for a transition period, this charter amendment was to take effect on January 1, About five months after the voters approved the change to the governance structure, the incumbent mayor resigned.following a special election,a new mayor was elected in November 2005, bringing with him a mandate to institute fiscal and pension reform. Now, more than three and a half years later, San Diego is possibly a poster child for pension decisions once again, but this time as a leader. The first step was for the city to start paying the full ARC, beginning in fiscal This was no small feat, since the annual payment ballooned from roughly $75 million (approximately 10.5 percent of the annual salary budget) to more than $160 million (more than 38 percent of its annual salary budget) in just one year. The city would also need to make additional payments to start catching up.at the same time, the city needed to establish a workable balance between paying for benefits and critical services.it was necessary to make fundamental structural changes to the pension plan and develop a more reasonable and affordable pension benefit. In fiscal 2008, the budget included extra funding to cover 100 percent of the interest on the unfunded liability, and some principal. The supplemental payment was approximately $20 million. In fiscal 2008,the Board of Retirement for the city s pension system the San Diego City Employee Retirement System (SDCERS) also modified the methodology its actuary uses when calculating the ARC, resulting in a more conservative approach to funding the plan. All annual market gains or losses are now smoothed over a four-year period. The city will recognize losses, even dramatic ones such as those experienced in fiscal 2009, over a very short period of time. Most pension plans amortize gains and losses over five,10,or even 15 years. In addition,the time period for which the plan s unfunded liability is amortized was fixed essentially, SDCERS took a snapshot of the plan s unfunded liability as of June 30, 2007, and amortized that liability over 20 years. While these actions will help accelerate the funding of the plan, they also increased the city s ARC, making the city keenly aware of how expensive the previously awarded pension benefits had really been. It also became clear how the city had masked this reality through its underfunding agreements with the SDCERS board.other jurisdictions have taken similar actions, masking how expensive their pension benefits are and concealing the true strain these benefits put on the annual budget. Employers do this by using plan assets, when they are in excess of plan liabilities,to cover all or a portion of the ARC, resetting the amortization period for funding the unfunded liability, spreading the recognition of losses over a longer period, etc. Once city officials understood the true cost of the pension plan, they took the only step that seemed logical.they closed the plan to new employees and provided a fair but much more affordable retirement plan for new hires. The new plan had to recognize that today s employee is generally healthier,living longer,and drawing a pension check for more years than employees did when the original plan was created. The city could no longer assume the financial risks associated with its original defined benefit plan. City officials also needed to develop a plan that would not provide incentives for employees to retire early and draw a pension for 20, 30, or even 40 years, periods that were longer, in some cases, than they had worked. COMPARING RETIREMENT PLAN OPTIONS While there was a general sense that something needed to be done,getting there was another matter.the city first turned its attention to its miscellaneous and general employees,who constituted more than 50 percent of the workforce. The new retirement plan for this group of new hires had several objectives. City officials wanted to develop alternative program designs that would be aligned with the city s workforce and financial goals. The new plan needed to be fair and reasonable. Employees needed to share in both the longevity risks and investment risks that had been solely assumed by the city. City officials analyzed benefits, costs, and risks associated with the current and proposed retirement programs, from the perspectives of both the city and the employees. They also compared current and proposed programs against a peer group of employers. The city began by obtaining a better understanding of the differences between a defined benefit plan and defined contribution plan, and what those differences meant financially to the city and its employees. Under a defined benefit plan: The annuity benefit at time of retirement is defined based on pay, years of service, and other factors. 28 Government Finance Review August 2009

4 Exhibit 1: Risk Attributes of Defined Benefit and Defined Contribution Plans Responsibility for for Fund Selection Responsibility for Asset Allocation Investment Risk Liability Risk (Before Retirement) Inflation Risk (After Retirement) Longevity/Mortality Risk (Outliving Assets) Defined Benefit Defined Contribution Employer Employee Employer Employee Asset Risk (if COLA is Inflation Risk inadequate) Employers and employees contribute the amount necessary to fund the benefit, even though the employer often pays the employees share. The accrual pattern generally favors older employees with more years of service. The employer retains all financial and longevity risks. Under a defined contribution plan: The contributions (both employer and employee) are put into individual accounts for the benefit of the employee. The account balance grows with contributions and investment returns. The amount of the benefit at retirement is the balance of assets in the employee s individual account. The accrual pattern generally favors younger, mobile employees. The employee bears all the financial risks and, typically, the longevity risks as well. The financial and longevity risks are the reason government employers need to take a close look at their defined benefit plans.expected mortality is one of the components actuaries factor into their calculations of a plan sponsor s liability. Expected mortality, coupled with the expected age of retirement,helps determine parameters for how long a beneficiary might be drawing a retirement check.the number of years by which a retiree outlives the projected mortality is the longevity risk assumed by the employer. The improved retirement benefits which encourage early retirement only increase the potential financial costs. Funded levels for a defined benefit plan can be volatile, as can contribution levels, under circumstances such as those faced by San Diego.Defined contribution plans do not,in general, share these concerns. From a funding perspective, actuarial gains can reduce defined benefit funding requirements, while actuarial losses will increase them. Under a defined contribution plan, asset gains or losses will increase or decrease employee benefits,and the funding requirements as a percentage of payroll are typically unchanged. Needless to say, switching from a defined benefit to a defined contribution plan shifts the risk from the employer to the employee, and anyone undertaking such a change needs to recognize that there will be resistance to this fundamental shift. (Exhibit 1 compares and contrasts the risk attributes associated with a defined benefit versus a defined contribution plan.) THE OLD AND THE NEW Once city officials understood the potential differences between the two kinds of plans, both in terms of their specific goals and their impact on the city s budget, a number of alternative scenarios were developed.they considered hybrid models ranging from a defined contribution plan with a small defined benefit plan component to a defined benefit plan that had significantly lower benefit factors at younger ages, along with a defined contribution component. August 2009 Government Finance Review 29

5 The Original Plan. In addition to offering a 401(k) plan and a 457 deferred compensation plan both voluntary programs the city also provided a very expensive defined benefit plan.the formula for determining benefits for an employee retiring at age 65 is 2.8 percent multiplied by the employee s single highest year of pay multiplied by years of service. The multiplier is 2.65 percent for employees retiring at age 62, 2.55 percent for employees retiring at age 60, and 2.5 percent for those retiring at age 55. Employees are vested in the plan after 10 years of service at age 62 and after 20 years of service at age 55. The city also provides a supplemental defined contribution retirement plan.the city and the employee make a mandatory contribution of 3 percent each,and the employee can contribute an additional 3.05 percent, which the city will match at 100 percent. Employees keep all of their own contributions from day one, and there is a vesting scale of 20 percent per year on the city s match,with the employee being 100 percent vested in five years. City officials looked at the retirement plan next to the statewide California Public Employees Retirement System as well as plans offered by other large public employers in California.In comparison,the city s plan was very generous to the employee as well as being expensive and unsustainable for the city.it also provided a retirement benefit that was much greater than the benefits provided by its peers. In some instances,the retirement benefit was even more than the compensation the employee had earned while working. The New Plan. Establishing a new retirement plan is never easy. San Diego met with substantial resistance from collective bargaining units, including arguments that the city would no longer be able to attract qualified and competent workers. There was also varying degrees of resistance from the City Council. There was a general support for labor s position to not change retirement benefits. None of this should deter the resolve or the realization that change is necessary. agreement with the city to lower retirement benefits and eliminate many of the more expensive features of the existing retirement plan. Because pension-related retirement benefits have been determined to be vested rights for current employees,the new plan affects only those employees hired after July 1, The city s new hybrid retirement plan contains elements of both a defined benefit and a defined contribution plan. For an employee who is aged 65,the formula for determining benefits under the defined benefit piece of the new plan is 2.6 percent multiplied by the average of the three highest years of pay multiplied by the employee s years of service. For an employee who is aged 62,the multiplier is 2.24 percent; for an employee aged 60, the multiplier is 2 percent; and for an employee aged 55, 1 percent. Retirement benefits are limited to a maximum of 80 percent of what an employee earned while working. Employees are fully vested in the plan after 10 years of service at age 62 and after 20 years of service at age 55,as they were in the original plan.for the defined contribution piece of the plan, there are two components. Each employee contributes 1 percent of salary into a 401(k)-type type plan, and the city matches this contribution at 100 percent. In addition, each employee contributes 0.25 percent of salary into a retirement health-care trust; the city also matches this contribution at 100 percent. The city s voluntary 401(k) and 457 plans also remain available to each employee. It has been estimated that these changes in benefits will save the city approximately $22.8 million per year after 20 years. As the workforce turns over and employees who are covered under the old plan retire, the normal cost (the current year s allocated cost as determined under the plan s actuarial cost method) portion of the city s ARC could be reduced After months of collective bargaining negotiations that were going nowhere, the mayor finally forced the issue by threatening to place a new pension plan on the ballot and let the voters decide.when the City Council agreed to that approach and to what the plan would look like,organized labor willingly come to the negotiating table with a meaningful compromise proposal that could be discussed.negotiating as a coalition, the three affected labor organizations finally came to an 30 Government Finance Review August 2009

6 by 30 percent or more. In the short term, the savings will start at approximately $500,000 in the first year and grow by $1 million per year thereafter. As an additional step to get pension costs under control,the city also changed the benefit formula for new sworn police personnel from 3 percent multiplied by the highest year of pay multiplied by the employee s years of service at age 50 to 3 percent at age 55.This is still a very generous retirement benefit, but if all current public safety employees (both police and fire) were under the new formula, the city s ARC would decrease by approximately $25 million annually. CONCLUSIONS The City of San Diego realized that its pension plan was unsustainable. Officials looked at the problem, identified potential solutions, and decided that the answer lay somewhere between offering an extremely expensive defined benefit plan and scaling back to a defined contribution.the solution for San Diego turned out to be a hybrid plan. Other jurisdictions will come to different decisions, but whatever they decide, public employers need to think about the retirement commitments they have made to their employees. It is too late to change the retirement plans for current employees,but it is not too late to plan for the future. The reforms the City of San Diego implemented have not solved all of its financial challenges, but it is hard to imagine what the future would hold without them. Making these changes has been a lengthy and unpopular process with organized labor, but this process will be the new standard, going forward. Will the city have problems attracting new employees? People who are in the later stages of their careers may think twice, but overall, the city is not anticipating any problems attracting qualified workers who are bright and enthusiastic to help guide San Diego s future. JAY GOLDSTONE is the chief operating officer for the City of San Diego, California. He oversees the city s daily operations, and implements mayoral and council initiatives and policies. Before that, he was chief financial officer, the city s first. Before coming to San Diego, Goldstone was director of finance for the City of Pasadena. He holds an MBA from the University of Santa Clara, a Masters of Public Administration from Arizona State University, and a Bachelors of Science from the University of Minnesota. August 2009 Government Finance Review 31