AGENDA ITEM
TO: HONORABLE MAYOR
AND MEMBERS OF THE CITY COUNCIL
FROM: CARLO TOMAINO
CITY MANAGER
BY: SHARON DEL ROSARIO
ADMINISTRATIVE SERVICES OFFICER/FINANCE DIRECTOR
SUBJECT:
title
CALPERS UNFUNDED PENSION LIABILITY STRATEGY
summary
Summary:
The City Council will consider a Fresh Start pension strategy for the City’s unfunded pension liability administered through California Public Employee’s Retirement System (CalPERS) for all Miscellaneous and Sworn rate plans. The Fresh Start pension strategy would stabilize the pension plan, preserve liquidity, reduce the annual cost of payments, reduce interest costs, and shorten the term of the unfunded accrued liability (UAL).
Strategic Plan Goal(s):
Goal No. 1 Financial Stability: Ensure the City’s long-term financial stability and resilience.
recommendation
Recommendations:
1. Direct staff to enter into an agreement with CalPERS to initiate a Fresh Start alternative amortization payment schedule for the existing unfunded accrued liability (UAL) for all Miscellaneous and Sworn CalPERS rate plans.
2. Direct staff to make any additional pension payment for Fiscal Year (FY) 2023-2024 in the amount of $500,000 utilizing the PERS reserve to reduce the annual pension payment to approximately $3,778,143 according to the suggested Fresh Start payment schedule.
3. Adopt a resolution, entitled:
A RESOLUTION OF THE CITY COUNCIL OF THE CITY OF SIGNAL HILL, CALIFORNIA, AUTHORIZING A BUDGET APPROPRIATION AND AMENDING THE FISCAL YEAR 2023-24 ANNUAL OPERATING AND CAPITAL BUDGET.
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Fiscal Impact:
The initial fiscal impact is a reduction of the General Fund PERS reserve (115) in the amount of $500,000. The long-term financial impact is an estimated interest savings of $843,534 over the life of the UAL amortization schedule.
Background:
Cities across California participate in the CalPERS system, a pension and health benefits system for public employees. An integral aspect of fiscal planning for these cities is managing their unfunded accrued liability, UAL, a term that indicates a shortfall between the pension fund's assets and its obligations to retirees. The minimum required employer contribution to CalPERS is bifurcated into two primary components:
• Normal Costs: This is the cost of accruing retirement benefits for current service, which is calculated as a percentage of the payroll. This figure is dynamic and can increase when the payroll expands, due to factors such as salary raises or the hiring of additional staff. Conversely, this cost decreases when the payroll contracts, which may occur due to layoffs or salary reductions.
• UAL Payments: This component pertains to past service costs that have not been funded. Unlike normal costs, UAL payments are set as a fixed dollar amount each year. This fixed payment includes any deviations from actuarial assumptions - essentially, the difference between expected and actual experiences, such as life expectancy, wage growth, and investment returns. Additionally, this accounts for the interest that would have been earned on these funds had they been available in the pension plan's assets.
CalPERS sets an annual investment return target, which currently stands at 6.8%. This target directly influences the financial health of the retirement system and, by extension, the UAL of participating cities. When CalPERS achieves or surpasses this goal, the additional earnings can help reduce the UAL, decreasing the gap between the system's assets and owed pension benefits. Conversely, when the investment return falls short of the 6.8% benchmark, the shortfall exacerbates the UAL by increasing the deficit within the pension fund. When CalPERS does not meet its annual investment target, this puts a strain on current resources and may also compel cities to contribute more into the retirement system.
Analysis:
In recent years, the City has focused on addressing long-term financial impacts to better predict the direction of the City’s fiscal stability. In a concerted effort to stabilize the City’s long-term fiscal landscape and address ongoing and future pension liabilities, the City engaged GovInvest to conduct a comprehensive Cost Volatility Assessment. Staff’s primary objective was to devise a robust pension strategy that would not only stabilize the City's normal employer costs but also reduce the UAL. This strategy includes a multi-tiered approach comprising predictive cost modeling, evaluating pre-payment plan options, and implementing an approach to smooth the volatility of cost year over year to avoid substantial spikes in financial commitments. The assessment provided by GovInvest considers the City’s unique financial position and obligations.
Based on the latest actuarial valuation as of June 30, 2022, the City’s total financial commitment would require $68 million, with interest, to pay down the $40 million UAL. This liability represents a substantial financial commitment that requires strategic planning and thoughtful management to contain and reduce unexpected cost increases over time. The City’s employer pension costs are on an upward trajectory and projected to increase by up to 77% depending on the performance of the CalPERS investment return. As reflected below, these projections conservatively estimate an increase in the current annual payment from $3.1 million to approximately $4.5 million by the Fiscal Year 2031-2032; these higher annual payment rate would continue through Fiscal Year 2035-2036.
The chart above also reflects that the projected costs would reduce over time due to membership attrition in the Tier 1 and 2 PERS pension program as well as the increase in the number employees belonging to the Public Employees’ Public Reform Act (PEPRA) tier retirement system. Notwithstanding these long-terms changes, the City would undoubtedly experience a period of substantially increased costs that could reduce funding for other critical programs by continuing with the current payment program. Given the variability of the City’s revenue structure, which is comprised extensively of sales tax, staff does not recommend relying on CalPERS to consistently outperform its benchmark investment rate.
Policy Options for Consideration:
When conducting this analysis, one of the City’s priorities was to develop a pension stabilization plan that would preserve liquidity, reduce the annual cost of payments, reduce interest costs, and shorten the term of the UAL. In considering the City’s future financial situation relative to its retirement costs, staff identified two potential options for the City Council’s consideration. These options include continuing to make payments that adjust based on the CalPERS rate of return as noted above or making an additional discretionary payment under the CalPERS Fresh Start program.
• Option A: Status Quo - Continue with the current payment plan, adhering to CalPERS’ “Five-Year Ramp Up Direct Rate Smoothing” policy, which gradually increases the City's payments to ease budgetary impact. Although this method minimizes short-term fiscal pressure, it ultimately costs more due to the accrual of unpaid interest being added to the principal. In addition, payoff duration varies with market performance.
• Option B: Fresh Start Program - The City also has the option of implementing the CalPERS Fresh Start program to amortize the UAL over a shorter period. As discussed here and as shown below, the program would initially increase the City’s annual costs but stabilize these over a longer period of time. In addition, this option would also save interest payments and reduce the City’s overall financial liability.
To better assess the impact of increasing the City’s discretionary payment relative to the annual payments and UAL term, GovInvest analyzed three scenarios: the status quo (Option A); a scenario with a $500,000 discretionary payment (Option B); and another payment option with a $1,000,000 discretionary payment (Option C). The purpose of this exercise was to understand the potential benefits of making payments compared to the status quo and analyze the possible tradeoff between preserving liquidity against the opportunity cost of making a larger payment.
As reflected above, Option B and C, which include an additional discretionary payment, provide the City with financial benefits in terms of reducing the term of the UAL and providing interest savings compared to Option A. However, of the two options that include the additional discretionary payment (i.e., Option B and Option C), the difference between $500,000 and $1,000,000 does not provide a substantial savings to the City over the long term; there are clear diminishing returns associated with contributing a larger one-time discretionary payment.
Staff would also note that while the initial annual payments increase from approximately $3.1 million to $3.7 million starting in Fiscal Year 2024-2025, the City experiences a substantial savings in these annual payments, in Option B and C, starting in Fiscal Year 2027-2028 through Fiscal Year 2035-2036. This approach has the effect of stabilizing the City’s annual payments for approximately 10 fiscal years. In addition, revenue increases over time and net present value would reduce the percentage that the $3.7 million payment represents as a portion of the City’s General Fund operating expenditures.
Recommendation:
As noted above, staff provided GovInvest with key considerations as part of the analysis. For instance, it would not be in the City’s best interest to make a large one-time discretionary payment as this could deplete the City’s CalPERS reserve and offer nominal benefits relative to a smaller payment. In addition, the opportunity cost of making such large payments would mean the City would have fewer dollars to invest in the current market and generate a higher return on its investment portfolio. Therefore, making a one-time discretionary payment that balances the City’s desire to preserve liquidity and adjust the annual payments to a level that accommodates the City’s budget is the most pragmatic approach. Based on the analysis above, staff recommends Option B as it preserves liquidity, reduces interest, and retires the UAL at a more accelerated rate compared to Option A.
Conclusion:
As noted throughout this report, the City’s goal is to evaluate and recommend approaches that will secure its financial future in the long-term. However, it is important to remember that the UAL fluctuates with market conditions, benefits changes, and actuarial assumptions. In addition to making the proposed discretionary payment as part of the Fresh Start program, staff also recommends an annual assessment of the City’s normal costs and the overall UAL. Concurrent with this annual evaluation, the City could also contribute annually to its existing PERS Reserve to offset deviations from the projected annual payment and be in a position to make an additional contribution during the last seven to ten years of the City’s estimated remaining UAL. Implementing the recommendations above would increase the City’s opportunity to remain financially solvent for many years.
Subject to the City Council direction, staff would make the proposed $500,000 payment under the Fresh Start program from the City’s PERS Reserve and would budget the annual payment as part of the Operating Budget starting in Fiscal Year 2024-2025.
Reviewed for Fiscal Impact:
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Sharon del Rosario
Attachment(s):
A. Resolution - Budget Appropriation
B. Exhibit A - Budget Adjustment Summary