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Home / Articles / News / News /  Pension scandal for dummies
. . . .
Wednesday, Jun 15, 2005

Pension scandal for dummies

Understanding San Diego's $1,700,000,000 pain in the ass

By Daniel Strumpf

Chaos rules in San Diego. The city is in deep financial and politicalndoo-doo, and city officials are either resigning, being forced to resign or beingncharged with crimes one after the other. But ask your average urban dweller hownour city—once touted as a paragon of financial virtue—fell from grace into thenmunicipal manure pile, and you'll either get a blank stare or a mumblednexplanation that has something to do with a pension system. At the same time,ntalking to an “expert” can be a lot like drinking from a fire hose.

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That's why CityBeat decided to boil down the inherently complex tale of hownour city ended up $1,700,000,000 in the hole and what led to multiple civil andncriminal investigations.

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We've removed all of the advanced mathematical mumbo-jumbo, enough acronymsnto cause a cerebral hemorrhage and whittled three decades worth of history downnto the bare essentials. What's left is a hopefully digestible tale of how SannDiego ended up in the dire situation in which it finds itself these days. Wenoffer it to our readers with the hope that knowing how we got into this mess willnhelp us find our way out.

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How a pension fund works

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Employees of the city of San Diego get money from city's pension plan fromnthe time they retire until the day they die. To provide that, the system dependsnon three sources of funding:

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1. City employees contribute a portion of their annual pay.

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2. The employee contribution is matched by their employer, the city.

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3. The money collected from these two sources is then invested in hopes ofngenerating profits, which are funneled back into the system.

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How exactly that money is invested is controlled by a board of 13 trusteesnwho, under state law, must act prudently and diligently to protect the integritynof the fund—a duty that takes precedence over any other.

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To determine how much the city and its employees have to chip in, thesentrustees rely on a type of accountant called an actuary. That person determinesnhow much money the system needs to pay its current retirees, as well as how muchnmoney it needs to invest that year to eventually support current employees whennthey retire.

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To do that, the actuary uses a series of complex calculations taking intonaccount factors like the number of recent retirees who will start withdrawingnmoney from the system, the number of retirees who've recently died who no longerndraw a monthly check, anticipated pay raises and potential investment earnings.n

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That cost is then evenly spread out over a given period of time, just like ancar payment or mortgage, to determine how much money the system needs to operatenthis year. Subtract the assumed investment income, and the remaining totalnrepresents the amount the city and its employees owe the system. If both groupsncontribute half, then the system is fully funded according to the actuary'snprojections, or, is said by those in the biz to have achieved “full actuarialnfunding.”

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Fast fact

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Unlike the not-so-secure federal Social Security program—which takes moneynfrom a current worker and gives it to a current retiree (leading to big problemsnwhen retirees eventually outnumber workers)—the city's pension system puts thenemployee's money away for safekeeping, investing it so that small sum grows overntime into enough money to support that same employee at retirement.

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How it all began

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In a prelude to a series of deals that led to the intentional under-fundingnof the pension plan, city officials and pension trustees developed a number ofnbad habits and policies that would eventually add to the retirement system'snproblems.

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In the early 1980s, the City Council began counting the profits from thensystem's investments that were over and above those anticipated by the actuary asnextra earnings—or, free money!—and using them to pay for additional employeenbenefits. That prevented those profits from being reinvested, undermining thenactuary's assumptions and leaving no cushion for years when investments performednbelow expectation.

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In the early 1990s, a faltering national economy and the first Gulf War hitnSan Diego hard in the ol' wallet. In 1992, City Auditor Ed Ryan, who also servednas a retirement trustee, convinced his fellow trustees and their actuary to playna few accounting tricks in hopes of reducing the amount of money the city wasnsupposed to kick down to the pension plan. Ryan succeeded in reducing the dollarnfigure the city owed to the pension fund by using a less conservative method ofncalculating that contribution, but ensuing increases in retirement benefits andnlow employee turnover would actually increase the city's contribution. Oops!

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Where's Ed?

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When Ryan's name was not among those who received federal subpoenas in 2004nand 2005, some observers privately mused that he was probably in a back room atnFBI headquarters singing like a bird.

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Despite Ryan's accounting tricks, the city's tab for the pension bill jumpednby nearly $10 million in 1995. Added to state raids of city property-tax coffersnand a national recession, the increase left city officials-who were busy planningnexpensive special projects like hosting the 1996 Republican NationalnConvention-short of funds.

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No doubt envious of the city's impressive investment returns, in 1995 Ryannpersuaded his fellow trustees to make an exception to the rule requiring the citynto make the full payment recommended by the actuary. Instead, he suggested usingnsome of the system's extra investment income to cover what the city was supposednto pay into the fund. The trustees approved the plan with a 7-6 vote, hoping tonprevent what Ryan said were otherwise necessary city employee layoffs, but thenpension system's lawyers jumped in front of the oncoming train.

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The city would have to stick to the rules and make its full contribution thisnyear, they said-but the seed of things to come had been successfully sown.

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Big Fat Mistake No. 1

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The following year City Manager Jack McGrory, the top municipal employeenaccountable directly to the City Council, came up with a plan that would finallynsway the trustees and their attorneys. He offered to increase employee andnretiree benefits—including those of a majority of the pension trustees, becausenthey're city employees—but only if the trustees agreed to let the city pay lessnthan what the actuary said it owed.

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Fateful decision

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That stipulation raised at least one trustee's eyebrows about an apparentnconflict of interest, but the pension system's lawyers ultimately approved thendeal. No one bothered to mention that both the City Charter (which is like anconstitution) and the Municipal Code (a book of laws) required the city to makenthe full payments recommended by the actuary.

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As an alternative, the city would switch to a rigid payment plan designed tonimmediately save the city money by lowering its 1996 bill. Over time, thenpayments would gradually increase to the level recommended by the actuary, withnthe largest payments coming in later years to be paid by future taxpayers, anfavored trick of politicians hoping to avoid tough decisions.

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The plan also envisioned transferring the burden of providing healthcare forncity retirees from the city to the retirement system, a move that later won voternapproval, but the city has since neglected to provide funding for that benefit.nInstead, more of the system's excess investment earnings were to be used to covernthe cost.

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In exchange, the scheme established several new employee benefits, such asnthe drowsy-sounding “deferred retirement option program” (DROP), which allowednsenior employees to start drawing pension checks up to five years before theynactually retired. Woo-hoo!

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But because the plan raised the system's expenses—increasing benefits andnadding the cost of retiree healthcare—while simultaneously reducing the city'snpayments, the pension fund took a double hit. Knowing that there'd be some impactnto the bottom line, McGrory poked two safeguards into the agreement: a provisionnthat the deal would expire by 2009 and the city would return to kicking down itsnfull share of funding, and something called the “trigger.”

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The trigger

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If for any reason the system's funding level—basically, how much moneynthe system has versus what it owes-fell below 82.3 percent, the city would havento make an immediate “balloon” payment to the retirement system, enough to raisenthe funding level back to 82.3 percent, and from that day forward the city wouldnhave to resume making the full actuarially recommended contribution.

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McGrory's plan initially proved effective, lowering the city's annual paymentnto the system and, had everyone stuck to the plan, it just might have worked innthe long run.

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If that weren't enough...

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During the next five years, several factors further undermined the pensionnfund, although their full effect was masked by the booming stock market.

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* Post-retirement pay was allowed to exceed an employee's annual salary.

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* Employees were allowed to purchase up to five years of employment credit atnprices lower than what they normally would have contributed to the system,nincreasing their annual retirement pay.

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* In 2000, the city settled a lawsuit filed by employees correcting an errornin the way benefits had been calculated in the past, resulting in a largenincrease in benefits for employees and retirees.

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* The DROP program was made permanent.

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But, all the while, the city didn't increase its contribution to the pensionnfund as it was raising benefits, and its continued reliance on surplusnstock-market earnings to fund those benefits put a stranglehold on the retirementnsystem. As extra earnings were removed from the pension fund, system trustees hadnless and less money to invest, creating a negative spiral. The annual assessmentnof the system's finances in 2000 showed that, despite a substantial hit from thensettlement of the lawsuit, the funding level had increased to 97.3 percent, thenretirement system's highest mark in a decade. But in the coming year, the stocknmarket took a nosedive, causing the funding level to plummet, and decliningninvestment returns were only a small part of a much larger problem.

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McGrory's payment schedule hadn't assumed a stock-market bust, and with eachnpassing year the gap between the amount the city was paying and the amount thencity really should have contributed to keep the system sound began to widenndramatically, silently driving the retirement system deeper and deeper into debt.n

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A Blue Ribbon Cover-up

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By October 2001, Terri Webster, the city's assistant auditor and a pensionntrustee, could see that the pension fund's investment earnings had droppedndramatically, and she sent an e-mail alerting Cathy Lexin, the city's personnelndirector and fellow retirement trustee. It has become known as the “EEEK memo.”n

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EEEK! A memo!

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The “EEEK memo” is one of the most referenced pieces of evidence in the CitynHall investigation. In it, Terri Webster tells Cathy Lexin that, as of Aug. 31,n2001, stock-market earnings in the pension trust fund amounted to “about $15n[million] compared to $53 [million] same time 2000... a 71% drop! BEFORE 9-11-01!”n

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After 9/11, Webster had sent similar warnings of increasingly bad news tonRyan, her boss, and other officials, but she never shared her concern with thenso-called Blue Ribbon Committee, a group of local business leaders selected bynnewly elected Mayor Dick Murphy earlier in the year to make an independentnassessment of San Diego's fiscal health. Instead, she and Ryan fed the committeenstale information about the pension system while simultaneously trying toninfluence the findings of Richard Vortmann, the Blue Ribbon Committee guy taskednwith evaluating the pension system.

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Cassandra complex

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In memos from 2001 and 2002, Richard Vortmann, president of National Steelnand Shipbuilding Co., comes off as somewhat of truth teller, albeit in private.nVortmann repeatedly argued to city staff, Mayor Murphy and fellow pensionntrustees that cutting deals to push the cost of benefits into the future was anrecipe for financial disaster. But he never blew his whistle publicly.

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From their perspective, Webster and Ryan could see that the pension fund wasnin big trouble, and it was only a matter of time before the funding level fellnbelow the 82.3-percent trigger, forcing the city to make a payment ofnapproximately $150 million, which the city couldn't afford—no way, no how.

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And they had another good reason to keep the information under wraps.

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By the end of 2001, the city was scrambling to complete the financing for thenconstruction of the beleaguered Petco Park, and news of the city's financialntroubles could have, perhaps, scuttled the already-tenuous deal.

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The Blue Ribbon Committee would work for nearly a year before finallynpresenting its report to the City Council in April 2002, but by then the CitynCouncil had already been informed of the threat posed by the impending triggernpayment.

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With the burst of the tech bubble contributing to yet more budget woes, andnwith the results of six years of pension under-funding coming to a head, citynofficials once again faced the possibility of laying off workers. The CitynCouncil and City Manager Michael Uberuaga, who succeeded McGrory, decided tonborrow a trick from McGrory and appeal to the labor unions for help.

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Big Fat Mistake No. 2

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In April 2002, the city finished its annual negotiations with the unions andnoffered to grant large increases in employee benefits—as well as special benefitsnfor three union presidents—so long as the pension trustees agreed to absolve thencity of having to make the $150-million trigger payment.

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In June 2002, Lexin privately delivered some bad news to the City Council,ninforming them that the retirement board's actuary and lawyers had opposed anscheme, floated in May by City Manager Uberuaga, to lower the funding triggernfrom 82.3 to 75 percent. They rightly noted that it could jeopardize the system'snlong-term financial stability. Remember, the trustees' prime responsibility is tonthe system and its members, regardless of the city's ability to pay its bills.n

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The City Council voted to send Lexin to the pension board's July meetingnarmed with an approved fallback plan should the trustees reject the scheme tonlower the trigger to 75 percent. It's likely that Lexin coordinated with RonnSaathoff, president of the firefighters union and a pension trustee, on thenbackup plan because when it began to look like the City Council's desirednproposal would probably fail, Saathoff recommended something that looked a lotnlike Lexin's Plan B.

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Ron Clams up

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Ron Saathoff is a central figure in the pension fund crisis. In a May 21ne-mail to labor negotiator Dan Kelley, Terri Webster said Saathoff's approval ofnballoon-payment relief was crucial: “... especially need Ron behind releasing thentrigger since he runs the show” at the retirement system. Saathoff benefitednhandsomely when, under the deal, his union-president job time was counted as citynemployment when it came time to dole out pension pay. Interesting side note: WhennCityBeat editor David Rolland recently overheard Saathoff and some of hisnfirefighter colleagues complaining about media coverage of the pension crisis atna Mission Valley bar, Rolland offered to publish Saathoff's side of the story.nSaathoff at that time agreed to sit down with CityBeat, but he has yet to returnnRolland's call to set up an appointment.

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The trustees approved Saathoff's idea, which left the 82.3-percent triggernbut rendered it pointless because the trustees gave the city a five-year gracenperiod to pay a balloon payment of what some thought was as low as $25 millionnbut others said was more like $150 million. Four months later, on Nov. 15, 2002,nbefore finally signing off on the deal, the trustees took the unusual step ofnrequiring the city to take responsibility for any resulting legal actions againstnthem.

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On Nov. 18, the City Council was scheduled to vote on the plan—without publicndiscussion—but Diann Shipione, a pension trustee who had previously written tonthe mayor expressing concern about the city's efforts to under-fund thenretirement system. She appealed to Murphy and the City Council to look beneathnthe surface, warning that the benefits-for-payment-relief deal might ben“corrupt.”

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Notable & quotable

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“What concerns me is that the benefit enhancements were conditioned upon thenretirement board approving this agreement, and that is, in my opinion, ethicallyntroubling.... I'll be quite frank with you, it almost appears to be corrupt.”
n-Diann Shipione's comments to the City Council, Nov. 18, 2002

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After hearing from Shipione, as well as plan supporters Saathoff, Lexin andnAnn Smith—a lawyer representing the Municipal Employee's Association, the city'snlargest labor union—only visibly disturbed City Councilmember Donna Frye voicednconcerns. In a fateful 8-1 vote, the City Council approved the deal. Frye votednno. That same day, the City Council also voted unanimously to approve the benefitnenhancements.

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The pension trustees and the city responded to Shipione's allegations byncircling the wagons and taking aim. Newly hired Deputy City Manager Lamont Ewellnwrote a memo to the City Council, charging that Shipione had “omitted, slantednand misrepresented the facts” and her fellow trustees went a step further tondiscredit her warning, taking out an ad in the Union-Tribune announcing, n“Chicken Little would be proud.”

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The Retirees Strike Back

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Shortly after the 2002 deal was inked, Jim Gleason, a former city employeenand pension trustee, filed a class-action lawsuit against the city and thenretirement system on behalf of his fellow retirees, claiming that city officialsnviolated local law by making less than the actuarially recommended contributionsnand that the pension trustees who profited from the deal violated statenconflict-of-interest laws. After more than a year of litigation, the city settlednin August 2004, agreeing to make a $130-million payment to the system in 2004-05nbudget, start paying the full actuarial payment every year as of July 1, 2005n(and never under-fund again) and put up $550 million of city real estate asncollateral just in case.

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The agreement effectively repealed the under-funding schemes created undernCity Managers McGrory and Uberuaga, although the expensive benefits given tonemployees and labor leaders under the 1996 and 2002 deals remain in place. Andnthere was another downside-the settlement froze the actuary's calculation untiln2009, meaning that the city's contribution wouldn't change along with the system.nAs a result, the current payments aren't as large as they should be to keep thensystem sound.

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The Disclosure Dilemma

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In September of 2003, after Gleason filed suit, Shipione discovered thatnoutdated and incorrect information about the city's funding of the retirementnsystem had been included in a city bond document. Designed to provide potentialninvestors with an assessment of city finances, the document was subject tonfederal government regulations, and the errors probably amounted to securitiesnfraud.

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Shipione blew her whistle again, causing upheaval at City Hall and promptingna review of the city's previous financial statements to investors. That reviewnuncovered additional errors, some unrelated to the pension system. The city thennhired KPMG, an outside auditing firm, to re-audit its 2003 statements.

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In mid-January, City Auditor Ryan, who was ultimately responsible for thenaccuracy of the city's financial reports, announced his early retirement. Hisnassistant, Terri Webster (the one who kept the Blue Ribbon Committee in the dark)nwould eventually be named acting city auditor, and on Jan. 27, the citynvoluntarily filed an official mea culpa, submitting changes to its annualnfinancial report. In doing so, the city admitted to making errors and omissions.nAnd federal regulators with the Securities and Exchange Commission (SEC) thoughtnto themselves, Hmmm... very interesting.

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Did you know?

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Dozens of other faulty disclosures have since been found in documents datingnback as far as 1996.

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Eight days after the filing, a Wall Street firm lowered the city's creditnrating, curtailing its ability to borrow money at reasonable interest rates. OnnFeb. 13-Ryan's last day with the city-the Securities and Exchange Commissionnofficially requested documents related to Ryan's error-laden disclosures, and thenU.S. Attorney's office announced that it had launched an investigation intonpossible fraud and public corruption. That's pretty much when all hell brokenloose.

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That news sparked additional downgrades to the city's credit rating, CitynManager Uberuaga announced his resignation, Deputy City Manager Ewell was tappednto replace him in April and, as the new top dude, Ewell quickly learned that thenSEC's inquiry had blossomed into an official investigation of possible securitiesnfraud when subpoenas started arriving at City Hall.

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By the end of June, the retirement system's debt had swelled to $1.3 billion.n

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Descent into Madness

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The city's settlement with its retirees in August meant it would soon benforced to make record contributions, taking a huge bite out of its annual budget.nWith that prospect looming on the not-to-distant horizon, attention turned towardntwo reports issued in mid-September 2004.

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The first, authored by the Pension Reform Committee, a group of ninenprofessionals recruited by Mayor Murphy in 2003, presented the City Council withn17 recommendations—only five of which have since been implemented—to help bailoutnthe retirement system.

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The second, an exhaustive exploration of the policies that led to the pensionnunder-funding and the city's related disclosure practices, came from Paul Maco. Anpartner in the Washington, D.C., firm of Vinson & Elkins and a former SECnofficial whose clients include failed energy titan Enron, Maco was also recruitednby the City Council to represent the city in its dealings with the SEC. Criticsndecried Maco's dual roles as investigator and defense attorney as an obviousnconflict of interest and, while his report did paint an ugly picture of citynbureaucracy, it stopped short of saying city officials broke laws.

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Days after the reports were released, the city's credit rating was suspended,nmaking it impossible to borrow money. Amid persistent chatter, Murphy and Ewellntried to assure the citizens and the media that San Diego was not in danger ofngoing bankrupt.

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In October, auditors from KPMG expressed concern about Maco's report and thencity's failure to conduct “an adequate investigation in order to conclude thatnlikely illegal acts have not occurred....”

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In an attempt to satisfy KPMG—and perhaps help the U.S. Attorney and the SECnpick off white-collar criminals in City Hall—newly elected City Attorney MikenAguirre began his own investigation in January of 2005, publishing the first ofnfive reports to date. Among other things, Aguirre has opined that Murphy and thenentire City Council—excluding Michael Zucchet and Tony Young, who had yet to benelected at the time of the 2002 deal—could all be liable for violating securitiesnlaws. He also claims some of the benefits granted in return for pension-paymentnrelief were illegal. The City Council eventually formed an audit committee,ncomprising former SEC Chairman Arthur Levitt and two other high-pricednconsultants, to reconcile Aguirre and Maco's reports in hopes of satisfying KPMG.n

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During his investigation, Aguirre confiscated more than 20 boxes containingnwhat he said were previously subpoenaed, yet unreleased, documents in the officesnof Webster, Lexin and City Treasurer Mary Vattimo, who, like Lexin and Webster,nwas also a pension trustee. The City Attorney accused them of obstructingnjustice, but Lexin claimed some of the documents belonged to the retirement boardnand were protected under attorney-client privilege.

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Let me get this straight

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The retirement system wants the city to pay its debt, the city wants to issuenbonds to pay its debt but needs a better credit rating to borrow money, thenrating agencies want to see the city's audits first, the auditors want to see ancredible investigation, and the investigators want to see documents that thenretirement board won't turn over.

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Pension trustees also invoked the attorney-client privilege for certainndocuments subpoenaed by the U.S. Attorney. Mayor Murphy and others unsuccessfullynappealed to the board in February to waive that right in hopes of facilitatingnthe ongoing investigations but were rebuffed.

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Under a successful ballot proposition, the pension board of trustees wasnrestructured in late February so that a majority of its members were notnfinancially tied to the system. Under the previous arrangement, nine of the 13ntrustees had such ties. Murphy appointed seven new trustees but made thencontroversial decision not to precondition their appointments on a willingness tonwaive the attorney-client privilege. In April, the new board declined to waiventhat privilege.

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With lots of stinky rotten egg on his face and prior supporters nownexpressing zero confidence in his ability to lead the city out of this mess,nMurphy announced his resignation in April—prompting a special election innJuly—but indicated he would stay on to complete ongoing labor negotiations and annespecially painful budget process.

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Going Nowhere Fast

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Different approaches to the impending labor negotiations helped pit Aguirrenagainst Murphy and members of the City Council in the soap opera that continuesnto play out at City Hall.

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Shortly after taking office, Aguirre proposed a plan to reduce the pensionndebt by rolling back some of the benefits granted since 1996. He cited bankruptcynas the other alternative. The mayor, a majority of City Council members and unionnleaders vehemently opposed the roll-back option, noting that once the benefitsnhad been granted, they became the vested property of the employees.

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Once again rejecting the possibility of bankruptcy, the mayor offered anothernproposal, approved by the City Council, that included a two-year freeze ofnbenefit and salary increases, some benefit reductions for new employees andnretirees and the issuance of $400 million in bonds to help pay the city's debt,nnow estimated at $1.7 billion on the low end.

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Ultimately, the city and the unions settled on a watered-down version ofnMurphy's plan, which critics claim wouldn't put a significant dent in the city'snpension debt.

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When Ewell presented his budget for the coming year to the City Council innMay, he made it clear that despite an influx in revenues the city's required $163nmillion payment to the pension fund would take a significant bite out of its $857nmillion general-fund budget. Ewell proposed cuts to virtually everyndepartment—with exceptions for police and fire—eliminating positions andnincreasing fees charged to businesses and citizens. (Please see side story onnPage 12.)

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Hammer Time

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On May 17, 2005, District Attorney Bonnie Dumanis filed charges against sixnpension trustees, alleging they violated state conflict-of-interest laws becausenthey personally profited from their 2002 vote (please see graph above).

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The accused include Saathoff, Lexin, Webster and Vattimo as well as SharonnWilkinson, elected to the board in 1992 by city workers, and John Torres, vicenpresident of the Municipal Employees Association, who was elected by the union'snmembers in 2000. Of the six people charged, Torres is the only remaining pensionntrustee. Additional charges from the DA are expected, and many believe the mayornand some City Council members may be next.

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The U.S. Attorney and SEC are also continuing to investigate, and last weeknthe plot thickened when the U.S. Attorney subpoenaed all documents dating back ton2000 related to compensation paid by the city to Lexin, Ryan, Saathoff, Websternand Deputy City Manager Bruce Herring, who served as a point man for both citynmanagers McGrory and Uberuaga during the 1996 and 2002 negotiations. Similarndocuments pertaining to Webster's husband, Russell Webster, and Lexin's husband,nMadison Wiggins, who both work for the city, were also subpoenaed.

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(Hardly) The End.

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nFOR DUMMIES