Response Form Grand Jury Report Title: Unfunded Liability-our Children’s Inheritance Report Dated: Jun 7, 2010

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The MCERA Board and Administrator closely monitor the impact of the retirement fund on the County budget, rather than comparing the performance with other counties. (All Findings) YourPublicMoney.Com partially agrees. Again, this is complicated. By law MCERA is obligated to consider its impact on the County’s budget, but that is subordinate to fulfilling its fiduciary responsibility to present and future retirees. Yes - MCERA should consider the County’s budget, but it should focus most intently on building and maintaining the soundness of its Pension Fund. If it turns out that even though the Pension Fund is well managed (which I believe has not been the case) but the demands for funding from the County are deemed by the BOS to be excessive, then the BOS is responsible to adjust its retiree benefits so their cost bears a proper relationship with all the other financial demands made on the County. The County’s financial officials (Auditor-Controller, Treasurer-Tax Collector, Executive Office, and BOS) should very carefully monitor the impact of the Pension Fund and MCERA on the County’s finances. I assert these officials have been very deficient in this duty for the better part of two decades.

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The BOS immediately take steps to rectify the unfunded liability. YourPublicMoney.Com partially agrees. Again, this is very complicated. It’s very hard to “make right” the unfunded liability. It must be reduced. How, and will it lead to the destruction of vital County services? First - the BOS has chosen to make it easier on itself in the short term but also to impose a much greater burden on the future. The County and MCERA have adopted a method of eliminating the unfunded liability that we believe is extraordinarily irresponsible. The current plan is to eliminate the unfunded liability over 30 years using an amortization method called “Level Percent of Payroll”. First an estimate is made of how much the County’s total payroll will be in each of the next 30 years assuming it will grow the same percent each year (the County adopted a 4% yearly payroll growth rate). Then a percentage is calculated that when applied to each year’s payroll will produce enough money to eliminate the unfunded pension debt in those 30 years. That’s the County’s yearly payment. This method produces payments that are less than the annual interest expense for the first 12 years. This is called “negative amortization” which means the debt is going up, not down. The unfunded pension liability would increase 20% to 25% in those 12 years. In fact, the unfunded balance won’t get back to today’s level for 20 years. That means - all other things remaining equal - the dollar value of today’s unfunded pensions will be entirely paid from 20 to 30 years from now. We are forcing kids in elementary school to pay for retirement costs that were economically incurred 10 to 20 years ago. Second - The Government Accounting Standards Board (GASB) recently released for public comment several concepts it intended to develop into a new set of requirements for pension accounting. Among these concepts are a) unfunded retiree liabilities would be reported as liabilities directly on balance sheets as opposed to footnotes, b) the value of unfunded retirement debt will be calculated using the market value of assets, not the “actuarial” value, c) the amount of future pension payments that have already been earned but that aren’t currently “funded” will be “discounted” using a municipal bond rate instead of the target rate of return (this will greatly increase the value of unfunded pension debt), d) the full “interest expense” of unfunded pensions will be reported each year, e) unfunded pensions will be amortized over much shorter periods of time (12 to 15 years instead of 30), and f) amounts of unfunded pensions over 15% of total pension liabilities will be immediately reported as expense. Altogether these changes would greatly increase both the County’s unfunded pension liability and annual pension expense. My calculations indicate the debt would about triple and annual expense would be somewhere between two to three times that reported today. Indications are that these concepts will be implemented in new accounting standards in about five years. Assuming Mendocino County still has significant unfunded pension debt, the debt would almost certainly greatly increase - the “opposite” of being “rectified”. ATTACHMENT John G Dickerson/YourPublicMoney.Com Response Further Information about Finding 4 The information immediately below supports my statements A and C above. Statement D is discussed in the following section. On March 17, 2010 the Retirement Board met with this item on its agenda - “Discussion and Possible Action Regarding the use of Excess Earnings”. The meeting was recorded by Ukiah Valley Community TV and is available to be viewed at their website - http://www.uvctv.org/vid/ret031710/ At the request of some members of the Retirement Board Former Retirement Administrator and County Treasurer-Tax Collector Tim Knudsen gave a report on the history over the past 10 years of how MCERA paid for retiree healthcare. Mr. Knudsen provided a written memo and table to support his presentation. The written memo is dated March 3, 2010 to the Board of Retirement - Subject: Excess Earnings/Health Insurance. The following quote is from this memo (underlines added): During this time period (stated earlier to be 2003 through 2006) MCERA began a process for payment of retiree health insurance that was thought necessary in order to be in compliance with Internal Revenue Services Regulations. The instructions we had (from the IRS through the actuary) regarding retiree health insurance payments were that all payments must be made by the county. During this time we followed a process of “diverting” a portion of the monthly County Contributions made to the Retirement System into the reserve for retiree health insurance ... After a numbers of years we were informed by the actuary that since the county was not making any contributions toward an unfunded liability, because of the 2002 POB agreement, the process of diverting money to the reserve to pay for retiree health insurance meant the county was not making the “normal contribution” to the retirement system and violated certain sections of the 1937 Act Government Code. With the receipt of this information we immediately reverted to the system of recognizing a portion of market value appreciation and repaid the full amount that had been diverted from the county contribution amounts. We also recognized an amount ($3,427,200) that would cover expected health insurance payments for the remainder of that FY thereby using a total of $9,557,912 from the actuary recommended plan. It should be noted here that this amount has remained on the retirement systems books since that time and has been carried in the “Actuarial Value of Unrecorded Earnings (Account 1300). Item A) Diversion of $6.1 million from County Pension Contributions California Government Code Section 31587 referred to by the Grand Jury states: The (retirement) board shall apply the contributions of the county or district to its obligations under the system in the order and amounts as follows: First, in an amount equal during each fiscal year to the liability accruing to the county or district because of service rendered during such year and on account of service and disability pensions, in an amount determined by the actuarial valuation as interpreted by the actuary. ... According to the table provided by Mr. Knudsen to the Retirement Board these were the amounts taken out of the County’s contribution to the Pension Fund in those years: Fiscal Amount Diverted Year to Pay Healthcare 2004 $1,728,689 2005 2,662,304 2006 1,739,719 A table on of the Report on the Actuarial Valuation as of June 30, 2009 produced for MCERA by its Actuary - Buck Consultants - showed the County contributed these percentages of its Annual Required Contributions to the Pension Fund: 2000 100% 2001 100% 2002 100% 2003 100% 2004 63% 2005 47% 2006 79% 2007 100% 2008 100% 2009 141% (I question the accuracy of the 141% contribution in 2009 - but that’s not relevant to this Grand Jury finding.) This table indicates the County contributed significantly less than its required annual contributions in 2004 through 2006. However, it appears the County paid an amount close to or equal to its required annual contribution and these percentages reflect the amount of those contributions that were not diverted to the healthcare fund. Former Retirement Administrator Knudsen specifically stated in his memo: ... we followed a process of “diverting” a portion of the monthly County Contributions made to the Retirement System into the reserve for retiree health insurance . Knudsen specifically states MERA diverted approximately $6.1 million from the County’s annual contributions to the Pension Fund from 2004 through 2006. That action appears to not conform to the language of California Government Code Section 31587 cited above. In its response to this finding in the Grand Jury Report MCERA’s Administrator Andersen stated these diversions were “presented to the Board of Retirement as being compliant with the California Employees’ Retirement Law of 1937 and IRS code. The Association does not believe that the action was in conflict with Government Code sections 31584 or 31587.” However, Andersen no where cites specific Code Sections or other specific legal authority to support that position. In contrast, the description of the events given by former Administrator Knudsen seems clearly to not conform to the requirements of Code Section 31587. Therefore I agree with the Grand Jury’s Finding as it relates to the approximately $6.1 million diverted from the County’s required annual Pension contribution - it appears to be in conflict with Government Code Section 31587. Item C) “Repayment” of $6.1 million of County Contributions to the Pension Fund and of $3.4 million Transferred from Pension Fund in 2006 The quote cited above from Tim Knudsen’s memo to the Retirement Board states: With the receipt of this information we immediately reverted to the system of recognizing a portion of market value appreciation and repaid the full amount that had been diverted from the county contribution amounts. We also recognized an amount ($3,427,200) that would cover expected health insurance payments for the remainder of that FY thereby using a total of $9,557,912 from the actuary recommended plan. It should be noted here that this amount has remained on the retirement systems books since that time and has been carried in the “Actuarial Value of Unrecorded Earnings” (Account 1300). The transaction Knudsen states “paid the County back” must be analyzed to understand the financial and legal issues. Code Section 31587 states the County’s contributions in each year must first go to: ... the liability accruing to the county or district because of service rendered during such year and on account of service and disability pensions, in an amount determined by the actuarial valuation as interpreted by the actuary. The liability that accrues to Mendocino County for service rendered during each year is its obligation to the Pension Fund. The focus of this Code Section is not on whether or not the County is “credited” for having paid its required annual Pension contribution; it’s on where the money goes - it is supposed to go into the Pension Fund. What was supposed to happen is that all the cash would have gone into the Pension Fund and the County would have been “credited” for having paid what it was supposed to have paid into the Pension Fund. What happened is that only part of the money that was supposed to go into the Pension Fund was actually deposited in that Fund - AND the County only got credit for having paid that amount into the Pension Fund. Then - the amount that was diverted - a total of $6.1 million over those 3 years, was deposited into the Healthcare Fund and the County got credit for paying that much into the Healthcare Fund. Right there it appears MCERA did not conform to Code Section 31587. But then later in order to “make things right” MCERA would have had to transfer $6.1 million out of the Healthcare Fund and into the Pension Fund. And, to “balance” the transaction that amount would have been taken out of the account that records the County’s contributions to Healthcare and added to the account that records the County’s contributions to the Pension Fund. MCERA made the second of those two entries. It’s that “crediting” of the account that records the County’s contributions to the Pension Fund that Knudsen claims constitutes “paying the County back”. But, again, that’s not the issue. The issue is where is the money? MCERA had already spent the money on Healthcare - it was gone. There was no money in the Healthcare Fund to move to the Pension Fund. So - what was the County supposedly “paid back” with? It was “paid back” with what Knudsen says is an asset account on MCERA’s books titled “Actuarial Value of Unrecorded Earnings”. (In fact to “make things right” an amount equal to the compounded target rate of return - 8% - would also have to be moved from the Healthcare Fund to the Pension Fund because since the money wasn’t in the Pension Fund’s investments that Fund could not earn investment returns - which are absolutely necessary to be able to pay future pensions in full. But I’ll keep this explanation simple and not include “lost income”.) Knudsen also reported that an additional $3.4 million was taken out of the Pension Fund in 2006 to “cover expected health insurance payments for the remainder of that FY” (fiscal year). And so the total in “Actuarial Value of Unrecorded Earnings” was $9.6 million - the $6.1 million represented by the diversions from the County’s contributions and the $3.4 million taken out of the Pension Fund (there is a slight rounding error in these numbers). What is “Actuarial Value of Unrecorded Earnings”? I earned my MBA in Strategic Planning and Economic History from the University of Texas which was generally ranked the #1 graduate accounting school in the USA at the time. I have 30 years of experience in financial management, accounting, financial/industry/market analysis and similar fields. I’ve never been able to understand any explanation offered by anyone associated with MCERA of the nature of “Actuarial Value of Unrecorded Earnings”. Although I can’t say with absolute certainty I very much doubt this account would truly qualify as an “asset”. I believe “Actuarial Value of Unrecorded Earnings” is really a claim against future so- called Pension Fund “Excess Earnings” in some uncertain year in the future. It is essentially a claim against future “profits” if and when they occur. How can MCERA claim that future Excess Earnings at some uncertain date is an asset? It makes no sense to me. In my experience Generally Accepted Accounting Principles (GAAP) do not allow the “capitalization” of expected future profits that have not yet been earned - that is, I don’t believe GAAP allows the expectation of future but as of yet unearned profits to be listed as an Asset on the Balance Sheet - or Statement of Net Assets. To me this appears to be a “fake” asset. However - since most of my experience has been in the private sector I can’t say it isn’t an asset with absolute certainty because I am not as experienced with how GAAP in governmental accounting defines what is and isn’t an asset. I can say that no explanation of this account provided so far from MCERA I’ve seen makes sense to me and certainly doesn’t justify listing it as an asset, in my experience. My judgment is it isn’t an asset - but there is a slight uncertainty in my opinion. I believe this view is confirmed by the fact that the Retirement Board has elected to “write off” the $9.6 million in this account essentially as “uncollectible” during the 2010- 2011 fiscal year - as if it were a “bad account receivable.” They have explicitly declared the account has no value. I believe it’s further confirmed by comments made by the video of the 3/17/2010 Retirement Board meeting. On that video Retirement Administrator Andersen states at one point when discussing this account: There’s still $9.557 million (in the “Actuarial Value of Unrecorded Earnings” account) that’s still outstanding from that practice (Actuarial Adjustment). ... there may be a way we can “eliminate” that asset. ... This liability that’s sitting on the books(referring to the same account) - what is the disposition of the Board as far as addressing that in the future? But regardless of the legal status of “Actuarial Value of Unrecorded Earnings”, the fact is that $6.1 million was diverted out of the County’s pension contributions and that cash was never put into the Pension Fund. That appears to me to be a direct violation of Code Section 31587. Item D) California Government Code Section 31584 This Grand Jury finding states the actions of MCERA described in the finding may have been in conflict with Code Section 31584. This isn’t correct because that Code Section applies to the County - not to the Retirement Association. Code Section 31584 states: The board of supervisors shall make the appropriations, and if it fails or neglects to make the appropriations, the county auditor shall transfer from any money available in any fund in the county treasury the sums specified by this chapter and this transfer shall have the same force and effect as it would have had if the required appropriation had been made by the board of supervisors. I believe other Code Sections indicate the “appropriations” refers to all the monies the County is obligated to pay to the Retirement Association under the 1937 Law, which for Mendocino County is almost totally Pension obligations. It appears the County paid approximately the amount it was told to pay by MCERA’s Actuary during 2004 - 2006. However, as seen above, MCERA diverted $6.1 million out of those payments and put that cash into the Retirement Healthcare Fund. The following makes me believe the County knew about this diversion and effectively agreed with the diversion. * Tim Knudsen was both the County Treasurer-Tax Collector and MCERA’s Retirement Administrator during those years. Clearly he knew about the diversions and was an elected County official responsible to safeguard the County’s financial assets. * The County Board of Supervisors, Administration, Auditor-Controller, and obviously the Treasurer-Tax Collector all received copies of MCERA’s annual Actuarial Valuations. As shown above, those Valuations contained tables showing the County’s contributions to the Pension Fund were significantly less than required. The percentages reported in the Valuation were based on what was left in the County’s pension contributions after the approximately $6.1 million diversions to the Retiree Healthcare Fund. It appears the County never objected to this indication from MCERA and its Actuary that MCERA’s records indicated the County did not pay a significant amount of the required annual pension contribution defined by the Actuary. * Footnotes in the County’s audited annual financial statements for those years indicate the County contributed significantly less to the Pension Fund that it was supposed to. So - the County actually paid about the amount it was told to contribute to the Pension Fund by MCERA’s Actuary, but the County’s financial reports indicate it didn’t. This indicates many County officials knew about these diversions and had to agree with them. Even though the Board of Supervisors may have “technically” appropriated the amounts it was told to for the Pension Fund in its budget, its clear County officials knew MCERA was diverting $6.1 million to healthcare and was not depositing that amount into the Pension Fund. While the BOS may have technically satisfied the requirements in Code Section 31584 in its budgets, I believe it knowingly did not fulfill the substance of the requirement of that Code Section - which is that the County should pay all its annual pension contribution into the Pension Fund. Further Information for Finding 6 Actuaries produce “Actuarial Valuations” for Pension Funds. One aspect of such Valuations is determining how much the Fund is worth compared to the amount of money it should have so it would be able to pay all the pensions that have already been earned by employees in the past. The financial position of the County’s Pension Fund is determined by: Pension Fund Assets - Pension Fund Obligations Unfunded or Over-Funded Pension Obligations If Assets are less than Obligations, there is an “Unfunded Obligation”. If greater, the Fund is “Over-Funded”. Actuaries use two different values for Pension Fund Assets: • Market Value of Assets • Actuarial Value of Assets Therefore there are two values for Unfunded or Over-Funded Pension Obligations. This table shows their values based on data contained in the 6/30/09 Actuarial Valuation of the Pension Fund: Market Value Actuarial Value Pension Fund Assets $271 million $336 million Less Total Obligations - 403 million - 403 million Unfunded Pension Obligations ($132 million) ($67 million) The Unfunded Obligation based on the Actuarial Value of Assets is called the “Unfunded Actuarially Accrued Liability”, or “UAAL”. The Unfunded Obligation based on Market Value of Assets is not the UAAL. Therefore - this is one correction offered to this Grand Jury finding. There is no “UAAL” based on the Market Value of Assets. “UAAL” is a “technical term” that refers only to the value of the Unfunded Pension Obligation measured using the Actuarial Value of Assets. However, it is absolutely correct to say that the Unfunded Pension Obligation measured using the Market Value of Assets was twice as much as that measured using the Actuarial Value of Assets. And, the gap between Actuarial and Market Value of Pension Assets on 6/30/2009 was the largest it’s ever been - the Actuarial Value was $65 million more than the Market Value. That is also the gap between Unfunded Pension Obligations based on Actuarial Value of Assets compared to Market Value of Assets. The importance of this distinction is related to its impact on 1) the amount of Unfunded Pension Amortization Payments the County must pay over several years, and 2) the amount the Pension Fund actually has to invest seeking to earn its required investment profits. County Unfunded Pension Amortization Payments Both the County and its employees make annual contributions to the Pension Fund. These are intended only to fund the pensions that are being earned by employees that year. But if an Unfunded Pension Obligation develops large enough to threaten the Pension Fund’s ability to make future payments of all pensions already earned only the County is obligated to eliminate it by making additional payments. It’s this second kind of payment - the “Unfunded Pension Amortization” payment - that creates the need for a modified value of the Pension Fund’s Assets - the “Actuarial Value of Assets”. The stock market is notoriously volatile. If the Actuary used the Market Value of Assets to determine the value of the County’s Unfunded Obligation Amortization payments those payments would often change radically from year to year. This would play havoc with the County’s budget stability from year to year. Pension Funds are long-lived financial entities. The point is to maintain the Fund’s financial strength over the long run rather than immediately correct small short falls. Right or wrong, Actuaries decided that over the long run the damage to year to year government budgetary stability would cause more harm than misstating the Value of Pension Fund Assets, within limits. Actuaries developed a formula to “slow down” the rate of change of the County’s required payments. This is a reasonable objective as long as the use of the modified Actuarial Value doesn’t lead to a dangerous distortion of real Asset Value or obscure poor performance. The Market Value of the Pension Fund’s Assets is what they are really worth. It’s what the Fund has to invest, pay pensions, and pay expenses. Most of the Assets are investments - stocks, bonds, real estate, etc. Their Market Value is what they could be sold for. It’s easy to establish what stocks and bonds are worth - it’s what they are selling for in the market. For real estate an estimate or appraisal is needed. An Actuary modifies the Market Value to produce the Actuarial Value of Assets using two formulas: Smoothing: MCERA uses a five year smoothing period. The amount that its actual returns are more or less than its target in any year is recognized in that and the following four years in equal amounts - 20% a year. This is what “slows down” the changes in the County’s Unfunded Pension Amortization Payments. Corridor Limits: A Limit on Smoothing: This limits how much the Actuarial Value of Assets may differ from the Market Value. The Actuarial Value can’t be more than 25% different from the real Market Value. The Corridor Limit was raised from 20% to 25% for the 6/30/2009 Valuation in order to increase the amount the Actuarial Value of Assets could be higher than the Market Value so that the County’s Unfunded Pension Amortization Payments would be lower than had the Limit remained at 20%. For the first time ever as of June 30, 2009 the Smoothing process produced a “Smoothed Value of Assets” that was more than the Corridor Limit - and therefore the Smoothed Value was not used - the Corridor Limit was. Market Value of Assets $271 million Upper Corridor Limit (125%) 339 million Smoothed Value of Assets 356 million The Smoothed Value was $17 million more than the Upper Corridor Limit (25% more than the Market Value). Therefore the Corridor Limit was used. Two reserves totaling $3 million were deducted from that value to produce the final “Net Actuarial Value of Assets” of $336 million. Using this Net Actuarial Value of Assets the UAAL was $67 million. The County was obligated to begin making UAAL Amortization payments on that amount in fiscal year 2010-2011. The importance of the difference between Actuarial and Market Value of Assets as regards Unfunded Pension Amortization Payments is that the County’s payments in fiscal year 2010-2011 is calculated using only half of the real “Market Value” of Unfunded Pension Obligations. The Pension Fund earned $135 million less than its target returns in 2008 and 2009. However, $100 million of that sub-target investment return is not yet included in the UAAL - it has been “smoothed” to be incorporated into the UAAL over the next four years. The Fund enjoyed returns over its target in 2006 and 2007 - but the remaining amount of those “over target returns” to be included for the first time in the UAAL is only $12 million. Even if the Fund earns its target rate of returns of 8% over the next four years, the value of the UAAL will increase by around $100 million over the next four years - mostly but totally because of the gradual inclusion of the $100 million under- target returns in 2008 and 2009. That means the County’s UAAL Amortization Payments will almost certainly greatly increase over those years - more than double. This is one of the inherent dangers when the Actuarial Value of Assets is much greater than the “real” Market Value - unless the Fund can completely earn back its sub-target returns over the next four years the County’s UAAL Amortization payments will very significantly increase. I don’t think the County or MCERA has calculated what that increase will be. My calculations indicate the UAAL Amortization payments will increase from about $4 million in fiscal year 2011 to around $10 million in fiscal year 2015 - a very large increase. Potential Returns on Investment The other main inherent danger when the real Market Value of Assets is much lower than the Actuarial Value as was at the last available Actuarial Valuation is that people make the very grave mistake of thinking the Actuarial Value of Assets is “real” - that is, as if the Pension Fund has that much money to invest. It doesn’t. The Pension Fund was supposed to have $400 million as of June 2009 but in fact only had $270 million to invest. The Fund can’t earn investment returns on money it doesn’t have. The actual mathematical assumption underlying the Pension Fund is that it will have all the money it’s supposed to have in any year and it will earn its target rate of return each year on that amount. The Pension Fund’s target rate of return is 8% - but that means that it needs to earn $32 million during the current fiscal year (8% of $400 million) in order to “stay even” with its Pension Funding Plan. But if it only earns its target rate of 8% on the $270 million it actually has it will earn only $22 million - $10 million less than what it really needs to earn. In order to earn $32 million the Fund would have to earn 12%. That means if it earns 50% more than its target rate of return on the money it actually has to invest it will only be “staying even”. If it earns its target of 8% it will fall $10 million below its target - which increases the real value of Unfunded Pensions by that amount. These are the two main reasons the distinction between Actuarial and Market Value of Assets is so important to understand given the Pension Fund’s current situation.