AUDIT AND FINANCE

INTRODUCTION

The Santa Barbara Civil Grand Jury (GJ) is mandated under California Penal Code Section 925 to "…investigate and report on the operations, accounts, and records of the officers, departments, or functions of the County…". It was decided some 35 years ago to retain an independent outside auditing firm to audit the County's financial statements. To avoid duplication of effort, the GJ joined with the Auditor Controller (AC) and the County Administrator (CA) to retain the same independent auditor.

The Grand Jury Audit and Finance Report will consist of two sections:

Section I.

The independent audit of the County's general purpose financial statements, including comments and recommendations of the current auditors, KPMG Peat Marwick LLC.

Section II.

Santa Barbara County Employees' Retirement System.

SECTION I

OBJECTIVE/PROCEDURE

To fulfill the statutory requirements of California Penal Code 925, the Grand Jury reviewed all pertinent activities of the Auditor Controller, staff, consultants and primary interfaces such as the County Administrator and staff. It also reviewed KPMG's management letter dated July 31, 1999.

BACKGROUND/OBSERVATIONS

In 1994 Peat Marwick (KPMG) was selected, on a competitive basis, as independent auditor to conduct the audit for 1994-1995. The County's fiscal year runs from July 1 to June 30 of the succeeding year. Although there have been arguments regarding periodic changes of auditing contractors, the excellent performance of KPMG has enabled them to obtain contract renewals up to the present time. The 1997-1998 Grand Jury perceived a conflict of interest and did not join the County in signing the three-year contract. Other Grand Juries will have the option to do so in the future.

As part of each audit, the independent auditor in its management letter, makes findings and recommendations for improvement in the County operations. The management letter and the County's responses are a matter of public record. The following findings and recommendations were found in the latest management letter, accompanied by the County's responses.

Management Concerns

In its annual management letter, KPMG registered concern in six areas and made recommendations that would improve the County's internal control or result in other operating efficiencies. The areas of concern are:

Disaster Recovery

During the audit, KPMG found no formal countywide disaster recovery plan in place to ensure the physical protection of computer operating system programs, data files and documentation. The auditors recommended instituting and monitoring such a plan. The County, through General Services, coordinated with each department and all departments have complied, including instituting contingency plans for the year 2000. Furthermore, as part of its annual Information Technology assessments, the County will review and update, if necessary, all department disaster plans.

Federal Grants

There is no formal countywide grant application process or grant maintenance function, making it difficult to identify and track federally funded grants or identify new Federal or State grant opportunities. The County needs to appoint a "grants coordinator" who can service these needs and assist the County in identifying grants available that best support its service strategy. The County's Auditor-Controller currently has a project underway to assess the needs in this area and to undertake enhancement of its automated systems to collect grant information and monitor grant activity.

Changes in the Government Reporting Model

The Governemental Accounting Standards Board (GASB) issued a revolutionary new reporting model in June 1999, which dramatically changes the presentation of the governments' external financial statements. This will substantially affect the County's financial data accumulation and financial statement presentation processes. For instance, under the new standard, the County must report infrastructure assets acquired within the last twenty five years at historical cost. Implementation for the County will be completed in the year ending June 30, 2002.

In response, the County studied the impact of GASB Statement No. 34 on its systems and processes, and in January, 2000 the Auditor's office formed a GASB 34 Implementation Project Team under the direction of the Chief Deputy Controller, to study and develop strategies to implement the changes.

Fixed Assets

In past years, fixed assets relating to construction in process, land and buildings, were updated only once a year, and fixed assets relating to equipment were recorded once a month. In fiscal year 1999, the County began the process of reconciling detail fixed assets records. The auditors recommended that the County implement the new fixed asset policy and procedures as soon as possible, and provide training for individual departments. Furthermore, a countywide physical fixed assets inventory should be updated and performed at regular intervals with more frequent inventories for certain classes of fixed assets such as computer equipment. Detailed listings of all fixed assets should be provided to Department heads. Once an inventory has been conducted, it should be sent back to the Auditor Controller.

General Litigation

The auditors have recommended to the County that they develop a plan for calculating litigation costs on a quarterly or semi-annual basis. The County prepared a mid-year update for the Board of Supervisors in February, 2000. Furthermore, a system is under development to calculate the litigation liability on a quarterly basis.

Related Party Documentation

Certain County employees are required to file Form 700 Statements of Economic Interests annually as required by the Fair Political Practices Commission. During the audit it was noted that these forms were not always available. The County Clerk Recorder Assessor's office now includes a transmittal sheet that summarizes the individuals required in each department.

COMMENDATION

The Grand Jury wishes to commend the Auditor Controller, his staff and their able consultants, KPMG Peat Marwick, LLC, for their use and oversight of the standard budgeting process and controls that have performed well for the last three years.

Section II

SANTA BARBARA COUNTY EMPLOYEES’ RETIREMENT SYSTEM

INTRODUCTION

The Grand Jury (GJ) conducted a comprehensive review of the policies and procedures that govern the management, administration, investment advisory, consulting advisory, fiduciary compliance, and due diligence oversight of the Santa Barbara County Employees’ Retirement System (SBCERS) investment portfolio. The purpose of this study is to ensure that the Santa Barbara County Board of Retirement is performing its fiduciary obligation to provide prudent investment oversight of the SBCERS investment portfolio on behalf of the current and future plan participants.

BACKGROUND

The GJ conducted extensive research to verify all relevant legal obligations of the Board of Retirement are duly performed by the Board of Retirement as provided in Section 17 Article XVI of the California Constitution and in Sections 31580 et.seq. of the Government Code (Article 5 of the 1937 County Retirement Act). The focus of the investigation was to verify the sections of California law which stipulate that “the assets of a public pension or retirement system (SBCERS) are trust funds and shall be held for the exclusive purposes of providing benefits to participants … and their beneficiaries and defraying reasonable expenses of administering the system. ”[1] Furthermore, “The members of the retirement board of a public pension or retirement system shall discharge their duties with respect to the system with the care, skill, prudence, and diligence under the circumstances then prevailing that a prudent person acting in a like capacity and familiar with these matters would use in the conduct of an enterprise of a like character and with like aims.”[2] Similarly, the GJ sought to verify the Board of Retirement’s fiduciary obligation “to provide for actuarial services in order to assure the competency of the assets of the (SBCERS).”[3]

PROCEDURE

In order to perform this investigation, the GJ compiled and reviewed all custodial and performance measurement reports, investment summaries, actuarial reports, Board of Retirement internal allocation summaries, as well as performance reports from similar public retirement systems.

In addition, the Grand Jury conducted personal interviews:

On November 5, 1999, the Santa Barbara County Grand Jury met with the Managing Director of PCA. The purpose of the meeting was to gain an understanding of the nature, depth, and history of the Board of Retirement’s relationship with PCA.

On March 8, 2000, the Santa Barbara County Grand Jury met with the Santa Barbara County Board of Retirement. The purpose of the meeting was to have the members of the Board demonstrate, in detail, performance of their fiduciary obligation to provide investment oversight of the retirement portfolio as defined in California Law (Article 17 of the California Constitution and Section 31580 of the Government Code). The GJ provided the Board with an agenda (see Reference) designed to give each Board member an opportunity to demonstrate a capacity to perform their fiduciary obligations. However very few members participated since the Board depended upon the Treasurer to explain the investment process to the GJ .

OBSERVATIONS

Management of the SBCERS investment portfolio is an extremely complex process. In order for the Board of Retirement to successfully perform its fiduciary obligations to the plan participants, they must rely on numerous consultants and advisors. In addition, they must coordinate and review extensive actuarial, investment, and analytical information which is often quite technical and requires specific skills to interpret, correlate, and evaluate. As of December 31, 1999, SBCERS assets were approximately $1.23 billion. The Grand Jury believes with this amount of assets, more emphasis needs to be placed upon understanding the risks inherent to institutional investing and making informed, qualified investment decisions. Although the Board of Retirement sends new board members to an introductory one-week investment educational class, the GJ thinks these classes are insufficient to prepare individuals - some with little financial expertise - for the responsibility of providing competent, qualified, or knowledgeable investment oversight for the SBCERS investment portfolio. The ability to comprehend sophisticated investment tools, strategies, and methods (i.e. portfolio modeling, risk assessment, asset allocation, correlation, efficient frontier analysis, etc.) are paramount to successful performance of the Board’s fiduciary obligation.

The current custodian (State Street) also provides portfolio analytical services. Although this is not unusual, the GJ found the information difficult to understand in conjunction with another consultant (Pension Consulting Alliance) that provides the investment/economic review. It appears to the Grand Jury that combining the analytical services would enhance the investment oversight. If the portfolio analytical services were combined with the investment advisory services, the performance measurement reviews would be presented together with the investment/economic reviews. Furthermore, consolidating these two services would provide the Board of Retirement with a single, cohesive, and comprehensive portfolio review.

Government Code Section 31520.2[4] states that when a retirement fund exceeds $800 million, which this fund exceeded in 1997, the Board of Supervisors may create a separate Investment Board. Creating an Investment Board would provide the expertise the GJ feels is necessary with this growing asset. According to the code, the Board of Investments consists of nine members including four members appointed by the County Board of Supervisors. The four members appointed by the Supervisors shall not be connected with County government in any capacity and shall also have had “significant experience in institutional investing.”[5] The GJ concurs with the code regarding the importance of creating a board that includes members with "significant experience in institutional investing.”

It was brought to the GJ’s attention that the duties of the Board of Retirement appeared to be in conflict. The Board not only oversees retirement investments but it must also determine who shall receive disability benefits. Creation of a separate Board of Investments would remove any appearance of a conflict of interest between decisions regarding individual retirement/disability claims (Liabilities – Board of Retirement), and providing for current and future SBCERS plan participants (Assets – Board of Investments).

FINDINGS AND RECOMMENDATIONS

Finding 1: The portfolio analytics and investment advisory reports are currently provided by separate entities.

Recommendation 1: Consolidate the portfolio analytics and investment advisory review so one consultant can produce a single, comprehensive investment review.

Finding 2a: The Retirement Fund has exceeded $800 million and the BOS has not created a separate Board of Investment.

Finding 2b: The BOR not only oversees retirement investments, but must also determine who shall receive disability benefits, giving the appearance of a conflict of interest.

Finding 2c: The current structure of the BOR does not guarantee that Board members possess the financial expertise necessary to adequately supervise the investment portfolio.

Recommendation 2: The 1999-2000 GJ recommends that the BOS invoke Government Code Section 31520.2 to establish a Board of Investment for Santa Barbara County Employees Retirement System.

Finding 3: Currently the BOR receives one week of investment training.

Recommendation 3: If the Board of Retirement continues to manage the retirement investments, more extensive orientation and ongoing investment training is essential.

AFFECTED AGENCIES

Santa Barbara County Board of Supervisors:
Finding 2a, 2b, 2c
Recommendation 2

Santa Barbara County Board of Retirement:
Findings 1, 3
Recommendations 1, 3.

BIBLIOGRAPHY

State Street Analytics, Custodian and Performance Measurement Analytics

Comparison, State Street Universe Report

Measurement, Performance Evaluation

Analysis, Portfolio Analytics

End of Year Custodial Report, 1999

Pension Consulting Alliance, Pension Investment Advisor

Quarterly Performance Reports (2nd, 3rd, 4th Quarter 1999)

Santa Barbara County Recommended Benchmark Changes, September 1999

Consultant Agreement dated February 1, 1991

Consultant Biographies

Board of Retirement

Investment Goals, Policies, and Procedures, September 1999

Comprehensive Annual Financial Report as of June 30, 1998

Actuarial and Investment Workshop Book, September 1999

Santa Barbara County Retirement System Asset Allocation Review

Internal Report

Buck Consultants, Actuarial Consultants

Report on the Actuarial Valuation as of December 31, 1998

California Public Employees Retirement System

Investment Performance Analysis, June 30, 1999

APPENDIX

Article XVI, Section 17 of the California Constitution:

“The State shall not in any manner loan its credit, nor shall it subscribe to, or be interested in the stock of any company, association, or corporation, except that the State and each political subdivision, district, municipality, and public agency thereof is hereby authorized to acquire and hold shares of the capital stock of any mutual water company or corporation when the stock is so acquired or held for the purpose of furnishing a supply of water for public, municipal or governmental purposes; and the holding of the stock shall entitle the holder thereof to all of the rights, powers and privileges, and shall subject the holder to the obligations and liabilities conferred or imposed by law upon other holders of stock in the mutual water company or corporation in which the stock is so.

“Notwithstanding any other provisions of law or this Constitution to the contrary, the retirement board of a public pension or retirement system shall have plenary authority and fiduciary responsibility for investment of moneys and administration of the system, subject to all of the following:

(a) The retirement board of a public pension or retirement system shall have the sole and exclusive fiduciary responsibility over the assets of the public pension or retirement system. The retirement board shall also have sole and exclusive responsibility to administer the system in a manner that will assure prompt delivery of benefits and related services to the participants and their beneficiaries. The assets of a public pension or retirement system are trust funds and shall be held for the exclusive purposes of providing benefits to participants in the pension or retirement system and their beneficiaries and defraying reasonable expenses of administering the system.

(b) The members of the retirement board of a public pension or retirement system shall discharge their duties with respect to the system solely in the interest of, and for the exclusive purposes of providing benefits to, participants and their beneficiaries, minimizing employer contributions thereto, and defraying reasonable expenses of administering the system. A retirement board’s duty to it participants and their beneficiaries shall take precedence over any other duty.

(c) The members of the retirement board of a public pension or retirement system shall discharge their duties with respect to the system with the care, skill, prudence, and diligence under the circumstances then prevailing that a prudent person acting in a like capacity and familiar with these matters would use in the conduct of an enterprise of a like character and with like aims.

(d) The members of the retirement board of a public pension or retirement system shall diversify the investments of the system so as to minimize the risk of loss and to maximize the rate of return, unless under the circumstances it is clearly not prudent to do so.

(e) The retirement board of a public pension or retirement system, consistent with the exclusive fiduciary responsibilities vested in it, shall have the sole and exclusive power to provide for actuarial services in order to assure the competency of the assets of the public pension or retirement system.

(f) With regard to the retirement board of a public pension or retirement system which includes in its composition elected employee members, the number, terms, and method of selection or removal of members of the retirement board which were required by law or otherwise in effect on July 1, 1991, shall not be changed, amended, or modified by the Legislature unless the change, amendment, or modification enacted by the Legislature is ratified by a majority vote of the electors of the jurisdiction in which the participants of the system are or were, prior to retirement, employed.

(g) The Legislature may by statute continue to prohibit certain investments by a retirement board where it is in the public interest to do so, and provided that the prohibition satisfies the standards of fiduciary care and loyalty required of a retirement board pursuant to this section.

(h) As used in this section, the term “retirement board” shall mean the board of administration, board of trustees, board of directors, or other governing body or board of a public employees’ pension or retirement system; provided, however, that the term “retirement board” shall not be interpreted to mean or include a governing body or board created after July 1, 1991 which does not administer pension or retirement benefits, or the elected legislative body of a jurisdiction which employs participants in a public employees’ pension or retirement system.”

Government Code 31595:

“The board has exclusive control of the investment of the employees retirement fund. The assets of a public pension or retirement system are trust funds and shall be held for the exclusive purposes of providing benefits to participants in the pension or retirement system and their beneficiaries and defraying reasonable expenses of administering the system. Except as otherwise expressly restricted by the California Constitution and by law, the board may, in its discretion, invest, or delegate the authority to invest, the assets of the fund through the purchase, holding, or sale of any form or type of investment, financial instrument, or financial transaction when prudent in the informed opinion of the board. The board and its officers and employees shall discharge their duties with respect to the system:

(a) Solely in the interest of, and for the exclusive purposes of providing benefits to, participants and their beneficiaries, minimizing employer contributions thereto, and defraying reasonable expenses of administering the system.

(b) With the care, skill, prudence, and diligence under the circumstances then prevailing that a prudent person acting in a like capacity and familiar with these matters would use in the conduct of an enterprise of a like character and with like aims.

(c) Shall diversify the investments of the system so as to minimize the risk of loss and to maximize the rate of return, unless under the circumstances it is clearly prudent not to do so.

Government Code 31520.2:

“In any county in which the assets of the retirement system exceed eight hundred million dollars ($800,000,000), the board of supervisors may, by resolution, establish a board of investments. The board shall consist of nine members, one of whom shall be the county treasurer. The second and third members shall be the general members of the association elected by the general membership of the association for a three-year term and, on the effective date of the amendment to this section during the 1970 Regular Session, shall also be members of the board of retirement. The fourth member shall be a safety member elected by the safety membership of the association for a three-year term and, on the effective date of the amendment to this section during the 1970 Regular Session, shall also be a member of the board of retirement. The eighth member shall be a retired member of the association elected by the retired membership of the association for a three-year term and, on the effective date of the amendment to this section during the 1976 Regular Session, shall also be a member of the board of retirement. The fifth, sixth, seventh, and ninth members shall be qualified electors of the county who are not connected with county government in any capacity, and shall be appointed by the board of supervisors. They shall also have had significant experience in institutional investing, either as investment officer of a bank, or trust company; or as investment officer of an insurance company, or in an active, or advisory, capacity as to investments of institutional or endowment funds. The first person chosen as a fifth, sixth, or seventh member, shall serve for three years, the second person chosen shall serve a four-year term, and the third person chosen shall serve a two-year term. The ninth member shall be appointed for the balance of term ending December 31, 1978. Thereafter, all terms of all appointed members shall be three years. The general members, the safety member, and the retired member shall serve on the board of investment until their current term as members of the board of retirement expires.

The board of investment shall be responsible for all investments of the retirement system.”

REFERENCE

AGENDA

SANTA BARBARA COUNTY BOARD OF RETIREMENT MEETING
WITH THE SANTA BARBARA COUNTY GRAND JURY
AUDIT AND FINANCE COMMITTEE

The purpose of this meeting is verify and report on the Board of Retirement’s compliance regarding investment oversight and the performance of fiduciary obligations to the County beneficiaries. Specifically, Article XVI Section 17 (c),(d), and (e) of the California Constitution, as well as Article 5 of the Government Code, Section 31595 (a), (b), and (c), define the fiduciary obligations of the Board of Retirement as follows:

“Article XVI Section 17:

(c) The members of the retirement board of a public pension or retirement system discharge their duties with respect to the system with the care, skill, prudence, and diligence under the circumstances then prevailing that a prudent person acting in a like capacity and familiar with these matters would use in the conduct of an enterprise of a like character and with like aims.

(d) The members of the retirement board of a public pension or retirement system shall diversify the investments of the system so as to minimize the risk of loss and to maximize the rate of return, unless under the circumstances it is clearly not prudent to do so.

(e) The retirement board of a public pension or retirement system, consistent with the exclusive fiduciary responsibilities vested in it, shall have the sole and exclusive power to provide for actuarial services in order to assure the competency of the assets of the public pension or retirement system.”

“Article 5 of the Government Code, Section 31595 (a), (b), and (c):

The board and its officers and employees shall discharge their duties with respect to the system:

(a) Solely in the interest of, and for the exclusive purposes of providing benefitsto, participants and their beneficiaries, minimizing employer contributions thereto, and defraying reasonable expenses of administering the system.

(b) With the care, skill, prudence, and diligence under the circumstances then prevailing that a prudent person acting in a like capacity and familiar with these
matters would use in the conduct of an enterprise of a like character and with like aims.

(c) Shall diversify the investments of the system so as to minimize the risk of loss

And to maximize the rate of return, unless under the circumstances it is clearly prudent not to do so.”

The Audit and Finance Committee of the Santa Barbara Grand Jury would like the Board of Retirement to demonstrate, in detail, compliance with each of the preceding requirements. Please provide any relevant documentation and/or sources of documentation.

In addition, Government Code Section 31520.2 is the enabling Legislation for creating a Board of Investments which “shall be responsible for all investments of the retirement system.” The only prerequisite is that the retirement fund must exceed $800 million dollars. Does the Board of Retirement feel it would be prudent to create a separate Board of Investment at this time?