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Fiduciary Conflicts In Public Sector Plans

Bill Sheffler, ASA       May 9, 2009

NOTE to Readers of the Ramble: Earlier this year, Bill Sheffler finished a term as an appointed Trustee of the City of San Diego Retirement System

For the benefit of those not already immersed in pension actuarial science, it is worthwhile to review the basics of retirement plan funding.

The cost of a retirement plan is funded (paid for) over the working lifetime of each employee, much like a mortgage is paid off, in installments.

Each installment is invested and the income from those investments is used to reduce the total cost of employee’s pension. This investment income portion normally amounts to about 80% of the total cost of the benefits. If regular and continuous installment payments are not made, the amount of investment income is reduced and the cost of the benefits to the employee and the taxpayer are increased. Because investment income compounds over a long period of time, the cost of the plan increases exponentially due to those missed payments. In other words, skipping a $100,000 payment today would require a $215,000 payment if it wasn’t paid off in ten years.

Many state and local governments have delayed or skipped payments to their retirement plans. And although those governments are usually prohibited from taking money from the retirement plans, these skipped payments represent forced loans from the plan to their governmental sponsor. In the private sector the plan sponsor would be subject to sever penalties for that behavior. This is just one of the many protections granted to private sector plan participants that is not enjoyed by their public employee counterparts.

The tragedy is that taxpayers, who are ultimately responsible for the plan costs, are also left vulnerable by these financial shenanigans. Allowing public employees, and taxpayers the same protection as private sector employees should be a worthy objective. Unfortunately, governmental plan sponsors have traditionally resisted such regulation, and, to their everlasting discredit, the public sector union officials have not seen fit to demand it.

The “Corridor” Issue

Because investment income is not the same from year to year, plan costs will vary, since plan costs are offset by investment income. To allow the plan sponsor to budget for each years payments a mathematical process called “Smoothing” is applied. This is supposed to prevent ordinary market swings from causing disruption to typically tight municipal budgets.

Smoothing is not intended to mask extraordinary market changes, or ignore genuine economic events. This is true in both up and down markets. To allow these real and substantial changes to be recognized, smoothing is limited by a “corridor”. In the case of sdCERS, this corridor is 20% of market value. So if the actual market value of the plan assets is either less than 80% of the smoothed value or 120% then the additional change is deducted from or included in the smoothed value. For instance, let’s say there was a sudden dramatic drop in the stock market and the fair market value of the plan assets was $3 billion dollars, but the smoothed value was $4 billion dollars, then the smoothed value (or value used for actuarial cost) would be limited to $3.6 billion. This would force the plan to recognized at least $400 million in losses than if the corridor was not respected.

One of the arguments against corridors is that there are many public plans that do not use corridors on their smoothed assets. All private sector plans are required by law to use a corridor. But as I pointed out before, the law is a protection against abuse by plan sponsors. Public plan trustees can not excuse their own irresponsible behavior by pointing out that others do it too. In my opinion, the failure of some public sector plans to allow the protection afforded by corridors is irresponsible.

Existing Breaches of Fiduciary Duty

On the subject of irresponsible behavior, my last act as an sdCERS trustee was to point out the breach of fiduciary duty of a fellow trustee, and now board president Mark Sullivan. Mr. Sullivan was elected from the Police Officers Association (POA). There is a perception that board members elected from union groups, like the POA, must represent those unions, in preference to the whole retiree and participant population.

For this reason, the Pension Reform Committee recommended the removal of these conflicts of interest from the board entirely. The city council at the time, likely in respect for the financial support of the unions, reduced the overwhelming majority of vested interests on the board to a slight minority (which I call “elected” members). All of the progress of the last four years can be traced back to the reduction in the power of elected members, their vested interests and resulting conflicts, by this change. These types of conflicts have a long history, even the new testament in Luke 16:13, the words of Jesus are, "No servant can serve two masters”.

In this instance, the board members are also trustees. In law these are referred to as “Fiduciaries”. Important concepts to understand about a fiduciary are these:

“The fiduciary relationship is highlighted by good faith, loyalty and trust. The word itself originally comes from the Latin fides, meaning faith.

“When a fiduciary duty is imposed, the law requires a stricter standard of behavior than the comparable duty of care in common law. It is said the fiduciary has a duty to never be in a situation where personal interests and fiduciary duty conflict, a duty to never be in a situation where a fiduciary duty conflicts with another fiduciary duty, and a duty never to profit from their fiduciary position without express knowledge and consent. A fiduciary cannot have a conflict of interest.

And to the point:

“A conflict of interest exists even if no improper act results from it, and can create an appearance of impropriety that can undermine confidence in the conflicted individual or organization.

These conflicts are insidious. The casual acceptance of conflicts of interest, and the disregard for their importance led directly to MP1 and MP2. These were instances where board members agreed to changes for their exclusive benefit (presidential leave benefits) or for individual union groups, to the detriment of the plan. The plan detriment was a “quid pro quo” with the city to reduce the board’s requirement of city contributions in exchange for benefits. The phenomenal absurdity of increasing benefits and reducing contributions got the public’s attention, which led to retirement system changes.

New Challenges

Now we have new challenges. Since overt conflicts of interest have been exposed as improper, more subtle tactics must be used to achieve the goals otherwise prevented by law or public outrage.

These conflicts most frequently arise in the review of disability pension applications. The former board member elected from International Association of Fire Fighters Local 145, consistently voted to approve disability pension applications submitted by other firefighters, regardless of the merit of the application. In a collegial spirit (when the POA and Local 145 weren’t at odds) he would do the same for police applications. As an ingrained institutional behavior, I expect his successor to act the same.

These conflicts were the cause for my impeachment of Mr. Sullivan. He asserted disability claims for unqualified police applications. On other occasions, he attempted to disrupt the disability denial process by making meritless arguments, again exclusively for police matters.

Another fellow trustee, whom I respect far more than these two, argued that he could not approve a reduction in the DROP interest credit because his constituents would be unhappy.

These actions strike at the heart of fiduciary duty. The board members have a uniform duty to the trust and ALL participants. Favoring one group over another, or asserting exclusive rights of one group in opposition to the whole, is a breach. The fact that some board members are elected from segregated groups, or have long-standing duties to those groups makes it impossible for them to filter out their traditional motivations from those they have as plan trustees. And there is absolutely no opportunity to defeat the “appearance” of conflict of interest problem.

With this background, how can the public be confident that the city will not negotiate an informal arrangement with elected board members for the benefit of their respective interest groups, or related individuals?

Further, the mayor has refused to reappoint experienced and proven independent trustees (of which, admittedly I claim to be one), in favor of his own choices. Clearly, he expects them to favorably consider his proposals or to commit an outright breach of their fiduciary duty. In furtherance of his attempt to unduly influence the pension board he has announced his intention to convene a committee to formulate his own MP3 regards the corridor.

In fairness to the new appointees, this is my impeachment of the mayor’s office only. Any judgment on his appointees’ performance is withheld. In my experience, no board appointment is worth one’s personal honor. I hope the mayor is unsatisfied with his choices.

So the mayor has two opportunities to undermine the board’s independence. He can attempt to barter with the elected members, or exercise extraordinary influence over his own appointees.

The stage is now set for a bitter and divisive struggle, not seen since the last city attorney was removed from office.

Other Pension Funding Problems

According to the city charter, employees are responsible for paying one-half (50%) of the “normal retirement allowance”. Over many years, this requirement has been diluted to the point where employees now pay 19.6% of the cost of their benefits. Until this year, the city actually paid the majority of even that reduced amount. In city-speak, this is called a “pick-up”. In the next two years, by my calculations the employee contribution will drop to 12.1% of the total amount due.

How could that happen?

First, employees only pay for the cost of the “normal retirement allowance”. Although what term is supposed to include has not been conclusively determined, what is does not include has been steadily expanded. The excluded elements are, disability pension payments, any negotiated past service benefit increases, any losses due to plan experience (such as investments), early retirement subsidies, excess DROP interest, and death benefits.

Second, when benefits are improved in labor negotiations, part of the cost of the future benefits earned is supposed to be paid by the employees. It is the responsibility of the retirement board to update those employee contribution rates. Again, probably due to the preponderance of ‘vested’ interests on the board some of those increases were never put in place.

Third, there are a number of other small leaks in the pension boat, that don’t get passed on to employees. There is the famous “purchase service credit” that was under-priced for years. All of the losses due to that fiasco are borne by the city (and the taxpayers). The actual computation of employee cost was undercharged for several years. The taxpayer, by way of the city, pays for those losses. Then, there is pension ‘gaming’; these are abusive strategies used by some departments to artificially increase their pension benefits without paying more into the system. For example, retirement pensions are based on an employee’s highest 12 months compensation. Under this strategy, an employee close to retirement is given a temporary promotion to a higher salaried position, and then returned to their previous assignment. They get a pension as if they had justifiably attained the better position, and commensurate salary. The San Diego City employees retirement plan is much more complicated than the systems of similar cities. This complexity is a fertile ground for ‘gaming’ by exploiting loopholes or inconsistencies in the municipal code.

In the private sector, many of these abuses, and forced cost transfers are defeated by design. In these cases, contribution amounts are negotiated and then benefits set to cost no more than the funds available. If a series of losses is experienced then future benefits are reduced. The employer’s contribution can not be increased without his prior consent.

The pension provisions of the municipal code itself have been until recently fallen far short of the standard of practice exercised in the private sector. This was clearly illustrated when the pension board submitted the plan to the IRS for review. The IRS found that pension payments were being made in excess of the lawful limits, and that plan benefits (and of course plan assets) were being diverted to non-participants (the presidential leave benefit). Speaking of diversion of plan assets, in the course of this review, the IRS discovered that the city was raiding the pension fund to pay health benefits. Whether the old board was complicit in these transfers is now only a matter of historical interest, but again is illustrative of the effects of conflicts of interest and fiduciary breaches. Full restitution has yet to be achieved on this matter. The IRS was so alarmed by this review that it is now considering a special project to review other public sector funds.

In summary, there are continuing issues with the city retirement plan that will require active citizen vigilance. I am most concerned about the fiduciary issues, the willingness of the elected members to act selflessly (which is doubtful), and the ability of the independent trustees to contain the various attempts to undermine the financial security of the system, either from city management or other vested interests. These are serious matters and citizens should be alert to the subtleties of municipal politics and their impact on pension finance. The evidence of the last four years is that a good start has been made on reforming plan governance, but we are a long way from closing the book on a solution to city pension funding problems.

Author’s notes:

This commentary is chiefly deals with issues which arose during my tenure on the board of administration for the San Diego City Employees Retirement System (sdCERS).

Several former board members were indicted in 2006 on federal and state charges under various self-dealing statutes. The city convened a citizens committee (Pension Reform Committee) to investigate the problems of the system. As a result, the number of board members with vested interests in the plan benefits was reduced to a slight minority (6 out of 13), from the previous 9 of 13.

The current challenge to the board is maintaining the corridor (which is + or – 20%) on the moving average of plan assets. However, other problems I address, such as compliance with various IRS requirements and conflicts of interest, are prominent in most public sector retirement plans. Bill Sheffler San Diego

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