Authorization to Establish IRS Section 115 Trust Fund and Appoint the City Manager as the Plan Administrator

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1 Page 1 of 10 Office of the City Manager June 26, 2018 To: From: Honorable Mayor and Members of the City Council Dee Williams-Ridley, City Manager Submitted by: Henry Oyekanmi, Director, Finance Department Subject: Appoint the City Manager as the Plan Administrator RECOMMENDATION Adopt a Resolution appointing the City Manager as the Plan Administrator and authorizing the City Manager to take the necessary steps to negotiate and execute the documents to establish a Section 115 Trust Fund to use as a pension rate stabilizing fund, and delegate authority for managing the Section 115 Trust Fund investments. SUMMARY At the November 28, 2017 Council meeting, the City Manager was directed to bring back to Council a proposal to establish an Irrevocable Supplemental Pension Trust and other options as proposed by staff. The City wants to take steps to better manage and reduce its pension and other postemployment benefit liabilities. Until recently, the City s only option for reducing the unfunded actuarial accrued liability was to commit additional funds to CalPERS. Unfortunately, these funds would be subject to the same market volatility as the CalPERS investment policy, and the funds are not accessible to the City for other pension expenses. In the last couple of years, a private letter ruling was received from the IRS that establishes that under Section 115 of the Internal Revenue Code, public agencies or municipalities could create a separate trust to pre-fund its CalPERS unfunded liability. This will provide an alternative to sending the funds to CalPERS, and will provide greater local control over the assets and investment portfolio management. Staff conducted a research and concluded that the advantages of establishing a Section 115 Trust Fund to act as a stabilizer of the City s annual required CalPERS employer contribution rates far outweigh the disadvantages of not doing so, and enables the City to prepare for and partially offset unexpected CalPERS rate increases and CalPERS market losses. Some of the advantages of the Section 115 Trust are the following: 2180 Milvia Street, Berkeley, CA Tel: (510) TDD: (510) Fax: (510) manager@cityofberkeley.info Website:

2 Page 2 of Complete local control over the assets. The trust can be accessed at any time so long as the funds are used to pay the City s pension obligations. 2. Lower Net Pension Liability-contributions placed in the trust reduces the City s unfunded pension liability. 3. Pension Rate Stabilization-assets can be transferred to CalPERS at the City s discretion, which will help reduce or eliminate large fluctuations in employer contributions towards retirement benefits. 4. Investment Flexibility-the trust permits the City, under federal and state law, to invest in a more diversified array of appropriate investments to maximize returns on long-term investments, and reduce the City s liability. 5. Investment Management-Investment of plan assets can be managed by a professional fund management team, selected by and monitored by City staff. 6. Potential for Improved Credit Ratings-rating agencies may look favorably on actions to reduce post-employment obligations, since the City s growing pension obligations was Moody s main serious concern in its Annual Issuer Comment Report issued on May 18, The City has identified three agencies that provide professional investment advisory or management services: Public Agency Retirement Services (PARS), PFM Asset Management LLC (PFM), and Keenan. FISCAL IMPACTS OF RECOMMENDATION Merely establishing the Section 115 pension trust fund has no significant financial impact. CURRENT SITUATION AND ITS EFFECTS A League of California Cities Retirement System Sustainability Study and Findings (January 2018) revealed the following: 1. Rising pension costs will require cities over the next seven years to nearly double the percentage of their General Fund dollars they pay to CalPERS. Between FY and FY , cities dollar contributions will increase by more than 50 percent. For example, the impact would be the following for the City of Berkeley if CalPERS payments increased by 50 percent, as the League expects. Estimated Employer Contribution FY Estimate Received from CalPERS FY Based on California League of Cities Estimate Miscellaneous $ 29,388,574 $43,051,404 Police 14,571,950 22,185,095 Fire 7,326,604 11,671, For many cities, pension costs will dramatically increase to unsustainable levels; 3. Many cities face difficult choices that will be compounded in the next recession. 4. Tangible savings resulting from PEPRA will not have a substantial effect on city budgets for decades. Page 2

3 Page 3 of 10 According to the League, some things cities can do today are the following: 1. Develop and implement a plan to pay down the city s Unfunded Actuarial Liability (UAL). Possible methods include shorter amortization periods and pre-payment of cities UAL. 2. ider local ballot measures to enhance revenues. 3. Create a pension rate stabilization program: Establishing and funding a local Section 115 Trust Fund can help offset unanticipated spikes in employer contributions. 4. Change service delivery methods and levels of certain public services 5. Use procedures and transparent bargaining to increase employee pension contributions. 6. Issue a pension obligation bond (POB). However, financial experts including the Government Finance Officers Association (GFOA) strongly discourage local agencies from issuing POBs. Moreover, this approach only delays and compounds the inevitable financial impacts. This Council report deals with part of the third item listed above that can be done: establishing a local Section 115 Trust Fund to help offset future spikes in employer contributions. Staff will bring back a report on proposals for the funding of the Trust Fund at a later date. Benefits of Establishing the Post-Employments Trust Fund for pensions: 7. Complete local control over the assets. The trust can be accessed at any time so long as the funds are used to pay the City s pension obligations. 8. Lower Net Pension Liability-contributions placed in the trust reduces the City s unfunded pension liability. 9. Pension Rate Stabilization-assets can be transferred to CalPERS at the City s discretion, which will help reduce or eliminate large fluctuations in employer contributions towards retirement benefits. 10.Investment Flexibility-the trust permits the City, under federal and state law, to invest in a more diversified array of appropriate investments to maximize returns on long-term investments, and reduce the City s liability. 11.Investment Safety- the City can choose the asset allocation model it is comfortable with. CalPERS has a relatively risky asset allocation profile, which will generally produce higher investment returns, if the equity and real estate markets remain hot. 12.Investment Management-Investment of plan assets can be managed by a professional fund management team, selected by and monitored by City staff. 13.Potential for Improved Credit Ratings-rating agencies may look favorably on actions to reduce post-employment obligations. Page 3

4 Page 4 of 10 City Council/ City Manager Options Until recently, the City s only option for reducing the unfunded actuarial accrued liability was to commit additional funds to CalPERS. Unfortunately, these funds would be subject to the same market volatility as the CalPERS investment policy, and the funds are not accessible to the City for other pension expenses. In the last couple of years, a private letter ruling was received from the IRS that establishes that public agencies or municipalities could create a separate trust to pre-fund its CalPERS unfunded liability. This will provide an alternative to sending the funds to CalPERS, and will provide greater local control over the assets and portfolio management. The City Council and City Manager have several options: City Council Options 1. Take no action to establish a Section 115 Trust or send additional money to CalPERS to reduce the UAAL The Council can take no action, and leave the City in a position to scramble to get the funds to make unanticipated increases in CalPERS employer contributions. 2. Periodically send the money to CalPERS to reduce the UAAL Pros a. CalPERS has a relatively risky asset allocation profile, which will generally produce higher investment returns, if the equity and real estate markets remain strong. a. If the equity and real estate markets stay flat or decline, investment returns will probably be lower, and possibly negative. CalPERS has a relatively risky asset allocation. Specifically, CalPERS new portfolio asset allocation announced on December 18, 2017 is 63 percent invested in equities and real estate (50% in global equities and 13% in real assets), and these two asset classes are very vulnerable to an economic downturn. With the end of the US last recession nine years behind us and the Dow Jones Industrial Average nearly four times higher than its 2009 low, the risk of a bear market is increasing. In 2017, U.S. stocks gained nearly 22%, which is more than double the historical average. And since the start of 2009, when the market bottomed out in the wake of the global financial crisis, equities have gained an annualized 15%. In its 2018 outlook, Vanguard estimates that U.S. stocks will gain 3% to 5% a year over the next 10 years, Page 4

5 Page 5 of 10 while bonds are expected to return an annualized 2.5% to 3.5%.When the downturn arrives, funded ratios will fall and unfunded liabilities will climb. b. The City loses control or oversight over the funds forever. Once the funds are sent to CalPERS, CalPERS controls everything. 3. Set the money aside, but not in a Section 115 Trust and not sent to CalPERS Pros The Council could use the funds for other purposes. a. Investment flexibility would be limited to the debt securities restrictions authorized by the State, and returns would likely be lower. b. The funds would not be considered restricted for pension obligations, and would not be considered a reduction in pension obligations. 4. Adopt the attached resolution appointing the City Manager Plan Administrator and authorizing her to take the necessary steps to negotiate and execute the documents to establish a Section 115 Trust Fund to use as a rate stabilizing fund, and delegate authority for managing the Section 115 Trust Fund investments. Pros a. Complete local control over the assets. The trust can be accessed at any time so long as the funds are used to pay the City s pension obligations. b. Lower Net Pension Liability-contributions placed in the trust reduces the City s unfunded pension liability. c. Pension Rate Stabilization-assets can be transferred to CalPERS at the City s discretion, which will help reduce or eliminate large fluctuations in employer contributions towards retirement benefits. d. Investment Flexibility-the trust permits the City, under federal and state law, to invest in a more diversified array of appropriate investments to maximize returns on long-term investments, and reduce the City s liability. e. Investment Management-Investment of plan assets can be managed by a professional fund management team, selected by and monitored by City staff. f. Potential for Improved Credit Ratings-rating agencies may look favorably on significant actions taken to reduce post-employment obligations. a. Funds transferred to the trust fund are restricted to funding pension obligations. Page 5

6 Page 6 of 10 City Manager Options 1. Determine whether to maintain the investments management in-house or Under the Direction of a Professional Investment Advisor or Investment Manager. A. Determine to maintain the investments management in-house. Pros a. More security for investments. The City can have a less risky asset allocation than CalPERS. b. Maintain total control over the investment decisions. c. The City controls when and how much of the funds set aside to send to CalPERS to offset fluctuations in the annual required contributions. d. Could start the process sooner by avoiding RFP process. e. No additional cost to manage the investments. a. No in-house experience selecting and managing equity investments. b. No in-house experience developing asset allocation models, and adjusting them based on changing circumstances. c. Attorney fee costs to set up the Section 115 Trust B. Determine to use a professional investment adviser or investments manager. Develop a Request for Proposal (RFP) and set up the Section 115 Trust under a professional investment advisor or investment manager. The City has identified three agencies that provide these services: Public Agency Retirement Services (PARS), PFM Asset Management LLC (PFM), and Keenan. Pros a. Have a less risky asset allocation than CalPERS. b. Maintain oversight over the investment decisions. c. Have experienced investment managers determining the asset allocation and recommending the investments or making the investment selection decisions. a. An annual fee would be required. Staff have seen administrative, trustee and investment management fees as high as.60% of assets managed for portfolios $5 million and under, but are lower as the size of the portfolio increases (the cost of.60% on a $5 million portfolio would be $30,000). Page 6

7 Page 7 of 10 b. May take longer to implement because of RFP selection process and complying with the process required by the vendor selected. c. Less control over the investments selection and process. BACKGROUND At the November 28, 2017 Council meeting, the City Manager was directed to bring back to Council a proposal to establish an Irrevocable Supplemental Pension Trust and other options as proposed by staff. Compensation packages for the City of Berkeley employees include California Public Employees Retirement System (CalPERS) pensions, a Police Retirement Income Benefit Plan and three retiree medical plans (Miscellaneous Retiree Health Premium Assistance Plan; Police Retiree Premium Assistance Plan; and Fire Employees Retiree Health Plan), referred to as other post-employment benefits (OPEB). Recent changes in rate smoothing strategies by CalPERS have increased volatility in employer contribution rates in pensions. Monies set aside in a Section 115 Trust can be used to ease budgetary pressures resulting from unanticipated spikes in employer contribution rates. For example, a CalPERS employer that has extra money after making its current CalPERS contribution might set aside some or all of the surplus to use in future years when the required contribution is less affordable. The City wants to take steps to better manage and reduce its pension and other post-employment benefit liabilities. These actions will represent best practices for financial management, slowing the increases in the City s annual pension costs, and positioning the City to achieve retiree medical cost savings into the future. Steps already taken by the City to address pension costs include implementing pension reform by establishing second-tier pension plans for all new employees. PEPRA miscellaneous will be enrolled in a 2% at 62 plan and PEPRA safety members (police and fire) will be enrolled in a 2.7% at 57 plan. PEPRA members are required to pay half the normal cost of their plans. However, changes by CalPERS, and past investment market losses by CalPERS have led to rapidly increasing pension rates and costs. The related ramp up in annual costs will continue for the next several years. ENVIRONMENTAL SUSTAINABILITY There are no identifiable environmental effects or opportunities associated with the subject of this report. RATIONALE FOR RECOMMENDATION Page 7

8 Page 8 of 10 Until recently, the City s only option for reducing the unfunded actuarial accrued liability was to commit additional funds to CalPERS. Unfortunately, these funds would be subject to the same market volatility as the CalPERS investment policy, and the funds are not accessible to the City for other pension expenses. In the last couple of years, a private letter ruling was received from the IRS that establishes that public agencies or municipalities could create a separate trust to pre-fund its CalPERS unfunded liability. This will provide an alternative to sending the funds to CalPERS, and will provide greater local control over the assets and portfolio management. Recent changes in rate smoothing strategies by CalPERS have increased volatility in employer contribution rates in pensions. Monies set aside in a Section 115 Trust can be used to ease budgetary pressures resulting from unanticipated spikes in employer contribution rates. For example, a CalPERS employer that has extra money after making its current CalPERS contribution might set aside some or all of the surplus to use in future years when the required contribution is less affordable. Such changes by CalPERS (often without much warning), and past investment market losses by CalPERS have led to rapidly increasing pension rates and costs. The related ramp up in annual costs will continue for the next several years. Amounts held in trust may be used to offset pension and OPEB liabilities for Governmental Accounting Standards Board (GASB) purposes only if: The contributions and earnings to the trust are irrevocable; The assets of the trust are dedicated to providing plan benefits to plan participants and the funding arrangement is actually used to pay benefits; and The assets of the trust are legally protected from creditors. A Section 115 Trust meets these requirements. ALTERNATIVE ACTIONS CONSIDERED See the pros and cons of each options described above. CONTACT PERSON Henry Oyekanmi, Director, Finance Department, Attachments: 1: Resolution Exhibit A: Summary of CalPERS Plans Total Pension Liability, Plan Net Position (assets), and Plan Net Pension Liability. Page 8

9 Page 9 of 10 RESOLUTION NO. ##,###-N.S. ESTABLISH A SECTION 115 TRUST FUND TO USE AS A RATE STABILIZING FUND FOR UNFUNDED PENSION OBLIGATIONS WHEREAS, it is determined to be in the best interest of the City to set aside funds for the pre-funding of its CalPERS pension obligation to be held in trust for the exclusive purpose of making future contributions of the City s required pension contributions and any employer contributions in excess of such required contributions at the discretion of the City; and WHEREAS, a tax-exempt trust performing an essential governmental function within the meaning of Section 115 of the Internal Revenue Code (as amended) and the Regulations issued thereunder, and is a tax-exempt trust under the relevant statutory provisions of the State of California; and WHEREAS, the City s establishment and operation of the Section 115 trust has no effect on any current or former employee s entitlement to post-employment benefits; and WHEREAS, the terms and conditions of post-employment benefit entitlement, if any, are governed by contracts separate from and independent of the Section 115 trust; and WHEREAS, the City s funding of the Section 115 trust fund does not, and is not intended to, create any new vested right to any benefit nor strengthen any existing vested right of any former, current, or future City employee; and WHEREAS, the City reserves the right to make contributions, if any, to the Section 115 trust fund. NOW THEREFORE, BE IT RESOLVED by the Council of the City of Berkeley that the City Council hereby grants authority to the City Manager to take the necessary steps required to establish a Section 115 trust fund to help pay for pension obligations; and the City Council hereby appoints the City Manager or her/his designee as the City s Plan Administrator for the Section 115 trust fund. BE IT FURTHER RESOLVED that The City s Plan Administrator is hereby authorized to execute the legal and administrative documents on behalf of the City and to take whatever additional actions are necessary to establish a Section 115 trust fund and establish the authority for the management of the Section 115 investments.

10 Page 10 of 10 Exhibit A City of Berkeley Summary of CalPERS Pension Plans Total Pension Liability, Plans' Net Position (assests), and Plans' Net Pension Liability As of June 30, 2017 Total Pension Plan Net Net Pension Funded Liability Position Liability Ratio Miscellaneous Plan $902,228,876 $641,339,412 $260,889, % Police Plan 372,226, ,135, ,091, % Fire Plan 246,704, ,593,232 70,111, %