Second pension fund pays San Diego retirees millions in “excess benefits”

by Kelly Thornton | inewsource

San Diego has paid out almost $4.3 million over the past three years from a second pension plan – financed by general operating revenues – to cover retiree benefits that are so generous they exceed IRS limits.

The City Council approved this second fund in 2001 but it’s been only a blip on the radar of the public and the media. inewsource analyzed payouts and the reasons the city created the fund.

San Diego is one of many public entities that set up Preservation of Benefits plans to pay pensions the IRS says exceed what legally can come from a traditional pension fund. The maximum allowed for a retiree ages 62 to 65 is $195,000.

Because the IRS does not allow the supplemental payments to come from the pension portfolio, city taxpayers and ratepayers fund the entire amount, not sharing the burden with employee contributions or interest earnings.

The city has staggered under the weight of its pension obligations for years, and as more dire news surfaces about million- and billion-dollar funding shortfalls of public-sector pensions, politicians and reformers are scrutinizing the practice for the first time.

Although Mayor Jerry Sanders is determined to reform the city’s pension system with a ballot measure before his term expires next year, proposed reforms will not eliminate excess benefits that have been promised to retirees.

City Councilman Carl DeMaio, who has crafted his own agenda for remaking city finances in advance of his run for mayor, questioned not only the fund but the generous pensions that make it necessary.

“The city of San Diego pension system for some employees is so lavish it has triggered an IRS rule that was originally designed to keep corporate CEO fat cats from spiking their pensions and sheltering corporate funds from taxes,” he said.

After being contacted by inewsource about the second fund, DeMaio asked the city attorney to evaluate whether the city can get out of paying the so called “excess benefits.” A spokeswoman for City Attorney Jan Goldsmith could not say when that report might be finished.

City and pension officials said the second plan is the only way public entities can make good on contractual promises to employees.

And they contend that the city’s obligations to the regular pension fund are reduced by the amount it pays into the second fund, so it essentially “is a wash.”

“It’s not an extra benefit beyond what (retirees) are legally entitled to in their labor agreement with the city. It’s just paid out of two sources,” said Mark Hovey, CEO of the San Diego Employees’ Retirement System, or SDCERS.

Most of the 60-plus San Diego retirees who receive money from the Preservation of Benefits fund are high-ranking managers or elected officials who retired too young to collect full pensions under IRS rules.

For instance, because former City Attorney Casey Gwinn retired in his 40s, the IRS only allowed him to receive $44,496 of his $98,826 pension in 2010 from the SDCERS plan. So he collected the difference – $54,330 – from the second plan – via the city’s general fund. Gwinn has received a total of $193,977 since 2007 from the second plan, the 7th-highest amount paid out.

Similarly, Ralph Inzunza, the councilman who resigned after he was convicted in 2005 of federal corruption charges, started collecting a $23,162 pension in 2008, when he was 35. That year, $9,856 came from the Preservation of Benefits fund. Over three years, the fund paid him $13,896. Inzunza is free pending appeal.

Under IRS rules, if a public entity decides to pay benefits that exceed legal limits, the money must come from a fund that is different from a traditional pension fund. It can’t be supported tax-deferred contributions from employees and employers, and there is no investment that accumulates over time. Most of the money San Diego uses to pay the extra benefits comes from the taxpayer-supported general fund – the same fund that pays for services like police and fire.

SDCERS gives the city an invoice once a year; the city pays that amount in a lump sum to the Preservation of Benefits plan from its general, water and wastewater funds.

Tax-shelter limits

IRS code 415 (b) establishes annual dollar limits on benefits that can be paid from qualified tax-exempt pension plans like the SDCERS fund. The limits vary and are significantly lower for younger retirees. The intent of the rule, imposed by Congress in 1974, was to cap the amount of money that high earners – particularly in the corporate world – could set aside in tax-sheltered investment accounts.

When public agencies protested the limits, Congress reacted in late 1996 and established 415 (m), which allows public agencies, but not private companies, to create the second funds.

The city of San Diego’s primary retirement fund had been illegally paying excess benefits for more than a decade until the second fund was activated in 2007. At that time, an actuary estimated the city’s future liability for the excess benefits at $22.8 million.

Pension critics around California are beginning to seize on the subject of excess benefits, saying cash-strapped governments like San Diego are exacerbating their financial messes by circumventing the IRS limits to excessively pay a relatively small group of high-ranking pensioners.

“The fact that the city entered into contracts that even the IRS considers to be an abusive tax shelter is outrageous,” said Marcia Fritz, president of the California Foundation for Fiscal Responsibility, a nonprofit that advocates for pension reform. “The city is telling the pensioner you’re still going to get that contract. We’re still going to pay it to you, but not through the pension system. We’re going to do it through our own treasury.”

Fritz and actuaries interviewed said excess benefits are coming up now because the IRS changed the formula for calculating limits in 1994, making more high-level workers subject to them, retroactively. Those workers are now reaching retirement age, and because many governments improved benefit packages in the 1990s, their excess benefits are significant.

“We’re starting to get these big pensions coming through that exceed the limits, especially in public safety,” Fritz said. Police and fire officials have benefit packages that enable them to retire at younger ages with higher compensation levels.

The benefit increases that exceeded IRS limits were triggered in part by the now-infamous 1996 and 2002 deals in which the city agreed to pay significantly higher retirement benefits to employees and SDCERS agreed to simultaneously allow the cash-short city a break on annual retirement fund payments.

This created a massive debt that contributed to today’s $2.1 billion pension deficit and led to suspension of its credit rating and state and federal prosecutions of pension officials. Conflict-of-interest and fraud charges were eventually dropped. The city wasn’t able to restore its credit until 2008.

The city council unanimously passed the Preservation of Benefit ordinance on March 19, 2001 at the request of the SDCERS retirement board. The fiscal impact was described as “None.” The city did not seek the required IRS approval for the plan or start paying for excess benefits from it until 2007.

Greg Bych, director of the city’s Risk Management division and the mayor’s representative on the SDCERS board, said the second plan was activated in 2007 for a couple of reasons: Benefit increases in 1996 and 2002 spiked some pensions up and over the limits; and, pension administrators learned they were violating the IRS code by paying for the excess benefits from the SDCERS plan.

Amid the criminal and civil investigations in 2005, pension administrators initiated an evaluation of its practices. The city’s outside law firm turned up violations, and the city reported them to the IRS as part of a program that would allow it to voluntarily correct any issues and avoid penalties, Bych said.

Why set up a mechanism for the second fund in 2001 and not activate it until 2007?

“Why does the city do a lot of things? I have no logical explanation,” said Jay Goldstone, the city’s chief operating officer, who was not on the city staff in 2001. “I just stop asking why and just try to keep fixing these problems. It’s a fair question. I just don’t have an answer.”

Goldstone said Mayor Jerry Sanders activated the POB fund in 2007 when he learned from the outside law firm that the city was making illegal pension payments from the main pension fund.

“He’s saying so long as we have an obligation to pay these benefits we are going to follow the law,” said Goldstone, speaking for Sanders. “If someone else wants to challenge whether we are legally obligated to pay, that’s a separate issue. That’s all we’re trying to do is follow the law.”

Calculations of how much the city paid in violation of the IRS limits have varied.

One report said the city paid $4.2 million in excess benefits between 1996 and 2007. The remedy that satisfied the IRS was that the city had to repay that amount, with interest, to the SDCERS fund, the document said.

But in a 2007 report, former City Attorney Michael Aguirre accused city and SDCERS officials of downplaying the extent of its IRS violations. Based on correspondence between the IRS and SDCERS, Aguirre reported that the city first calculated its overpayments at $2 million, and when pressed by the IRS, revised the number to $8 million.

Since the city voluntarily submitted to a review and agreed to correct this matter and several other problems, the IRS agreed not to sanction the city.

The Debate

Former City Councilwoman Donna Frye saw a line in a city PowerPoint presentation on the budget in 2007 that said that SDCERS had reduced its pension liability by $22.8 million due to “proper treatment of IRS benefit limitations.”

In a recent interview, she said she asked Jay Goldstone, then the city’s chief financial officer, to explain it. He told her the debt was transferred to the city to comply with the IRS rules limiting pension amounts.

She said it took her more than four months to wrestle the background from Goldstone and Mayor Jerry Sanders’ office, but she finally learned the $22.8 million liability was shifted to the city because SDCERS had been illegally paying too much for pension benefits, in violation of IRS rules.

Frye said she asked for a legal determination on whether the second pension fund is allowed by the charter or requires a public vote. Nothing ever came of it, she said.

Frye said she believes the city shouldn’t pay benefits that the IRS has capped.

“The question is, is it really a best practice for a pension? I would say it’s not. I would say look at what the IRS limit is and go by that.”

Aguirre went further, contending that it’s illegal to pay excess benefits. He reasoned that the fund was not permitted by the City Charter, nor was it activated by the city until February 2007 – after voters approved Proposition B, which requires voter approval of any employee retirement benefit increases with the exception of cost of living adjustments. He issued an extensive report on the subject in 2007, urging Sanders to refrain from making POB payments. The report was ignored.

SDCERS officials disagree.

Hovey said, “If the city says they don’t want to pay that size of retirement benefit they would need to change their benefit programs. A lot of benefits have been litigated. Once somebody has a benefit you can’t take it away from them.”

Goldstone said the City Charter is “silent” on the subject. And, Prop. B does not apply because benefits were not increased, he said.

“All we did was we change the way previously promised benefits are being paid. That’s all this preservation of benefit does. It didn’t increase peoples’ pension payments.”

“The mere fact the previous city attorney said we shouldn’t pay it – he said a lot of things we shouldn’t do that were proved wrong and we would have lost,” Goldstone said.

Many public entities have created second funds to pay the higher benefits, including the county of San Diego, the California Public Employees’ Retirement System known as CalPERS, the state teachers’ retirement fund known as CalSTRS and the University of California.

The county’s second pension plan currently pays 25 employees about $516,000 a year in excess benefits. The county would not release names, only departments. Top recipients worked in the Health & Human Services Agency, the Community Services Group in the Chief Administrative Office, and the District Attorney’s office. The Board of Supervisors established the fund in 2002.

All the pensions are in trouble. San Diego’s is underfunded by $2.1 billion; San Diego County’s shortfall has grown to $1.6 billion. And, a recent report by the Stanford Institute for Economic Policy Research found that the three other state systems were collectively underfunded by $425 billion – the equivalent of about five state general fund budgets.

The Port of San Diego and the Regional Airport Authority also have second funds which are administered by SDCERS, but only two people qualified to receive them in 2010.

Hovey and Goldstone say that the San Diego’s second fund has had no real financial consequence for the city beyond the $10,000 to $15,000 annually for administrative costs. The city’s annual pension contribution is reduced based on what it has to pay for the second pension plan, he said, contending, “It’s all a wash.”

The city’s annual pension payment in 2010 was $229 million to some 8,000 retirees compared to $1.5 million for excess benefits to about 60 people, Hovey said.

Some critics believe it’s more expensive for the city to have to pay from its general fund, rather than to contribute to an investment plan with significant tax advantages.

Critics like DeMaio and Aguirre disagreed with the contention that the second fund has no financial impact on the city.

“It’s not even a wash even assuming their logic,” Aguirre said. “It’s not amortized, there’s no interest earned, there’s no money invested. It’s a net loss.” And more importantly, he said, the city shouldn’t pay for the excess benefits in the first place.

Hovey said the city has no choice; the IRS does not allow the city to prefund the second plan.

Several actuaries contacted for this story asked not to be identified by name because they work for government entities. Some said the financial impact of a second plan is negligible; others said the second plans can be financially problematic because they are not funded the same way as a traditional pension fund.

Traditional qualified plans are prefunded by the employer and employee during that worker’s time of employment, and qualified plans have tax advantages the IRS does not afford to the second plans.

“The point of prefunding is that you want to have enough money in the fund when a person retires,” said Frank Todisco, who is chief actuary of the U.S. Government Accountability Office in January. He agreed to speak generally about second pension plans created under IRS rules and noted that he is not familiar with practices in San Diego.

“You want to be paying for the pension while getting services from the worker,” he explained. “If you’re not prefunding it – which means you are not paying for it while these executives are working for you – then you have to pay for it all after they’re long gone from the workforce.

“And you do that,” he said, “and you’re really creating a legacy debt for yourself. That’s potentially a recipe for trouble.”

A version of this story can be found on signonsandiego.com and in the print editions of The San Diego Union-Tribune, April 17, 2011.

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