In their most recent actuarial reports CalPERS for the first time provided pension cost estimates for the next 8 years, from 2015 to 2023.
How high are these costs going for California’s cities who retroactively increased their pensions at CalPERS urging over the past 15 years? To answer that question I looked at the largest city in my county, Santa Rosa and this is what I found.
Data Sources for this Report
The data used to develop the spreadsheet analysis done as part of this report are NOT numbers that I calculated. The past numbers for 2002 to 2015 are taken directly from the City of Santa Rosa’s Comprehensive Annual Financial Reports found on the City’s website (This page has the links to Santa Rosa’s CAFRs from 2001 through 2015. In each of these CAFRs, the pension information is found in the section entitled “Notes to Basic Financial Statements” under the heading “Employees Retirement Plan.”). The projected growth of certain costs – such as retiree healthcare benefits (also known as “other post employment benefits,” or OPEB), the payroll and sales and property tax revenues – use inflation rates or growth rates similar to what CalPERS uses.
The future pension costs were obtained directly from the 2013 and 2015 Actuarial Reports prepared by CalPERS and found on the CalPERS website. Since the future costs are based upon CalPERS achieving a 7.5% net rate of investment return, I believe their costs are understated, but I used them anyway. But since the pension plan has $804 million worth of assets if the pension fund returns 6.5%, in a single year it will add $8 million to the City’s pension debt and a 5% return would add $20 million.
Looking at the data going back 16 years what I found is that in 2000, Santa Rosa’s pension contribution was $1.8 million and the plan was 122% funded, meaning there were $1.22 worth of invested assets in the fund for every $1.00 worth of benefits earned.
With CalPERS wholehearted support and assistance, on August 6, 2002, the Santa Rosa City Council passed a board resolution to enact a new contract with CalPERS that changed formulas from 2% per year of service at 55 years of age for non-safety Miscellaneous employees to a 3% at 60 formula. The new formula was provided prospectively, meaning it only applied to future years of service, not past years.
For Police and Fire employees, the new contract was adopted retroactively so it applied to past and future years of service. Their formula went from 2% per year of service at 55 years of age to 3% at 50. This represents a more than 50% increase in the benefit, since along with the “multiplier” increasing from 2% to 3%, the age of eligibility dropped from 55 to 50. But it was the retroactive granting of this benefit that caused even more significant financial liability. This is because the multiplier was increased by 50% even for years already worked and raised pensions from 60% of salary to 90% of salary for 30 years of service.
These changes ended up having a serious impact on the pension costs and the unfunded liability because CalPERS used an overly optimistic rate of investment return of 8.25% compounded per year in their cost analysis. Over the past 15 years since the increase, CalPERS has only achieved a 5% compound rate of return. Many experts believe in this current low interest rate environment returns will remain at the 5% return level for the foreseeable future.
In July of 2003 the City took on $53 million worth of new debt by selling Pension Obligation Bonds (POB) and giving the proceeds to CalPERS to pay down the unfunded liability that was created by the new formulas. With interest these bonds will divert over $100 million from government services to debt service.
CalPERS Flawed Cost Analysis and Lack of Proper Disclosure
CalPERS cost analysis provided to the City in 2002 stated the cost for the new 3% at 50 formula for Safety members would be 13.27% of salary and the cost for the 3% at 60 formula for Miscellaneous members would be 9.87% of salary. However, as previously stated, these estimates were calculated assuming that pension assets would grow at 8.25% per year into the future. Since CalPERS investments have only averaged 5% over the past 15 years the increases have created $287 million in unfunded pension liabilities for the City as of 2015.
In addition, the analysis did not provide the City with any warning or disclosure regarding what would happen if the 8.25% investment return was not achieved. CalPERS simply wrote “For many plans at CalPERS the financial soundness of the plan will not be jeopardized regardless of the new formula choice made by the employer.”
The Growth of Pension Costs Since the Increase
In 2001, the City’s pension contribution was $1.5 million and in the first 4 years following the increase it grew to $11.5 million. In addition, the funding ratio dropped from 122% in 2001 to 70% in 2005 meaning the fund, instead of $63 million in excess assets now had $128 million in unfunded liabilities.
In 2006, the annual cost grew by another $5 million hitting $16.6 million and by 2015 had grown to $21 million. However, this was a very modest growth considering CalPERS lost 29% of its assets during the Great Recession in 2008 and 2009. CalPERS lowered contributions in order to help cities and counties who saw their tax revenues during the recession drop. So CalPERS extended the amortization period on the unfunded liabilities from 9 to 20 years and smoothed their investment gains and losses from 4 to 15 years into the future. Basically, these were accounting gimmicks that resulted in severe underfunding of the pension plan and these changes exist today. The chart below shows the growth of Santa Rosa public employee retirement costs (click here to see the underlying calculations).
However, now CalPERS is worried that the plans are not being properly funded and pension contributions need to be doubled over the next 9 years.
Projected Future Costs
In their 2015 actuarial reports, CalPERS provided the City with their normal employer contribution as a percentage of payroll and the unfunded actuarial liability (UAL) as a total cost each year from 2015 to 2023. Using a 3% payroll growth assumption and their UAL numbers, I calculated the annual costs going forward. In addition, I added the pension obligation bond debt service each year going forward along with the cost of retiree healthcare benefits using a 5% annual cost increase assumption as CalPERS does.
My analysis indicates that during the next 8 years, the cost for retiree benefits will increase from $31.0 million or 33.7% of payroll in 2015 to $59.1 million or 48% of payroll in 2023.
The nearly doubling of pension and retiree healthcare costs means the City will need to cut salaries, benefits, services and/or increase taxes each and every year going forward by $3.2 million per year to meet their retiree benefit costs.
Pension and Healthcare Costs as a Percentage of Tax Revenues
More important than pension costs as a percentage of payroll are pension costs as a percentage of tax revenues because tax revenues are what enables the City to pay for its benefits. Once retiree benefit costs exceed the City’s ability to pay them, they will no longer be able to be fully paid and at that point either they will need to be reduced in bankruptcy or through significant pension reductions. The chart below shows the growth of pension costs relative to that of general fund property tax and sales tax revenues.
The results of my analysis are staggering. Over the past 15 years’ sales and property tax revenues have climbed an average of 3% per year, while employee retirement costs have increased an average of 19% per year. This has led to a growth of retiree benefit costs from 3.5% of major tax revenues in 2001 to 47% in 2015 and an estimated growth to 70% of major tax revenues by 2023 (Editor’s note: the city receives other revenues which may also be available to finance pension costs).
Growth of the Unfunded Liability
The unfunded liability of the pension plan is calculated by taking the assets in the plan minus the present value of the benefits already earned by current employees and retirees, considered the plan’s liability. The funding ratio is determined by dividing the market value of assets in the plan by the liability.
CalPERS discounts the long term liability by assuming before the money is paid to retirees, it will earn investment income. CalPERS currently uses an assumed 7.5% rate of investment return to calculate the liability and payments to the plan. So if the assumed investment return is lowered, the unfunded liability of the plan increases along with the cost of paying off the liability. Unfunded liability costs are borne by taxpayers and are not a shared expense with the employees.
Currently, using a 7.5% assumed rate of return, the pension fund has $287 million worth of unfunded liabilities and pension bond debt and is 74% funded. However, many experts believe in this low interest rate environment a lower investment return assumption should be used. Many experts think that a 5.5% to 6.5% rate should be used. Other experts believe a 3.5% rate should be used since this is about the rate private pension plans are required to use and what CalPERS uses if a City wanted to buy their way out of the CalPERS system. I won’t guess what the future investment returns will be, but here is what happens to the unfunded liability at various rates of investment return assumptions:
- At 6.5% the unfunded liability would increase to $426 million and $50 million per year to would be added to the City’s pension costs.
- At 5.5% the unfunded liability would increase to $585 million and $97 million per year would be added to the City’s pension costs.
- At 4.5% the unfunded liability would increase to $755 million and $137 million per year would be added to the City’s pension costs.
- At 3.5% the unfunded liability would increase to $967 million and $187 million per year would be added to the City’s pension cost.
Santa Rosa Analysis of Unfunded Liability at Various Rates of Investment Return
City Pension Plan Status Using ERISA Standards
Under the Federal ERISA rules for private pensions, a high quality bond rate of return is used to determine the assumed rate of investment return. Today that is around 3.5%. ERISA also defines the health of a pension plan as follows:
- Less than 80% funded is considered “seriously endangered”
- Less than 70% funded is considered “at risk”
- Less than 65% funded is considered “critical status”
So under ERISA standards, the City of Santa Rosa’s pension plan at 45% funded when assuming a 3.5% return is 20 percentage points below what ERISA would consider “critical status”. So one could more accurately describe the pension system as being on “life support”. Also, under ERISA rules the pension benefits each year would stop being accrued until the plan becomes 60% funded to keep the hole from going deeper.
ERISA also requires the plan sponsor pay off their unfunded liabilities over 7 years. CalPERS currently allows public agencies to pay off their liability over up to 30 years. If the City was required to pay off its unfunded liability over the next 7 years, their annual contribution to the pension fund would grow from $28 million to $146 million in 2015 alone. So under ERISA rules pension costs would increase by $120 million per year and take them to 145% of payroll.
The City of Santa Rosa and all cities in California who retroactively increased pensions need to restructure their pension systems. Otherwise it is increasingly unlikely they will be able to afford the benefits that have already been earned and provide taxpayers with the services they deserve for their tax dollars.
City officials can no longer pretend a crisis does not exist. They would be well advised to form a Pension Advisory Committee and bring all the stakeholders to the table to look at all the options, have an actuary determine the savings for each option and make informed decisions to save the pension plan and benefits people are counting on to fund their retirement.
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About the author: Ken Churchill is the author of numerous studies on the pension crisis in California and is also the Director of New Sonoma, an organization of financial experts and citizens concerned about Sonoma County’s finances and governance.
REFERENCES AND RELATED ARTICLES
California Court Ruling Allows Pension Changes, August 26, 2016
How CalPERS has Created a Ticking Time Bomb, November 30, 2015
Sonoma County’s Pension Crisis – Analysis and Recommendations, January 12, 2014