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Attachment 4From: Phil Koen <pkoen@monteropartners.com> Sent: Tuesday, December 11, 2018 10:17 AM To: Rob Rennie; BSpector; Marcia Jensen; Marico Sayoc; Steven Leonardis; tduryea@AOL.COM; Rick Tinsley Cc: Laurel Prevetti; Stephen Conway; jak vannada Subject: Recap of Finance Committee discussion regarding the 2018 CAFR and actions items for Staff Dear Members of the Town Council and Finance Committee, Thank you for the time spent reviewing the CAFR last night. I thought the discussion was constructive. While the discussion was still fresh in my mind, I thought it might be helpful if I reinforced a number of key points regarding the statement of net position and document my specific requests regarding more disclosure in the MD&A section. Critical points regarding the Statement of Net Position and Statement of Activities • Since FY 2014, the consolidated cash position of the Town (this includes all cash held by the Town for governmental purposes but excludes an additional $5.4m held by fiduciary funds) has increased by $13.5m from $60.4m to $73.9M. During this same period of time the unfunded pension liabilities have increased $20m and now exceed $53m. The Town earns roughly 1.3% on it cash balances. The auditor specifically stated that the cash position was "very healthy" and higher than his other clients. • The auditor also pointed out that the interest expense on just the Miscellaneous Plan pension liability (refer to page 92) was $6.8m for FY 2018. While the CAFR does not report the interest expense charged for the Safety Plan, we can compute this to be approximately $1.4m. That means that the Town was charged approximately $8.2m in interest in FY 2018 on its pension liabilities. CALPERS charges interest at approximately 7.35%. The time has come to use this excess cash and pay down $10m of the unfunded pension liabilities which in turn will reduce the interest charged on the pension liability. • There is $19.2 m of deferred pension outflows recorded in statement of net position. This is offset by $3.9m of deferred pension inflows. Netting these, this means that there is $15.3m of deferred "pension expense" on the balance sheet which has yet to flow through the statement of activities. This is a timing issue and these charges will be released to the statement of activities over the next 3 to 5 years. To understand the significance of this, you should reduce the Unrestricted net position which is currently $170k by $15.3m to get a better understanding of the "true" unrestricted net position for the Town. In essence, barring some miraculous turn around in CALPERS investment performance, the Town will eventually have its entire Unrestricted Net Position wiped out. To frame this, in FY 2014 the unrestricted net position of the Town was $44.4m. • Slide 14 of the auditors presentation was eye opening. In FY 2016 the net cost of service was $20.8m. For FY 2018 it had increased to $28.8m, a staggering 38% increase in 2 years. To be very clear, this represents the total cost of all governmental activities (i.e. general government, public safety, parks and public works, etc.) net of any charges for services provided, grants and contributions. There was very limited discussion by the committee as to the cost elements that drove this $8m increase. And to be very specific, this increase is not due to an increase in capital expenditures since in the Statement of Activities cost of assets are capitalized and reported as depreciation expense. This leads to the second part of the discussion, namely the requirement to have a wholesome MD&A section in the CAFR. GASB 34 is very clear on the importance of management providing their insights of the financial results by giving readers an "objective and easily readable analysis". Specifically GASB 34 requires that "this analysis should provide users with the information they need to help them assess whether the governments financial position has improved or deteriorated as a result of the year's operations". GASB 34 does not limit in anyway the amount of disclosure nor the 1 form of disclosure. Its goal is simply to "give government officials a new and more comprehensive way to demonstrate their stewardship". Recommendations to improve the MD&A • Comparison of prior year's actuals to current years actuals in the statement of activities o There should be additional discussion regarding the $1.4m in charges for services received. What drove this? Where there increases in rates charged or just more volume? o There should be additional discussion regarding the increase in operating grants and contributions received. Are these onetime grants? How were they obtained? o There should be additional discussion regarding the specific increase in police department expenses ($1m), general government expenses ($2.4m) and parks and public works ($.5m). What were the cost drives and provide detail as to the amount. o There should be additional discussion which explains the increase in total expenses. The current explanation only discusses $1.2m of a $3.7m increase. What were the cost drivers for the additional $2.5m. • Comparison of budget and actual results in the fund balance o There should be additional discussion regarding the favorable variance in charges for services. Why was this so favorable to both the original budget and the final budget? What was the driver of this? o There should be additional discussion as to the underspending in administrative services, public safety, community development and library services. What spending which had been included in the plan did not occur and why? If it is due to lower headcount the number of heads should be disclosed. o There should be a more detail discussion as the cause of under spending in total expenditures. The explanation of "staff vacancies" should be more wholesome with a discussion of exactly how many positions were vacant and why. I would like to make one last point. It isn't easy for the average resident to understand the financial statements of the Town. They aren't accountants or trained financial professionals. Given this, it is managements responsibility to make it easy and provide to the best of their ability easy and complete explanations. That is the purpose of the MD&A. I fully understand the Staffs desire to have an approved CAFR submitted to the GFOA by December 31, 2018. The reason for this deadline is that to qualify for GFOA's annual award the CAFR must be submitted to them by year end. However, it is very important that the Town Council balance this desire for an award vs issuing a complete CAFR. Let's not let the desire to meet a deadline for an award short cut the need for a complete and transparent CAFR. Phil Koen 2 To: Honorable Mayor & Members of Los Gatos Town Council Submitted by: Terry Duryea Dated: Dec 13, 2018 As a member of the Town Council Finance Committee, I would like to share information related to the draft 2018 CAFR presented at the recent Finance Committee meeting to supplement any information Town Staff provides the Town Council The Finance Committee reviewed the CAFR at the December 10, 2018 meeting. There is a lot of good information buried in its 138 pages, but it is hard to find and interpret. There was significant discussion at the recent meeting to make the disclosures in the CAFR, particularly in the Management Discussion and Analysis, more informative and easier to understand. The Finance Committee did not approve the CAFR, but instead asked the Town Staff to makes changes as Staff felt appropriate based on the discussion at the Finance Committee meeting. The following information is from a presentation to the Finance Committee by Mr. Badawi, CPA, the Town's Auditor. I provide below my personal observation based on the information provided. All numbers are in $1,000's. Deferred Outflows and Inflows as recorded on the Town's Statement of Net Position: Deferred Outflow of Pension/ OPEB Resources -see note Deferred Inflows of Pension/ OPEB Resources- see note Net (Inflow) Outflow 2016 $ 6,648 $10,245 ($3,797) 2017 $15,666 $5,778 $ 9,888 2018 $19,177 $3,924 $15,253 Note: a Deferred Outflow from the Town's Statement of Net Position (balance sheet) will flow into the Town's Statement of Activities over the next 3 to 5 years as an expense. A Deferred Inflow will flow int( the Statement of Activities over the next 3 to 5 years as an expense reduction (or income) Observation: In the next 3 to 5 years the amount of money that will flow into the Town's statement of activities, has shifted by $19,050 from $3,797 that was going to be an expense reduction to $15,253 that will be an increased expense. Unrestricted Net Position on the Town's Statement of Net Position 2016 $12,744 2017 $15,134 2018 $ 170 Observation: If there are no other developments, events or changes in assumptions, the Deferred Outflow of $15,253 described above that will recorded as expenses over the next 3 to 5 years, will wipe out the Town's $170 positive Unrestricted Net Position, causing it to become negative by $15,083 Net Cost of Service to Tax Revenue 2016 2017 2018 Cost of Net Service $20,846 $28,789 $28,803 Tax Revenue $25,521 $28,399 $28567 Surplus (Deficit) $ 4,675 ($ 390) ($ 236) Observation: In 2016 tax revenues covered the Town's Cost of Net Services by $4,675 while in 2017 and 2018, the Town's tax revenues did not cover the Cost of Net Service. This represents a deterioration of the Town's ability to cover it Cost of Net Service with tax revenues. General Fund Expenditure Coverage -a measure of financial strength Per Mr. Badawi, CPA, this is defined as the ratio of General Fund Unrestricted Fund Balance to General Fund Total Expenditures and is measured by the number of months of coverage 2016 2017 2018 Unrestricted Fund Balance $29,574 $29,181 $30,428 Total Expenditures $36,166 $34,543 $37,104 Number of months 10 months 10 months 10 months GFOA recommendation 2-4 months Observation: The Town's Unrestricted General Fund balance is well in excess of the CFOA recommendation. Is there a better use of these funds that will improve the sustainability of the Town's quality of life? Town's Unfunded Pension Liability and OPEB Liability June 2016-(2015 measurement date) June 2017-(2016 measurement date) June 2018--(2017 measurement date) Misc Pension Plan $23,209 $27,893 $30,788 Safety Pension Plan $10,200 $19,378 $22,415 Total UAL $33,409 $49,271 $53,203 See Note Note: This amount should be reduced by $1,206 to recognize the amount transferred to the Town's Section 115 Pension Trust Fund OPEB $12,739 $13,337 $11,165 Total Unfunded Liability $46,148 $46,148 $64,368 Observation: The Town's Pension UAL has increased $19,794 ($18,588 when you include the Section 115 Pension Trust Fund) over the last 3 years at the same time the Town's has increased the pension contributions and the stock market has been very strong. I believe the Town is not doing enough to address this financial risk Observation: The Town's has chosen to pay off the OPEB UAL at a faster rate than the Pension UAL even though the OBEB is incurring interest expense at 6.75% while the Pension Plan interest rate is higher at 7.15%. As a result the Town's Pension UAL increased $19,794 ($18,588 with the Section 115 Pension Trust Fund) while the Town's OPEB UAL has decreased $1,574. I believe the money used to pay down the OPEB unfunded liability should be redirected to pay down the Pension UAL Sensitivity of Pension Plan and OPEB Plan to interest rate assumptions The Pension Plan assumes a 7.15% interest rate, the OBEP Plan assumes a 6.75% interest rate. Note: Currently, CALPERS says it expects to earn approximately 6.2% a year over the next 10 years, well below the rate of return assumed in all of the Town's pension information. A Pension Fund portfolio return of 1% less that the assumed 7.15% would increase the $53,203 UAL by $25,142 to a total of $78,346 for the combined Safety and Misc pensions. (Note: this does not include the $1,206 the Town has in the Section 115 Pension Trust Fund.) A OPEB Fund portfolio return of 1% less than the assumed 6.75% would increase the $11,165 UAL by $3,230. Observation: The return assumptions assumed in the computation of UALs understate significantly the potential obligation the Town is facing if the portfolios do not earn well above what CALPERS is currently forecasting over the next 10 years. If this happens, the obligations to fund the Town's benefit plans will consume an even larger share of the Town's operating budget than it is already forecast to consume. I believe the Town needs to do more to address the Pension UAL.