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Tuesday, Mar 29 2011 10:00 PM

PENSIONS IN PERIL: Bad decisions have piled up

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BY JAMES BURGER, Californian staff writer jburger@bakersfield.com

Kern County's pension system is in crisis and losing ground. In just a little more than two years, actuarial estimates predict, the system will have only half the money it needs to meet its long-term obligations. Financial analysts generally consider a fund healthy if it's 80 percent funded.

How it got here is a 26-year story full of compounded mistakes and bad oversight when viewed through the harsh lens of hindsight.

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PENSIONS IN PERIL

This is Part Two of a three-part series examining Kern County's troubled pension system and possible fixes.

PART ONE: How big the problem is now and what will happen if we don't act.

PART TWO: A slew of bad decisions and flat-out malpractice helped create the mess. And lots of little pay bumps compound the problem. Plus, not all county pensioners live large.

PART THREE: There are proposed solutions, but none is a quick fix.

HOW PENSIONS WORK

Public employee pensions are guaranteed levels of pay received by government workers after they retire, funded by years of contributions by the employee and the county that have been invested in the stock market.

Here's how the "3-at-50" and "3-at-60" benefits enjoyed by most Kern County workers function:

3 at 50

County sheriff's deputies, probation officers, detention officers, firefighters and other public safety employees can retire at age 50 with an annual pension that is equal to 3 percent of their highest pay during any 12-month period multiplied by the number of years they worked for Kern County.

Here's how it works for a top-paid senior deputy sheriff in Kern County who retires at age 50 with 25 years of county service.

Average annual pay: $70,265

Formula: 3 (percent) X 25 (years) = 75 (percent). 75 (percent or .75) X 70,265 = $52,698

Retirement benefit: $52,698

3 at 60

Pensions for general county employees, those who aren't sworn safety officers, work generally the same as those for sheriff's deputies and firefighters with the one exception that the target retirement age is 60 years old, not 50.

Here's how it works for a top-paid social service worker, step 5, who retires at age 60 with 25 years of county service.

Average annual pay: $68,534

Formula: 3 (percent) X 25 (years) = 75 (percent). 75 (percent or .75) X 68,534 = $51,400

Retirement benefit: $51,400

Note: Pay and pension amounts in these calculation do not include any supplemental pays that an individual employee might receive.

Kern County supervisors and the Kern County Employees' Retirement Association board made bad decisions, often misled by flawed financial reports, heady stock market returns and a false sense of security in a retirement fund that had been propped up with hundreds of millions of dollars in borrowing.

Warning signs developed shortly after the most damaging of those decisions -- retroactive 50 percent increases to the pension formulas that set county employees' retirement pay -- took effect.

County contribution rates spiked, funded ratios dropped and the future cost of retirement benefits increased sharply.

Then the housing market's bubble burst in 2008, and one quarter of KCERA's revenues disappeared. The receding tide of cash revealed -- and amplified -- the trouble the fund was in.

If the basic structure of the county pension system is not changed by the 2020-2021 fiscal year, actuarial consultants for KCERA said, pension funds will be sucking in $365.8 million annually -- the vast majority from the county of Kern's annual operating budget -- to prop up the accounts that power public pensions for thousands of current and past county, court and special district workers.

That's up from $226.8 million this year. Kern County's share of that bill is $206.6 million. The $39.3 million in principal and interest on pension obligation bonds boosts the county's actual costs to $245.9 million.

Here are some of the major decisions that have caused the drain on county finances or contributed to the retirement system's sluggish ability to recover from the financial downturn.

SUPPLEMENTAL BURDEN

When: 1984

What: Kern County supervisors and the county retirement board approved a benefit that has siphoned off millions of dollars the main pension funds earned in the best market years. The action has hampered the main fund's ability to recover from market crashes in the last decade.

Since 1998, $92.4 million in investment earnings have been diverted to the "Supplemental Retiree Benefit Reserve," the fund created by supervisors and the retirement board to supplement pension payments of already-retired employees. It does that by guaranteeing that the purchasing power of their retirement will never drop below 80 percent of the benefit they had when they retired.

Kern County's pension system is expected to earn 7.75 percent a year when averaged out over any 26.5-year period. When the fund earns more than that target return, roughly 50 percent of those "excess earnings" are captured by the SRBR.

The SRBR captured the money in only four of the 13 years since 1998.

But those were KCERA's four best years -- the years when investment surges above 7.75 percent were supposed to make up for all the years when the fund performed below that target rate.

In effect, the SRBR benefit makes it very difficult for KCERA to hit its target funding mark because the fund suffers all the pain of bad investment years but can't fully capitalize on the excess of the best market years.

Impact: Because of SRBR, "investment returns are likely to be insufficient to fund the base pension benefits if contributions are based upon that 7.75 assumed rate of return," wrote actuarials Karen Steffen and Daniel Wade of Milliman.

During a recent system audit of KCERA, Milliman and another firm estimated that the SRBR benefit reduces the expected 7.75 percent long-term earnings of the main pension fund by between .78 and 1.03 percent

Only two other counties in the state -- out of 20 counties that operate their own retirement programs -- have created an SRBR benefit. KCERA Executive Director Anne Holdren said the retirement agency board's fiduciary legal counsel has made it clear that it is not possible to change the way the benefit is funded.

State legislative action could potentially alter the system, but that could trigger hot legal battles.

Decision makers: Supervisors Gene Tackett, Ben Austin, Pauline Larwood, Trice Harvey and John Mitchell.

Tackett said that at the time, retirement payments were very low and inflation had eaten away at county retirees' ability to survive on the benefits they earned.

"I remember it seemed like a good idea to build a reserve in good times to help when buying power was low," Tackett wrote in an email to The Californian.

HIDDEN COST

When: 1995, 2003 and 2008

What: When Kern County's pension main accounts sagged below fully-funded in 1995 and in 2003, the Board of Supervisors chose to prop up the investments with bonds, borrowing $516 million that Kern is still paying back.

The 1995 bond was a $227.8 million issue. The 2003 bond totaled $288.2 million, and was refinanced in 2008 for an additional cost of $50 million.

This fiscal year, Kern County will pay $39.3 million in principal and interest on the bonds' remaining balance of $451 million.

Both infusions of bond cash floated the county's retirement accounts close to full funding, painting rosy pictures of the retirement program's status.

Those rosy pictures were what Kern County supervisors were looking at when -- not long after the bonds hit KCERA coffers -- they granted generous improvements to county employee benefits.

But former Supervisor Barbara Patrick said the choice to sell bonds to fund the pension system's debt were pure business calculations.

"The concept is you borrow money at a lower level and you leverage that by investing that at a higher level," she said.

But current Supervisor Jon McQuiston acknowledged the impact of the bonds on the county's retirement picture.

"They're kind of in the shadow of the things we talk about," he said. "But they are real dollars. They are a real impact."

Impact: Annual costs of up to $57 million through 2028.

COUNTY PICKUP

When: 1997

What: Supervisors agreed to pick up 100 percent of most county employees' individual contributions to their retirement accounts after they completed five years of work with the county.

Previously, workers were paying 50 percent of the employee contribution rate, a rate that was based on their age when they began working for the county.

County general employees, in exchange, agreed to give up union-negotiated raises for the 27-month term of the contract and have new employees begin paying 20 percent of their health insurance premiums in exchange for the reduced retirement contribution.

The cost of the benefit is not a drain on the retirement fund. But it is a cost to the county of Kern -- a financial burden that has been magnified by future decisions about county pay and pension benefits.

Then-acting County Administrative Officer Scott Jones, in 1997, told supervisors in a memo the change in contribution rates was a win-win for the county and unions.

Workers got more take-home pay, he wrote, and the county avoided paying for raises while only spending an estimated $2.7 million to cover the employee contributions to pensions, an amount that was supposed to shrink in proportion to county payroll as time went on.

But tucked into the county's thought process was an assumption that has proven to be disastrously wrong: that contribution rates to county retirement systems would not "fluctuate dramatically."

According to Holdren, when responsibility for employee contributions was shifted to the county, the size of those contributions stopped being calculated on the age of the individual employee and began being calculated in the same way as all other county contributions.

That made the once-fixed cost of the "employee contribution" wildly variable. It was subject to the many market and demographic forces that have battered Kern County's contribution rates.

County contribution rates for general members spiked from 8.27 percent of payroll in 1997 to 34.98 percent of payroll for 2010-2011 as the impact of improved pensions and the global economic crash drove up the cost of pensions.

Impact: Currently the county estimates the cost of the 100 percent retirement benefit for members of the Service Employees' International Union -- by far its biggest union -- at around $15.7 million a year. That puts the current cost of the county's 1997 decision to pay all of general employees' calculated share of pension contributions at just under $8 million annually.

Other county unions also have 100 percent county-covered employee contribution rates. The total annual cost of all those benefits, the county says, is $31 million a year.

Supervisors and county unions are locked in a heated battle as supervisors push for older employees to start paying the full value of their calculated share of retirement contributions out of their paychecks every two weeks.

Decision makers: Supervisors Jon McQuiston, Steve Perez, Barbara Patrick (absent), Ken Peterson and Pete Parra.

Supervisor Jon McQuiston said he remembers that with county coffers drained by a state shift of property taxes from cities and counties to schools in 1992, it was a way for supervisors to offer employees some increase in take home pay.

"In 1997, that was my first year on the board," he said. "If it had been my fifth year on the board, I think I might have made a different decision."

Chuck Waide of the Service Employees International Union said the deal hashed out in 1997 included all new employees paying 100 percent of their retirement contribution for the first five years of their employment with the county.

"It was a package deal negotiated with the county that was beneficial for both sides," he said in a written response to questions.

SAFETY BOOM

When: 2000

What: In August 2000, passage of a state law made a new, higher pension formula available for public safety employees of local governments.

Not a single state legislator -- Democrat or Republican -- voted against it.

In Kern County the benefit formula, known as "3-at-50," allowed safety workers to retire at age 50 and claim an annual retirement worth 3 percent of their final 12 months of salary for every year they worked for the county. A 30-year employee could leave the job and still pull in 90 percent of his or her final annual compensation, which could be boosted by one-time payouts and other benefits like uniform pay and car allowance.

Kern County supervisors approved the benefit here barely four months after Gov. Gray Davis signed the bill.

"In that era, the public employee unions were much more politically influential than they are now. They had a lot of clout," said retired County Administrative Officer Scott Jones. "The 3-at-50 benefit -- I've never seen so much effective political pressure exerted."

Joe Pilkington, president of the Kern County Sheriff's Command Association, got involved with another sheriff's union, the Kern Law Enforcement Association, just after the deal went through.

While it was true that public safety unions had influence, he said, it was also true that there was strong support for the change from county negotiators and supervisors.

"To say we extracted it through pure political muscle is a little bit of an exaggeration," he said.

Previously, Kern's safety employees had to work to age 55 and only earned a maximum of 2.6 percent of their final salary for each year of service. For those who retired at age 50, the new benefit was a 50 percent increase in the value of their retirement.

Safety retirements immediately spiked as employees who had not paid a dime into the increase in the value of the benefit -- and had not had the county contribute anything for them, either -- cashed out.

Watson Wyatt & Co., the actuarial firm that represented KCERA at the time, wrote a thin two-page report for county administrators that predicted the benefit would cost Kern County only $3 million a year -- an increase in county costs of 3.7 percent of safety employee salaries.

But in mid-2001, just six months into the 3-at-50 benefit, the estimated cost of the benefit had more than doubled to $6.5 million a year.

By mid-2002, the price was up to $8.5 million.

Jones said that in general, counties rely very heavily on the data in actuarial reports because local elected officials and bureaucrats don't generally have the expertise to do that specialized financial prognostication.

The actuarial consultants, he said, "made an assumption on the rate of return and, as is true nationwide, the assumptions were too optimistic."

In 2000, KCERA's retirement system had been overfunded -- having 103 percent of the money for future benefits. In 2002, hit with both investment losses and the unexpectedly high cost of the new pension plan for law enforcement and firefighters, that funding percentage had fallen to 83 percent.

In December 2002, Kern County and Watson Wyatt & Co. reached an out-of-court settlement in which Watson Wyatt paid Kern County $9 million for undisclosed actuarial mistakes.

Soon after that, supervisors borrowed $288.2 million to shore up the depleted pension fund.

Impact: In its initial report to the county, Watson Wyatt said granting the increased retirement benefit would increase the cost of benefits by $50.9 million.

But between December 2000 and December 2002, the amount of money needed to fund future benefits for all county employees -- the actuarial accrued liability -- had increased by $510 million.

Decision makers: Supervisors Jon McQuiston, Steve Perez, Barbara Patrick, Ken Peterson and Pete Parra.

Retired Supervisor Barbara Patrick said she based her decision on the data in front of her. And she was motivated, she said, by the need to make sure the county took care of a critical resource.

"Your employees are your most valuable asset," she said.

THE OTHER SHOE

When: 2004

What: Supervisors approved a second massive increase in benefits, moving all the rest of their existing employees from a 2-at-60 benefit to a 3-at-60 benefit -- a 50 percent increase.

In return, as part of the negotiated deal, all new employees would be required to pay all of their contribution to retirement and health care for their full careers.

Like the increase in fire and sheriff's benefits, the general county employees' pension formula allowed workers to retire at age 60 with 3 percent of their highest 12 months of compensation for every year they were employed by Kern County.

Once again the county relied on an actuarial assessment of the cost of the benefit that showed only a minor impact -- this time from a new actuarial firm called Public Pension Professionals.

But this time one Kern County supervisor voted no.

Supervisor Jon McQuiston had a gut feeling the real price of the benefits would be more than expected -- more than the county could afford.

Everyone knew that the cost of giving away the retroactive benefit to employees would be a future burden on the county, he said.

The argument was that the employee concessions would be enough to cover the cost. McQuiston said he didn't think the concessions would save enough money to do that.

"I just couldn't understand how we could take five to six thousand general employees and give them a benefit retroactively," McQuiston said. "I couldn't challenge the actuarials. I couldn't challenge the numbers. I just didn't believe it would work. I just trusted my instincts."

Bob Jefferson, a former KCERA governing board member and former bargaining team member for the Service Employees International Union, Local 521, said approval of the benefit retroactively has given a bad name to a reasonable employee benefit.

"Three-at-60 is not the problem," he said. "Three-at-60 not paid for ahead of time is the problem."

"Given the information we were given at the time -- including the county's assurances that they could and would pay for it -- it was a good decision. We made significant concessions at the time to help the county afford it," SEIU's Chuck Waide said in a statement to The Californian.

Supervisor Ray Watson now tells The Californian he opposed the idea -- even though he voted for offering the benefit.

"I was adamantly opposed to it in closed session. I should have been a lot more vocal but I wasn't," Watson said.

He is certain that even his public opposition wouldn't have changed the outcome.

"It was a foregone conclusion that it was going to happen," he said.

The benefit went live in January 2005. The number of retirements in the first three months of 2005 was 250 percent larger than the previous year's total as 198 county employees left and began collecting the increased retirement benefit.

Impact: In just one year the county's future pension bill -- its actuarial accrued liability -- increased by $526 million.

Between 2004 and 2006, the annual amount the county contributed to fund its share of general employee pensions more than doubled from $30.5 million to $66.8 million.

In late 2004, KCERA fired Public Pension Professionals. The county and KCERA sued the company for malpractice, eventually winning a joint $25.9 million judgment. But PPP principal Ira Summer -- who has had similar problems with public pension systems across the country -- had let his professional insurance lapse. Public Pension Professionals currently makes small monthly payments of around $1,000 to KCERA to meet that legal obligation.

Decision makers: Supervisors Jon McQuiston (voted no), Don Maben, Barbara Patrick, Ray Watson and Pete Parra.

Jones said the supervisors made a good decision given what they knew at the time.

"I can't say that it was a bad decision at the time. Given the totally different economic climate and the collective bargaining and the inability to see the prolonged downturn in the economy, I can't say it was a bad decision," he said.

But Jones said that in hindsight, the benefit increases were not the best move for the county.

"That decision should not have been made, given what we know today."

FINAL BLOW

When: 2007

What: Looking for a way to handle the unexpected impacts from increased retirement benefits, supervisors tried to craft a do-over with general county employees.

They got agreement from the Service Employees International Union, Local 521 to eliminate the 3-at-60 retirement benefit for workers hired after the new deal was approved. Existing general employees retained the retirement benefit.

In return SEIU members received at least a four percent raise in each of the three years of the contract.

County officials also agreed to compare the pay and benefits of hundreds of job classifications to the same positions in other counties and, when the county employees were behind the median of those "comparison counties," to offer those specific employees raises larger than 4 percent.

The largest raise handed out topped 38 percent. The median increase in 2007 was 9 percent -- more than twice the assumed rate of payroll increase KCERA actuarials build into their annual valuations.

Impact: While the reduction in benefits will improve the health of the pension fund two decades from now, when more than a handful of new county employees actually gets the lesser pension, the spike in raises immediately increased the cost of future retirements, actually creating higher pension costs in the short and medium term.

Decision makers: Supervisors Jon McQuiston, Don Maben, Mike Maggard, Ray Watson and Michael Rubio.

McQuiston said the board quickly realized the impact of the 3-at-60 pension formula and was trying to reverse the problem it saw developing.

County Administrative Officer John Nilon, who was a county department head at the time, said the cost of the raises seemed manageable.

"Part of the issue in 2007, everybody thought the economy was going to go up," Nilon said. "In that context it appeared to be an appropriate decision."

"The equity raises were developed through a formula that considered wages, medical premiums and retirement benefits in Kern County and the counties of comparison," wrote Waide of SEIU. "We were told by the county that the reduction in retirement benefits for new employees would solve the problem, and that's why we accepted it."

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