‘Behind the Headlines’: Palo Alto’s pension problem

Palo Alto is facing a pension and retiree medical liability that City Councilman Eric Filseth says approaches $1 billion. How is the city going to pay for it?

Hear his conversation with Palo Alto Weekly Editor Jocelyn Dong and city hall reporter Gennady Sheyner in this “Behind the Headlines” podcast, or read the transcription below.

(Due to a technical issue, this week’s episode of “Behind the Headlines” is not available in video.)

JD: This week we’re going to talk about an elephant in the room, the 1,000-pound gorilla or the biggest problem that no one wants to talk about and that’s the city’s unfunded pension liabilities. Here to unpack that for us is the chair of the Finance Committee, City Councilman Eric Filseth. Thank you for being here.

EF: Thank you very much. Pleasure to be here.

JD: Now, it’s been your goal for a little bit of time now to address this issue, to have the city get its arms around it. I was wondering if you could help us just by starting off to talk about what’s the scope of the unfunded pension liabilities over time.

EF: There’s an official number, which is calculated by CalPERS, which manages our city retirement investments and accounting. They are a statewide agency, and they do it for a lot of cities, and Palo Alto is one of them. And most people think that the CalPERS estimates are significantly lower in terms of liabilities than true liabilities, and we think that in Palo Alto. I think that.

With that as a preface, the official CalPERS number for Palo Alto’s unfunded pension and retiree medical liabilities as of a year ago, 2016 — because we’re on a year-behind accounting cycle — was about $550 million. Now, a lot of people think that the number is actually much higher than that. I believe the number is close to a billion.

JD: A billion dollars owed to the city’s employees.

EF: I think we’re close to a billion dollars. And that’s a billion dollars that we owe our current and future retirees that we don’t have money to cover. That’s basically what that number is.

JD: Does this also include retiree medical costs?

EF: Yes. The jargon is OPEB, Other Post Employment Benefits, and retiree medical costs in Palo Alto are, you know, another 30 to 40 percent higher than pension costs.

GS: I feel like the scope of the problem is so huge that a lot of residents have a hard time getting their arms around it. When you see a number like $10 million to $15 million, you can visualize a garage or something like that. But $800 million — when you consider it compared with the size of the General Fund — it’s almost abstract.

Can you explain a little why it’s important for the city to get ahead of this problem? It’s so easy to ignore it.

EF: It grows every year, right? It grows significantly every year. … It’s growing like 10 to 20 percent a year. … A real tactical issue is we have to pay a certain amount just to service it. If you have a big, big balance on your credit card — which is essentially what this is — then you have to make a minimum payment, right? Turns out that the minimum payment is now approaching 10 percent of the General Fund, and that’s just for the pension piece, not the OPEB.

It’s now getting close to 10 percent of the General Fund and it’s growing 15, 16 percent a year, which is much, much faster than any other major expense in the city and also substantially faster than city revenues, General Fund revenues, which historically have been in the 4 to 5 percent per year range. So last year they were a little bit higher, 6 percent, right? But you’re looking at a big liability growing three times as fast as city revenues, right?

Basically what it means is it crowds out our ability to pay for other kinds of services: staffing, fixing potholes in the streets and so forth. And the implication from the numbers is that, as that liability continues to grow and as the cost of servicing grows, we’re going to be increasingly unable to afford the level of services in Palo Alto to which we have become accustomed.

We’re looking at fire services this week and then the Stanford contract and so forth. But it’s not just fire services. It’s sort of all of the services we’re going to be (looking at), as we currently structure those services.

JD: This may be pretty obvious but there’s a lot of money in the General Fund every year that’s going to pay people who are retired at this point who are not contributing services — I mean, that’s kind of the definition of it. But just so people are clear, that’s a lot of money.

EF: That’s certainly a significant piece of it. I mean those are contracts we’ve entered into.

JD: Sure.

EF: And we’re making good on it.

JD: Yeah. I think there was some figure that I saw that 60 percent of the contributions into the pension fund are going to retirees at this point.

EF: That’s possible. Can I show a slide? ( SHOWS SLIDE)

So, what you’ve got here: Over the last 15 to 18 years, the green line here is the revenue to the General Fund. OK? The red line is the expenses from the General Fund, which pays for most of our city services other than utilities, right? Utilities services is a separate financial operation.

And what you can see are our revenue and expenses out of the General Fund, as accounted for, track pretty closely, so, every year, we pretty much break even in the city, which is a sound way to manage your finances.

But what it doesn’t account for is the unfunded pension liability, which is the blue line, here. And a lot of people don’t really understand this, but this problem is less than 20 years old, and it stems back to a change made under the Gray Davis administration at the turn of the millennium, which basically gave a very, very large increase to public employee benefits, that there wasn’t anyway to pay for.

And the result has been that we’ve ran up close to a billion dollars’ debt in the last 16, 17 years … which basically means the city’s spending maybe $60 million a year more than we think they are. Alright?

There’s a lot of a sort of accounting protocol and convention involved in you exactly how you relate that to revenues and expenses, but essentially it’s a significant number of understated expenses. And actually, the numbers that we show — the official number of $550 million — the big problem is that CALPERS assumes that they are going to get 7 or 7.5 percent returns. Nobody thinks that they are going to do that well. Most people think put their estimates in the 6, low 6 percent. And that is a huge difference.

GS: I was going to ask you about that because to me it’s one of the kind of difficulties in discussing pensions is that we know the number is huge but it changes, and there are so many changes and there are so many variables that it depends on the methodology that CALPERS uses and things like that, and you mentioned $550 million is official, but it could be much higher. How much higher you think it could be, and to what extent do these CALPERS assumptions affect the fluctuations?

EF: Right. So — so, again, I think the number is around $900 million today. Maybe a little bit higher than that. There are people who think it’s substantially north of that — it really depends heavily on what you assume for CALPERS investment returns and what rate you discount the liability at, right?

There are people, who have very conservative beliefs about the discount rate, that think our number’s actually much higher than that. I think it’s between 900 and abillion. I think what we need to do as a city, and it’s one of the things that the council directed the finance committee to go look at is, go figure out what the number really is.

GS:You think it’s possible?

EF: I actually do. Again, the major factor is, what is a realistic discount rate or investment return rate for CALPERS? So, about a year ago, CALPERS own consultants, Wilshire Associates, estimated that the proper discount rate, looking forward, would be about 6.2 percent. CALPERS took that data, consulted all their stakeholders and so forth, and said, “Well, we think maybe 7 percent’s a better number,” and then they gave everybody three years to get this 7 percent, plus a five-year grace period, so it’s really eight years.

The difference between 7 percent and 6.2 percent, that makes a huge difference. But I think if the city were to calculate its liabilities based on a 6.2 percent rate or somewhere in that range — it could be 6 percent, it could be 6.3 percent, it could be 5.8 percent — I think we’d come close to the actual number …. because the real issue is “What are we going to have to pay?” We’re going to need to know that before we can really get serious about a plan for how about how we’re going to address it. That’s the most important first step.

GS: Once you get past that first step, what kind of tools does the city have in its toolbox to deal with it, with such a huge number? I mean, we’re talking about an animal shelter that might cost $10 million. This is, what, 16 animal shelters or more than that?

JD: The pension liability is a contractual obligation we can’t scale that back any so the city has to come up with other means …

EF: I can tell you how agencies across the state are looking at this. … Lots and lots of cities and state agencies and counties have this problem and they’re all looking at it. I mean the levers are cut services, raise taxes, renegotiate contracts, sell off assets. I mean these are the — this is the toolkit. It’s not a huge toolkit, the ways of dealing with it.

GS: So that’s when you’re going to start getting people’s attention —

EF: Well — well, they should be aware of it now. I mean, even now, just the cost of servicing liability is in general between $15 and $20 million a year (in the General Fund, which doesn’t include utilities) and it’s going up fast, so I mean we’re already seeing — $15 to $20 million a year, growing 15 percent a year, I mean, like you said, we could buy a couple animal shelters for that.

GS: Right. Or a (parking) garage per year.

EF: Right. It’s already cutting back. It cuts away from everything we do, affordable housing, you name it. I actually personally think that this is probably the single biggest problem facing the city over the next several decades. I mean, yes, we have a lot of challenges — housing, transportation — but this just touches everything.

GS: Because if you can’t pay for these …

EF: If you can’t pay for them, exactly.

GS: And I think it’s worth pointing out that your committee has spent a lot of time digging into possible solutions. That conversation you’ll be having next week — and the prior council has also done that — some steps have already been taken. I was hoping we could go over those in terms of restructuring of contracts, and recently you guys started putting money into a trust —

EF: Section 115 trust, yup —

GS: Specifically for this problem, can we just go over some of the things the city has done in recent years to address this?

EF: So I think some of the things that we’ve done is the city has introduced new tiers of benefits for new employees, a third tier. A lot of cities — some cities only have one, a lot of cities have two — we actually have a third one. Again, I think the issue here is not wages. I think wages are — I think we pay well and we should pay well.

I think the issues are the pension benefits that are accruing liabilities. So we issued some new contracts for that, but again, we can’t touch the old contracts, so it really applies to sort of people who come forward.

GS: So when a new worker comes in they’d be in a new tier with a different pension.

EF: Now, one of the issues with the new tier is that the state introduced a set of guidelines called PEPRA (Public Employees Pension Reform Act). … Under PEPRA pensions are supposed to be fully funded, so a new employee isn’t racking up unfunded liability for the city. But unfortunately it doesn’t work because PEPRA assumed 7.5 percent or greater return. And so because the actual rate of return is very unlikely to be 7 percent, the difference gets picked up by the city.

So even a new employee that starts tomorrow is still racking up new unfunded pension liabilities in the city of Palo Alto and basically all the cities under CalPERS. San Jose, for example, is not under CalPERS and so they rejiggered their own finances differently and they’re going through a lot of hardship as I think everybody knows.

GS: And now and then you hear a suggestion, like on Town Square, “Maybe Palo Alto can ditch CalPERS.” But that creates a whole other huge obstacle.

EF: Yeah — CalPERS — they kind of don’t want people to go away from them; they’re like the Hotel California. You can check in but it’s pretty hard to check out.

GS: Yeah, you have to pay like a huge sum to get out.

EF: Yeah, I mean basically what CalPERS does is they value your liability. When they tell you how much you have to pay, they tell you, “Your liability is based on the 7 percent investment return rate.” But in order to get out of CalPERS, they want the whole thing up front, valued at the T-Bill rate, so 2.5 percent or something like that, which nobody can afford to do.

Basically, you can’t get out of CalPERS. But I actually think CalPERS as a portfolio manager is probably okay.

I think as a “managing your city finances” manager, I think that’s probably not a good situation for any city to be in, including Palo Alto.

And that’s one of the directions we have to move, so we’ll stay in CalPERS, but we have to sort of do our own accounting and our own saving, not to mention the trust. And that’s one of those elements we set up a couple of years ago. It’s called a Section 115 trust, which is a trust that you can put money in to save to pay down your unfunded liabilities, and we’ve got a few million dollars in there right now. Which is not anywhere near a billion, but it’s a start, and I think that’s one of the elements that healthy cities trying to get out from under this burden do.

JD: Getting back to your question about what else the city has done recently. The CalPERS contract was renegotiated recently, and the employees are now picking up some of the city’s contributions. Is that correct?

EF: Yes. The way these contracts are negotiated, the costs of the pensions are divided between the employer and employee. A mix of how much is picked up by employer and employee is shifting over time. To me, the delineation — as a finance person — the delineation between what percent is the city’s versus the employees — to me that one seemed always to be artificial.

It’s part of the contract and it’s in the bucket along with everything else, with vacation time and all the other issues that go ahead with the contract. The share of pension is part of the mix. It’s significant, but the delineation between employer and employee — at the end of the day, it all goes to pay the pension.

GS: I think in the past, the city picked up 100 percent of its own share and the employees’.

EF: Yes. That was the full share at 7.5 percent, plus the unfunded share — the “don’t ask don’t tell” share of what the difference was … what it would really cost, assuming it’s 6 percent.

By the way, I have another slide with an explanation of how we got into this problem. ( SHOWS CHART) What you’re looking at here is: Over the last 50 years, interest rates and CalPERS projected return rates. I think everybody knows there is a correlation between interest rates and “risky assets” return rates like stocks and real estate and stuff like that.

Stocks have to be a higher return than the T-Bill rate because the T-Bill is no risk, and if they were the same no one would buy the risky things because they’d just (get) T-Bills. But they track. They go up and down together. Certainly, those of us whose parents had adjustable rate mortgages in the ’70s , when interest rates were 15, 16, 18 percent — the interest rates and stock returns used to be a lot higher. Those were the days of oil shocks, and stagflation and Vietnam War and stuff like that.

And so what happens is in ’80s and ’90s, state agencies in California were actually running small surpluses on pensions. In about 2000, under the Gray Davis administration, Sacramento and CalPERS got together and said, “We’re making all this money, looks like we’ll have huge investment returns for the indefinite future — 8 percent, 10 percent and so forth” — and they made a deal to vastly increase the value of pension benefits based on the assumption that they’ll make these huge investment-return rates.

But what happened was that interest rates were already falling at that time. Any one looking at that should have looked and said, “Hmm, I’m not sure we can really project stock returns, real estate returns and all the other stuff CalPERS invests in. Might not be a good idea to project those things will stay high forever.” But they did and they basically doubled pensions everywhere. And then what happened since then is interest rates continued to fall, asset return rates continue to fall and what you can see here — and this is a chart from Stanford professor Jeremy Bulow — CalPERS never lowered the discount rate.

And the difference between what CalPERS projected as an investment rate and what we and all other agencies in California base our contracts on versus what they’re really making — that’s the result of basically everything you see here. It all comes back to that. It’s actually simpler than it looks.

GS: It’s wishful thinking by CalPERS on a very long-term basis, even with changing conditions, it sounds like. But I want to ask about two big-picture ways to possibly deal with the problem No. 1, the Fire Department and No. 2, Utilities. Every now and then we get comments, “Why doesn’t the city just outsource these services? Fire can go to the county, utilities can go to PG&E for most of them.” Is that something you see the council even considering in the next couple of years, as it tries to get a grip on pensions?

EF: First of all, outsourcing things doesn’t do anything about your existing commitments, but it may help you not pile up future commitments. I wouldn’t want to single out any particular agency. I would think outsourcing things is one of the tools in the toolkit.

It’s a little bit wrong-headed because in the private sector, most people outsource things they don’t consider to be their strategic core competency. Anything that’s a strategic core competency they would keep in house.

In public-sector economics, the crazy world of CalPERS, pensions and retiree benefits—it means that it pushes you to outsource stuff that you would consider to be your strategic competence in the city. It’s completely upside-down. But that’s where we are. Ultimately, there’s only so much money and we have to figure out how to use it.

GS: Sounds like the conversation must happen. It is in the toolbox.

EF: It has to be. I don’t think Palo Alto’s … Obviously there’ve been some other cities in the news, you know, that have come up with pretty drastic solutions — Stockton and so forth. I don’t think Palo Alto’s in that boat today, but if we don’t take action. we could potentially get there. These are very, very large numbers. The whole state problem maybe approaches a trillion dollars. I can’t imagine how the whole state is going to pay a trillion dollars.

You know if you read (Thomas) Piketty, every major western nation that ran up a big war debt never paid it off — they all defaulted or inflated, with one exception: Britain paying off the Napoleonic wars in the 19th century.

So if you read your Jane Austen — you’re supposed to marry someone with a big income, right, Mr. Darcy and Mr. Bingley. That’s where it went: It was invested in British government debt. They paid it off over a hundred years. Everybody else defaulted.

JD: To Gennady’s question: There was an interesting comment on Town Square related to the fire department downsizing, which was, “Is the city really charging Stanford, for example, for the pension liability (for fire personnel) or are they just paying for the salaries and other compensation?”

EF: That’s a really good question. I am not intimately familiar with the discussion with Stanford. … They are certainly not paying for the unfunded pension liability. And probably they should be. They’re not paying for the blue line (on the chart, indicating unfunded liability).

GS: Are other cities paying for the blue line when it comes to the animal shelter — Los Altos, Los Altos Hills — or the Regional Water Quality Plant, there’s various cities participating in that?

EF: No, because we don’t account for it.

GS: But it’s Palo Alto shouldering the blue line costs? Is that something you’re interested in the future asking East Palo Alto, Mountain View, others in the sewage plant (consortium) to contribute to the pensions?

EF: That’s one of the things that the council directed the finance committee to look at in its assessment of what are the numbers here. And yeah, we need to know. In fact it’s on the agenda for Tuesday — I don’t know how far we can get (in the agenda) — what are the true costs, including the unfunded liability. And yes, it applies to both to external agencies, and you’re right, Stanford’s not the only one, there are other districts we deal with.

JD: I wanted to toss one question your way: If we have an employee who is working for Palo Alto but they previously were working for the city of Mountain View, what is Palo Alto’s portion of this pension liability?

EF: It’s proportionate to how long they worked in Palo Alto versus how long they worked in Mountain View.

JD: OK, that’s pretty straightforward.

GS: So Palo Alto’s just got to marry a rich city.

EF: There is one thing that came up in the (Town Square) discussion of fire (staffing) that I thought was interesting … Some of the points of discussion, like about response time, that are of the interest in the community are being discussed in the meet-and-confer process, which is basically closed. There was some commentary that, “Geez, there are major interests of the community discussed in a closed-door environment. Is that really the right thing to do?” And I wonder about that. I think that’s something we need to think about.

JD: Nothing comes out of meet and confer? There’s no report to council?

EF: No, it’s a closed door.

GS: I would love to know what goes on in there. I totally support your opening the doors of every closed-door negotiation.

JD: So, the finance committee is going to talk about pensions this week.

EF: We’re going to talk about it this week; (and) I expect the discussion to continue. Our focus right now is we need to understand what the numbers really are. I mean, there’s a couple of variations: There’s the normal cost and interest costs.

GS: So it’s either an elephant in the room or King Kong in the room.

JD: Get out the scale and figure out what it is! Well, Eric Filseth, thank you so much for joining us for this discussion on pensions.

EF: Thank you very much for having me.