Grand jury urges county cities to prepare for crushing pension costs

Few budget-eating monsters weigh as heavily on the financial futures of California cities as a notably unsexy pest: pension costs. And, according to the findings of a new civil grand jury report, San Mateo County’s cities are not doing enough to incapacitate that pest before it becomes capable of wreaking Godzilla-like levels of havoc on city finances.

Pension primer

According to the report, San Mateo County’s cities offer their employees pension plans through CalPERS, the state’s public employee retirement system. Pensions are funded with a set of sources: employer contributions, which make up about 26 percent of pension money and come from cities, and by extension, taxpayers; employee contributions, which make up about 13 percent of pension money, in some cases; and CalPERS.

The bulk of pension money, about 61 percent, comes from CalPERS’ returns on its investments. The agency invests employer and employee contributions, and operates with a series of assumptions about how much it will earn back each year, plus considerations like expected inflation, salary growth, and pension recipient longevity.

When the agency’s assumptions are wrong, though, the burden falls on cities to pay for the difference, which is considered an “unfunded pension liability.”

In the past, CalPERS has assumed that its investments yield a 7.5 percent return on investment, a number some experts say is overly optimistic.

In the past three years, the agency’s net return on investment has been only 4.6 percent. Over the past 20 years, that average annual return has been 6.6 percent.

To increase the accuracy of its projections, the CalPERS board in December 2016 voted to reduce its assumed rate of return from 7.5 percent to 7 percent in phases by the 2024-25 fiscal year. It may sound like a small change, but it’s expected to double pension costs for many cities around the state.

And there’s no guarantee that CalPERS won’t reduce that assumed rate of return – called the “discount rate” – again. Consultants have told the CalPERS board it should expect a return on investment of only about 6.2 percent over the next decade, according to the report.

Unfunded pension liability is particularly hard on cities because they have to pay “amortization” costs on it, which is the principal of the amount plus interest accrued at high rates over long periods. Interest is generally set at the same percentage of CalPERS’ assumed return on investment, and repayment has generally been set over a 30-year period.

In February, the CalPERS board shortened future amortization periods to 20 years, which is expected to eventually decrease overall costs but increase annual funding requirements.

According to the report, cities already spend the majority of their pension dollars – about 60 percent – on amortization costs, of which a major part is interest, in addition to regular annual pension costs (though this breakdown varies widely in the county).

In the 2017-18 fiscal year, East Palo Alto paid a low of 38 percent of its total contribution costs for amortization, while Half Moon Bay paid a high of 79 percent. Menlo Park fell somewhere on the lower side among cities in the county, spending about 51 percent on amortization costs.

Preparing for the hit

So what can cities in the county do to prepare for soaring pension costs?

The report presents a range of policy tools cities can use to mitigate their pension obligations with a key directive: Don’t wait to make a plan.

“If cities do not address unfunded liabilities now, when will they ever be able to?” the report asks. “Now is the time for the Cities to engage their residents in the issue and, with the residents’ support, take the difficult actions necessary to secure a bright future for their communities.”

The reports cites options cities can pursue to reduce pension obligations: increase contributions to CalPERS beyond the minimum required payments, develop a pension reserve, negotiate to share pension costs with employees, shorten the “amortization” periods over which unfunded liability is paid back, make sure salary increases don’t surpass what CalPERS has assumed they will be, reduce operating costs, or find new revenue sources.

Shortening the amortization period from 30 years to 20 years could result in savings for Redwood City of $55 million or, if shortened further to a 15-year amortization period, $134 million. But cities aren’t allowed to reverse their decisions once they decide to shorten it.

Menlo Park

According to Nick Pegueros, the city’s financial and administrative services director, Menlo Park has already taken a series of proactive steps to mitigate its future pension costs.

But costs are still expected to rise substantially, with projections indicating the city can expect to pay $11.2 million for pension costs by the 2024-25 fiscal year, up from $5.7 million in 2017-18. That’s an increase in average cost of about 13.7 percent a year between now and then.

Pegueros explained that the city has negotiated a cost-sharing program with nonsafety city employees, or everyone except the police department, which requires the employees to pay half of the city’s future pension cost increases. For nonsafety personnel, after employee cost sharing, the city’s contribution is projected to be approximately 25 percent of employee payroll in the 2027-28 fiscal year, up from approximately 18 percent in the 2016-17 fiscal year.

For safety personnel, the expected contribution will be higher, and is currently projected to be 57.5 percent of safety payroll in 2027-28, up from 29.3 percent in 2016-17.

The city has also created a strategic pension reserve fund. Since the time the grand jury report was compiled earlier this year, the City Council has added $1 million to that fund, bringing its total to about $4.2 million, or a reserve of about nine months’ worth of current pension costs.

Other cities have put pension reserve dollars into a restricted pension trust, called a “Section 115 trust,” which could boost the city’s rate of return on investment from its current 1 percent to 4 percent but would limit how the funds can be used. Redwood City, Burlingame and Brisbane have Section 115 trusts to address pension costs.

Changes ahead?

Some statewide pension reform has occurred in recent years, and more could be on the way.

A 2013 state law called the California Public Employees Pension Act, or PEPRA, curbed pension benefits for public employees hired after 2013, created salary caps used to calculate pensions, and disallowed certain loopholes that enabled public employees to boost their pension incomes, such as “spiking” their salaries by reporting overtime, bonuses, severance or unused vacation or sick leave. Whether some of those provisions can apply to people hired before PEPRA passed is pending review in a couple of cases brought to the California Supreme Court.

CalPERS has also promised to lower the amortization period to 20 years, from 30 years.

Other things that could be done to ease pension burdens on cities appear not to be options right now, the report says; they include renegotiating pension formulas for employees, creating a defined contribution pension plan