Nuts & Bolts

by John Sakowicz, April 22, 2010

In Part One of this series, “A History Lesson”, about the gross mismanagement of the Mendocino County Employee Retirement Association, or MCERA, we discussed my personal history with MCERS, going back to my employment with Sheriff’s Office from 20001 to 2004, and when I attended my first MCERS meeting, as a county worker, in May, 2004.

We named names, in a Gallery of Rogues, of those responsible for the gross mismanagement of MCERS, although we forgot to mention one rogue, former county counsel, Peter Klein (more about him, later).

“A History Lesson” gave us some hint of the cau­tionary tale that lies ahead.

In Part Two of this series, we get down to nuts and bolts…everything you wanted to know about our pension system, but were afraid to ask.

We’ll call Part Two of this series, “Nuts and Bolts”. Here we go.

Background You Have To Know

• Current employees of Mendocino County — approximately 1,100 of them — and the retirement plan’s sponsor, Mendocino County itself, both make contributions to the retirement system, which is administered as a trust managed by an independent Retirement Board; the County doesn’t manage the trust. Employees make biweekly contributions through payroll deductions. The County makes an annual contribution, which is computed by an actuary. This annual contribution is usually expressed as a per­centage of payroll expense.

• When actuarial experience does not match the assumptions used, a shortfall is created. The shortfall is spread, or amortized, over time and payments are made by the County to ultimately make up the differ­ence.

• Mendocino County typically makes up this short­fall by issuing a Pension Obligation Bond. The County does not need to go to the voters in a referendum to either get approval to issue this bond or to add to the County’s debt load.

• Our last Pension Obligation Bond was issued in 2002, in the amount of $96 million. Including an early Pension Bond in 1996, the total borrowed was $110 million.

• According to data from the State Controller, Mendocino County has the highest debt per capita of all the 58 counties in California, and we also have the lowest junk bond rating in all of California.

• When there is a shortfall in the retirement sys­tem, it means that the money that would otherwise be invested in the retirement system’s investment port­folio is now not generating investment returns, fur­ther contributing to the shortfall. This is called “fore­gone earnings”. This phenomenon tends to create a snowball effect — it makes a bad situation, worse.

• The County’s CEO recommends, and the Board of Supervisors approves, the retirement system’s bene­fits. County employees bargain for these benefits through their union, SEIU, or through their various collective bargaining units.

• Benefits, once agreed upon, are guaranteed by the California Constitution. This “locks” the County into a timeline of obligations, or liabilities, that it must pay out, regardless of either the dollar value of its assets under management or investment returns on those assets. Indeed, investment returns are not con­stant. And returns may be sharply negative. Returns may fall precipitously, as they did in 2000 to 2002, and in 2007 to 2008.

• The Retirement Board administers the retire­ment system, and decides its policies. But the Board of Supervisors remains ultimately, and financially, entirely responsible for the financial results of deci­sions made by the Retirement Board.

Current Unfunded Status

• Complying with the Governmental Accounting Standards Board (GASB) Statement # 25, our retire­ment system discounts future liabilities at the same rate we expect to earn every year on invested assets. This rule has been exploited by the Retirement Board to understate publicly reported pension liabilities.

• Our retirement system currently uses an 8 per cent expected rate of return in its actuarial calcula­tions.

• The quirks of GASB make apples-to-apples and oranges-to-oranges comparisons virtually impossible. Comparing pension obligations incurred today, rela­tive to invested fund assets, is necessary for calculat­ing the correct discount rate for future liabilities. Future liabilities have to be discounted at a rate that most accurately reflects their inherent risk. But GASB reporting rules don’t require “stress tests” for retire­ment systems, like MCERS, that project scenarios into the future in which actual investment returns are below expectations.

• So, what is the “real” risk inherent in our retire­ment system? First, pension liabilities are effectively riskless to employees. California law has upheld that public pensions are a form of “deferred compensa­tion”, and, once vested, pensions are a contractual right (Betts vs. Board of Administration. 1978. 21 Cal. 3 d.855). Second, since pension liabilities are effec­tively riskless, they should be discounted and reported as risk-free rates.

• Adjusting the discount rate used on liabilities to a risk-free rate, the funding shortfall at MCERS jumps way up. It spikes.

• So what are Mendocino County’s unfunded obliga­tions at this point in time? Good question. And the answer we usually get from the Retirement Board is an apples-to-oranges comparison. Using a “market value” approach, the most recent calculation of Men­docino County’s unfunded pension liability is $131 million. But using the “actuarial” approach — the approach favored by Retirement Board — we get $67 million.

• Why the difference? It goes back to the tradi­tional metric of calculating pension fund health….a funding ratio determined by simply dividing assets by liabilities. Ideally, a funding ratio should be at 100 per cent.

• However, in calculating the MCERS funding ratio, our Retirement Board overstates the value of its assets by using an “actuarial value”, instead of the true “fair market value” of its assets, and the Retire­ment Board also understates its liabilities by “dis­counting” its liabilities (as discussed above).

• In quoting John Dickerson, at www.yourpublicmoney.com, “Fair market value is what a pension fund is really worth. It’s based on the real value of its assets. It’s the actual dollars that a pension fund has to invest and to pay pensions. ” Dickerson continues, “Actuarial value uses a formula that slows down value changes caused by the stock market’s volatility.” But Dickerson warns that actuar­ial value is not real value.

• As of the most recent calculation, the Retire­ment Board states the actuarial value of MCERS’s assets at $336 million. Meanwhile, fair market value was closer to $271 million.

• So in juicing its assets, and discounting liabilities, the Retirement Board makes MCERS look healthier than it really is.

• And remember, $110 million of the Pension Fund’s assets was provided by the Pension Obligation Bonds. The Retirement Board doesn’t have to pay that back - the County does. So the Retirement Board doesn’t list that as a liability - but in fact the residents of Mendocino County still owe over $80 million on those Bonds. So from our (the people’s) point of view, the pension deficit we are responsible to fill is not just the $131 million the Pension Fund was short based on market value, but in fact is more like $210 million including the Pension Bonds we still owe.

• Even using these misleading accounting tricks, MCERS is still under-funded, meaning it has a fund­ing ratio of well-below 100 per cent. And that’s where a whole new set of accounting tricks comes in. One trick is called “amortization”. The Retirement Board amortizes its under-funding by adjustments to com­pounding. (not sure what this means)

• Geometric compounding is one such example. Geometric compounding means that if a portfolio increase by 10 per cent in year 1, and decreases by 10 per cent in year 2, the net increase is negative not zero. In this way, the “duration” of future liabilities can be goosed. (not sure this gets the point across)

• Concepts like “amortization”, “duration of future liabilities”, and “investment corridors” are all examples of the voodoo accounting principals that some actu­aries use. Buck Consultants, the actuary firm hired by our Retirement Board, is present being sued by the retirees of Stanislaus County because of the alledged flawed use of some of these concepts that severely damaged their Pension Fund.

Retiree Healthcare

• Current retiree healthcare is presently being paid from a special reserve within the retirement system

• At one time, retiree healthcare was a “pay as you go” plan, but retiree healthcare is now bankrupt.

• It is virtually certain that the Board of Supervi­sors will soon eliminate retiree healthcare, a benefit that was promised to 800 current retirees.

• Retiree healthcare was usually funded out of what the Retirement Board called “excess earnings” on its investment portfolio.

• But the concept of excess earnings is a fiction. If, in any given year, MCERS had exceeded its target of an 8 per cent return, (Note: excess earnings has nothing to do with the market’s performance - only about the pension funds), then that surplus should have been put in a reserve account for such time as the target rate was not achieved and MCERS “under-performed” in the stock market. Market volatility, and bull market-bear market cycles, should have been expected by the Retirement Board.

• Even ignoring the fiction of excess earning, retiree healthcare was doomed to fail in Mendocino County. Our retiree healthcare plan assumed cost inflation based on the annual 5 per cent “Medflation” rate, when, in truth, annual healthcare costs have risen at higher rates.

How We Got To This Crisis Point

• Investment performance has been below average.

• One example? Peter Chan, who had been the County’s sole investment advisor for 27 years, put a lot of money into a bond fund managed by Dodge & Cox. This bond fund was heavily invested in the debt instruments of what are derisively called the “Dogs of the Dow”, which included Bear Stearns, Lehman Brothers, Fannie Mae, and Freddie Mac. The loss to MCERS? Many millions of dollars.

• Even to this day, the county’s pension assets remain unhedged. Our contingency plans for another bear market? Beats the hell out of me. No covered options writing. No short fund ETFs. No bear market mutual funds. No long-short mutual funds. No com­modity exposure. No foreign currency exposure. No alternative investments.

• The County deliberately, knowingly, and willfully under-funded the retirement system. It would appear as if past Retirement Boards believed that the econ­omy would always be good, and that they could always “go to the well” with another Pension Obligation Bond.

• Even if the Retirement Board had not been so deluded by pipe dreams of an economy that would never slow down and a stock market that would never collapse, the unfunded pension liability still would have ballooned due to the amortization system, and other actuarial assumptions, we have embraced as a County.

• The payment of retiree healthcare exacerbated the drain on pension assets. Excess earnings were not retained to pay future retirement benefits, but were instead siphoned off.

• It would appear that previous Boards of Supervi­sors did not understand — or want to understand — the implications of a deliberately under-funded retirement system. It should have been obvious that the retirement system was fundamentally “unsustain­able”.

• It would also appear that many, if not most, of the members of previous Retirement Boards also did not understand how unsustainable the retirement sys­tem really was.

• The fact that there are no term limits on the Retirement Board also exacerbates the problem of poor leadership. While members of the Retirement Board may have come and gone over the years, the “Gang of Three” — Tim Knudsen, Tim Pearce, Dennis Huey — have remained intact on the Retire­ment Board for the last 20 years, or more.

• This is the really big underlying cause of the pen­sion crisis — the Slavin Study. In 1999, the Board of Supervisors commissioned the Slavin Study, which significantly raised salaries of county employees across the board, which caused pension obligations to also spike. These pay increase were above those assumed by the retirement system.

So that’s it for “Nuts and Bolts.” In Part Three of this series, the next part I call, “Solutions”, we’ll explore solutions to the problem of huge and recur­ring unfunded pension liabilities in Mendocino County.

Many of these recommendations have been made by current members of the Board of Supervisors, and by most of the candidates running for the 3rd and 5th District. At least one candidate, however, has little in­terest in MCERS, and its implications for county debt and the county deficit.

Many of the recommendations are obvious, i.e. the County should switch from a defined benefits plan to a defined contributions plan for new employees, or some hybrid of the two plans.

Another recommendation is studying whether Mendocino County should join the California Public Employees Retirement System, or any other retire­ment system.

Me? I would like to see an actuarial audit. I also have some other ideas for supplemental audits studies, and investigations.

I would also like to see a citizens committee study the problems at MCERS, and have this committee be fully supported by the Board of Supervisors.

I think a grand jury investigation would be appropri­ate, too. I’m still not convinced that the Gang of Three hasn’t crossed the line of misfeasance into malfeasance. Their arrogance is telling.

And we need term limits at the Retirement Board. Also, the make-up and the representative constitution of the Retirement Board should be reconstructured.

Finally, we won’t forget our “exit interview” Tom Mitchell.

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