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Mayor Edwin Lee on San Fran's pension problem and keeping Twitter in town

June 3, 2011: 11:42 AM ET

Interview by Adam Lashinsky, senior editor at large

San Francisco Mayor Edwin Lee

San Francisco Mayor Edwin Lee

FORTUNE -- One of the problems San Francisco interim Mayor Edwin Lee inherited when he took over for now Lt. Gov. Gavin Newsom was the city's underfunded pension system (see: San Francisco's Pension Smackdown). Backed by billionaire venture capitalist Michael Moritz, San Francisco Public Defender Jeff Adachi has been pressing an independent initiative to require public employees to contribute more to their pension plans. Labor unions opposed to Adachi have worked with billionaire financier Warren Hellman on a parallel proposal. On May 24, Lee announced a coalition plan supported by the unions, business groups and most of the city's board of supervisors. He discussed his plans, as well as his efforts to keep San Francisco-based Twitter from moving to the suburbs, in an interview on May 27. An unedited transcript follows.

ADAM LASHINSKY: So, Mayor Lee, San Francisco is not unique among American cities with grievous pension problems. Can you characterize what the problem is in San Francisco briefly, and then how you're attempting to deal with it?

MAYOR EDWIN LEE: Well the problem is basically that we haven't paid attention to it, and for years our pension program--well it's a modest program, it's not a very rich program, but really it came about in the 2008 stock market crash, the Lehman days, where all of our costs went up. But including when the investments didn't return, then, by law and by our agreements, the city contributions had to increase.

What we didn't do was take a close look at rules and regulations in our pension system that had been there for many, many years, where we didn't get corresponding increases in contributions from our employees, and also where there were formulas that were built in over many years, that caused a lot of the increases, so that we were looking at this year an increase of $125 million in one year just based on the pension increase cost.

ADAM LASHINSKY: And this is a fund that's approximately $16 billion in assets, a little bit less than that?

MAYOR EDWIN LEE: That's right, that's right.

ADAM LASHINSKY: And some of the formulas and things baked in that you're talking about, examples of this are overtime formulas or retirement formulas that allow certain civil servants to earn a lot of money based on what their most recent salary was when they retired?

MAYOR EDWIN LEE: That's right, so-called spiking, where an employee during the last couple of years or the last year, they'll get a higher paying job, and perhaps not really do that job for a year but get the higher pay, and then they'll retire off that--that's called pension spiking.

But a lot of other things, too. We had what we call a cost living adjustment formula that was embedded into the pension system where the retirees would get a bump. And this year was a bump of over $100 million based not on the solvency of the system, but based solely on the fact that there was one year that the fund made money, and therefore the COLA went into effect.

ADAM LASHINSKY: And this is even in a very low inflation environment...

MAYOR EDWIN LEE: Absolutely.

ADAM LASHINSKY: ...for a number of reasons, why you would not need a COLA adjustment in a year like that?

MAYOR EDWIN LEE: That's right. And it's those kinds of formulas, it's not having any mechanisms to watch health care costs go up. And even simple questions or simple challenges, like choosing generic drugs over brand name drugs, could be resulting in millions of dollars to the health care systems that we have as part of the retirement.

ADAM LASHINSKY: So what's interesting about this debate in San Francisco is that it mirrors debates that are happening in many jurisdictions throughout the country--Wisconsin and New Jersey have gotten some of the most exposure, at a state level. And yet here the protests came in the form of a politician, Jeff Adachi, who put a ballot initiative on the ballot last year, 2010, before you were mayor that was opposed by the unions and defeated. What's interesting to me is what happened next.

MAYOR EDWIN LEE: That's right. Proposition B from last November was soundly defeated, but it was also a wakeup call. Persons like Warren Hellman...

ADAM LASHINSKY: The private equity executive in San Francisco.

MAYOR EDWIN LEE: ...but we've known him and others for many years. And he had a very serious talk with us, and said, "Look, he's going to put together a ballot measure to clean this up, unless the city does something serious."

So we got together in a very serious fashion beginning last December, right after the defeat of Proposition B, and the organization, particularly labor met with the mayor's office, and actually agreed with Warren Hellman that if we didn't do our own, some form of Proposition B would come back.It might be worse, we don't know. But it would be out of their control, if you will, out of their influence.

And so we did what we basically believed would be the San Francisco tradition, what we call meet and confer. We actually started meeting, conferring among ourselves--what could we do? And we allowed something very unique: we allowed the comptroller's office and the retirement persons to come in and tell us, in actuarial terms and in numerical terms, what our challenge was and what would happen to the system if we didn't do anything. And then what would happen if we did some things, baby steps versus larger steps.

ADAM LASHINSKY: Broadly speaking, at that stage in the conversation what was the worst case scenario for San Francisco?

MAYOR EDWIN LEE: The worst case scenario was really a guess. If we did nothing and if the returns on our pension systems were as low as they are, although they're still doing pretty good.

But some of the lower numbers were to occur, if the worst case scenario, then we'd probably be looking at $300 million of additional cost, each year rising, that even to our general fund would be obligations that we would have to pay as the city contribution, without any corresponding increase of payment from the employees' side. And in addition to that we're staring at $4 billion unfunded medical costs that we weren't paying attention to, and as everybody knows medical costs have skyrocketed.

ADAM LASHINSKY: So the worst case scenario was a situation where a giant percentage of the city's budget each year would be going to pension and health care costs?

MAYOR EDWIN LEE: Yes. And that ringed very significant to not only us as city managers, but to the unions themselves. These are the very same unions whose workers' jobs would be on the line, in two ways: their own pensions would be challenged, because it wouldn't be solvent enough; but then their own jobs--we're talking about serious layoffs in general funded departments--that's specific to our health department, to our human services department, to our youth, police and fire.

ADAM LASHINSKY: So an interesting political twist in other words, that in order to satisfy obligations to city workers, city workers would be losing their jobs, if you didn't do anything?

MAYOR EDWIN LEE: That's right, and that's why the city family, as we call it, came together. The city department heads, the comptroller's office, independently elected officials came together to really figure out what we could do. And we did it in a way in which we've always done a lot of things: we talked to our unions, talked to them directly. And then we didn't talk politics.

That's a big change. We talked numbers, we talked programs, and we talked about how we can cut costs. And again, I emphasize that one of the most important things we did with the unions, is we agreed at the front end to allow the numbers to speak to us, so that the politics and the blame about whose fault was this--we didn't spend too many hours blaming each other.

ADAM LASHINSKY: Is this San Francisco tradition or the San Francisco family a function of the fact that, for all intents and purposes, there are no Republicans at the table here, there are no Tea Party activists marching on city hall and San Francisco? Was this doable because it's a Democrat on Democrat, liberal on liberal discussion.

MAYOR EDWIN LEE: Well, I think there's a few Republicans, and there might be some Tea Party activists...

ADAM LASHINSKY: I agree there are, but they don't count.

MAYOR EDWIN LEE: They don't appear in big numbers. You're absolutely right. I'm not sure that the way we did it falls much on party lines, if you will. I do think that we've always had a tradition in this city that we talk to labor. We have a tradition. And even as a department head for over 20 years, I've always felt that if you're going to change work rules, if you're going to change the way we do things--usually, as a manger, to improve them--you want to talk to the people that you're working with, so that they can go along with that.

And I've always had, as the city administrator, as the public works director, as the human rights director, and as the purchaser, all of the employees I've worked with, they always came to my viewpoint if I worked with them and showed them consequences of not doing things better.

We have had an increasing amount of demand from our constituents throughout the public, whether it's cleaning streets or getting potholes done. But we've always managed to do it better, and to do it well if we got labor involved. And then sometimes talking labor out of--it's not always an increase in staffing that does the job. Sometimes, maybe it's new methodologies, it's using technology.

It is staying the extra mile, if you will, in many cases, where people will focus on the new demands of their job and get a lot of things done in that way, knowing that there might not be a corresponding increase in their salaries or in their pension benefits.

ADAM LASHINSKY: You know, there's a fascinating political situation at play here that the rest of the country may not be aware of, which is that you were not elected by the voters of San Francisco--you're an interim mayor--and you noted that this process you've been going through is by the numbers not a political process.

MAYOR EDWIN LEE: That's right.

ADAM LASHINSKY: And I have to ask: is there something to that? Is there something to an unelected mayor that may have been critical to the success of this?

MAYOR EDWIN LEE: Well not having ever run for a public office here, I don't know the politics side of it, except by observation. Of course, I've worked for four different mayors in their administrations, and I've helped elect a couple of the mayors, in fact, but I've never really been at the heart of a political election.

So for me running the city has always been about more administrative.You take the facts, and you get the people who are stakeholders around it, and then you talk them through, and then you serve up the options. And then the options generally will let you know how far you can go and how much money you have at that time, and what you can save, and what you can do. That kind of process I'm very used to, and that's how we've approached virtually every problem that we've tried to solve, whether it's the current budget or the pension challenges.

ADAM LASHINSKY: So, we'll come back in a moment to how you solved the pension plan problem. But listening to you speak, I am a voter in San Francisco, I could see myself voting for a person like you for mayor. There is a positive whisper campaign that you should run for mayor, and you've said publicly you're not interested. Why not?

MAYOR EDWIN LEE: Well again, I think that would be a very different conversation. I mean, first of all, I've never sought the office. When I was in Hong Kong and the board of supervisors and the mayor were calling me...

ADAM LASHINSKY: You were on business, or on vacation?

MAYOR EDWIN LEE: I was on vacation. In fact, I was celebrating my re-up, my re-confirmation as city administrator for the next five years, at a higher salary I might add.

ADAM LASHINSKY: You mean a higher salary than the mayor's salary?

MAYOR EDWIN LEE: That's correct, that's correct. And I was enjoying it with my wife and two kids. And they were celebrating because the next five years--I thought then I could retire. And that will be it, and hopefully a job well done. But as we were vacationing in Hong Kong the calls were made, and they said that the other candidates, there seemed to be some issues with them, and everybody didn't have an issue with me. And they asked me to consider it.

It took me a couple days of intense discussions because I had been very resistant to being part of an elected office. It's not been part of my goals to go through politics. And I agreed on some conditions. I agreed that I wouldn't run, and I knew that that was something that the board of supervisors sought out as being very valuable. Because they wanted somebody there who knew the city, but also knew and would present the answers, hopefully, and the avenues to answers, in a non-political way. And that's been my forte, and I'm more natural in doing so...

ADAM LASHINSKY: We should explain by the way, excuse me, that the former mayor of San Francisco, Gavin Newsom, was elected Lieutenant Governor of California, which opened the position.

MAYOR EDWIN LEE: That's right. That's right. Lieutenant Governor Newsom was our mayor, he had one year left. But because of the vote for him and his success as Lieutenant Governor, he left the office a year early. And then our rules indicate that the board of supervisors would, by their vote, choose who would be the interim mayor.

ADAM LASHINSKY: Are there any circumstances under which you would change your mind and run for mayor, or would agree to serve as mayor, after your interim term is up?

MAYOR EDWIN LEE: It would be very hard. I mean, I'm not looking or even spending any time thinking about that, because I've been so busy with the five top priorities I have. Pretty much three of them were out of the way: we had the police chief that we've dealt with; we've started the America's Cup, which is extremely important to our city; I've been a big fan of Local Hire, and we've gotten that ordinance implemented. And so, two things left, was pension, and our budget. And pension was just released. And then we introduce the budget next week.

After I do the budget... I've learned through the fast moving first five months, there are so many other things that people would like me to work on. Whether it's building workforce housing or helping with our education system--there's so many things that we're challenged with, as any urban city is. And if I can help out with that, I'd be glad to.

ADAM LASHINSKY: Now, explain to me briefly, if you would, the solution that your office came up with, with labor and other interested parties, to solve the pension problem?

MAYOR EDWIN LEE: Well, on the pension side as the numbers became very clear about what we had to do, we literally had to think of ways in which we could overcome what other cities had not been able to do. And certainly if the mayor's office had dictated at the beginning a number, it would not be very welcome. I think many of the labor unions who would be affected by this challenge, might not understand why the numbers had to be.

So what we did was we introduced several scenarios and allowed enough time--we're talking way back in January when we started. We knew that this is complicated stuff. Because the pension is not simply about the amount that we contribute: it's also about formulas that have been in the works for a long time; it's about different classifications; it's about different tiers of people. So we had embarked upon a comprehensive plan, one that talked about pension spiking, as one idea, and also the obligations that new hires would have to pay that would be different than current workers.

Part of the nuance of these pensions is the deeper understanding that you're talking about rights of current employees, employees who have been in the system for a number of years. In many cases, arguably, they could be interpreted as vested right. When you're talking about people's vested rights, it never can be a one-way conversation--it has to be by some kind of an agreement.

If you ask vested right employees to pay more when they've spent a number of years anticipating a particular type of pension plan, they've got to be able to see some benefit to them, if they're going to pay more. And so we evolved with the deliberations of the union employees, and our wonderful director of human resources, a chart that allowed numbers to float. And we came up with a concept where if we, the city, was required at any given year to contribute more into the fund, then there would be a corresponding increase of contributions from the employees.

At the same time if there were great years, where our pension investments do so well, that the city contribution would be less, we would then also provide a benefit to the employees by them contributing less. Well that float, that float chart, allowed us to discuss vested rights with employees in a very positive way. They saw the benefit, they saw the challenge, and that was where we made the biggest breakthrough with current employees. Because we knew that if the current 26,000 employees didn't increase their contributions, all the other things we would do would pale in comparison to that contribution, and we wouldn't be able to make a big of a dent into the deficits that we're facing on the pension.

ADAM LASHINSKY: And now, you've said that because of this float scenario you can't have a specific number for how much money the reform will save, but you've estimated it will be between $800 million and $1 billion over a decade?

MAYOR EDWIN LEE: That is correct.

ADAM LASHINSKY: Listening to you talk about the process and contrasting with what's going on in other parts of the country, it almost sounds far too sensible and mature for a big city in the United States to have done.

MAYOR EDWIN LEE: Well, these are complicated formulas, complicated pension systems. They should never be, in my opinion, ones that are just simply pronounced by a politically elected official. I think that's been really the big lesson that we've learned here.

And the other things that we're doing--whether it's pension spiking, whether it's creating new tiers. We increased the retirement age for new hires from 62 to 65, in miscellaneous, and for our public safety from 55 to 58; we've been able to increase contributions for the new hires. When you look at all the things we're doing, then it's going to be much more than just the current pension payouts that we have to contribute to that savings. All of those would not have happened unless you have a very open dialogue, to search out every aspect of it. And then the most sensitive point, is that distinguishing from Mr. Adachi's proposal we have...

ADAM LASHINSKY: This is the public defender of San Francisco, Jeff Adachi.

MAYOR EDWIN LEE: That's right. Right. We actually have current employees and all future employees paying into a health care trust fund, for the very first time, that will start bringing down the over $4 billion of unfunded health care costs.

ADAM LASHINSKY: Now, to delve into San Francisco politics for just a moment. You have two hurdles that you still need to clear to enact this plan: it has to be voted on by the voters of San Francisco--I guess three--the largest labor union is at the table with you, but they've not signed off on it; and third, Jeff Adachi still plans to have his.

So, take the second and the third, if you will. Will you get the union that represents janitors and other workers in the city to support this? And secondly, what effect with Jeff Adachi have on this process in November?

MAYOR EDWIN LEE: The Service Employees International Union, it was very significant that they had a representative appear at our press conference announcing the pension reform. And while they couldn't say that they fully endorsed it, they also said that they didn't oppose it. So, that was very significant.

They do have an issue, and that issue has nothing to do with a pension, by their own admission and by our knowledge, it has to do with an old dispute around some labor issues that were done back in 2009, in order to rectify an imbalanced budget during those years--and they would like my participation in negotiating with them a resolution to that old problem. So, by their own admission they know this. I have that meeting set up next week. And my hope is we will find a way to resolve it in the negotiation process, and then there will be a board.

ADAM LASHINSKY: Interesting. And the public defender Adachi's plan, which he's gathering signatures for, raising money to support, and still intends to push in November?

MAYOR EDWIN LEE: Yes. Well, Mr. Adachi I've actually kept him informed all these five months, as we've met. And we've reviewed his proposals, and we know that there are some legal challenges that would easily occur in his proposals, because he hasn't done the kind of homework we've done. And in particular, with the very sensitive issue about vested rights. He has not approached his proposal in that fashion. So we know that should he be successful in getting his signatures to this ballot, that there will be some litigation surrounding his proposal.

ADAM LASHINSKY: Very briefly before we finish, I want to ask you to talk about the unusual actions that the city took to keep Twitter from moving its offices outside of San Francisco. Could you describe that a little bit?

MAYOR EDWIN LEE: Certainly. Twitter being, as many people know, one of the foremost companies, that is growing leaps and bounds, they are actually currently headquartered here in San Francisco. But their site at Fourth and Folsom is too limiting. And they have some currently about 350 workers, 65 percent of them apparently are residents of San Francisco: they bike to work and they love working there. But as I visited their office and met with the CFO and the CEO and all the engineers, they said that one of their considerations was to find larger offices for their expanded workforce, perhaps not in San Francisco--perhaps in south San Francisco, where rents would be cheaper.

ADAM LASHINSKY: And south San Francisco being outside the city lines and the county lines?

MAYOR EDWIN LEE: Absolutely. So we had the clear potential, and it was a business decision that they were making. It wasn't about the city being a bad place, at all. In fact, the city workers themselves, the employees at Twitter, said that they love the city, but they wanted me to work with their bosses to find out what we could do to keep them in here, because they love being in the city.

And as we cut to the discussion we realized that it was rent, but it was also this thing called the payroll tax. We have kind of a unique taxing system here in San Francisco where historically we've actually taxed employees' growth, and that's kind of a business punisher, if you will. If you're going to grow the employees, why would we punish that? So it's kind of a reverse psychology, and we've been under review with that idea, in the first place. But for Twitter the urgency of making a decision was immediate, in front of them.

And so as we worked together we were looking at areas where we would actually have space for them, and we looked at Mid-Market. Mid-Market is admittedly one of our very challenged areas in the city: it's Market Street from 6th to 10th Street. And it's extremely challenged because a lot of investment has not been forthcoming, there's a lot of rundown buildings, and a lot of street activities that are very challenging for business to be located.

ADAM LASHINSKY: For people watching this who may visit San Francisco as tourists, it's somewhat near Union Square, but a world away from Union Square.

MAYOR EDWIN LEE: Absolutely. Absolutely. And we combined their interests with our interests, by declaring Mid-Market to be, kind of something like a redevelopment area. But we called it an area where we can provide a tax break, so that those companies that would locate in that Mid-Market, we would then give them a six-year break from the payroll tax. And in exchange they would make all the investments to be there. And those employees that they hired in addition, only in addition to the numbers that they already had, would then be exempted from the payroll tax.

Well they have the potential, and their plans, Twitter, was to grow from 350 to 2,500 in the next three years--that's an incredible growth. But we saw the numbers, we understand why they are growing that fast, because their global attraction has been huge. And they said already that even if they were to stay, without that, they would invest their own money into building their headquarters here. So we enticed them with this proposal, the Mid-Market tax exemption proposal. And we allowed them to consider being the first anchor of perhaps a number of companies, maybe tech companies can also take advantage of this.

We presented that, we were co-sponsored with supervisor Jane Kim and supervisor David Chiu. They're some of the young best and brightest that have been recently elected to supervisors, and co-sponsoring with me on this. And we sat down with Twitter, and said, "Would that work for you?" They said, "If you pass that, we'll sign the lease, and we'll be here." And we did our share.

Two weeks ago they did their share, they signed the lease--and guess what? The Shorensteins, who bought the building that they're going in, they're spending $80 million retrofitting that building to make it seismically safe. And then on top of that Twitter is going to spend $20 million moving in to that office space, so that we get $100 million in the first couple of years before they're ramped up. That's an incredible benefit to the city.

ADAM LASHINSKY: And what's your estimate of the payroll tax that you're foregoing?

MAYOR EDWIN LEE: That will be close to about five million a year.

ADAM LASHINSKY: OK, so easy math. Five million a year over six years, versus a one-hundred million dollar investment, so far?

MAYOR EDWIN LEE: Absolutely.

ADAM LASHINSKY: It seems like a no-brainer to kill the payroll tax altogether. How long is that going to take you?

MAYOR EDWIN LEE: It will take, probably next year. In fact, we've created a tech counsel as a result of our good relations with Twitter. Companies like Zynga and others have surfaced, and we've formed a technology advisory council that represents some 30 different companies. They're all giving us good advice, and next week we're about to sign another ordinance that will exempt all of the companies from having to pay a stock options tax.

ADAM LASHINSKY: This is throughout the city?

MAYOR EDWIN LEE: Throughout the city. Yes, city-wide, and it will be for a six-year period. And that's to entice those companies that are not gone public yet. They were thinking that they would have to move outside of the city if they went public, because their stock options would be so valuable to them, to keep their very valued employees--they would then see it as a punishment if they had to pay taxes on that.

And we calculated it that we weren't that dependent upon the stock options in the first place, so we could provide at least a six-year moratorium on that while we figured out overall what to do more permanently with our payroll tax challenge, that we might put on the ballot next year.

ADAM LASHINSKY: Let me just ask again. He just want me to frame it in a form of a question, which is in addition to giving a payroll tax break in this Mid-Market area to Twitter, you're doing something just on the issue of stock options for all companies in San Francisco? Is that right?

MAYOR EDWIN LEE: That's right. So, we're one of the very few cities, perhaps not only in the Bay area or in California, or even in the country, where we actually tax stocks, stock options, as part of compensation.

ADAM LASHINSKY: I see.

MAYOR EDWIN LEE: Now, we've never really distinguished stock options; we've always taxed compensation just like any payroll tax would. But we didn't realize that stock options was something very special to the tech companies. And as they've grown, they've educated us about how valuable those stock options are. And some of them at the beginning, when they're offering it to very key employees, they're not worth much of anything. But as the value of the company increases because of the product rollout that they have, with the brilliant engineers that they hire, then those stocks become valuable over time. When they are about to be paid out, that's when they want to retain those employees the most.

ADAM LASHINSKY: Yeah.

MAYOR EDWIN LEE: And our taxing of those, when they become compensation, was viewed as a punishment to companies that had been successful. And so we thought as a matter of course that many of the companies would suffer when they went to public stock, and this changeover was when they really would hurt them. And they were then... A slew of them had informed us. And these are small companies whose names, if I tell you, you wouldn't even recognize them. But they're evolving companies, that were concerned that they would have to move out of the city in order to avoid that tax.

ADAM LASHINSKY: Although there is one very big company that is rumored to be going public soon, namely Zynga. This will have a big impact on Zynga employees--right?--not on the company?

MAYOR EDWIN LEE: Absolutely. And Zynga had just done a marvelous thing for the city: they signed a long-term lease for some 270,000 square feet, in the southern part of Mission Bay. And they are a major game developer, and we want all those game developers to be here, because they employ, again, the kind of engineers that are graduating from the wonderful Bay area schools, and these are great long-term jobs. So in an effort to save those companies from leaving, the board of supervisors worked with our office to present an exemption for the stock options.

ADAM LASHINSKY: Are you encouraging a San Francisco rivalry with Silicon Valley here? Are you saying Silicon Valley tech companies should be here?

MAYOR EDWIN LEE: Well, there's enough tech companies to go around. I know the technology companies in Silicon Valley are very large and they're very well established. In talking with Mayor Reed, as well as...

ADAM LASHINSKY: Of San Jose?

MAYOR EDWIN LEE: Of San Jose. We've always agreed there's room for everybody here in the Bay area. We're not really competing against each other at all. What we want to make sure, is that we're competing well outside the region. Whether it's Los Angeles, or Zurich, or China: we want companies to actually feel very comfortable they can be in the Bay area. And we share good transportations with each other, we share good economies with each other. So, we're not really competing with each other at all. At the same time if a company wants to move to San Francisco, we'll entice them as best as we can.

ADAM LASHINSKY: Very good. Thank you so much.

MAYOR EDWIN LEE: Thank you.

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