Sonoma County's Pension Crisis – Analysis and Recommendations

INTRODUCTION

New Sonoma, a volunteer organization of financial experts and citizens concerned about the finances and governance of the County has just completed an extensive study of the County’s pension crisis.

In addition to describing how the County has incurred over a billion dollars in unfunded pension and retiree health care liabilities, how the County ignored the requirements to notify the citizens of cost of the benefit increase and failed to follow the Board of Supervisor’s resolution requiring the employees to pay for the increase, this report also provides a first-of-its-kind comparison of Sonoma County’s pension system with neighboring counties.

The following is a summary of the study’s findings.

(1) Sonoma County is approaching balance sheet insolvency, which means the County’s liabilities will exceed their net assets when the GASB’s new accounting standards take effect. These will require the County to list their pension liabilities on their balance sheet in 2014, and unfunded retiree medical liabilities by 2016.

(2) The key driver of the pension problem was the retroactive increases which took effect in 2003 and 2006 for Safety and 2004 for General employees. The increases lead to higher pensions, accelerated retirement rates and reduced the average retirement age by 5 years.

(3) The retroactive increases combined with a new definition of pensionable compensation increased pensions by 66% for General Employees and 69% for Safety Employees after the increases were enacted.

(4) Even though the Board of Supervisors Resolutions authorizing the new formula required the General Employees to pay the entire past and future cost of the increase and Safety Employees to pay the past cost, the resolutions were never enforced. In fact, in the 2008 contract negotiations the County picked up all but 1% of the employee contributions.

(5) The County’s pension costs have climbed from $24 million in 2001 to $122 million in 2012. Even with these increased costs, the system has $1.3 billion dollars in unfunded pension, retiree health care and pension obligation bond liabilities.

(6) When comparing Sonoma County’s pension costs with Tulare, Mendocino, Alameda, San Mateo, Marin and Contra Costa counties the study found that their average pension costs were 16% of the General Fund while Sonoma’s were more than double at 36%. As a percent of the general fund, no other county in California has pension costs as high as Sonoma County.

(7) When adding payroll costs, the total climbs to 120% of the General Fund. The average for the other six counties analyzed is 60%.

(8) The County currently has a funding ratio of 60% for pension and retiree health care benefits. That means there is only 60 cents available for every dollar for benefits already earned. This ratio assumes a 7.5% return on investments. If a more conservative 5.5% return is used, the funded ratio drops to 50%.

(9) Sonoma County employees receive on average $110,000 per year in salary and pension benefits, plus health insurance for life after 10 years of service. This is double the average salary and retirement benefits of Sonoma County residents.

(10) Increased pension costs in the years ahead have far reaching implications for the all Sonoma County residents, including; (a) unsustainable annual costs for taxpayers, (b) burden on active County employees, (c) threats to vital public services, and (d) the potential for the County to run out of money and go bankrupt resulting in loss of health care and a reduction of pensions for retirees as has happened in Stockton and Detroit.

This report is a call to action on the part of all stakeholders to work together to solve this deepening crisis, which threatens the quality of life and economic prosperity of all Sonoma County residents.

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SONOMA COUNTY’S PENSION CRISIS – ANALYSIS AND RECOMMENDATIONS

Newly mandated financial reporting requirements by the General Accounting Standards Board indicate that Sonoma County will be required to recognize a $1 billion reduction in net assets next year, reducing them from $1.2 billion to about $200 million.  After adding on the $297 million in unfunded liability for retiree healthcare, the new rules will wipe out the net assets of the County.

A fair and sustainable retirement system plays a critical role in recruiting and retaining talented employees on whom we depend for quality public services, such as taking care of our fellow citizens in need, maintaining our roads, protecting our environment, policing our streets and highways, and prosecuting lawbreakers. The system is also designed to provide a level of secure income to these employees, once they retire. To be viable, the County’s retirement system must be affordable for both the employees and the taxpayers who support it.

This report was published by New Sonoma, a nonpartisan, volunteer group of financial experts and concerned citizens.  All the financial information in this report is taken from publically available documents. This report provides the first-of-its kind rating and assessment of the financial impacts of hundreds of millions of dollars in unfunded retiree debt owed by the County. It also compares Sonoma County with our neighboring counties and Tulare County, a county with a sound retirement system to demonstrate how our retirement system compares with others.

Ensuring a common understanding of the current pension situation and how we got here is critical to fostering a lively and informed debate among all stakeholders, including; employees, retirees, taxpayers, and elected officials.

Prior to 2002 we had a sustainable pension system. From the 1940’s until 2002, Sonoma County provided its employees with sustainable pension levels that provided career employees with 60% of their salary upon retirement combined with social security and health care benefits. It was a sustainable, affordable system that required the County to contribute 7% of the payroll and employees 7% of their salary to properly fund the system. From 1994 to 2001 the County’s pension costs averaged $20 to $25 million per year.

Today, this is not the case. Sonoma County’s retiree pension and health care system provides neither retirement security nor financial sustainability and it is in dire need of re-design. At the end of 2012 the retirement fund had unfunded liabilities of $527 million and unfunded retiree health care liabilities of $297 million. In addition, the pension fund has consumed $600 million in pension obligation bond funds that taxpayers will pay principal and interest on for the next 20 years. At its simplest, an unfunded liability is the additional amount of money required to be infused into the system today, to fully support the promises made to retirees and current employees for service already rendered. It does not include amounts required to fund benefits for future service. In fact, most of the money going into the system today is to pay off these unfunded liabilities.

This challenge is not unique to Sonoma County, but as the County’s financial statements and the pension funds annual actuarial valuations indicate, our pension costs as a percentage of the General Fund are double those of our surrounding counties and when payroll is added, the pension and salary costs exceed the County’s General Fund, leaving limited funding for the services citizens expect and deserve for their tax dollars.

Each year that the County delays action to address its fundamental structural pension issues, the more risk the system faces and the harder and more painful it will be to fix. Recently in Stockton, the retirees lost their medical benefits in the bankruptcy settlement and in Detroit, the bankruptcy judge ruled that pensions can be impaired, meaning retirees will see their benefits significantly reduced.

This report is a call to action on the part of our elected leaders, County employees, employee unions, and citizens to work together to create a sustainable pension system that will provide retirement security for our valued employees and enable the County to continue to provide the services we need to maintain our quality of life and a thriving economy.

The Key Drivers of the Problem – Retroactive Increases and Accelerated Retirements

In 2002, the Sonoma County Board of Supervisors enacted pension increases for both General and Safety Employees and adopted the highest allowable formulas, 3% of salary per year of service at 50 years of age for Safety Employees and 3% at 60 for General Employees. The increased benefits were combined with a court settlement called the Ventura Decision, which also added 46 special pay items to what was considered pensionable compensation.

All of these benefit increases were applied retroactively back to the date people were hired. This means that many employees were able to retire at younger ages with richer benefits. Since employee and taxpayer contributions needed to fund these improved benefits during prior periods of service were never collected the unfunded liability increased substantially.

After the increase, the average retirement age for General Employees dropped from 62 to 57 and for Safety Employees from 56 to 51. The increases also resulted in a 69% increase in pensions for new retirees from an average cost of $35,803 in 2002 to $60,697 in 2006. This had a huge impact on the funding status and created additional unfunded liabilities because pensions were funded for 5 fewer years and retirees received benefits for 5 more years.

Currently, the funding ratio is at 50% to 60%, meaning there is only 50 to 60 cents on the dollar available to pay for retiree pension and health care benefits already earned.

How the Increase Was Supposed to Have Been Paid For

The County Supervisors were told by the Sonoma County Retirement Association before pension increases were enacted that the costs of these benefit increases could be covered with an additional 3% of payroll contribution to the pension fund by the employees.  Based upon these numbers, the Supervisors passed the increase. What the Plan Administrators of the retirement board did not tell the supervisors was the cost they presented for General Employees did not include the impact of accelerated retirements. Those accelerated retirements have cost the County tens of millions in additional pension costs each year as more and more employees started drawing their pensions instead of contributing to them.

The costs of the benefit increases were also magnified by the lower than anticipated stock market returns. The pension fund’s actuary used an assumed rate of investment return of 8% when calculating the cost of the increase. Since the increase, the investment fund has fallen $570 million short of its assumed rate of return. As a result of increased retirements and investment shortfalls, the actual cost of the increase is approximately three times the cost that was provided to the Supervisors.

The Failure to Provide Required Public Notification of the Benefit Increase

After sending out letters requesting information under the Freedom of Information Act, New Sonoma received and reviewed the County documents surrounding the benefit increase. We discovered that when they were enacted, the Supervisors did not follow the requirements to perform their own actuarial study of the costs, nor did they notify the public of the increase as required by Section 7507 of the California Government Code. Some legal experts believe this should void the increase back to the date it was enacted.

Understanding the Consequences of Further Inaction

Increased pension costs in the years ahead have far reaching implications for the all County residents, including; (1) unsustainable annual costs for taxpayers, (2) burden on active County employees, (3) threats to vital public services, and (4) the potential for the County to run out of money and go bankrupt.

So far, additional pension costs have caused deep cuts to services and have greatly reduced the County’s ability to maintain its roads and infrastructure.  According to the Supervisor’s Ad Hoc Committee Report on Roads, 86% of the County’s roads are not receiving pavement preservation and we now have the worst roads in the state according to the state’s Pavement Condition Index’s (CPI) report.

In addition to service insolvency, the County is approaching balance sheet insolvency. New government accounting standards have been enacted that will have a drastic effect on the County’s balance sheet. Currently the County lists $1.2 billion in net assets in their most recent financial statements. After the new reporting requirements, the County will need to write off $472 million in pension assets and post about $527 million in new pension liabilities on the balance sheet for a $1 billion reduction in net assets. And if the $297 million in unfunded liability for employee health care is added, the County’s liabilities will exceed its assets.

Employees Breached the Agreement to Pay for the Increase  

Upon reviewing the 2002 Board Resolutions approving the benefit increase we found the resolutions stated the General Employees were required to pay for 100% of the past service and prospective cost of the increase and Safety Employees were required to pay for just the past service cost, estimated to be 50% of the cost of the increase.

The initial cost estimates for the increase provided by the County’s Actuary Rick Roeder to the Sonoma County Employee Retirement Association Plan Administrator in 2002 stated that if employees contributed an additional 3% of salary for 20 years, the $93 million cost would be offset by the employees.

In his 2002 Annual Actuarial Report Mr. Roeder came up with a completely different cost for the increase. The new, more detailed cost analysis concluded that increasing the General Employee formula to 3% at 60 and Safety Employees to 3% at 55 would increase the unfunded liability of the plan by $152 million, even after adding in the new employee contributions.

Even though the employees had agreed to pay the 3% of salary estimated cost of the increase the Supervisors agreed to pick up more of their contribution. The employee MOU’s indicate that when the County negotiated the 3% of salary additional contribution with the Safety employees the County agreed to pick up 2% of their previous contributions so the net Safety Employee contribution was 1% of salary.

In 2008, after paying the 3% of salary for 4 years, SEIU employees received a 2.25% pickup of their previous contribution so their net contribution was .75% of salary.

Even though the employee contributions were falling significantly short of paying for the increase, the Board of Supervisors negotiated for the employees to pay even less.

The Current Supervisors Have Ignored Their Own Pension Report

The Board of Supervisors has ignored its own Ad Hoc Committee Pension Report dated November 3, 2011, which included the following text on Page 18 identifying the failure of employees to pay their share and the recommendation to address this in labor negotiations. Here is the text from the report:

“In 2002, Sonoma County agreed to retroactive increases which became effective in 2004 for general members and 2006 for safety members. This decision while part of a legal settlement and negotiations was made with the understanding that employees would bear the full cost of the enhanced retroactive benefit. At the time, the long term cost was actuarially estimated and labor negotiations provided for contract provisions to pay for the cost over the course of 20 years. However, those initial estimates and stock market volatility caused an increased cost to the County to cover pension costs”.

“The Ad Hoc Committee recommends staff commission a new calculation to identify the shortfall, if any, and to work with the labor organizations through negotiations to meet the intent of the prior agreements regarding the enhanced benefit formulas costs”.

We have asked the Supervisors for the results of this calculation and were informed it has never been performed. As a result, we believe the citizens of Sonoma County deserve a full accounting and explanation of what went wrong and what corrective actions should be taken to bring the County into compliance with their own Board Resolution.

Because of the numerous problems with the increase process including: (1) not notifying the public, (2) not presenting accurate cost estimates to the Board of Supervisors, and (3) ignoring the Board Resolutions requiring the employees to pay for the increase, New Sonoma believes an independent committee of experts should be hired by the County to evaluate the situation and propose corrective actions to bring the fund into compliance with the law and the Board Resolutions.

We also believe that a Pension Advisory Committee made up of experts, union and retiree representatives should be formed to develop a plan for paying off the pension’s unfunded liabilities over the next decade and to ensure that the County complies with governance issues in the future. It is evident that there are too many conflicts of interest between staff and the supervisors over pensions and an independent committee needs to be formed.

The charts on the following pages demonstrate the problems faced by all stakeholders including; taxpayers, employees and retirees. These include:

• The unaffordable impact of the benefit increases on retirement rates and payments
• Evidence that Sonoma County’s salaries and pension benefits are significantly richer than those of surrounding counties,
• County employees receive compensation that is double the average for county residents,
• The County’s pension fund costs are soaring and unsustainable, and
• The pension and health care funds are significantly underfunded.

The chart below demonstrates how the number of new retirees jumped significantly after the increase. In addition, the average age of new retirees dropped 5 years from 62 to 57. This meant people paid into the retirement system for 5 fewer years and will receive retirement funds for 5 additional years. As previously discussed, the retirement association did not have their actuary include the impact of accelerated retirements in their cost analysis, as was recommended.

In addition to lowering the retirement age, the increase to 3% at 60 also resulted in an immediate jump in pensions for new retirees of 66% from an average cost of $22,468 in 2003 to $37,715 the following year.

The Sonoma County Board of Supervisors adopted two new pension formulas for Safety Employees. A 3% at 55 formula took effect in 2003 and a 3% at 50 formula took effect in 2006. As a result, the average age of new retirees dropped from 56 to 51 resulting in 5 fewer years of employee contributions and 5 more years of retirement.

The increases also resulted in a 69% increase in pensions for new retirees from an average cost of $35,803 in 2002 to $60,697 in 2006.

 

This graph demonstrates how the cost for pensions has soared for the County, now reaching 40% of payroll. However, the cost that employees pay,  has stayed flat at 12% of payroll or less than the amount shown because the graph does not account for the County’s pickup of employee contributions, which is difficult information to obtain from County reports.

This chart provides the total annual cost of pensions each year. Pension costs were stable at about $25 million per year from 1994 to 2000 and from 2001 to 2012 the average annual cost jumped 600% to an average of $155 million per year.

This chart shows the growth of the unfunded liability, which is money owed to current employees and retirees for work already performed. It is the difference between what they are owed and the assets in the fund. Bond funds used to buy down the debt are added back in to provide the true unfunded liability the County faces. The pension bond debt is currently at $495 million. It will end up costing the County $856 million when interest is added. In addition, the County had $527 million in unfunded pension liabilities at the end of 2012 as well as $297 million in unfunded medical liabilities.  These amounts assume the County will receive a 7.5% return on its investment earnings. If they receive less, the unfunded liability increases dramatically.

This graph shows the disbursements to retirees and disabled workers. The payments have increased 600% over the past 12 years from $28 million in 2000 to $122 million in 2012. From 2000 to 2004 payments to retirees increased by about $4.2 million per year. After the increase in benefits, payments to retirees increased an average of $9.4 million per year.

Comparing Sonoma County Pension Costs with its Neighboring Counties

Sonoma County’s annual pension costs as a percentage of the General Fund are more than double neighboring counties and 7 times the cost of Tulare County.  In addition, Sonoma County expects its pension costs to climb to $209 million per year by 2020, an amount equal to 50% of today’s General Fund.  We have not seen any other city or county with a ratio as high as Sonoma County’s.

But it even gets worse. When Sonoma County’s $300 million in payroll costs is added onto its pension and social security costs, the total reaches 119% of the General Fund, double the average of the other counties.

The Earned Retiree Benefits Funding Ratio is the present value of pension and other post employment benefits earned by retirees and employees to date. Generally 80% funded is considered a healthy plan and 60% is a plan in significant financial stress and risk of insolvency. We calculated the funded ratio based upon three rates of investment return of 7.5%. 5.5% and 4.8%. Tulare and Alameda County did not retroactively increase benefits and therefore have a funded ratio of almost 90%.

Average county employee salary and pension costs are now $110,000 per year, double the salary and retirement costs of the average county resident. A 3% employer contribution to a 401k account was added to the non-government employee salary for comparison purposes. That is the most typical amount contributed by employers.

Comparison of Sonoma with Tulare County

Tulare County has about the same population as Sonoma County, but their finances are in great shape because they never retroactively increased pensions and they controlled salaries. Their payroll is 37% less than Sonoma County’s even thought they have 577 or 15% more employees. This data is from the 2012 Annual Actuarial Valuations of both counties.

PROVIDING A FRAMEWORK FOR SOLUTIONS

With a clear understanding of the nature and extent of the challenges we face as a County, we must find a workable solution. Indeed, only by addressing and solving this urgent financial challenge can we move to a healthy local economy and provide retirement security for employees and retirees.

To begin this process New Sonoma believes a Citizens Advisory Board made up of union, retiree and taxpayer representatives along with independent legal, actuarial, and financial experts needs to be formed to develop a long term solution to this growing crisis. It is our intent to ask the Supervisors to form this Board and if they refuse, to place an initiative on the ballot that will let the voters decide. The initiative would also include other measures, such as reducing pension formulas going forward if the Reed Initiative slated for the 2014 election passes.

The path to comprehensive pension reform should begin with agreement on a definition of retirement security – once we have agreement on a level of post-retirement income that ensures security and that the County can afford, we can design a sustainable system to provide that security.

Sonoma County residents, retirees and employees should share the following goals in creating a secure, sustainable retirement system that:

• Attracts and retains quality employees
• Provides a level of benefits that retirees can plan on being there
• Accumulates assets to cover 80% or more of its projected liabilities
• Allows the County to continue to invest in public services
• Eliminates the need for piecemeal reform by instituting self-correcting mechanisms that are triggered when funding levels dip below acceptable thresholds.

Any comprehensive solution should be informed by the following:

1. Accurate and transparent assumptions: Today’s system was largely built by policymakers using little accurate data. Retirees, employees and taxpayers rely on government leaders to be honest about the system’s liabilities and to have safeguards in place that require accurate accounting. Public employees should depend upon their union leadership to insist on conservative, realistic assumptions. Using overly optimistic assumptions hurts everyone because these assumptions underestimate the true cost of pensions and increase the risk that not enough money will be set aside to pay for granted pension benefits.

2. Equitable and reasonable changes: Fair and balanced eligibility rules, benefit levels and contributions for all members must be required of any retirement system reform. This report underscores the truth that any reform impacting only new employees will not affect the existing $1 billion in unfunded pension and medical liability for past service. This problem is over a decade in the making and all stakeholders must now share in the solution. The following, among many other ideas, should be analyzed as possible areas of reform:

• Increasing the retirement age
• Lowering the accrual rate of benefits
• Cost of living adjustments
• Hybrid plans and portability
• Eliminating the ability to spike pensions and purchase Service Credits

As we analyze the various options for fixing our retirement system, we must again remind ourselves that real people and real families are connected to every change we consider. While all stakeholders must be prepared to collaborate in achieving a fair and sustainable system, we must also consider possible hardships that these changes may impose.

Therefore, reforms could be structured so that they have a smaller impact on plan members at lower income and lower benefit levels. One of the principal purposes of a public retirement system is to sustain public workers during their retirement years. Reforms that provide protection to sustenance level benefits must be part of any reform.

3. Intergenerational fairness: New County employees are receiving a lower pension formula (2% at 62), but are required to pay the additional 3% of pay for an enhanced formula their predecessors’ received. In addition, they shoulder the greatest risk that money will not be there in 20 to 30 years when it is time for them to retire.

And when there are budget cuts today that result in lower wages and furlough days, it is the current employees that endure these challenges. Any solution needs to ensure fairness between newer and more veteran employees and retirees.

4. Comprehensive and self-correcting processes: As the collaboration on reform begins, it is important that any solutions protect the County from ever again facing the massively underfunded system that it has today. To maintain a defined benefit system at all, it is critical that the County adopt structures that provide for automatic self corrections.

5.  Unfunded liability is the lion’s share of the problem: A real challenge in reforming the pension system is that it is extremely underfunded today and any solution must address the unfunded liability, the bill for past service. It is likely that any solution will require a change to benefits to both retirees and current employees in order to address this problem.

THE TIME TO ACT IS NOW

The Board of Supervisors have enacted some reforms to limit spiking of pensions and have changed benefit levels for new hires. However, these reforms will not provide substantial savings for decades. It is time to take a different approach to solving this problem. We must begin this time by defining retirement security and designing a system that provides security in retirement for our valued public employees.

This new system will necessarily also address budgetary concerns because no one is secure if they are promised a benefit that the County cannot afford. Each day the County avoids comprehensive reform, the liability grows. It is unfair to ask taxpayers to pay for the growing level of required contributions and it is dishonest to let County employees and retirees believe that full benefits will be there for their retirement.

The time to act is now because it is in the interest of everyone to solve this problem, once and for all.

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About the Authors:  This report is a collaborative effort headed by Ken Churchill, the director of New Sonoma, an organization of financial and business experts and concerned citizens dedicated to working together to solve Sonoma County’s serious financial problems. Ken Churchill has over 40 years of business and financial management experience as founder, CEO and CFO of a solar energy company and environmental consulting firm. He sold both companies and now grows wine grapes and produces wines under his Churchill Cellars label. For the past three years, Ken has been actively researching and studying the pension crisis and published a report titled The Sonoma County Pension Crisis – How Soaring Salaries, Retroactive Pension Increases and Poor Management Have Destroyed the County’s Finances.