SDCERS Board Meeting September 16, 2005

Notes by Patricia Karnes, as far as she understood the finances (morning session) and DROP distribution rules (afternoon session), etc. presented at the Board meeting. Some topics have been condensed and re-arranged for increased clarity.

FINANCE AND INVESTMENT SESSION at 9:30a.m. Attended by Lopez, Sullivan, Flynn, Hebrank, Meyer, Preovolos, Lori Chapin, Torres, Sheffler, Kipperman. Staff: Lori Chapin, Grissom arrived after 11:30am, Doug McCalla, and Patrick Lane replacing Paul Barnett as Chief Finance/Technical Division Manager. (New trustee, James Warning, arrived for the afternoon session after being sworn in at City Clerk's Office.)
New trustee, Thomas Hebrank sworn in. Preovolos recommended that he arrange for psychological support as he joined the Board.

FINANCIAL STATEMENTS THROUGH JUNE 30, 2005, prepared by the City for SDCERS, were unanimous ratified.

PAYMENT OF HEALTH INSURANCE: The City is now making monthly payments for retiree health insurance, as billed monthly by SDCERS. Preovolos asked if the City had made any reimbursements for past SDCERS' retiree health insurance costs paid by SDCERS. Meyer responded that past health insurance costs were paid from funds set aside in reserves, so it was difficult to make a case for reimbursement now. Sheffler didn't consider the question dead and inquired if past payments had been taken out of SDCERS' assets? Preovolos agreed with Sheffler' viewpoint. Lopez asked if payment of health insurance was part of MPI or II. Chapin answered, it pre-dated MPI. Doug McCalla said, that in the past, a portion of earnings, predicated on the waterfall excess, had been deposited directly into the 401H health reserve. The SDCERS' 401H reserve is now depleted and the City is making the payments. (The IRS will be requiring organizations to fund health insurance benefits separately from pensions, in the near future.)

AUDITING OF THE 2004 COMPREHENSIVE ANNUAL FINANCIAL REPORT (CAFR): Grissom said that the final draft of SDCERS' financial statement, the 2004 CAFR, is on route to auditors, Brown Armstrong, for them to verify. (Initially, there was trouble in getting information from the City to put together the CAFR, because of the investigations of the City and document processing.) The last delay was due to structural issues: Brown Armstrong had requested a change from de-centralized accounting (City producing the CAFR?) to central accounting (produced by SDCERS?) and expanding staff at SDCERS. (Additional information: SDUT Sept. 22, 2005 page B1, "29 pension fixes urged by auditors" by Jennifer Vigil, notes problems with SDCERS reconciling cash balances, which may lead to a qualified opinion from Brown Armstrong. In the article, Sheffler says that SDCERS' June 30, 2004 audit, usually out in four to seven months, is still unfinished at nearly 15 months.) (The funding ratio of SDCERS, for June 30, 2004 and June 30, 2005 have not been available as a result.)

SDCERS' "REALIZED GAINS" RETURN (after selling investments):
               Quarter ending  9-30-04      1.796%
                                      12-31-04      2.921%
                                        3-31-05      2.326%
                                         6-30-05      2.62
June 30. 2004 to June 30, 2005 Total compounded= 10.02% for year

The return for the first quarter of June-July-August 2005 is 2.8%.

When the HANSON SETTLEMENT of $14 million (SDCERS sued outside attorneys for bad advice on MPII) is received, and lawyers for the lawsuit are wired $3 million, then the $11 million remaining will be used for SDCERS real estate purchases.

FIDELITY INVESTIGATION BY SEC: SDCERS' lawyer did not expect any impact on SDCERS because Fidelity's offending employees were removed and no action against Fidelity is expected.

TARGET ASSET ALLOCATION AND INVESTMENT STRATEGY was presented by Callan Associates, (they recommend money managers to SDCERS). Strategic planning may be the most important decision of the Board they said. Every five years they do an asset/liability study of outcomes, then 10 year and 15 year outcomes. They review the economic environment, economic environment and asset classes, what is happening inside asset classes, market insight and then they test their integration in an expert review committee.
Callan representatives said that the last recession wasn't as deep, but recovery wasn't as robust either and growth has been slower and steadier than media would indicate. Inflation, at 3%, is a low level threat and interest rates are low. Even the spike of oil is not a concern, except it takes money away from other purchases and reduces consumer spending. CPI is 4% with oil, but if oil is removed as a factor, then inflation is flat.
Katrina will be positive for business, but not for individuals. No one has gone "Chicken Little", but there will be long term dislocations in the Southeast, with Federal stimulus governing spending there.
However, Callan added, the leadership in economic growth has passed from "consumers" to "businesses". Businesses have been keeping profits. The sheer is in the wages. Wealth has been perceived in the increasing value of real estate. As housing slows, spendable income drops. Credit card payments are being made. The way a person is employed is different as more people are "contracting out" and are not counted as employees.
Callan sees a concern about non-U.S. investors buying mortgage debt and the increased use of "creative financing". This is the first time that economic growth is coming from businesses. The situation is generally good, but not great. As long as foreign investors are happy, Lopez added. The dollar was expected to depreciate further, yet the month before SDCERS Board meeting, it had risen.
Callan predicts the expected return, on an investment split of 60% stocks and 40% bonds, is 7.4%. (Doug McCalla said SDCERS has a limit of 63% stock. Much of SDCERS' past years performance came from real estate profits.)) While earnings in the past have generally matched the GDP, there currently are no bargains left out there, and no rebounds are expected. Now "fixed income" is not "returning" and is "over valued". The bond market is only great in a faltering economy. The question was asked: When is the return on Standard and Poors, greater than a 10 year Treasury Note? There has been a demand for long term debt, but not a supply.
CONCLUSIONS:
· SDCERS' target portfolios are expected to earn a return of 7.32% over the next five years. Callan explained that they use a lower inflation factor than the SDCERS' actuary uses, and this would equal SDCERS' 8% expected return.
· If SDCERS wants more than 8%, then SDCERS must be more aggressive.
· Private equity investments were presented to the SDCERS Board as a way to increase return on a long term basis only. No changes, on investment policy in order to expand to private equity investments, were voted on by the Board. The Board will continue with their current policy, unless they decide otherwise, and in the meanwhile will work on an education in this area from Callan. Callan said this is a complex area, that the Board had not had the votes in the past. Preovolos inquired into the added risk. Callan responded, risk in volatility terms; risk of this, of that and assign a number; and concluded that if you can't have 5% don't bother. Preovolos asked if this would be adventure capital? Callan answered, that the concept is that skillful people are applying their expertise, it takes about 10 to 12 years to play out and more money is needed than public equity investments. It is important to have a long term plan that is stuck to, in order to benefit from private equity. Pension Board will not be successful, if a new Board withdraws from a previous Board's private equity investment too soon. To diversify a private equity is $100 million for a $2 ½ billion fund and a manager would be hired to build this. Doug McCalla said something about inflating the volatility expectation. Callan responded that this is not a hedge, but is diversification.

OPERATIONS SESSION at 1:30pm. New trustee, James Waring, joined the Board.

REVISION OF DROP DISTRIBUTION REGULATIONS to comply with the Final Regulations issued under Internal Revenue Code section 401(a)(9) regarding minimum distributions, to take effect Jan 1, 2006. No longer account balance distributions, no partial distributions. Options: Lump sum or fixed payments.
An attorney from Ice Miller, was unable to salvage annually changing periodic payments for DROP participants who retire before January 1, 2006.
Anyone who doesn't elect one of the new fixed distribution options will default to lump sum before 70 ½ years of age, with "floating" interest on DROP as long as funds remain in SDCERS. Lump sum checks will not be sent out if retirees don't respond to mail.
8% FIXED DROP INTEREST RATE: If fixed distributions are selected by the retiree, Lopez was told that a fixed rate of interest is needed to come up with fixed payments, and that current rate is an unchanging 8%. This rate may change for future retirees, but will remain fixed.
Unfortunately, due to non-trustee rules for IRAs, it is not possible to change DROP to Defined Contribution within SDCERS at this time, but DROP can be rolled-over to a qualified outside Defined Contribution plan.
Notification materials will be sent out to participants. Joe Flynn found it unreasonable to give retirees only two months to change their financial plans when the IRS gave SDCERS an 18 months notice. John Casey also expressed concern about retirees and employees understanding the new choices and re-doing financial plans in two months. Grissom explained that there have been too many political and emotional issues, so the old Board thought the new Board might have better solutions. Sheffler said, "But there were time lines here." Ron Saathoff protested and expressed concerns about little notice of this change, application of Colas, and meet and confer issues. Preovolos said the change was not negotiable with the IRS, so it was a "done deal". Saathoff was referred to the City regarding any meet and confer issues. Steve Meyer added that he hoped he would never be on the opposite side of the negotiating table with Saathoff. Sheffler thought the meet and confer was a "red-herring", as the Unions have known all year about the IRS Final Regulations, and Sheffler asked if the delay is to expose the plan to illegality? Ice Miller said there was no grace period for the IRS to examine SDCERS rule changes, and it would take 12 to 18 months to hear from the IRS. There was no interest by the Board to offend the IRS, as SDCERS has requested an in-depth review of the SDCERS' plan by the IRS. Preovolos said the Board would be unable to negotiate with the future IRS review if SDCERS was non-compliant. As there are approximately 900 retired DROP and 550 active DROP, there was general concern about the capacity of two staff to process choices before January 1, 2006. Grissom said calculations must be made on an individual basis. John Casey was concerned that staff may fail to process his choice by the final date. Grissom was concerned that making changes retroactive to January 1, 2006 would compound the risk of error and tax ramifications.
Steve Meyer said it was foolish not to act on legal advice and asked why a driver should wait for a CHP officer to slow down a bus, filled with retirees, if was going too fast? Flynn relieved some frustration in the audience when he added, "I don't think a bus going 90mph took 15 months to get here." The DROP rule change passed 8 to 1, Kipperman voting no, probably due to the 8% interest rate that he thought would cost SDCERS $20million, and Torres recused.
Grissom added that with fixed distributions, there is no longer a way to protect retirees from outliving account balances.

USING "457" TO PURCHASE SERVICE: Chapin said that decision will be out in about one year.

SELECTION OF A NEW ACTUARY: There were 9 respondants. Rick Roeder's contract had ended, but due to his corporate memory he had been retained for the extra year. As Roeder was local, he had high availability for meetings and service. At Sheffler's request, Chapin will check on the conflict of interest that Mercer may have as they audited SDCERS previously. Preovolos appointed a committee to make the final decision: Sheffler as Chair, Lopez, Meyer, Kipperman, and Grissom.

LAWSUITS
Litigation Committee is Preovolos, Meyer and Sullivan.

SDCERS VS CITY OF SAN DIEGO AND AGUIRRE: Regarding the results of the August 23rd hearing, Lopez asked if SDCERS had independent counsel? When the newspaper reported the August 23rd hearing, Judge Barton seemed to say SDCERS had independent counsel "in this instant case". Aguirre interpreted the Judge saying that independent counsel was only for this case. Chapin's impression was that it was for all time, but just for SDCERS, not necessarily for other retirement systems. She said Judge Barton will determine if Aguirre's or SDCERS' attorneys' impressions are correct. Grissom added that no trial in the spring was ever contemplated. (The hearing on this lawsuit, scheduled for Sept. 30th, was "continued" to November 18th.)

CLOSED SESSION-AUGUST 15th:
People of the State of California vs. Lawrence Grissom, et al., SD Superior Court- Honorable Judge Wickersham. Regarding conflict of interest in voting for pensions under the Political Reform Act of 1974. (At the September 30th hearing, Aguirre's lawsuit was tossed out.)
Police lawsuit- US District Court case #05CV1581, Honorable Judge Huff. The police are versus the City, SDCERS, SDCERS' administrator, City Attorney, past and present City Counsel members, certain SDCERS Board members, former City Auditor, past and present City Manager. SDCERS' attorneys are Seltzer, Caplan, McMahon, Vitek.

CLOSED SESSION-AUGUST 30th:
Authorized (vote 7-1) the initiation of litigation against the City if it attempts to remove Preovolos and/or other appointed Board members, or otherwise interfere, with constitutional and charter mandate of an independent retirement board.
Also unanimously authorized to initiate litigation to seek reimbursement of trust funds paid to the legal counsel of trustees acting within the course and scope of their retirement board duties.

NO CLOSED SESSION SEPTEMBER 16th.