Attachment 1
PREPARED BY: STEPHEN CONWAY
FINANCE DIRECTOR
Reviewed by: Town Manager and Town Attorney
110 E. Main Street Los Gatos, CA 95030 ● 408-354-6832
www.losgatosca.gov
TOWN OF LOS GATOS
FINANCE COMMITTEE REPORT
MEETING DATE: 03/23/2017
ITEM NO: 2
ITEM NO: 11
ATTACHMENT 1
DATE: MARCH 17, 2017
TO: COUNCIL FINANCE COMMITTEE
FROM: LAUREL PREVETTI, TOWN MANAGER
SUBJECT: REVIEW, DISCUSS, AND RECOMMEND STRATEGIES FOR TOWN COUNCIL
CONSIDERATION TO ADDRESS THE CALIFORNIA PUBLIC EMPLOYEES
RETIREMENT SYSTEM PENSION AND OTHER POST-EMPLOYMENT BENEFIT
UNFUNDED LIABILITIES FOR THE TOWN OF LOS GATOS:
A. ISSUE A REQUEST FOR PROPOSAL TO BEGIN A PROCEDURE TO
ESTABLISH A SECTION 115 IRS TRUST IN THE AMOUNT OF
APPROXIMATELY $1,000,000.
B. AUTHORIZE AN ADDITIONAL DISCRETIONARY PAYMENT (LUMP
SUM) OF $650,000 TO BE PAID TO THE CALPERS PENSION TRUST.
C. AUTHORIZE AN ADDITIONAL DISCRETIONARY PAYMENT (LUMP
SUM) IN THE AMOUNT OF APPROXIMATELY $650,000 TO BE
DEPOSITED INTO THE TOWN’S OPEB PREFUNDING TRUST
ACCOUNT.
D. IMPLEMENT THROUGH THE TOWN’S BUDGET PROCESS A STRATEGY
TO PHASE IN ADVANCED DISCRETIONARY PAYMENTS IN THE FORM
OF PAYING A HIGHER THAN REQUIRED EMPLOYER CONTRIBUTION.
E. DIRECT TOWN STAFF TO EXPLORE COST SHARING FOR
PENSION/OPEB COSTS WITH TOWN EMPLOYEES AS PART OF
FUTURE COLLECTIVE BARGAINING PROCESSES.
RECOMMENDATION:
Review, discuss, and recommend strategies for Town Council consideration to address the
California Public Employees Retirement System (CalPERS) pension and Other Post-Employment
Benefit (OPEB) unfunded liabilities for the Town of Los Gatos:
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SUBJECT: CalPERS/OPEB UNFUNDED LIABILITIES
DATE: MARCH 23, 2017
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RECOMMENDATION(cont’d):
1. Authorize the Town to issue a Request for Proposal to begin a procedure to establish a
Section 115 IRS trust in the amount of approximately $1,000,000.
2. Authorize an additional discretionary payment (Lump Sum) of $650,000 to be paid to
the CalPERS pension trust.
3. Authorize an additional discretionary payment (Lump Sum) in the amount of
approximately $650,000 to be deposited into the Town’s OPEB prefunding trust
account.
4. Implement through the Town’s budget process a strategy to phase in advanced
discretionary payments in the form of paying a higher than required employer
contribution.
5. Direct Town staff to explore cost sharing for pension/OPEB costs with Town employees
as part of future collective bargaining processes.
EXECUTIVE SUMMARIES:
Unfunded long term liabilities for Town employee pension plans and Other Post-Retirement
Benefits continue to be a prominent issue with respect to the Town’s long range financial
planning and financial health. This report includes a recap of the pension plan and post-
retirement benefit plans, and a discussion of the status and history of the unfunded liabilities.
Staff identifies a number of potential strategies to address the unfunded pension and OPEB
liabilities including pros and cons of each strategy. After examining the pros and cons of each
strategy based upon principles outlined in the report, staff is recommending a comprehensive
approach to address this issue. This will be discussed with the Town Council Finance Committee
in anticipation of recommendations being brought forward to the full Town Council for
adoption on Tuesday, April 4, 2017.
BACKGROUND:
New accounting standards have dramatically impacted local government fin ancial statements
by requiring the net pension/OPEB liability (OPEB effective date is FY 2017/18) be reported as a
liability on the Town’s Statement of Net Position; thereby, reducing the Town’s financial net
position (assets in excess of liabilities). Prior to the change in accounting standards the long
term liability amounts referred to as unfunded accrued actuarial liability were not included on
the Town’s balance sheet. Annual payments for pension and OPEB costs were paid on a “pay-
as-you-go” basis, therefore no additional accrued actuarial expenses were added to Town
pension or health care costs and there was not an additional liability reported on the balance
sheet. The addition of these unfunded long term liabilities to the entity-wide financial
statements has brought these liabilities to the forefront of attention amongst public officials
and citizens nationwide.
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SUBJECT: CalPERS/OPEB UNFUNDED LIABILITIES
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DISCUSSION:
Town Plans
Town of Los Gatos permanent employees participate in the CalPERS. Sworn employees are
covered under the Safety Plan which is a pooled plan, while all other employees are covered in
the Miscellaneous Plan, which is a separate plan and non -pooled. A pooled plan was required
by California law for those agencies who had fewer than 100 active members, which was
applicable to the Town’s safety plan assets. These assets and liabilities are pooled with all other
safety plans in the State with fewer than 100 active members to provide a large, risk sharing
pool. This risk sharing dramatically reduces or eliminates large fluctuations in an employer’s
safety pension contribution rate caused by unexpected demographic events.
Depending on an employee’s position and hire date, a Town employee is included in one of the
five possible plans as follows:
Plan Miscellaneous Safety
Classic
Members
2.5% at Age 55 (Effective FY 2007/08) 3% at Age 50 (Effective FY 2001/02)
Miscellaneous
Tier 2
2% at Age 60 (Effective FY 2012/13) No Tier 2 for Safety
PEPRA Plan 2% at Age 62 (Effective Jan 1, 2013) 2.7% at Age 57 (Effective Jan 1, 2013)
Funding for the Town’s CalPERS retirement plans is supported by both employer and employee
contributions. Using current fiscal year rates these contributions are detailed below:
Plan Employee Misc. Rate Employee Safety Rate
Classic Members 8% 9%
Miscellaneous Tier 2 7% No Tier 2 Safety
PEPRA 6.75% 12.25%
Plan Employer Misc. Rates Employer Safety Rate
Classic Members 26.956% 36.18%
Miscellaneous Tier 2 26.956% No Tier 2 for Safety
PEPRA 26.956% 12.821%
The annual employer contributions are determined by actuarial valuation reports prepared by
CalPERS for each of the Town’s plans. Due to the amount of data involved, the employer rates
for FY 2016/17 are set forth in the June 30, 2014 actuarial valuation report. The latest actuarial
valuation report for June 30, 2015 set the employer contribution rates effective for FY 2017/18.
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SUBJECT: CalPERS/OPEB UNFUNDED LIABILITIES
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DISCUSSION (cont’d):
Beginning January 1, 2018, public agencies that have collectively bargained in good faith and
have completed impasse procedures (including mediation and fact finding) will have the ability
to unilaterally require classic members to pay up to 50% of the tot al normal cost of their
pension benefits. However, the employee contribution rate may only be increased up to an 8%
contribution rate for miscellaneous members and 12% contribution rate for safety members.
CalPERS Funding Review
The CalPERS retirement system is funded by three main categories: (1) CalPERS Investment
Earnings, (2) employer contributions to CalPERS, (3) employee contributions to CalPERS.
CALPERS reports that over the past twenty years every average dollar spent on public employee
pensions has been sourced from the following as of June 30, 2015
65 cents – CalPERS Investment Earnings
22 cents – Employer Contributions to CalPERS
13 cents – Employee Contributions to CalPERS
On March 8, 2017, CalPERS announced the following average returns on its investment
portfolio:
7.8% percent over the past five years
4.6% over the past ten years
6.9% over the past twenty years
Per CalPERS, the average retiree pension is $30,500 per year. The benefit paid to a retiree
varies depending upon the number of years they have worked for a CalPERS participating
government agency, the employee’s salary, and the government agency’s retirement formula.
The Town is one of over 3,000 government employers who participate in the CalPERS
retirement system.
CalPERS Pension Fund Stability Initiatives
Over the past few years CalPERS has taken steps to stabilize and improve the system’s fiscal
strength and lower future risk to the pension trust’s sustainability. The expected rate of return
on the pension fund’s investments referred to as the “discount rate” was reduced from 7.75%
to 7.5% effective FY 2014/15. In December 2016, CalPERS voted again to lower its discount rate
in steps beginning in FY 2018/19 from 7.5% to 7.0%. Lowering the discount rate impacts local
governments because with lower returns expected over time will require contribution rates to
increase to provide sufficient assets to pay benefits.
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SUBJECT: CalPERS/OPEB UNFUNDED LIABILITIES
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In November 2012, California voters passed the Public Employees’ Pension Reform Act (PEPRA)
providing that new employees hired after January 1, 2013 are required to contribute more to
their pensions and must also work longer before they can retire and begin to receive the
DISCUSSION (cont’d):
benefits promised by their employers. CalPERS announced in the four years since PEPRA
reforms were put in place that employers like the California State government have
experienced cost savings of 1.2% of payroll for miscellaneous employees and 5.1% of payroll for
safety employees.
Other Post Employment Benefits
The Town also provides cost sharing of retiree health benefits for Town employees who retire
directly from the Town under a CalPERS service or disability retirement. Similar to liabilities
incurred for pension benefits, the unfunded liability for OPEB benefits is the actuarially accrued
liabilities in excess of the actuarial value of assets set aside in the Town’s OPEB trust account
with the California Employers Retirement Benefit Trust (CERBT).
Unfunded Liability Status Pension Plan and Other Post Employment Benefits
As reported in the FY 2016/17 Mid-Year finance update, the Town’s current actuarial valuation
reports (June 30, 2015 valuation date) calculated unfunded liabilities referred to as the
Unfunded Accrued Liability as shown below:
Plan Unfunded Accrued Liability
Town Miscellaneous Pension Plan $24,507,666
Town Safety Employees Pension Plan $16,380,573
Town OPEB Plan $12,739,000
Total $53,627,239
Funded Status
The following table presents the funded status of the Town’s pension plans and OPEB plans.
This percentage represents the value of the assets in Town’s trust at the end of the fiscal year
compared against the projected benefit obligation.
Plan Funded Percentage
Town Miscellaneous Pension Plan 73.0% (06/30/15 valuation)
Town Safety Employees Pension Plan 78.2% (06/30/15 valuation
Town OPEB Plan 48.0% (6/30/17 projection)
In comparing the Town’s funded status for its plans, the average funding status for local
government pension plans across the nation is approximately 72%. Best practices for pension
plans advocate funded status goals of over 80% be maintained. At a recent mid-year review
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SUBJECT: CalPERS/OPEB UNFUNDED LIABILITIES
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Town staff presented a survey conducted by Bartel Associates with over 200 California
government clients indicating that more than half of these governments had a 0% funded OPEB
status. The Town’s projected OPEB funding level of 48% for June 30, 2017 places the Town in
the top 25% of OPEB funding levels reported by Bartel Associates over 200 California clients.
DISCUSSION (cont’d):
Origins of the Pension Unfunded Liabilities
Experts like John Bartel of Bartel Associates, a leading California actuarial consulting firm, have
pointed out in public presentations that because investment returns have provided 65% of the
retirement funds paid out to retirees the primary reason for the development of unfunded
liabilities for local government pension plans has been due to lower than expected investment
returns and not primarily due to enhanced benefits that may have been agreed to in past years
through the collective bargaining process. According to information released by CalPERS, the
Town’s pension unfunded liabilities developed because of two major market downturns since
1995. The first being the downturn in the early 2000’s related to the “dot com” stock market
bubble and the second major loss related to the global economic “Great Recession” of 2008.
Another large impact was a series of “assumption changes” made by CalPERS actuaries that
added millions of dollars to the Town’s accrued pension liabilities. These assumption changes ,
such us increasing the expected life span of retirees, among other factors increased the
expected payments made to retirees out of the trust.
Town Proactive Steps Taken to Date
The Town prudently addressed a major new unfunded liability pertaining to a “side fund”
liability created by CalPERS when state law required the Town’s safety pension plan be placed
in a state pool. Upon doing this, the Town incurred a side fund liability determined by CalPERS
for the Town’s proportionate share of pooled unfunded liabilities. On June 5, 2014 , the Town
authorized payment of the entire approximate $4.5 million side fund liability, thereby
decreasing the unfunded liabilities significantly and this is the major reason funding levels are
at 78% for the safety plan compared to 73% for the miscellaneous plan. Recently, the Town
introduced dependent cost sharing and a reimbursement cap to Medicare eligible employees
who retire on or after February 1, 2016 with estimated savings approaching $200,000 per year.
Investment Return History
One of the most critical assumptions in attaining full funding goals for the CALPERS pension
plan is the rate of return on investments in the trusts. CalPERS’ current annual rate of return
(ROR) assumption is 7.5%. Assuming this rate of return is attained, then funding of the pension
obligations would be derived 65% from investment gains and 35% from contributions. If the
7.5% rate of return is not realized, then contributions from employers and employees will have
to increase. Unfortunately, this ROR has not been achieved by CalPERS in the past two years
(2.4 % in 2015 and 0.6% in 2016) and the outlook from the investment community and
actuaries for a 7.5% annual rate of return for the near future is increasingly pessimistic. In fact,
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the average actual rates of CalPERS returns in the table below have fallen below expectations in
several time periods.
DISCUSSION (cont’d):
The CalPERS investment returns over a twenty year time period are presented below compared
against the assumed 7.5% discount rate which is presented by the solid black line on the graph.
Origin of OPEB Unfunded Liability
The origins of the OPEB unfunded liability are linked to the previously mentioned change in
accounting standards. Prior to the implementation of GASB 45 in FY 2008/09, the Town paid its
retiree health obligations on a “pay-as-you-go” basis and the annual payments equaled the
expense reported on the financial statements. With the implementation of GASB 45 in the
Town’s June 30, 2009 Comprehensive Annual Financial Report (CAFR), the Town had to
immediately report in the footnotes to its financial statements a value of $14,265,000 in
actuarial accrued liability with assets set aside for this liability as of June 30, 2009 as zero. The
Town Council prudently established an OPEB pre-funding trust and began making payments
each succeeding fiscal year to address this liability. The OPEB trust has a current balance as of
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SUBJECT: CalPERS/OPEB UNFUNDED LIABILITIES
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March 10, 2017 of approximately $10.5 million dollars set aside as plan assets to meet the
actuarial liabilities. Per the June 30, 2015 actuarial update the unfunded
actuarial accrued liability was reduced from $14.3 million upon implementation of GASB 45 in
2009 to a projected amount of $12.6 million as of June 30, 2017.
DISCUSSION (cont’d):
Comparison of CalPERS and OPEB Annual Returns
The chart below provides return comparisons for both the Town’s pension plan and its OPEB
trust. Since FY 2008/09, the average annual CalPERS return was 5.69% compared to 14.69% for
the Town’s OPEB trust. The OPEB trust has a greater degree of local control as to timing of
deposits made to the trust. As an example, staff held off on timing its placement of funds in FY
2008/09 until nearly the last day of the fiscal year thereby strategically avoiding the investment
losses sustained in the CalPERS pension trust during that fiscal year when the stock market
suffered a major collapse in the fall of 2008. The other advantage is that the Town currently
has a choice of three alternative funding strategies to choose from each fiscal year giving
greater local control of investment options.
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SUBJECT: CalPERS/OPEB UNFUNDED LIABILITIES
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DISCUSSION (cont’d):
Future Pension/OPEB Employer Cost Forecasts
As stated earlier, in December 2016 the CalPERS Board announced a plan to lower its discount
rate from its current rate of 7.5%. Effective FY2018/19 the phase-in of the discount rate change
approved by the Board is as follows:
Valuation Date Fiscal Year for Required
Contribution
Discount Rate
June 30, 2016 FY 2018/19 7.375%
June 30, 2017 FY 2019/20 7.25%
June 30, 2018 FY 2020/21 7.00%
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The immediate effect of this change is the actuarial valuation report being prepared for June
30, 2016 by CALPERS which sets the employer contribution rate for FY 2018/19 at lower
discount rate of 7.375%. This action will lead to increased actuarial accrued liabilities because
with lower expected returns there are lower projected assets to meet the expected pension
obligations. Town staff has already anticipated increases in employer contributions in its Five-
Year Financial Plan, but the rates in years three through five of the plan increased beyond staff
estimates due to the lowering of the discount rate as demonst rated in the table below:
Fiscal Year 5 Yr. Forecast
Before
CalPERS Change
to Discount Rate
5 Yr. Forecast Updated
with Dec 2016
CalPERS–Discount
Rate Change
Annual Increase
(Decrease) in
Pension Cost
FY 17/18 Employer PERS $4.9 M $4.9 M $0.0 M
FY 18/19 Employer PERS $5.4 M $5.5 M $0.1 M
FY 19/20 Employer PERS $5.8M $6.3 M $0.5 M
FY 20/21 Employer PERS $5.8M $7.0 M $1.2 M
FY 21/21 Employer PERS $5.8 M $7.5 M 1.7 M
Total $27.7 M $31.2 M $3.5 M
As illustrated in the table above, the Town’s Five-Year Financial Plan is estimated to be
impacted by approximately $3.5 million of additional costs that must be incorporated into the
Town’s annual operating budget due to the discount rate change. Forecasts including new
discount rate indicate revenue shortfalls beginning as early as FY 2018/19.
Speculations are being raised about future actions the CalPERS board may take including
potentially reducing its discount rate below the 7.0% rate target approved by the board in
December 2016. CalPERS executives pointed out in a March 2017 conference call with many
California finance officers that the CalPERS Board has adopted a Risk Mitigation policy that will
be effective in 2020 once the effect of the change of the discount rate to local governments has
DISCUSSION (cont’d):
been phased in by CalPERS. This policy will take advantage of years when returns exceed 2%
above the forecasted returns for the CalPERS investments. In those years, CalPERS will make
gradual cuts of 0.05% to 0.25% lowering the discount rate over an expected 20-year phase in to
a new target of 6.0%. This strategy would allow CalPERS expected returns to align better with
CalPERS actual returns for the next thirty years (according to Wilshire Advisors - 6.2% over the
next decade and 7.8% in following two decades). The Risk Mitigation Strategy also takes
advantage of return years above forecasts by shifting investments into less risky (less volatile)
investment instruments/categories over the same timeframe.
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Possible Strategies to Meet the Future Unfunded Pension/OPEB Challenges
Concluding that the unfunded liabilities arise chiefly out of investment returns that fail to meet
CalPERS expectations or result from CalPERS changes in assumptions, it would appear that local
government have limited opportunities to influence the balance of the unfunded liabilities as
calculated by CalPERS. However, there are opportunities/choices available that the Town can
explore to address this issue including the following:
Status Quo: Continue to make minimum annual contribution as determined by CalPERS
Annual Valuation Reports based upon an unfunded liability amortization schedule
averaging 29 years with a discount rate of 7.0%. The Town currently elects to prepay
the unfunded amortization amount. The FY 16/17 the amount was $640,223 saving
$40,223 in interest charged by CALPERS versus paying it monthly over the fiscal year.
Shorter Amortization Schedule (Fresh Start): This option would involve working with the
staff at CalPERS to establish an alternate amortization schedule, for instance amortizing
the unfunded liabilities over a 20 year period instead of a 29 to 30 year amortization
period.
Lump Sum “One-Time” Payments: Described by CalPERS as Additional Discretionary
Payments, this option involves the Town making additional payments either once
annually or making additional discretionary payments above the amounts required by
CalPERS on a monthly or a payroll cycle basis during the fiscal year.
Section 115 Pension Trust: This option would involve prefunding the pension unfunded
obligations through an IRS approved independent retirement plan administrator such as
those currently administer by Public Financial Manager (PFM), Keenan Associates, or
Public Agency Retirement Services (PARS).
General Fund Reserve for Pension/OPEB: Established in June 2016, per General Fund
Reserve Policy if year-end savings are available, $300,000 is placed into the General
Fund reserve for Pension/OPEB.
Pension Obligation Bonds (POB’s): Consider issuing taxable pension obligation bonds,
the proceeds of which would be used to make additional discretionary payments to
CalPERS or to the OPEB trust reducing the unfunded liability but also increasing the level
of Town bonded debt.
DISCUSSION (cont’d):
Employee Cost Sharing: With the passage of PEPRA, local governments are allowed to
agree to cost share the employer required contributions with their employees. There
may also be options to limit future benefits and eligibility requirements for Town
employees for the Town’s OPEB plan.
Line of Credit: This idea originates from a Southern California city forum on unfunded
liabilities. Essentially it involves using “one-time” balances such as the Town’s $4.7
million in catastrophic reserves as a funding source for additional discretionary
payments for pension or OPEB unfunded liability pay-downs. The Town would match
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the withdrawal with a bank line of credit to borrow against should the need arise for the
catastrophic reserve balances. The current borrowing rate for the line of credit is likely
to be less than the rate charged by CalPERS on the unfunded balance.
Analysis of Unfunded Liability Funding Strategies
Status Quo
Pros
Because of the somewhat arbitrary nature of CalPERS unfunded pension liability
calculations, this option gives the “minimum” payment to the CalPERS pension trust.
Preserves local control of cash assets for other discretionary Town purposes beyond the
amounts actuarially required to be paid to the pension/OPEB trust s.
Cons
If rates of return continue at historic low levels, CalPERS will be adding to the unfunded
liability an “asset loss” which is amortized at up to 7% over approximately 30 years.
Much like a home mortgage, the interest costs amortized over that per iod will be
substantially higher than the original amount of asset gain or loss. The current
amortization schedule supplied by the Town’s CalPERS actuaries indicates that the Town
would pay approximately $46.8 million in total interest costs over the 30 y ear
amortization period to bring the unfunded balance to zero.
The unfunded liability is likely to grow to higher levels with corresponding increased
amounts of required employer contributions needed to fully amortize them. This
situation has the potential to adversely impact the Town’s future operating budgets.
Shorter Amortization Schedule - “Fresh Start”
Pros
This option would shorten the current amortization schedule from 30 year s to 20 or 15
years. This option would require the Town to commit to a higher annual employer
pension payment level, much like a homeowner refinancing their home mortgage over a
15-year period from a 30-year amortization period, whereby the loan would be paid off
earlier but the monthly payments would increase from amounts paid for a 30 year
mortgage.
DISCUSSION (cont’d):
Should the Town apply for a “Fresh Start” to a 20 or 15 years amortization period, the
Town could expect annual payments to increase by an average of $1.3 million to $1.8
million to per year respectively.
Based on current data, the Town would experience total interest savings of
approximately $2.1 million on a 20-year fresh start and $10.2 million if the Town chose a
15-year amortization period.
Cons
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If the Town were to establish an alternate amortization schedule, the annual average
annual budgeted pension employer contribution is estimated to increase by $1.3 million
to $1.8 million based upon the 2015 Actuarial Valuation report data. This action would
likely require a corresponding reduction in Town funds dedicated to support operating
budget service levels to accommodate this increase in pension expense for each future
fiscal year affected.
The Fresh Start program is not flexible. Once the Town commits to the new
amortization, it cannot change to a longer period to reduce costs and balance its
budget. There may be one possible way to lengthen it again, but it would require the
Town to declare itself in a fiscal emergency.
Lump Sum “One-Time” Voluntary Payments
Pros
This option includes many different varieties of additional payment options. The Town
could elect to make an additional annual or monthly payment, or intentionally pay a
higher amount per covered payroll with the excess payment applie d to the unfunded
balance.
The Town’s additional payments are discretionary as to time and amount of payment,
providing flexibility if future circumstances allow for higher, lower or perhaps no
payments for that particular fiscal year.
Interest savings are dependent upon amount of additional payment but based on the
current staff estimates a “one-time” payment would yield the following interest savings
over the amortization period estimate:
$300,000 payment equals total interest savings of approximately $770,000
$650,000 payment equals total interest savings of approximately $1,622,000
$1,000,000 payment equals total interest savings of approximately $2,494,000
Functioning very much like a homeowner making additional mortgage principal
payments, this strategy provides flexibility and if the Town commits to a funding
strategy with regular pay-downs, the unfunded liability could be retired ahead of the
scheduled amortization period by a number of years.
DISCUSSION (cont’d):
Cons
CalPERS has advised that additional discretionary payments can only be applied against
outstanding unfunded liabilities. For instance, if the Town were to elect to pay off the
unfunded liability in its entirety and the returns over time exceeded CalPERS estimates
CalPERS would not return or credit the Town’s plan for the excess amounts paid in to the
trust.
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CalPERS has advised staff that once monies are paid into the pension trust, they are
never returned back to the Town. Future assets in excess of liabilities should they occur
will not be refunded back to the Town.
Volatility of annual returns is a major concern for lump sum payments. Because of the
aggressive nature of the CalPERS investment program, amounts paid into the pension
trust are subject to large scale downturns in the stock market. For instance, had the
Town made a large lump sum payment to CalPERS prior to the stock market crash of
2008, the amount paid in would have incurred an approximate 30% “haircut” with only
70% of the amount paid in being available to apply against the unfunded liability.
Future Town Councils may not view the discretionary payments as a priority and the
fiscal discipline to make these payments may decline as service level demands on the
operating budget increase in future budgets.
Section 115 Trust (Pension Plan)
Pros
This option would establish an Internal Revenue Service (IRS) sanctioned trust to
accumulate assets to pre-fund the unfunded liabilities in a manner similar to the Town’s
OPEB trust. The Town would make periodic payments to the trust over time, building an
asset portfolio that is irrevocably dedicated to funding pension obligations.
The trust can be set up with alternative investment objectives from the aggressive
approach used by CalPERS which could serve as a hedge against the volatility of placing
all the Town’s available funds into the CalPERS pension trust.
The Town retains local control of the trust. If a future budget year ha s fiscal difficulties,
the Town could draw monies out of this trust (recommended as a “one-time” draw) to
pay for pension expenditures, freeing other General Fund operating revenues to be
used for other expenditure categories.
Monies could be transferred out of this trust at any time with Council approval to f und
additional discretionary payments to pay down CalPERS unfunded liability.
Cons
Monies placed into the trust are irrevocable under IRS rules. The funds must be used
only for employer pension contributions. They cannot be withdrawn and used for
another governmental purpose in the future unless the unfunded liability was fully paid
and no liability existed for which the funds were placed into trust.
DISCUSSION (cont’d):
At this time, staff believes the amounts placed in the trust would not be allowed to be
factored into the Net Pension Liability under current Government Accounting Standard
Board (GASB) guidance. Staff understands that GASB is reviewing its position and may
allow it to be a direct offset against the calculated Net Pension Liability amount
disclosed in the Town’s CAFR.
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General Fund Reserve for Pension/OPEB
Pros
Established in 2016 by Town Council, the Town’s current reserve policy provides that in
years that targeted levels of contingency reserves are met, funds not to exceed
$300,000 annually shall be placed into the CalPERS /OPEB Reserve.
Funds in this reserve are available for use as a funding source for any of the strategies
approved by Town Council including additional discretionary payments, pension or
OPEB trust pre-funding.
Funds held in the reserve generate interest earnings that can be used for the Town’s
General Fund operating budget.
Cons
Though held as a committed reserve, a future Council could re-direct these reserve
funds to another governmental purpose by resolution.
Funds held in reserve are not considered irrevocable and cannot be used as a direct
offset to reduce net pension liability on the Town’s financial statements.
Pension Obligation Bonds (POB’s)
Pros
Pension Obligation Bonds are taxable bonds (meaning they carry a higher interest rate
than tax-exempt bonds) issued by the local government. The proceeds could then be
used to pay down the unfunded liability.
In the best case scenario, over the long term the interest cost of borrowing to the Town
would be lower than the total returns made in the pension trust.
Cons
The proceeds of the bonds paid into the trust may fail to earn more than the taxable
interest rate owed over the term of the bonds, causing the actual pension shortfall in
terms of debt to increase.
Pension Obligation Bonds are complex instruments that car ry considerable risk.
Issuing taxable debt to fund pension or OPEB liabilities would increase the Town’s level
of bonded debt burden, limiting potentially uses of debt capacity for other purposes and
possibly lowering the overall Town’s credit rating.
DISCUSSION (cont’d):
In January 2015 the Government Finance Officers Association (GFOA) issued a Best
Practices/Advisory recommending that state and local governments do not issue
pension obligation bond. GFOA commented, “the use of POB’s rests on the assumption
that the bond proceeds, when invested with pension assets in higher yielding asset
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classes, will be able to achieve a rate of return that is greater than the interest rate
owed over the term of the bonds. However, POB’s involve considerable inves tment risk,
making this goal very speculative. Failing to achieve the targeted rate of return burdens
the issuer with both the debt service requirements of the taxable bonds and the
unfunded liabilities that remain unmet because the investment portfolio did not
perform as anticipated.”
Employee Cost Sharing
Pros
With the passage of PEPRA, the Town’s employees are permitted to agree to cost share
the employer’s pension contributions.
Based upon budgeted salaries, if employees were to cost share 1% of the employers
required pension contribution, the Town could experience approximately $160K in
annual expenditure savings that could be directed to additional discretionary payments
to pay down the unfunded liability.
Cons
Cost sharing would require bargaining with Town employees through the collective
bargaining process and is speculative as to whether or not an agreement could be
reached between the Town and its employees.
Bank Line of Credit
Pros
This strategy essentially involves using monies set aside for contingencies such as the
Town’s General Fund catastrophic reserve to pay down the unfunded liability. At the
same time the Town would secure a bank “line of credit” for a similar amount that c ould
be advanced by the bank at the time it would be needed, should a catastrophe event
arise.
No interest debt would be paid until the bank advances funds, so cost of borrowing
other than annual costs charged by the bank to maintain the line of credit.
Cons
The line of credit could be viewed by credit analysts as additional debt limiting new debt
capacity in the future.
There is an annual financing expense that would be incurred regardless of whether
funds were advanced from the bank.
CONCLUSION AND STAFF RECOMMENDED STRATEGY:
Currently the Town has approximately $2.3 million in committed reserves available in its
General Fund to address the unfunded pension/OPEB liabilities. Based upon the review of the
potential strategies staff recommends the following principles guide the Town’s strategy going
forward:
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Volatility Experts like John Bartel of Bartel Associates have advised local government
councils in many cities that an important goal in managing the risk of the unfunded
liability is to manage the volatility of the returns on the assets in the CalPERS pension
trust.
Diversification of Risk Volatility can be mitigated by diversifying the risk amongst
various strategies and liabilities (i.e. Pension vs. OPEB) so that were an adverse event
like a major stock market correction to occur, such an event’s negative consequences to
the unfunded liability would be lessened.
Local control of the assets is important More local control of assets is preferable to less
local control over the custody and risk tolerance of the invested assets.
Based upon these principles, staff recommends the Council Finance Committee consider the
following strategy regarding the approximate $2.3 million in committed funds in the General
Fund Reserve for CalPERS/OPEB:
1. Authorize the Town to issue a Request for Proposal to begin a procedure to establish a
Section 115 IRS trust to be used to pre-fund Town pension costs using a Town defined
investment strategy. The initial deposit to the trust is recommended to be approximately
$1,000,000. Funds placed in this trust will be available to meet future pension obligations
and remain under the Town’s local control until such time as they are paid out as pension
contributions to the CalPERS pension trust. Future GASB rulings may permit these assets to
be utilized as an offset to the net pension liability as they are placed in an irrevocable trust
for that purpose.
2. Authorize an additional discretionary payment (Lump Sum) to be paid to the CalPERS
pension trust in the amount of $650,000 providing a current estimated total savings over
the unfunded liability amortization period of approximately $1,622,000 . The payment to
the CalPERS pension trust will result in a direct $650,000 reduction in the calculated pension
net liability.
3. Authorize an additional discretionary payment (Lump Sum) in the amount of approximately
$650,000 be deposited into the Town’s OPEB prefunding trust account. The advantage of
which is to achieve current estimated total interest savings of approximately $1.6 million
based upon the current OPEB discount rate of 7.25%. The payment to this trust will result
in a $650,000 reduction in the calculated net pension liability.
CONCLUSION AND STAFF RECOMMENDED STRATEGY (cont’d):
4. Implement through the Town’s budget process a strategy to phase in advanced
discretionary payments in the form of paying a higher than required employer contribution
based on the Town’s bi-weekly payroll out of the Town’s annual operating budget,
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essentially moving the Town’s contribution to a level required under a lower discount rate
than that used by CalPERS. For example, if the Town were to charge itself an employer rate
of 40.6% versus the 39.6% required CalPERS contribution for FY 2017/18 for safety plan and
29.80% versus 28.80% for miscellaneous plan, this would result in an advanced
discretionary payment of approximately $155,000 which is estimated to save total interest
in the amount of $350,000 over the amortization period.
5. Direct Town staff to explore cost sharing for pension/OPEB costs with Town employees as
part of future collective bargaining processes, and explore potential OPEB strategies such as
eligibility to enroll employees and consider plan providers with lower costs.