Title
Recommendation to Receive an Update on Pension Cost Savings Strategies and Invest General Fund Reserves Committed to Unfunded Pension Liabilities. (Finance 2410)
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To: Honorable Mayor and Members of the City Council
From: Jill Keimach, City Manager
Re: Recommendation to Receive an Update on Pension Cost Savings Strategies and Invest General Fund Reserves Committed to Unfunded Pension Liabilities
BACKGROUND
As part of the City’s Fiscal Year 2017-18 and 2018-19 Budget Workshops, City staff worked with NHA Advisors (NHA) to better predict and understand the implications of the changes implemented by the California Public Employees Retirement System (CalPERS) and the financial impact those changes would have on the City’s financial health. Specifically, NHA assisted city staff in developing pension cost projections based on major assumption changes by CalPERS, as well as other impacts attributable to CalPERS recent investment returns.
As outlined in the budget workshop on May 17, 2017, NHA estimated that the City’s Unfunded Actuarial Liability (UAL) would be growing from $215 million to approximately $290 million over a three-year period. This was based on CalPERS discount rate (assumed earnings rate) being lowered from 7.50% to 7.00% as well as the 2015/16 poor returns of 0.6%.
Pension costs have been rising steadily, and will rise rapidly over the next 5 to 10 years. As a percent of payroll, the City’s pension costs for the Miscellaneous employee plan will rise from approximately 15% to 38% by 2024/25, and from about 35% to 75% for the Safety employee plan. As shown in the graph below, pension costs are growing from 10% to over 20% of the City’s total General Fund budget, crowding out other critical projects and putting pressure on the City’s operations and fiscal health.
Over the past several years, the City has prudently set-aside $8 million of surplus reserves to commit toward a pension cost savings strategy. $3 million of this was from the 2015 budget surplus and $5 million was from 2016 and 2017 surpluses. During the discussion on May 17th, staff was tasked to explore alternatives for investing these funds, and return to the City Council with a recommendation in the Fall of 2017, to coincide with the release of the updated CalPERS actuarial report. On June 8, 2017, Council adopted a policy to set aside 50% of year end surplus above the 25% reserve policy toward pension and OPEB unfunded liabilities.
DISCUSSION
In September 2017, CalPERS released updated actuarial reports for the City’s Miscellaneous and Safety plans. The combined UAL based on those reports is $265 million and incorporates the 1st phase of discount rate reduction (7.50% to 7.375%) and the Fiscal Year 2015-16 returns of 0.6%. The 2nd and 3rd phases of the discount rate reductions will add to the UAL over the next two years, but most of that is projected to be off-set from the positive returns of 11.2% that CalPERS earned in Fiscal Year 2016-17. Overall, NHA estimates that the net increase for phases 2 and 3, if any, will be minimal.
Updated Projections: The chart below reflects the projected payments for the City over the next 30 years based on the recent valuation report. The line reflects the costs attributable to just the General Fund. As shown, costs are projected to increase from $14 million in 2018 to $17 million in 2019, $19 million in 2020, $22 million in 2021, $23 million in 2022 and $25 million in 2023. This equates to $35 million of cumulative cost increases above and beyond current 2017-18 levels (as depicted in the dotted triangle below).
Addressing Rising Pension Costs: The City has been proactive in addressing rising pension costs over the last several years, including pension reform to increase the share that employees pay (9% to 15% for Safety employees and 7% to 8.868% for Miscellaneous employees), as well as developing an OPEB/Pension policy to formalize the process for setting aside a portion of budget surpluses to commit towards pension and OPEB costs. In total, the City has either invested or committed over $18 million (above and beyond what’s required by CalPERS) towards OPEB and Pension costs since 2015.
Currently, the City has $8 million set-aside to dedicate towards pension costs and has been working diligently with NHA Advisors to evaluate options for investing the funds. While $8 million is a small piece of the $265 million UAL, it can help create cash flow savings and additional flexibility for the City. As described later in the report, it is the City’s intention to also commit to annually “buying down” this UAL debt even further to make a larger impact over time.
$8 Million Pension Contribution - OPTIONS: A short summary of the options for these funds is shown below, with a more detailed comparison on the next page.
• Do Nothing - continue investing in lower yielding investments with other General Fund reserves (currently yielding under 1.0%)
• Option 1 - CalPERS Direct Pay Down - Give money directly to CalPERS to pay down the UAL. This option directly reduces the liability and removes the payments associated with that portion paid off (assumes earnings rate of 7.25%)
• Option 2 - Section 115 Trust - Money is invested in the City of Alameda Pension Trust established by the City in March 2017
o Does not directly reduce CalPERS UAL, but will serve as offsetting asset on City’s balance sheet;
o Available to offset annual required contributions (ARC) and/or make additional contributions above what is required; and
o 0.60% annual management fee.
While both options are effective strategies to reduce pension costs, there are several differences, which are shown in the comparison table below.
Comparison of Pension Saving Strategies
A direct pay down will directly reduce the UAL with CalPERS, and the annual required payments associated with that portion (“amortization base”) of the UAL. Savings from the pay down will begin immediately (FY 2018-19) and continue through the period of time that the amortization base was scheduled for. Some of the City’s amortization bases are as short as 13 years, and others as long as 30 years. The City will also be able to record this pension liability reduction in its financial statements.
A Section 115 Trust, which the City has already set up with Public Agency Retirement Services (PARS), is a separate vehicle that is solely dedicated to funding pension costs. This is completely separate from CalPERS and thus does not directly reduce the UAL or the current payments on the UAL with CalPERS. The money is managed by Highmark Capital, and invested in one or more of the various portfolio options offered (conservative, moderate, aggressive, etc.)
Benefits of a Direct Pay-Down with CalPERS: Assuming the City used the full $8 million for a direct pay-down, the City could save between $500,000 annually (for a medium-term amortization base pay off) and $720,000 annually (for a longer-term amortization base pay off). This amount would grow at 3% a year. The shorter the amortization base paid off, the more annual savings that will be generated. Conversely, a longer amortization base pay-down will generate lower annual savings, but more cumulatively since the savings are spread out over a longer period of time. As shown in the chart below, the City would save $13.4 million by paying down a 15-year base, and $19.5 million by paying down a 26-year base.
Savings as a Result of Direct Buy-Down (via CalPERS) of UAL
It should be noted that whether or not a pay down is executed, the UAL will continue to fluctuate based on actual CalPERS returns and any assumptions changes. Thus, just because a portion of the UAL is extinguished now does not mean there won’t be an increase (or decrease) in the future. This is applicable no matter whether a pay down is executed or not.
Benefits of a Section 115 Trust: The primary benefit of a Section 115 trust is flexibility. While the funds in the Trust are “irrevocable” and must be used for pension costs, they can be used to defray annual required costs during tough budget years (reducing the amount needed from the General Fund), be used to pay down “extra UAL” if desired, or even left untouched to grow over time and used at a later date to extinguish a larger portion of the City’s UAL. Since there are an infinite number of possibilities as to how and when the City will use this money, as well as several different investment objectives that can be executed, it is impossible to “quantify” the savings differential versus the direct pay-down options.
As mentioned, the key benefit is flexibility. In terms of investment earnings, it is likely that the Section 115 will be invested less aggressively and, thus, earn less over time versus the CalPERS portfolio. This is because the City will likely need this money in the near term to help deal with the spiking pension increases over the next several years, and therefore it would be prudent to invest the funds more conservatively than some of the more aggressive longer-term portfolios that PARS offers.
Both options should (over a longer period of time) provide more interest earnings than the City would otherwise garner in the Local Agency Investment Fund (LAIF) which is the current investment vehicle for General Fund reserves.
Options and Recommended Strategy
In evaluating all the ways to allocate the $8 million in funds, NHA and staff started with the most basic three options: (1) All money to CalPERS for a pay-down (see page 3 for savings estimated); (2) All money to PARS for the Section 115 Trust and (3) A 50/50 hybrid between the two.
NHA and staff then refined the options to align with the City’s top 3 objectives: (1) maintain at least $2 million for flexibility to assist in meeting the next few years of rising pension costs; (2) immediate savings and through the next 15 years; and (3) maximizing investment returns over the long haul.
Recommendation for Council Approval: 75/25 Split + Ongoing Commitment
1. Staff is recommending allocating $2 million of the committed reserves to the Section 115 Trust, which will provide needed flexibility in the near term to deal with rising pension cost increases. The remaining $6 million would be used to pay down the UAL with CalPERS. Assuming a 15-year amortization base is paid off, annual savings will range from $540,000 to $820,000, and over $10 million saved cumulatively over 15 years.
2. Staff is also recommending an annual commitment of funds to continue “buying down” its UAL. This will allow the City to make a more substantial impact to reducing its pension costs over time. While the actual ability to commit extra funds every year will be highly dependent on actual performance and the economy, the goal would be to apply $2 million toward pension costs every year moving forward - either for a direct pay-down or to further bolster the amount in the Section 115 Trust.
The graph below depicts the benefit of applying $2 million every single year for an additional UAL pay down. As shown in the dotted line, a continued commitment to pay down the City’s UAL will provide a much more significant reduction in the City’s overall UAL costs and also lessen the severity of the peak in payments over the next 15 years.
CONCLUSION
Pension cost increases arising from growing unfunded liabilities is a problem being faced by nearly every CalPERS member across the State. The City has been proactive in recent years through pension reform (increasing employee share of costs), adoption of an OPEB and pension policy, establishment of a Section 115 Trust, and by setting aside $8 million of General Fund reserves from budget surpluses over the past three fiscal cycles. While $8 million is a significant investment, the City’s future fiscal sustainability and ability to fund critical projects will necessitate further strategies - including other cost reduction measures and/or revenue enhancements. Irrespective of these additional strategies, a commitment by the City to continue paying down its UAL or funding its Section 115 Trust in future years moving forward is a prudent strategy to help improve the City’s future fiscal sustainability.
FINANCIAL IMPACT
If the 75/25 Split recommendation is approved, the City will apply $6 million to a UAL direct pay-down with CalPERS. This is estimated to generate between $540K and $820K in annual savings over the next 15 years. Additionally, $2 million will be deposited into the City’s Section 115 Trust with PARS.
MUNICIPAL CODE/POLICY DOCUMENT CROSS REFERENCE
This action does not affect the Municipal Code.
ENVIRONMENTAL REVIEW
This action involves government fiscal activities which do not involve any commitment to any project which may result in a potentially significant physical impact on the environment and is exempt from the California Environmental Quality Act (CEQA), pursuant to CEQA Guidelines section 15378(b)(4).
RECOMMENDATION
Receive an update on pension cost savings strategies and invest General Fund Reserves committed to unfunded pension liabilities.
Respectfully submitted,
Elena Adair, Finance Director
Financial Impact section reviewed,
Elena Adair, Finance Director