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Comparing Fresno City and County Pension Systems

As the Fresno Bee recently reported, the city of Fresno’s pension systems are in much better financial shape than the Fresno County Employees’ Retirement Association (FCERA). As of June 30, 2015, the city’s two systems reported a combined $349 million of assets (at market value) in excess of actuarially accrued liabilities. By contrast, FCERA’s assets were $1.043 billion below its liabilities. Actuarial surpluses are rare in California, and the discrepancy between the city and county is so great that we thought it would be worth diving into the finances of Fresno’s retirement system to explain the contrast.

The systems provide extensive financial reports on their websites. The two most useful are Comprehensive Annual Financial Report (which includes financial statements and 10-year histories for many data points) and the Actuarial Valuation Study (which provides in-depth data about system assets, contributions and benefit payments). FCERA posts its reports at http://www.fcera.org. The two city systems – one for Fire and Police, and one for non-public safety employees – publish their reports at http://www.cfrs-ca.org/.

Table 1 below compares some key metrics across the plans.

The Valuation Value of Assets (VVA) is used by system actuaries to determine future contributions. But for our purposes, VVA is less useful than the Market Value of Assets (MVA). While MVA is simply the total market value of all the bonds, stocks and other investments the system holds, VVA includes various smoothing adjustments – reporting practices, some of them legitimate, that can mask liabilities.

Benefits

Contributing to the difference in the financial health of Fresno’s city and county systems is the difference in benefit levels. For example, the City of Fresno limits public safety pensions to no more than 75% of final average salary (as per Section 3-333 of the municipal code). The county imposes no similar cap and also provides very generous benefit accrual rates, in some cases exceeding 3% per year of service. According to calculations we performed using the county system’s Benefit Calculator, a Tier 1 public safety employee retiring at age 60 with 30 years of service would get a pension equal to 97% of final salary. Tier 1 employees were hired before 2007; newer county employees receive less generous benefits.

The city does not cap miscellaneous employee benefits, but its employees earn substantially less credit for each year of service. According to the city’s Benefit Calculator, a miscellaneous employee retiring at age 65 with 30 years of service would receive 72% of final compensation, compared to 97% for a county employee retiring at the same age and the same number of service years.

 

Asset Returns

Another potential distinction between the city and county systems is investment performance. A pension plan can improve its actuarial balance by achieving higher asset returns. Over the five years ended June 30, 2015, the city’s investments outperformed the county’s. FCERA generated annualized investment returns net of fees of 9.8%. The two Fresno city systems, whose assets are jointly managed, achieved net returns of 10.9% over the same period. This 1.1% difference compounded over five years is fairly significant. One billion dollars growing at the county’s rate of 9.8% becomes $1.596 billion after five years, while the same amount growing at the city’s 10.9% annual rate becomes $1.677 billion – $81 million more.

However, when we look at the 10-year period that includes the Great Recession, the performance numbers reverse. Over the 10 years ended June 30, 2015, county assets grew at an annual rate of 6.8% versus 6.4% for the city. Both of these return rates are below the annual asset return rates assumed by each system (more on this below).

Further, it’s worth noting that funding levels for all systems declined over the 10-year period. Between June 30, 2005 and June 30, 2015, FCSERA’s funded ratio based on VVA declined from 91.5% to 80.7%. The Fresno Fire & Police plan saw a decline from 126.4% to 119.6%, while the city’s Employee Retirement System witnessed a funded ratio decline from 139.8% to 109.2%.

 

Discount Rates

In general, the market value of a plan’s assets is fairly easy to determine and is not subject to substantial estimation error. Most plan assets are invested in stocks and bonds that trade frequently and whose values are easy to establish independently.

By contrast, plan liabilities are based on numerous assumptions. How much a plan will have to pay in the future depends upon when employees retire and when they pass away. Expressing these future benefit payments in current dollars requires the choice of a discount rate – a choice subject to controversy.

Fresno city plans use a higher discount rate than FCERA. The city’s ERS and Fire & Police plans both assume annual returns of 7.50% and then use that rate to discount future benefit payments. FCERA uses a slightly more conservative rate of 7.25%. Both of these assumptions exceed the actual 10-year returns experienced by the city and county pension systems, and thus should arguably be reduced.

But to compare the systems, we don’t need to determine the ideal discount rate; we simply need to apply the same rate to each system. If we reduce the city’s discount rate from 7.5% to 7.25%, pension liabilities across the two city systems would increase about $61 billion and their funded ratio would fall by about 3.5%. (These estimates are discussed in an appendix at the end of this study). While significant, this fact only explains a small portion of the 38.3% gap in funded ratios between the city and county systems.

 

Mortality Assumptions

While the pension literature includes much discussion of discount rates, less has been written about mortality assumptions. But good death rate estimates are important: if beneficiaries live a lot longer than expected, pension payments will be much greater than forecast. This recently became clear in Detroit, where city officials faced a sudden spike in projected retirement payments after its pensions actuary switched to a new mortality table.

Mortality tables are produced by the Society of Actuaries. Most public pension plans use a table from the Society’s RP-2000 Mortality Tables Report produced in the year 2000. The large increase in Detroit’s projected pension costs occurred after actuarial firm Gabriel Roeder switched to the Society’s new RP-2014 Mortality Tables.

The RP-2000 report included a supplemental schedule that can be used to scale mortality rates to future years. The scaling procedure assumes a steady improvement in longevity, and thus a steady decrease in mortality rates over time. By applying the adjustment factor from the scaling schedule multiple times, an actuary can approximate what a future mortality table might look like. For example, by applying the scaling factors to the 2000 mortality rates 15 times an actuary can approximate 2015 mortality rates. In Detroit, Gabriel Roeder did not apply the scaling factor, thereby causing the big change when it transitioned to the newer mortality table.

Both the Fresno city plans and FCERA use the RP-2000 Combined Healthy Mortality Table and then scale the death rates from this table with factors in Mortality Projection Scale AA. However, there is an important difference. The city performs the scaling six extra times: it uses mortality rates scaled to 2021, while FCERA uses death rates scaled to 2015. This means that the city plans are projecting fewer deaths at any given retiree age – and therefore greater liability – than does FCERA.

The county’s mortality projections are thus more “optimistic” than those of the city plans, in the sense that its approach anticipates shorter-lived recipients – and that translates into lower expected benefit payments. The sooner an employee is assumed to pass away the less he or she is projected to receive from the system. If FCERA performed the same scaling as the city plans, its reported funding level would be worse. Without more data, we cannot say how much worse.

Finally, it ‘s worth noting that retirement rate assumptions differ between the city and county systems. The difference may be justified, and the impact is unclear. Since the plans have different benefit structures, they present different incentives to workers timing their retirements. When an employee retires early, he or she will receive benefits for more years but generally at a lower rate. So a change in retirement-age assumptions, may raise or lower projected system costs.

 

Conclusion

Overall, our conclusion is mixed. Fresno’s Employee Retirement System and Fire & Police Retirement System offer less generous benefits that the Fresno County Employees’ Retirement Association. This difference in benefit levels makes a substantial contribution to funding disparities between the systems.

FCERA uses a more conservative discount rate, while the city plans use more (financially) conservative mortality assumptions. These modeling differences affect the disparity between reported city and county funding levels, but they do not represent real differences and simply muddy our understanding of relative system performance. Ideally, all California pension systems would use the same actuarial assumptions (unless there are real demographic differences between workforces) so that we would be able to perform accurate comparisons.

 

Appendix: Recalculating AAL Using a Different Discount Rate

A pension system’s AAL is the discounted amount of future benefit payments. Unless one has a table of projected future benefit payments, it is impossible to precisely calculate AAL using another discount rate.

In 2013, Moody’s adjusted pension liabilities by using more conservative discount rate assumptions. The rating agency’s method of restating liabilities involves projecting forward the system’s reported liability for 13 years and then discounting the result back for 13 years using the more conservative rate. Moody’s refers to the 13-year re-discounting period as a “common duration” and recognizes that applying the same duration to all plans could be a source of estimation error.

Moody’s also noted at the time that more precise estimates would be possible once pension plans implemented enhanced reporting required under Government Accounting Standards Board Statements 67 and 68.

Under these new rules, pension systems must report the “Sensitivity of Net Pension Liability to Changes in the Discount Rate.” This new schedule shows the Net Pension Liability calculated using the current discount rate, a rate 1% higher and another rate 1% lower. For the Fresno city systems, we have Net Pension Liabilities based on rates of 6.5%, 7.5% and 8.5%.

We can estimate the impact on Net Pension Liability by linearly interpolating between the 6.5% and 7.5% values. For the two Fresno systems combined, the estimated impact of a change in discount rate from 7.5% to 7.25% is $69 billion.

Net Pension Liability as reported under GASB Statement 67 is higher than each system’s Actuarially Accrued Liability. In the case of the Fresno city systems, the difference is about 11.5%. If we reduce the Net Pension Liability difference of $68 billion by 11.5%, we arrive at the $61 billion estimate presented in the main text.

The author wishes to thank Lisa Schilling at the Society of Actuaries and Bill Bergman of Truth in Accounting for their assistance with some technical points in this study. Any errors are my responsibility.

Pension burden in 5 California counties now over 10%

Years after the Great Recession slammed their Wall Street investments, at least five California counties have broken through the 10 percent ceiling, spending at least one of out of every $10 to fund their government-employee retirement programs.

The resulting strain on local budgets, called the pension burden, is revealed in California Policy Center’s latest analysis of county reports.

Five California counties reported that their pension contributions now exceed 10 percent of total revenues: Santa Barbara County (13.1 percent), Kern County (11 percent), Fresno County (10.7 percent), San Diego County (10.4 percent) and San Mateo County (10 percent). We will consider each below.

A sixth county, Merced, is also expected to report that its required contributions topped 10 percent of 2015 revenue when it files its audit. We estimate Merced’s payments at slightly over 11 percent of revenue.

CPC’s review of audited financial statements filed by 30 California counties shows pension contributions accounting for between 3 percent and 13 percent of total county revenue.

“For years, public employee union leaders denied the pension burden was even close to 10 percent,” my colleague Ed Ring notes. “This study shows the burden is now approaching 15 percent of revenues.”

The surveyed counties, which account for more than 95 percent of California’s population, made over $5.4 billion in pension contributions during the fiscal year. These counties also made $660 million of debt service payments on pension obligation bonds, raising total pension costs to over $6 billion last year.

That figure accounts for about one-sixth of all California state and local pension contributions (not including payments on pension obligation bonds), estimated at $30.1 billion in 2014.

As investment markets remain relatively flat, it seems likely that many California counties will bow to pressure to cut government services or to raise cash through debt instruments or taxes.

METHODOLOGY

In 25 of 30 counties, we used 2015 audits. Five other counties had yet to file their 2015 reports; in these instances, we estimated revenues and pension contributions from 2014 audits, 2015 budgets and actuarial valuation reports.

Most large counties operate their own pension systems, rather than relying on CalPERS. These county systems often also serve special districts and even cities in the county. Our survey was limited to pension contributions made by the county governments themselves, and excluded separately reporting units – that is, entities that participate in county systems but produce their own financial statements.

In 2015, state and local governments implemented new accounting standards promulgated by the Government Accounting Standards Board (GASB). Aside from reporting net pension obligations as a liability on the government’s balance sheet, GASB Statement Number 67 requires filers to report “Actuarially Determined Contributions” and actual contributions made to their defined benefit plans. The Actuarially Determined Contribution (ADC), previously known as the Actuarially Required Contribution, is calculated by an independent actuary. The ADC is supposed to be the amount sufficient to finance pensions for current and future retirees while gradually closing any gaps in pension funding.

For the 25 larger counties that had released 2015 audits by late February, we recorded ADCs and total revenue, and calculated the quotient of these two values in order to get a rough idea of the relative burden that public employee contributions place on county finances. Because pension systems usually require their actuaries to assume high rates of return on their investments (typically 7.25 percent or more), it’s arguable that reported ADCs understate actual pension burdens.

That said, the reported ADCs provide a reasonable basis for comparison across counties. Further, California public agencies generally make pension contributions roughly equivalent to their ADCs, so the ADC is at least a good gauge of near-term pension burdens.

Total county revenues, ADCs and pension cost ratios appear in the following table:

California County Pension Burden
Total Annual Pension Payments As Percent of Total Annual Revenue
20160312-CPC-Joffe-County-Pensions2

  1. Santa Barbara County

Despite its strong economic performance, Santa Barbara County had the highest pension cost burden among the 25 counties we reviewed – by a considerable margin. Employer contribution rates ranged from 20.8 percent to 59.5 percent, and have risen substantially since 2007. Employer contribution rates represent the percentage of public employee salaries a public agency contributes to its pension plan; they are generally higher for public safety employees, who receive more generous retirement benefits.

In the fiscal year ended June 30, 2015, the Santa Barbara County Employees’ Retirement System (SBCERS) suffered a decline in its funded ratio, from 81.1 percent to 78.4 percent. The drop was largely due to a disappointing 0.83 percent return on plan assets, compared to an assumed 7.5 percent annual asset return.

Despite the decline, SBCERS is still on somewhat stronger footing than the state’s CalPERS – which was about 73.3 percent funded on June 30, 2015. SBCERS is also amortizing its unfunded liabilities faster than CalPERS, using a 17-year timeframe versus 30 years for CalPERS.

SBCERS ended the fiscal year with an unfunded liability of $698 million, about 93 percent of which was the responsibility of county government (the rest belongs to courts and special districts). The system was last fully funded in 2000.

According to a 2007 report commissioned by the county auditor, the system’s position deteriorated for a variety of reasons including poor investment performance and benefit improvements granted by elected officials. The report does not detail these benefit improvements, but they included a change to the final average salary calculation used to determine benefit levels. Liberalizing final average salary calculations can enable pension spiking – a practice under which employees work extra overtime or get last-minute promotions at the end of their careers to maximize pension benefits.

  1. Kern County

Although Kern County’s ADC/revenue ratio is two points lower than that of Santa Barbara County, its situation is worse in a variety of ways. According to the most recent Kern County Employees’ Retirement Association (KCERA) actuarial valuation report, the system was only 64.08 percent funded as of June 30, 2015 – down from 65.11 percent the previous year.

Also, as of June 30, 2015, the county had $284 million in outstanding pension obligation bonds. If the $51 million in scheduled debt service on these bonds is added to the $201 million in Actuarially Determined Contributions the county was required to make, its pension cost burden would exceed that of Santa Barbara County – which has not issued pension obligation bonds.

KCERA’s funded ratio reflects an assumption of 7.5 percent annual returns on its portfolio. This contrasts with an actual fiscal year 2015 return of only 2.3 percent. On the other hand, KCERA is trying to amortize its unfunded liabilities more rapidly than CalPERS – employing an 18-year amortization period versus 30 years for CalPERS. KCERA’s severe underfunding and rapid amortization help drive relatively high pension contribution rates, which range from 37.8 percent for Kern’s court employees to 63 percent for public safety employees.

Kern County shows other signs of fiscal distress. In January 2015, county supervisors declared a financial emergency, prompted by the precipitous decline in oil prices. When the emergency was declared, oil companies paid about 30 percent of the county’s property taxes. That said, it is worth noting that property taxes accounted for just 15 percent of the county’s total 2015 revenue. Counties receive a substantial portion of their revenue from state and federal grants, so declines in a major source of county tax revenue are often less damaging than they are for cities.

After the emergency declaration, Standard and Poor’s affirmed the county’s A+ rating (four notches below the agency’s top AAA rating) and changed its outlook to negative. No downgrade has followed.

Kern County’s liabilities exceed its assets, leaving it with a negative Net Position – another sign of fiscal stress. Since most of a government’s assets are already committed to specific requirements (like paying debt service) or tied up in capital assets that are difficult to sell, analysts often focus on its Unrestricted Net Position – a measure of reserves that could be freely allocated by elected officials. Kern County has a negative Unrestricted Net Position of almost $2.3 billion – suggesting a serious fiscal problem.

On the other hand, the county has a strong general fund balance – equal to more than six months of general fund expenditures. As we have reported elsewhere, low or negative general fund balances have been the best predictor of municipal bankruptcy in recent years.

More recently, the county made further budget cuts which could result in closures of fire stations, jails and other facilities. If the county was not paying over $1 in every $8 for pension contributions and pension obligation bond debt service, these reductions might not have been necessary.

  1. Fresno County

Like Kern County, Fresno County has used pension obligation bonds (POBs) to address pension underfunding. As of June 30, 2015, the county had $454 million in POBs outstanding. This balance actually exceeds the $402 million principal amount of the POBs when they were issued in 2004, because much of the 2004 offering consisted of capital appreciation bonds (CABs). Interest on CABs is added to principal over the life of the bond and then paid at maturity.

In fiscal year 2015, Fresno was scheduled to pay over $37 million in debt service on its POBs. If this is added to the $153.5 million in Actuarially Determined Contributions the county was obliged to make, its pension-cost-to-revenue ratio would (like Kern County’s) exceed that of Santa Barbara County’s, which did not issue POBs.

Fresno County has the highest employer contribution rates as a percentage of payroll of the counties discussed here. In fiscal year 2015, contribution rates range from 37.4 percent to 74.6 percent for certain public safety employees. The county’s retirement program provisions are relatively generous. According to the system’s actuarial report, most plans allow members to retire at age 50. If they remain on the payroll after 55, many classes of employees accrue additional benefits at accelerated rates.

On the plus side, the Fresno County Employees’ Retirement Association is amortizing its unfunded liabilities over a 15-year period and has a relatively strong funded ratio – 79.4 percent (down from 83 percent at the end of 2014).

Illustrating that optimistic investment forecasts plague local government financials, Fresno County assumes annual asset returns of 7.25 percent. Its actual return in fiscal 2015 was a dismal -0.10 percent.

  1. San Mateo County

Like Santa Barbara County, San Mateo County has a strong economy, so it’s surprising to see it near the top of our list. One driver of the county’s pension burden appears to be high employee salaries. Since pension benefits are based on final average salaries, high employee compensation translates into high pension benefits.

A San Jose Mercury News story revealed that San Mateo County had 78 employees paid over $200,000 in the 2013 fiscal year. More recent data available on Transparent California shows that number grew to 90 employees in 2014.

Employee contribution rates ranged from 28.3 percent to 65.5 percent. For a single employee earning $200,000, the county’s annual pension contribution could be as a high as $130,940.

A 2012 San Mateo Civil Grand Jury report noted that county pension contributions had grown from $78 million in fiscal 2006 to $150 million in fiscal 2012, but the plan continued to generate substantial unfunded liabilities. The jury made a number of recommendations including “significantly decreasing the number of county employees through outsourcing and/or reducing services, and by attrition.”

The county’s board of supervisors agreed with most of the Grand Jury’s findings but did not specifically respond to the call for headcount reductions.

In late 2013, the board of supervisors decided to make extra contributions to SamCERA (the San Mateo County Employees Retirement Association) in order to more rapidly cut its unfunded liability. The supervisors authorized a one-time payment of $50 million in fiscal 2014 followed by annual $10 million payments in each of the next nine fiscal years. These payments, totaling $140 million over 10 years, are above the county’s Actuarially Determined Contribution.

The extra contributions have improved SamCERA’s funded ratio despite lackluster stock market performance in the most recent fiscal year. The system’s funded ratio rose from 73.3 percent in 2013, to 78.8 percent in 2014 and to 82.6 percent in 2015. The system achieved portfolio returns of 3.5 percent in fiscal 2015 as opposed to a 7.5 percent projected return rate.

Since 2013, the system’s unfunded liability has fallen from $954 million to $702 million. SamCERA amortizes unfunded liabilities over a 15-year period. Given the improvement in SamCERA’s funded ratio, it seems likely that San Mateo County will fall off the list of highly burdened counties in future years.

CONCLUSION

Generous benefits, aggressive return assumptions and (in some cases) high employee pay have left a number of California counties heavily burdened with pension costs. This year’s poor stock market performance will likely mean additional stress.

Over the longer term, the state’s 2013 pension reform should provide some relief, as newly hired employees receive less generous benefits. But if the stock market continues to be weak or if county systems make poor investment choices, asset returns will remain below the 7.25 percent-7.50 percent typically anticipated in actuarial valuations. Under those circumstances, employer contributions and overall pension burdens may continue to rise. The result will likely be ballooning public debt, pressure to raise taxes and cuts in government services.

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About the author:  Marc Joffe is the founder of Public Sector Credit Solutions and a policy analyst with the California Policy Center. Joffe founded Public Sector Credit Solutions in 2011 to educate policymakers, investors and citizens about government credit risk. PSCS research has been published by the California State Treasurer’s Office, the Mercatus Center and the Macdonald-Laurier Institute among others. Prior to starting PSCS, Marc was a Senior Director at Moody’s Analytics. He has an MBA from New York University and an MPA from San Francisco State University.