Palo Alto's ticking time bomb
Employee pensions are helping fuel fiscal crisis
In 2007, the year Warren Buffett famously described public pensions as a time bomb with a long fuse, Palo Alto officials decided to add a little gunpowder to the city's benefits package.
The economy was booming, real-estate prices were surging and the council decided that the time was ripe to improve the pension benefit for employees represented by the Service Employees International Union (SEIU), about half the city's workforce. The rapidly rising cost of health care was of greater concern to city officials, who sought to switch the SEIU workers to a less generous health care plan. In exchange, the city offered to bump up the union's pension formula from "2 percent at 55" (that is, 2 percent of the employee's highest salary multiplied by the number of years worked before retirement at 55) to "2.7 percent at 55."
But Buffett's aphorism notwithstanding, the fuse on Palo Alto's time bomb wasn't particularly long. In 2008, as the stock market began to plummet and real-estate investments started to tank, city leaders realized that the city's generous pension packages — a lasting legacy of the pre-recession era — could not be sustained. The following year, they launched the period of unraveling that continues to this day and that is set to take center stage in the coming months, as the city tries to formulate a broader strategy for containing out-of-control benefit expenditures.
Some progress has already been made. In 2009, after loud protests, heated negotiations and a one-day strike by SEIU workers, Palo Alto became the first city in the region to implement a second pension tier for new employees, one with a less lucrative formula. Last year, the city's firefighters accepted a second pension tier as part of a new union contract, and in May, after nine months of negotiations, police officers followed suit.
But even with these changes, the fuse continues to burn at an accelerating clip. In 2002 and 2003, the city's pension expenditures were $3.8 million and $2.4 million, respectively. Since 2008, annual expenditures have consistently hovered around $20 million. The budget for 2013, which the City Council adopted last month, projects $23.1 million in pension costs. And with investments by California Public Employees' Retirement System (CalPERS) running far below projections this year, City Manager James Keene expects expenses to continue to grow in the coming years, he said in a recent interview.
The issue of pensions rarely strays far from the dais at City Hall — except during the spring when the council considers its annual budget. Increasingly, employee compensation is taking up a greater share of the budget, leaving the council and staff with less to fund city programs and services. This year, financial pressures prompted officials to propose outsourcing the city's popular animal-services operation in order to save roughly $500,000 a year. The city ultimately elected to keep the service in-house, but staff is now scrambling to find savings of $470,000.
Staff compensation now makes up about 63 percent of the General Fund. The benefits share has grown particularly fast in recent years. In 2002, the proportion of dollars spent on employee benefits to salaries was 23 percent. That ratio went up to 54 percent in 2010 and to 63 percent by fiscal year 2012.
Health care expenses jumped from about $10 million in 2002 to a projected $24 million in fiscal year 2013, which began July 1. They are expected to approach $30 million in two years. Pensions, meanwhile, jumped from $3.8 million in 2002 to $23.9 million in 2012. In 10 years, employee benefit costs will exceed salaries, the city projects.
Vice Mayor Greg Scharff alluded to these trends at a May 7 meeting, when the council was discussing the city's long-term financial forecast. Medical and pension costs, Scharff said, "are running at an unsustainable rate and crowding out everything else." As a result, he said, the citizens of Palo Alto aren't getting a fair shake.
"What we're asking people to do is to accept a lower quality of life so that we can fund pensions and benefits that are growing at an outrageous pace," Scharff said. "I don't accept that that should be the plan."
But, as city officials often acknowledge, identifying the problem is far easier than solving it. The city's annual expenditures hinge on a wide range of decisions, many of which get made in Sacramento. Palo Alto employees are among the roughly 1.6 million workers — active and retired — who participate in CalPERS, the largest pension fund in the nation.
"What we need to do is we need to basically bring down pension and medical costs, but we're really hampered in our ability to do that given state law and legacy issues and inability to change pre-existing costs for people who are retired and all sorts of issues out there like that," Scharff said.
Councilman Pat Burt echoed this sentiment and said that even under recent revisions to pension formulas, "Employees do very well."
"Retiree pension and retiree medical — that's what's blowing up the budget," Burt said.
He cited the "3 percent at 55" pension formula recently adopted by public-safety employees and the fact that all employees still get 90 percent of their families' medical coverage paid for by the city. Salaries may remain frozen or get trimmed, Burt said, but Palo Alto's benefits remain extremely lucrative.
"There's potential that they won't be getting a fair shake on salaries, but even new employees get a very fair shake on pension and benefits," Burt said. "On the benefit side, new employees still do very well."
Now, Scharff, Burt, Councilman Greg Schmid and Councilwoman Karen Holman hope to launch a broader discussion on reforming employee benefits. Last week, they released a colleagues' memo that calls for the city to come up with a "benefits strategy" that would guide future reforms. In the memo, they note that the cost of employee benefits and pensions "has risen dramatically for the City of Palo Alto, reducing the funds available for our community's necessary and valued services and infrastructure." They recommend the city work with employees to come up with solutions to the pension problem with the the goal of "building a modern, flexible workplace environment for Palo Alto City employees while also assuring sustainable costs for its citizens."
The council plans to launch this discussion in September.
Palo Alto employees make no secret of the fact that generous employee benefits were a major driver in their decisions to join the city's workforce.
Before a council meeting June 25, about 40 employees represented by the SEIU gathered in City Hall to address the council, which was scheduled to go into closed session to discuss the status of labor negotiations. Employees spoke about morale problems in the workforce and urged the council not to make any drastic benefit reductions.
Robert Item, an engineer in the Utilities Department, said he had previously worked as a consultant in the private sector.
"The (ctiy's) benefits were something I haven't seen in the private sector," Item said, explaining his decision to make the switch.
Palo Alto isn't unique in this regard. A March report from the Santa Clara Grand Jury noted that private-sector employees typically contribute more than 50 percent of the total cost toward their own pensions — 50 percent in the case of Social Security and an even greater share in the case of 401K plans. The generous benefits offered by cities are intended to counterbalance the higher salaries in the private sector.
"Cities reported that they felt compelled to enhance benefits to attract and retain the best work force possible," the Grand Jury wrote.
But benefits have been particularly generous in Palo Alto, where the city has until recently footed the entire bill for employee pensions, including the employees' share. The city has also traditionally paid employees' entire medical costs — a perk that's generally unheard of in the private sector. Only in the last three years did it start asking workers to chip in — a proposal that has been particularly unpopular among unions.
When it comes to pensions, veterans of the city's Police and Fire departments have done especially well. Former Police Chief Lynne Johnson, who retired in late 2009 after making comments that many interpreted as an endorsement of racial profiling, led all local retirees with a pension of $201,953 in fiscal year 2012, according to documents the Weekly obtained from CalPERS through a Public Records Act request. Former Fire Chief Nick Marinaro, who retired in 2010 under more amicable circumstances, drew a pension of $166,157.
But high pension payments aren't restricted to police officers and firefighters. The list of Palo Alto retirees getting hefty pension payments include Richard James, former director of the Community Services Department ($178,681), and William Miks, former manager of the city's water-quality control plant ($176,067). Frank Benest, the former city manager under whose watch the city bumped up the pension formulas for its labor unions, received $193, 351, second only to Johnson.
To be sure, most Palo Alto retirees make far less than that. Many midlevel managers draw pensions in the $65,000 to $70,000 range. A retired arborist received a $55,718 pension in 2012, while a former manager in the Community Services Department got $70,728.
But six-digit pension payments, while uncommon, aren't exactly rare. The list of 954 Palo Alto retirees who received CalPERS funds in 2012 includes 88 who received pensions greater than $100,000 in 2012. The Santa Clara County Grand Jury also noted in its report on pensions that the average pension for public-safety employees in Palo Alto retiring between the ages of 51 and 54 with 30 years of service is $108,000.
The pension problem is further compounded by the city's massive health care liability for retirees. According to the Grand Jury report, the city's pension liabilities totaled $153.9 million and its health care liabilities are $105 million — for a total of $259 million. Palo Alto's debt per resident was calculated at $4,021, higher than in any other city in the county (San Jose was a distant second with $3,320).
The problem of benefit costs isn't limited to Palo Alto or, for that matter, to California. Ever since the Great Recession hit, states across the country have been grappling with the fact that they can no longer honor the promises they made to their workers during better times.
A new study by the Pew Center on States, which surveyed financial data from 2010, found 49 states with liabilities in their pension funds (Wisconsin is the lone exception). The problem was particularly glaring in Illinois, Rhode Island, Connecticut and Kentucky, where pension plans were underfunded by about 50 percent. California pension plans were 78 percent funded in 2010, with a $112 billion funding gap, Pew reported.
Many states have taken steps to address this growing problem. Twenty-three states have both increased employee contributions and reduced benefits, a recent study by the federal Government Accountability Office found.
California's pension pains are exacerbated by how CalPERS' pension plans are structured. The fund operates under a "defined benefits" plan, which guarantees each participating employee a certain pension sum, thereby forcing employers to constantly revise their contributions to CalPERS based on the pension fund's returns on investment, known in industry parlance as "discount rates." The private sector, by contrast, uses the "defined contribution" model under which payments to the fund are constant but the pension amount ultimately depends on investment performance.
Under this system, workers in Palo Alto and elsewhere are guaranteed their pension payments regardless of CalPERS' investment performance. The city's contributions, which support the guaranteed payments, thus ebb and flow with the economic tides (lately, it's been mostly flow).
A recent report by the Santa Clara County Grand Jury urges public agencies to switch from the defined-benefit to the defined-contribution plans, in which "costs are predictable and therefore more manageable by the cities." Three states — Georgia, Michigan and Utah — have shifted since 2008 from defined-benefit plans to "hybrid" plans that "shift some investment risk to new employees," according to the Government Accountability Office report.
California Gov. Jerry Brown is trying to take a similar approach. His 12-point plan, which includes such reforms as second pension tiers for new employees and a 50-50 split between employer and employee contributions, also calls for a "hybrid" approach that includes both a defined-benefit and a defined-contribution component.
Rising pension obligations have already helped to push some cities to the brink of insolvency or, in some cases, beyond. When Vallejo declared bankruptcy in 2008, it had a $195 million unfunded pension obligation, the Grand Jury report notes (the bankruptcy, from which the Vallejo finally emerged in 2011, allowed the city to renegotiate its employee contracts and led to a reduction of pension and health care benefits). Stockton embarked on a similar path in late June when it passed a budget with a $26 million hole and became the largest city in the nation's history to file for Chapter 9 protection. The Grand Jury report notes that Stockton had less than 70 cents set aside for every dollar of pension benefits its worker are owed.
Other California cities have pushed through aggressive pension reforms in an effort to avoid similar fates. In June, San Diego and San Jose both passed major pension-reform measures with overwhelming support from voters. The San Jose measure gives city workers a choice between accepting a less lucrative pension plan and increasing their pension contributions to 13 percent (employee contributions currently range from 5 to 11 percent). The San Diego measure goes a step further and creates a 401K-like pension system for new employees, with the exception of police officers.
So far, Palo Alto's pension reforms have been relatively modest. The city's new contract with the police union raises the retirement age for collecting pensions by shifting new employees from a "3 percent at 50" formula to "3 percent at 55."
It also changes the way pensions are calculated. They used to be based on a single year of highest salary; now they're based on the average of three consecutive years with highest salaries. The reform addresses the problem of pension spiking, when an employee cashes in on unused vacation and sick days and pulls extra overtime in his final year to increase his "highest salary" and bump up his pension payments.
The city is also now asking its workers to fund the entire employee share of the CalPERS contribution. In the case of the police union — the latest labor group to agree to a contract — this comprises 9 percent of the total pension contribution. Other employee groups will soon be asked likewise to pick up the full share of employees' CalPERS costs, Keene said in a recent interview.
"In our current negotiations with the SEIU, one of our fundamental components is having them pick up that remaining 2.75 percent gap and paying the full employee share," Keene said. "We'll be working with the management-and-professionals group to have them move in that direction, too."
While state policies and economic trends have fueled Palo Alto's pension crisis, some of the wounds have been self-inflicted. In 2001, the city increased pension benefits for public safety workers by 50 percent, effective retroactively. Then came the 2007 agreement with SEIU, which resulted in a 35 percent lifetime benefit increase for employees. The city's newly passed budget points to these "large retroactive benefit increases" as a major reason for why "pension costs have skyrocketed (and will continue to grow)."
At the time, the city saw the increase in pension benefits as a reasonable exchange for a less generous health care plan. The average monthly health care cost per employee had jumped from $734 in 2004 to $1,009 in 2008 (it is projected to be $1,230 in fiscal year 2013).
"The City is balancing its risk between medical and pension costs by capping its medical premiums while enhancing the pension plan," then-Human Resources Director Russ Carlsen wrote in October 2006. "Since CalPERS manages the pension fund (one of the largest funds in the world) and has a 9.2 percent rate of return over the last 10 years, it is a more predictable expense versus extremely volatile health care expenses, which the City has little control over."
Other cities made similar calculations and opted for "predictable" CalPERS returns. Carlsen noted in his report that nine of the 11 benchmark cities Palo Alto had looked at had similarly "improved or are in the process of improving their retirement formula beyond 2 percent at 55 within the last several years."
Since then, the pension problem has added to what was already a perfect storm of budget calamities in Palo Alto. The Great Recession took a bite out of the city's sales- and hotel- taxes, major sources of General Fund revenues. Health care costs have been rising dramatically, putting the squeeze on the budget and forcing the city to cut workforce by about 10 percent.
But while tax revenues this year returned to their pre-recession levels, the twin problems of health care and pension costs are only getting worse. At the May 7 meeting, Scharff characterized the pension problem as one the city needs to own up to.
"This isn't a calamity that happened to us. This isn't a natural disaster. This is something that we did to ourselves and that the state did to us, frankly," he said.
Now, the city hopes to reverse the trend. Last year, Scharff, Burt and Holman spearheaded a measure to eliminate the long-standing requirement of sending disputes between the city and its public-safety unions to binding arbitration. Measure D easily passed last November, with more than two-thirds of the city's voters supporting it.
The move gives the city more flexibility in labor negotiations and allows it to impose benefit reductions on unions. And while the city has already succeeded in wresting some concessions from its workers, Keene and council members have consistently maintained that employees will have to make even more sacrifices in the future.
"We really have to make moves to reduce our long-term liability in this regard," Keene said, referring to pensions and other benefits. "What that means is increasing employee contributions to those costs. We made our first moves in that area, but I see in the OPEB (other post-employment benefits) area we'll have to make continual changes in the future."
No one expects these discussions to be easy. Recent reforms have taken a toll on employee morale and have prompted dozens of veteran employees to retire. Keene said the retirements are a testament to the city's "generous pay and benefit packages that allowed people to retire quite young in life." He also said the city has been successful in attracting and recruiting "a new generation of employees who are excited about government."
But not everyone sees the changes as positive. SEIU workers told the council June 25 that they are now doing far more work for less pay relative to their counterparts in similar cities. Lynne Krug, an inspector in the Utilities Department and former chair of SEIU, Local 521, said the city is no longer retaining its top workers because of it.
"We are really doing a lot more work than we ever thought we'd be doing," Krug said. "It's exhausting."
Her colleagues concurred. The loss of experienced workers, several SEIU workers told the council, will necessarily result in a lower quality of services in Palo Alto.
Ratu Serumalani, a maintenance worker in the Community Services Department, said employees are still feeling the pain from the concessions the city forced the union to accept in 2009. City workers are struggling to pay the bills, he said. Many have retired, he said. During this period of concessions, the city lost "a lot of talent," he said.
"There will come a time when you will have no one here actually training," Serumalani said. "There's no succession plan. What you have here is the very last of the very talented."
Staff Writer Gennady Sheyner can be emailed at email@example.com.