Palo Alto's financial climate remains sunny, with rising revenues fueling expanding city services, but one giant cloud continues to hover on the horizon: a $296-million bill for pension expenses.
The City Council last week held a special meeting to discuss the city's unfunded pension liabilities and made plans to consider its options for reducing the balance. The council's Finance Committee plans to delve deeper into the issue in the coming months, before it returns to the council for possible reforms.
Last week, the council heard a presentation about the scope of the problem, as well as potential solutions, from actuary John Bartel, president of Bartel Associates. In his report, Bartel recalled the recent trends and events that have sent the city's pension obligations through the roof.
Chief among them is the financial downturn of 2008, which sent investment returns plummeting for the California Public Employees' Retirement System (CalPERS), the mammoth fund that administers the pensions of Palo Alto and many other cities around the state. The majority of the unfunded liability, Bartel said, was due to low investment returns.
Demographic changes have also contributed, though to a less extent, Bartel said. People are living longer, which means more people are collecting benefits than before. Almost 60 percent of the city's contributions to employee pensions for non-public safety workers is now for retirees. In 1997, the percentage was 35 percent, Bartel said.
The city has already taken some steps since the financial crisis to change the pension formula for all of the city's labor groups so that employees now contribute more toward their pensions. Statewide, reform came in 2013, when the California Public Employees' Pension Reform Act instituted new tiers for public employees, providing lower benefits for newer workers. CalPERS is also now pursuing its own reforms, Bartel said, to account for a lower return rate and the changing demographics, an effort that he lauded.
"They are saying that the CalPERS' population not just active employees but retirees is becoming much, much more mature," Bartel said. "What this means is that investment volatility can have a very significant adverse impact on the unfunded liability and where contributions are going to go. CalPERs is in the process of trying to decide how they're going to accommodate that."
But while assuming a more modest return rate should reduce volatility, the changes are expected to increase the city's contributions to the pension funds. Even despite the recent reforms, the city has already experienced what a new report from the Administrative Services Department calls "significant pension rate increases in the last five years."
In 2011, the contribution rate for "miscellaneous workers" (those not in public safety) was 17.6 percent of salaries and the safety contribution was 24.7 percent. In the current year, the rates are 27.7 percent and 41.9 percent, respectively. The report notes that the changes in CalPERS assumptions and investment policy, along with demographic changes, "have created a growing unfunded liability for the City." Today, the $296-million bill includes $190 million for public-safety workers and $106 for the remaining workforce.
"The main point we wanted to show you here is the significant increase in the number of retirees and how the number has grown," the city's Chief Financial Officer Lalo Perez told the council. "That's the bulk of our unfunded liability and the fiasco of 2008 just made it worse."
To address the problem and lower the gap, the city has several options each with its own trade-offs. The city can pay more ahead of the required schedule thus saving on future interest costs. This can be done by exceeding the required contribution amount either every year or during surplus years. It can also contribute money into what's known as a Section 115 Trust, an irrevocable trust that is offered by two different agencies.
The trust, according to staff, would be a less risky option than contributing directly to CalPERS. At the same time, CalPERS would "likely invest the funds more aggressively and potentially attain a higher investment return than would the 115 fund managers," according to a staff report.
Another option is allocating an extra $1 million per year to close the gap sooner. If the city were to start doing that, miscellaneous contribution rates will have decreased by 1.2 percent and the unfunded liability by 2.9 percent over 10 years.
In its brief discussion, the council didn't make any commitments but agreed that the subject requires further discussion. Vice Mayor Greg Schmid cited the recent "dramatic changes" in the economy and in the demographics, and argued that the city should support more conservative assumptions about rates of return.
Councilman Pat Burt advocated for a "hybrid approach" in which the city raises its pension contributions during years in which it has surpluses.
"I'd be interested in having a minimal amount of General Fund revenue or percentage of all labor-related compensation or some amount that we'd pay every year and a supplemental amount that we'd pay on a discretionary basis when we do have surpluses," Burt said.
Staff is recommending exploring what the staff report calls a "dual approach" that uses both annual contributions to the Section 115 Trust and annual contributions to CalPERS to reduce the city's amortized payments. The council will consider these actions in the months ahead.
City Manager James Keene acknowledged that it won't be "a fast conversation unless we're going to write a $300 million check all at once."
"It's something that will unfold over the years that will have to be routinely revised," Keene said.