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LONG-RANGE FINANCIAL PLAN UPDATE AND ANALYSIS OF CALPERS DISCOUNT RATE CHANGES
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RECOMMENDATION
Informational item only.
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Summary
The City maintains a forecasting model to estimate the long-term financial impact of current budgetary decisions. The Long-Range Financial Plan (L-RFP) is updated periodically to reflect significant changes and the most recent revenue and expenditure data. This report includes a revised L-RFP that is consistent with the changes included in the Second Quarter Budget Status update and provides a preliminary analysis of the effect of recent CalPERS actions on the General Fund.
The CalPERS Board of Trustees recently adopted new policies to strengthen the long-term sustainability of the pension fund. Specifically, the Board revised policies regarding the assumed investment earnings (discount rate) and life expectancy assumptions. These changes are designed to reduce the risk associated with volatile investment markets and stabilize contribution requirements. While these changes will improve the likelihood of CalPERS achieving investment earnings, it will also increase employer contributions to offset the reduced earnings targets.
Although the City planned for increased CalPERS costs, the recent Board action exceeds prior L-RFP assumptions regarding contribution increases. CalPERS issued general instructions for public agency employers in January, and information specific to the City’s pension obligations will not be available until this summer. The following analysis is based on available information and prior actuarial reports commissioned by the City. Based on preliminary estimates, the City’s CalPERS costs will exceed those projected in the Long-Range Financial Plan (L-RFP) by $4.2 million in FY 2020-21, and $16.5 million in FY 2024-25 when the full annual effect is realized.
Based on this preliminary analysis, it is also evident that the City can make budgetary changes to prevent a negative General Fund balance and ensure continued financial sustainability. Prior Council action to rely upon reasonable revenue forecasts, limit expenditures to what can be afforded in the L-RFP and establish General Fund reserves positioned the City to manage the greater than anticipated CalPERS changes. Staff will continue to analyze the impact of CalPERS changes and future quarterly updates, and will provide future L-RFP updates for FY 2017-18 budget deliberations.
DISCUSSION
Background
One of the strategic initiatives developed to support the City Council’s “Fiscal Sustainability - Getting our Fiscal House in Order” goal was to use the financial forecasting model to monitor the fiscal health of the General Fund and to inform the City Council of any new developments that would impact the City’s financial condition. This report is being written as a supplement to the FY 2016-17 Second Quarter Budget Status update report to provide the Council with information on the CalPERS changes that will have a significant long-term negative impact on the City.
Present Situation
CalPERS
As anticipated, the CalPERS Board of Trustees adopted new policies regarding the discount rate (investment earnings) assumptions on December 21, 2016. Although the City expected a reduction in the discount rate, the CalPERS action exceeded prior estimates. CalPERS reduced its assumed discount rate to:
• strengthen the long-term sustainability of the fund,
• reduce negative cash flows,
• reduce the long-term probability of funded ratios falling to undesirable levels,
• improve the likelihood of CalPERS investments earning the assumed rate of return, and
• reduce the risk of volatile contribution increases.
The new CalPERS policies gradually reduce the assumed discount rate from 7.5 percent to 7.0 percent to reflect lower anticipated investment returns and to address the growing benefit costs of the CalPERS system. Because pension benefits are paid from a combination of contributions and investment earnings, lowering the anticipated earnings results in increased contributions. Consequently, increased costs for all CalPERS agencies will be phased in over the next several years. The CalPERS Board policy will adjust the discount rate over three years as follows:
Lowering the discount rate means local agencies will see increases in both the normal costs (the cost of pension benefits accruing in one year for active members) and the unfunded accrued liabilities (UAL). The UAL can fluctuate over time based on various factors, such as changes in investment earning or life expectancy. The increase in normal costs will be phased in over three years beginning in FY 2018-19. The increase in the UAL costs will be extended over seven years to reduce the impact to local agencies. Prior to CalPERS changes, the City’s Miscellaneous pension plan (non-safety employees) was 79 percent funded and the Safety Plan (police and fire sworn employees) was 72 percent funded. The combined UAL was $403.3 million in the most recent CalPERS valuation report based on June 30, 2015 data. The new policy to lower the discount rate is estimated to increase the UAL by $221.9 million or 55 percent in total. Based on preliminary estimates, the City’s combined CalPERS costs will exceed those projected in the Long-Range Financial Plan (L-RFP) by $4.2 million in FY 2020-21, and $16.5 million in FY 2024-25 when the full annual effect is realized. These figures are preliminary estimates based on available information. CalPERS will release its annual valuation report with actual FY 2018-19 figures in the summer of 2017.
Going forward, hiring of employees under the Public Employees Pension Reform Act of 2013 (PEPRA) is still expected to limit the growth in future pension costs and significantly improve the ability of CalPERS agencies to afford pension benefits. Employees hired under PEPRA receive reduced retirement benefits compared to Classic (pre-existing) CalPERS members. Stockton also took the additional step of implementing a second tier with lesser benefits for Classic CalPERS members that join Stockton from another member agency, further lowering future pension obligations. While the recent CalPERS changes will significantly increase costs, the changes do not affect the predicted long-term positive effects of the PEPRA. The PEPRA is still forecast to stabilize and lower pension obligations in the long-term. The following graphs show the Safety and Miscellaneous CalPERS rates at the previously projected 7.25 percent discount rate compared to the recently adopted 7.0 percent discount rate. Both Figure 1 and Figure 2 clearly depict increased costs because of the change in discount rate, and the positive effect of the PEPRA in the long-term.
Figure 1. Safety Plan Employer Rates by Discount Rate
Figure 2. Miscellaneous Plan Employer Rates by Discount Rate
Long-Range Financial Plan
Since the development of the L-RFP during the Bankruptcy, the financial model assumed a 0.25 percent reduction in CalPERS discount rate, from 7.5 percent to 7.25 percent. To prepare for future discount rate reductions, Council adopted a General Fund Reserve policy and allocated funds to the reserve as part of the final budget actions for FY 2015-16. Following analysis and review of the CalPERS discount rate change, the Budget Office revised the L-RFP to incorporate the new CalPERS policies and other new revenue and expense information from the FY 2016-17 Second Quarter Budget. The following graph represents the L-RFP as it existed before the CalPERS rate increases. The Figure 3 graph, provided to Council on January 24, 2017, incorporated the FY 2015-16 year-end results and the addition of positions authorized by Measure O in 2016.
Figure 3. L-RFP Fund Balance before CalPERS Discount Rate Change
As can be seen in Figure 3, a reduction in the fund balance was projected during the ten-year period of the 2020-2030, due to a variety of factors including higher salary costs, anticipated economic slowdowns, and CalPERS rate increases. During that period the General Fund was forecast to be below the 16.7 percent Working Capital goal, but well above the 5 percent minimum in most years. The fund balance excluding reserves dropped below the 5 percent minimum for three years starting in 2027. After the year 2030, the fund balances were anticipated to increase and return to the 16.7 percent Working Capital Reserve by 2036.
The following graph depicts the impact of the recent CalPERS Board actions, assuming no action is taken to mitigate the CalPERS rate changes.
Figure 4. L-RFP with CalPERS Discount Rate Change
Although the changes would not place the City into an immediate crisis, deficit spending would begin in the next two fiscal years and the General Fund balance would decline in future years. The General Fund balance is forecast to fall below the 5 percent minimum reserve level in 2023 and go negative in 2024. Absent mitigating actions, this course of action would result in a negative fund balance of $120 million by 2033.
However, with prudent and rapid action the City is well positioned to weather the CalPERS changes because of the responsible fiscal behavior since Bankruptcy. This behavior included relying on reasonable revenue forecasts, limiting expenditures to what can be afforded in the L-RFP and establishing General Fund reserves. For discussion purposes, the following L-RFP graph is presented to demonstrate that the City can take budgetary action to prevent a negative General Fund balance and ensure financial sustainability. Figure 5 represents a potential scenario for the FY 2017-18 Budget that successfully mitigates the CalPERS policy changes.
Figure 5. L-RFP with CalPERS Discount Rate Change, Second Quarter Update and Strong Communities Maintenance of Effort
This graph includes revenue and expenditure data consistent with the FY 2016-17 Second Quarter update, reflects implementation of the Strong Communities (Measure M) transaction tax and assumes potential actions to balance the budget. In regards to CalPERS costs, this graph reflects the middle of the range impact provided in the CalPERS circular letter. The actual cost impact as a percent of salary will not be known until CalPERS provides valuation reports later this summer.
The budgetary solution represented in Figure 5 also assumes that General Fund contributions to Library and Recreation activities are limited to the maintenance of effort (MOE) requirement contained in the Strong Communities ordinance. For this scenario, the L-RFP was revised to reflect $7.4 million General Fund for Library and Recreation activities consistent with the FY 2014-15 funding level during the years when the Strong Communities transaction tax is in effect. The financial model also reflects the additional cost burden of more than $11 million General Fund starting in FY 2034-35 assuming the Strong Communities (Measure M) transaction tax is not renewed. Due to this updated assumption, the potential of further program expansions or new programs has been delayed from 2035 to 2039 in this updated scenario.
Beyond these baseline adjustments, additional actions would be required to maintain a positive fund balance in the L-RFP. Consequently, this scenario also assumes that $11 million of the General Fund reserves and the savings identified in the Second Quarter update are directed toward the increased CalPERS contributions. Expenditures have also been adjusted to reflect increased salary savings consistent with the most recent expenditure data.
CONCLUSION
The L-RFP allows the City to protect current services by quantifying future financial challenges early and planning for them before service levels are impacted. As demonstrated in Figure 3, the City can take budgetary action to address the recent CalPERS changes, maintain current service levels and implement the Strong Communities initiative if appropriate action is taken during budget development for FY 2017-18. Staff will continue to refine the L-RFP in time for budget deliberations, including the most up to date information from CalPERS and changes associated with the Third Quarter Update for FY 2016-17. The updated L-RFP will provide the tool and analysis necessary understand the fiscal effect of various options to address the projected negative fund balance resulting from recent CalPERS changes.