MEETING DATE: 03/23/2017 ITEM NO: 2 TOWN OF LOS GATOS FINANCE COMMITTEE REPORT DATE: MARCH 17, 2017 COUNCIL FINANCE COMMITTEE

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1 TOWN OF LOS GATOS FINANCE COMMITTEE REPORT MEETING DATE: 03/23/2017 ITEM NO: 2 DATE: MARCH 17, 2017 TO: FROM: SUBJECT: COUNCIL FINANCE COMMITTEE LAUREL PREVETTI, TOWN MANAGER 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: PREPARED BY: STEPHEN CONWAY FINANCE DIRECTOR Reviewed by: Town Manager and Town Attorney 110 E. Main Street Los Gatos, CA ATTACHMENT 1

2 PAGE 2 OF 17 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, 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 postretirement 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, BACKGROUND: New accounting standards have dramatically impacted local government financial 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 payas-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.

3 PAGE 3 OF 17 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 2.5% at Age 55 (Effective FY 2007/08) 3% at Age 50 (Effective FY 2001/02) Members Miscellaneous 2% at Age 60 (Effective FY 2012/13) No Tier 2 for Safety Tier 2 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 % 36.18% Miscellaneous Tier % No Tier 2 for Safety PEPRA % % 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.

4 PAGE 4 OF 17 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 total 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, 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.

5 PAGE 5 OF 17 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 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 Town Miscellaneous Pension Plan Town Safety Employees Pension Plan Town OPEB Plan Funded Percentage 73.0% (06/30/15 valuation) 78.2% (06/30/15 valuation 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

6 PAGE 6 OF 17 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. 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 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 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,

7 PAGE 7 OF 17 the average actual rates of CalPERS returns in the table below have fallen below expectations in several time periods. 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

8 PAGE 8 OF 17 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, 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 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.

9 PAGE 9 OF 17 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 Discount Rate Contribution June 30, 2016 FY 2018/ % June 30, 2017 FY 2019/ % June 30, 2018 FY 2020/ %

10 PAGE 10 OF 17 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 demonstrated 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 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 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.

11 PAGE 11 OF 17 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. 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

12 PAGE 12 OF 17 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 trusts. 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 period 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 year 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 years 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. Cons 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.

13 PAGE 13 OF 17 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 applied 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. 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 into the trust.

14 PAGE 14 OF 17 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 has 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 Cons used for other expenditure categories. Monies could be transferred out of this trust at any time with Council approval to fund additional discretionary payments to pay down CalPERS unfunded liability. 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. 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.

15 PAGE 15 OF 17 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. Cons Funds held in the reserve generate interest earnings that can be used for the Town s General Fund operating budget. 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 Cons 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. 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 carry 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. 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

16 PAGE 16 OF 17 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 investment 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 could be advanced by the bank at the time it would be needed, should a catastrophe event Cons 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. 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:

17 PAGE 17 OF 17 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,

18 PAGE 18 OF 18 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.