Spend money to save money: How four cities are managing their pension obligations

This article originally appeared in Western City magazine on February 1, 2023. It is also jointly authored. Click here to view the original article.

California’s unfunded pension woes could become worse in the next few years. Last year, the California Public Employees’ Retirement System (CalPERS) suffered a 6.1% investment loss in the fiscal year ending on June 30, the first such loss since 2008. Cities will not feel these impacts immediately, but they will almost certainly be felt in the next few years. 

Thanks in part to the painful lessons of the 2008 recession, cities have more tools that can help them prepare. Education efforts have also increased employers’ awareness about their ability to make additional discretionary payments and the advantages of doing so. Western City spoke with city officials from Lodi, Roseville, Scotts Valley, and Upland to learn how cities can better prepare.

Although the historic bull market and near-zero interest rates are gone for the foreseeable future, there is still an opportunity to prepare for an uncertain future. “You need to make hay when the sun is shining,” Lodi City Manager Steve Schwabauer said. “And the sun was shining for the last eight years. And unfortunately, it’s probably not right now. So, make hay in the next two to three years if you can. If you have excess reserves, I would definitely invest them in cutting down my pension bill.”

Invest now for the rainy days ahead 

Making additional, one-time pension payments has some obvious benefits. They result in lower interest rates, less risk, a reduction in net pension liability, and most importantly, more money for critical services. Cities can make these payments monthly, quarterly, or even on an ad hoc basis depending on their fiscal health. These payments, while potentially painful in the short term, pay off in the long term. Roseville will save $800,000 per year for 20 years as a result of two additional, $6 million payments.

How those payments are funded depends on the city.

The city of Lodi has several additional payment strategies in place, most notably a pension stabilization policy. Any budget reserves over and above 16% must be invested in the city’s pension obligations. The city pays its entire unfunded accrued liability — the difference between the estimated costs of future benefits and how much is set aside to pay them — at once. CalPERS provides a discount for early payments, which the city forgoes, resulting in even more long-term savings. The city also maintains a diverse investment portfolio to provide liquidity in the event of an unexpectedly large pension payment.

As a result of these policies, the city has invested an extra $2-3 million in its pension obligations per year since 2017. Before these payments, Lodi was one of the worst-funded cities in California. Today, it is firmly in the middle.

“It takes a tremendous amount of fiscal discipline from a city to pursue this type of policy,” Schwabauer said. “There are a lot of calls on spending money. And a lot of them are very appropriate.”

For Lodi, this discipline paid off. The city anticipated its pension costs would go up by as much as $14 million. Instead, it went up by $8 million.

Spending money to save money

Pension stabilization policies are a great way to lower pension obligations, but this raises an obvious question: How? For many cities, this often means investing in a Section 115 Pension Trust Fund. Named after a section of the federal Internal Revenue Code, Section 115 trusts do not have a direct impact on a city’s reported pension liability or the size of its required annual contribution. More importantly, Section 115 Trusts can serve as a reserve to mitigate risk during economic downturns.

Preemptive, strategic thinking like this is critical, especially when market conditions — and the discount rate — fluctuate. “It’s really very difficult for cities to budget or predict when CalPERS … is constantly changing even what our liability number is,” said Scotts Valley City Manager Mali LaGoe, who is currently pursuing a Section 115 Trust.

LaGoe emphasized that managing pension investments through Section 115 Trusts is an important way to maintain local control. “Our liability was $16 million and all of a sudden it was $24 million,” she said. “If you have a strategy for a $16 million liability and then all of a sudden it goes up by 50% … [that makes it] very difficult for cities to plan. That’s where the 115 Trust shows that we are exercising some discipline, putting some money aside, earning interest on that money, but we’re also not just giving it to CalPERS.”

Section 115 Trusts can be particularly potent when combined with a disciplined pension funding policy. The city of Upland’s pension policy calls for several intentional contributions to its Section 115 Trust. Fifty percent of its budgetary cash savings made from additional discretionary payments to CalPERS are directed to its Section 115 Trust. The city also remits 40% of any year-end operating surplus to its Pension Stabilization Reserve.

Upland’s Section 115 Trust is part of a larger strategy that includes an accelerated payoff of any unfunded accrued liabilities, fund transfers, a lease investment, and several discretionary payments. As a result, the city has paid down $45.76 million of its $127 million unfunded accrued liability, with a projected savings of $66.8 million. Even after CalPERS’s historic losses in 2022, Upland’s current estimated savings are $54.6 million.

Another common way of funding additional payments are pension obligation bonds. These taxable bonds fund the unfunded portion of a city’s pension liability by creating a debt to the bondholders. However, policy experts have noted that these bonds are less financially compelling now that interest rates have risen well above their historic lows. The Government Finance Officers Association even specifically advises against the use of pension obligation bonds.

People-level changes

The most important step to reducing a growing pension obligation is to take a step. “The pension issue will not solve itself,” Upland Assistant City Manager Stephen Parker said. “Take an intentional look at the situation and begin to brainstorm what strategies can be undertaken to start chipping away at it. You don’t have to solve the issue all at once, but not doing anything is likely to just aggravate the situation.”

The size of this step will vary from city to city. One step many cities have taken is to renegotiate how they compensate employees. Agencies that pay more in salaries and contribute less towards health care insurance will experience high pension costs. Shifting that balance, in consultation with employees, can result in meaningful savings.

When talking about pension-related strategies — either with the public or employees — it is important to avoid jargon. Throwing out acronyms and mind-melting future cost estimations will only make it harder for people to understand why these changes are necessary.

For example, in addition to the strategies outlined in previous sections, Roseville held educational forums on CalPERS-related fiscal issues for its employees. The city also summed up the challenges facing the state pension fund, as well as the steps taken by CalPERS and the city in a neatly organized one-page handout.

“The general reception was positive; I had more than a few employees thank us for the information,” Roseville Assistant City Manager Dennis Kauffman said.

Looking at 2025

In 2025, CalPERS will consider changing the discount rate — the long-term interest rate used to fund future pension benefits — as part of its four-year Asset Liability Management process. In 2021, the discount rate was lowered from 7% to 6.8% as a result of CalPERS’  Funding Risk Mitigation Policy. Later that year, CalPERS voted to keep the discount rate at 6.8% for another four years.

If the discount rate goes down, cities will need to increase their contributions. For unprepared or financially overextended cities, this could lead to service insolvency or even bankruptcy. How much cities can prepare using the strategies outlined in the previous sections will vary based on the market and local demographics. With only a few exceptions,  employers are up to date with their contribution requirements, and many are making additional discretionary payments to improve their funded status and lower their overall costs.

“We’re pleased that our employer partners are finding the resources and tools we provide helpful,” CalPERS CEO Marcie Frost said. “We recognize and appreciate the unique needs that they have in delivering retirement and health care benefits and we are here to assist in this shared responsibility.”

Using these tools — and advocating for new ones — will become even more important in the next few years. Even well-funded, fiscally disciplined cities like Lodi, Roseville, Scotts Valley, and Upland are concerned about recent market declines and the impact of inflation on the state’s pension fund and its impact on city budgets.

“We’re not going to be bankrupt, but we could become service insolvent, with so much money going to the pension that we can’t pay a sustainable level of service,” Schwabauer said.