Is Your City Really Prepared for Rising Pension Costs?Categories: California Developments,PARS News,Pension Rate Stabilization
As published on Western City on October 1, 2020…
by Rachael Sanders, PARS Senior Manager, Consulting
and Charlie Francis, Former City Finance Director and PARS Senior Consultant
For years now, the rising costs of pensions have affected public agencies. Revenues are not keeping pace with the expenses of employee benefits and basic services, and these costs are eating away at local government budgets throughout California. In 2020, California cities have faced even more adversity due to the damaging effects of COVID-19. Similarly, pension systems like the California Public Employees Retirement System (CalPERS) have suffered in the current economic environment, realizing only a 4.7 percent return for fiscal year 2019–20, while its discount rate remains at 7 percent. Pension systems falling short of their targeted returns can mean only one thing for California cities: higher anticipated employer contributions.
City of Sausalito Case Study
The City of Sausalito considered its pension obligations very seriously and continually examined all options to reduce pension liabilities and annual costs. Consequently, Sausalito implemented policies for reform that focused on the variables that the city could control, such as not increasing benefits during the dotcom era, requiring that employees pay the employee portion of CalPERS contributions, paying off CalPERS side funds, creating new classic pension tiers in the months prior to the implementation of the Public Employees Pension Reform Act (PEPRA), keeping wage and salary growth less than actuarial assumptions, negotiating with employees to pay up to 50 percent of total employer normal costs, and similar measures.
But even all those improvements could not mitigate the rate and unfunded liability volatility from one CalPERS actuarial report to the next; there were just too many variables outside the city’s control. To stabilize rates charged to the city’s General Fund, the city’s Finance Committee looked at developing a pension funding methodology, which involved answering these questions:
- What is the desired funding target, and what is the desired timeline to achieve that target? (Though 100 percent funding would be the presumptive goal, achieving this quickly could require drastic service reductions with corresponding workforce and community impacts; thus, a balanced and thoughtful strategy was necessary.)
- Should the policy be evergreen (similar to a budget stabilization reserve policy)? It should guide staff and the council when certain parameters are met and should require action when those parameters are not met. The more conservative the policy, the more accountability it needs to include.
- What can the city afford?
- What is the most efficient use of its funding?
Based on its answers, Sausalito had to look for new tools that best aligned with its considerations. First, the city stress-tested its pension liabilities and costs, running various scenarios on discount rates, investment rates of return, wage and payroll growth, and so forth. As a result of the stress testing, Sausalito found that its long-term financial plan could afford pension charges to its General Fund in excess of the CalPERS actuarially calculated percentage of payroll and unfunded actuarial accrued liability payments without affecting current levels of service or resources. But what to do with the excess funds over and above the annual required contribution?
A Section 115 Trust provided the solution that Sausalito needed.
The Advantages of a Section 115 Trust
The city’s only prior option was to commit those additional funds to CalPERS (in excess of its annual required contributions) to reduce its unfunded liability. However, a Section 115 Trust provider received a private letter ruling from the IRS indicating that municipalities could create a separate trust to prefund their CalPERS unfunded liabilities. This would provide Sausalito with an alternative to sending funds to CalPERS that would allow for greater local control over assets and portfolio management by a registered investment advisor selected and monitored by the city, with future excess contributions transferred to CalPERS at the city’s discretion.
Sausalito realized the following benefits from this solution:
- Pension volatility risk mitigation.
- Investment flexibility.
- Opportunity to earn a greater return than the General Fund.
- Investments tailored to the city’s unique demographics.
- Oversight and local control of fund management selection and performance monitoring.
- Increased flexibility on the use of trust assets.
- Potential for a positive credit rating and investor consideration.