TO:
Honorable Mayor and Members of the City Council
THROUGH:
Mark Danaj, City Manager
FROM:
Bruce Moe, Finance Director
SUBJECT:Title
Establishment of a Pension Stabilization Trust Fund (Finance Director Moe).
ADOPT RESOLUTION NO. 16-0053; APPROPRIATE
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Recommended Action
RECOMMENDATION:
Staff recommends that the City Council: a) adopt Resolution No. 16-0053 establishing a Pension Rate Stabilization Trust Fund Administered by Public Agency Retirement Services (PARS) ; b) Appoint the City Manager as the City’s Plan Administrator; c) Authorize the City Manager to negotiate and execute the final documents of the Trust; d) appropriate $780,000 from unreserved General Fund moneys and authorize the transfer of those funds to the Pension Rate Stabilization Trust Fund; e) authorize the transfer of $500,000 in budgeted General Funds to the Pension Rate Stabilization Trust Fund, and f) assign responsibility and authority to the Finance Subcommittee to develop an investment policy and guidelines, and direct investments in the trust.
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FISCAL IMPLICATIONS:
The recommended initial funding of the Pension Rate Stabilization Fund is $1.28 million: $500,000 from budgeted funds in FY 2016-2017, and $780,000 (to be appropriated) in transfer fee proceeds from the sale of the Marriott Hotel in FY 2015-2016.
BACKGROUND:
The City of Manhattan Beach has been a leader in proactively addressing pension issues in recent years. Examples include issuing Pension Obligation Bonds (POBs) in 2007 to payoff “side funds” in the City’s CalPERS safety pension plans, saving $433,000 (the POBs were paid off in 2015); negotiating employee pickup of the employee share of the total pension contribution; and instituting employee cost sharing of the employer rate for safety employees. In 2008, the City also fully pre-funded its Other Post Employment Benefits (OPEB) liabilities for retiree medical (valued at $6.4 million at that time), for which the City is currently overfunded by $3.6 million.
Despite these steps, pension costs continue to rise for a number of reasons. CalPERS has made changes to actuarial assumptions including projected reductions in the investment rate of return, as well as increased life expectancy. These, and to a degree, the lower than expected rates of return over the past two years by CalPERS, are leading to increased pension contribution rates and growing unfunded liabilities. It is important to note that the rates paid by the City include a component to pay off the unfunded liabilities; as a result those unfunded liabilities are being addressed over time. It is equally significant that CalPERS has recognized that the assumed rate of return (discount rate) of 7.5% is not sustainable in the long term, and therefore has implemented a plan to reduce the discount rate to 6.5% over time to better reflect expected future returns.
The most recent CalPERS actuarial valuation reports (valued as of June 2014) indicated that the City has $44 million of unfunded pension liabilities. Recent projections by the City’s independent Actuary indicate that, given those actuarial changes at CalPERS and recent investment returns, unfunded liabilities may grow to $89 million by FY 2020-2021. Pension contribution rates as a percentage of payroll may also climb 50% to 121% over the next five years depending upon the discount rate utilized.
As part of the adoption of the FY 2016-2017 budget, and in an effort to proactively address rising pension costs and associated unfunded liabilities, City Council directed that a Pension Rate Stabilization Fund (PRSF) be established. Further, Council allocated $500,000 towards the PRSF.
DISCUSSION:
Until recently, the only option available for the City to reduce unfunded pension liabilities was to submit additional discretionary payments to CalPERS above and beyond the required contributions. However, those funds, once on deposit, are subject to the same market volatility risk as the other funds invested with CalPERS. There is now an alternative in the form of depositing funds into an irrevocable trust established specifically for pension rate stabilization purposes.
A Pension Rate Stabilization Fund (PRSF) has several benefits:
• The City maintains oversight of investment management and control over the risk tolerance level of the portfolio
• Assets can be accessed to offset unexpected rate increases thereby stabilizing on-going pension expenditures
• Assets held in the fund allow for greater investment flexibility and risk diversification compared to the City’s general investments
• Funds deposited into the trust offset the City’s Net Pension Liability which is now reported on the City’s balance sheet in accordance with Government Accounting Standards Board (GASB) Statement No. 68
• Depositing assets in a trust will be a positive development to Moody’s and Standard and Poor’s in the City maintaining Triple-A credit ratings from both of these entities
It is important to note that any funds deposited in the trust fund may only be used for pension costs and cannot be recaptured for other uses. However, use of funds may reduce reliance on existing unrestricted funds freeing those moneys for other uses.
The concept of the fund is that the City would deposit funds into the account and invest those moneys in instruments that have the potential to earn greater returns than can be achieved under the City’s existing investment policies and State law for general public funds. State law provides the framework for public funds investment in such trust funds. The principal and earnings may then be contributed to any one of the City’s three CalPERS plans (Police, Fire, Miscellaneous) at the City’s discretion. For example, the funds can be used as a buffer to reduce the impacts of large rate fluctuations in Employer rates from substandard investment returns.
Funding
The adopted FY 2016-2017 budget includes $500,000 in the General Fund to be deposited into the trust account once it is established. Additionally, staff recommends that funds totaling $780,000 realized from the sale (transfer) of the Marriott Hotel in FY 2015-2016 (which is currently included in the FY 2016-2017 unreserved General Fund balance) be appropriated and included in the initial funding of the account, bringing the total seed money to $1.28 million. Aside from the $500,000 annual contribution now in place, additional future contributions will be directed by the City Council, and may include year-end surpluses and other one-time receipts.
Staff, in coordination with the Finance Subcommittee, will return to City Council in the future with a discussion on amending the City’s Financial Policies in order to include guidelines on funding this pension trust.
Public Agency Retirement Services (PARS)
Section 115 Irrevocable Trusts have been in existence for many years. In the past several years, they have they been adopted as a mechanism for pre-funding public agencies’ OPEB liabilities (which the City did in 2008 through a CalPERS sponsored plan). Most recently, they have become a popular tool for pre-funding pension liabilities as a method to address unfunded liabilities and large variances in annual pension contribution rates.
The number of administrators offering Pension Rate Stabilization Trusts is limited since this is a fairly new financial adaptation of Section 115 irrevocable trusts. Two main entities have entered the marketplace: Public Agency Retirement Services (PARS) and Public Financial Management (PFM).
While both are clearly capable and experienced in Section 115 trust administration, staff believes PARS is best suited to meet the City’s needs for the following reasons:
• PARS is the leader in this marketplace having established 41 public agency PRSF trusts, including 18 cities
• PARS has a track record of being a leading provider of public retirement services. For example, the City has received excellent service from PARS in providing part time employees with the legally required retirement plan (this is an acceptable and lower cost alternative to Social Security)
• PARS’s asset management costs are marginally lower than PFM’s (all-in costs for administration, management, trustee and advisory fees of .60% versus .715%)
• The PARS program has been established as a multiple employer trust so that public agencies regardless of size can join the program to receive the necessary economies of scale to minimize administrative fees.
Portfolio Management
PARS has partnered with US Bank to serve as Trustee, and with its sub-advisor High Mark Capital Management to provide investment management services for the program.
Under the PARS Pension Rate Stabilization fund, the City maintains oversight of the investment manager and the portfolio’s risk level to mitigate undue risk. Several options exist for the portfolio management:
1. The City can utilize the Administrator’s (PARS) subadvisor, High Mark, to handle the investments on a preset basis. The City would select one of five preset options (Attachment #2) from active or passive (i.e., index funds) investments with High Mark determining the actual investments utilized. With this scenario, the City has the ability to influence the risk level and investment approach, but do not select specific investments (e.g., investing in a specific equity). For new plans that have not accumulated much by way of assets, this is generally the preferred route.
2. Once the asset levels are larger (e.g., over $ 5 million), it would be possible to work with High Mark on a more customized basis (for example, The City may guide High Mark to purchase individual bonds rather than bond mutual funds). Also, once customized, the City can develop a strategy that is different than the 5 preset options which could include more alternative investments.
3. As a third approach, the City could hire a separate investment advisor. In this capacity, US Bank would serve as Directed Trustee and would be custodian of the assets. High Mark would not be involved at all. The City’s investment advisor would manage the investments based on City direction and would be separately compensated. The issue to note is that at small asset levels, investment advisors may not be that interested until assets reach a more sizable level. As a result, some PARS agencies are taking the approach of working with High Mark until assets reach a more significant level and then may decide at a later point in time whether or not to use a different manager.
Staff recommends that the City Council assign responsibility and authority to the Finance Subcommittee to develop an investment policy for the trust, and direct investment decisions for the fund (e.g., Conservative, Moderately Conservative, Moderate, etc.) or another alternative listed above as deemed appropriate by the Finance Subcommittee. This is similar to the role of the Finance Subcommittee with regard to the City’s other investments. Further, staff will recommend to the Finance Subcommittee that initially the City utilize High Mark as the investment advisor utilizing one of the five preset options. However, advisory services for these investments may be changed at any time as deemed desirable.
Council Questions
City Council had a number of questions regarding the pension fund program during the August 16, 2016 meeting. Those questions, and associated answers, are provided below.
1. Describe the trust fund for retiree medical and how it works
In 2008, the City established a Section 115 Trust Fund for the purpose of prefunding the City’s “Other Post Employment Benefits” (OPEB). The OPEB trust is administered by the CalPERS’ California Employers' Benefit Trust (CERBT). The funds are invested in one of three options available; the Finance Subcommittee selected the mid-level risk option (as opposed to the lowest risk or highest risk).
The City’s OPEB liabilities in this fund stem from two retiree medical benefit programs: a) a stipend of between $250 and $400 per month depending upon the labor group and certain minimum service years, which terminates when the retired employee reaches age 65 or Medicare eligible, and b) the CalPERS requirement that any agency participating in the Public Employee Medical and Hospital Care Act (PEMHCA) medical insurance program, as the City does, must provide employees and retirees with a certain minimum contribution. Currently, that amount of $125 per month, subject to annual adjustment. Thirty-six percent ($2.1 million) of the City’s accrued liabilities relate to the City’s stipend while the CalPERS PEMHCA requirement accounts for 64% ($3.8 million).
The funds in the trust may only be used for OPEB related costs. Mechanically speaking, the City pays out the stipend to retirees monthly and seeks reimbursement from the trust at the end of the fiscal year. For FY 2015-2016, the OPEB reimbursement from the trust totaled $288,888.
The OPEB trust fund is currently funded over 160% of actuarially accrued liabilities. In dollars, assets total $9.5 million while accrued liabilities total $5.9 million, leaving $3.6 million in surplus assets. This cushion will allow the City to forego the normal scheduled contributions $285,793 for FY 2016-2017.
2. Describe how investing in the Pension Stabilization Fund reduces the pension liability and controls long-term risk
The main purpose of the Pension Stabilization Fund is to provide a cushion and smoothing against rapidly rising pension contribution rates. By design, the City deposits funds into the trust, invests at returns greater than achievable for General investments the City makes under State law, and then uses the program funds to reduce outgoing cash flow for pension costs, allowing City funds to be used for other needs as appropriate or desirable. This reduces pension costs through the ability to achieve greater investment results compared to the standard investments the City makes. In addition, assets in the Pension Stabilization Fund will directly reduce the City’s Net Pension Liabilities on its financial statements whereas assets in the General Fund cannot directly offset pension liabilities.
The annual total pension payments to CalPERS include a component that is applied to unfunded liabilities. As a result, any trust funds we use to pay pension costs also help address unfunded liabilities. Further, if deemed financially prudent, trust funds may be used to accelerate pay down of unfunded liabilities with CalPERS. However, it is important to note that once additional unfunded liability payments are sent to CalPERS, they are comingled with standard Pension Fund investments, and thus are subject to the same risk as the entire CalPERS investment pool since the funds are no longer in the City’s control. This may result in gains or losses which mirror the risk the City is already exposed to through the pension plan.
Because the stabilization program funds are controlled by the City, long term risk may be improved compared to the CalPERS portfolio. This will be dependent upon the investment policies and risk profile the City selects. Investment choices will include conservative to growth oriented portfolios, each with varying risk factors and corresponding expectations for rates of return.
3. What are the thoughts regarding guidelines and a distribution plan for the fund? Will there be benchmarks? What are we trying to accomplish for each department?
The recommendation is that the City Council assign responsibility to the Finance Subcommittee to develop policies on investment, sources and uses of funding. The policies may be reviewed and approved by the full City Council if so directed.
Other cities have varying funding policies. For example, Solana Beach contributes 50% of year-end surpluses to the pension stabilization fund. City of Sausalito contributes the difference between the required CalPERS contributions utilizing the current 7.5% discount rate, and a 2.8% discount rate. Finally, the City of Healdsburg set a maximum employer rate for the groups (Miscellaneous, Police, Fire) with the pension fund being utilized when employer contribution costs exceed stated levels.
Benchmarks may be established as a barometer of success. The options provided by High Mark (the initial recommended investment management advisory service) include benchmarks in their materials (Attachment #2), as do most advisory firms.
The goals for this fund are not set by department. Rather, the objective is to smooth impacts of rising pension contributions so as to not cause rapid negative impacts to other services. This would be done on a citywide basis.
4. How are other jurisdictions using similar funds?
In addition to the smoothing described above, other public agencies are using the funds to primarily accomplish the following:
• Help create new revenue sources from Trust Investment earnings to provide structural balance (i.e., helps revenue growth rate equal expenditure growth rate). (Town of Colma)
• Trust Assets act as a direct offset to Net Pension Liabilities under GASB 68 (City of Brea)
• Trust Assets act as a hedge against PERS investment risk (City of Upland)
5. How are other jurisdictions addressing the same problem? Do they have a similar fund? How has it worked for them?
Forty-one public agencies in the state of California have established similar Section 115 trusts with PARS. These other public agencies include counties, school districts, a community college district and special districts in addition to the 18 cities that have already adopted the same trust program under consideration by the City. The same benefits and advantages of the trust are also present for these other jurisdictions.
The concept of this program is relatively new, having only been established for a little more than a year. These liabilities that are being addressed are long-term liabilities that will take many years to correct, so the ultimate success of the program will depend on a variety of factors including the ability to fund the trust, the overall investment returns of the City-controlled trust, and the actual plan experience of the underlying retirement system (i.e., CalPERS).
To provide an example of how other jurisdictions are investing plan assets, here is a breakdown of those that 41 agencies that have already adopted the program:
Investment Strategy Type / % of Agencies in Strategy
Conservative (15% Equities) 10%
Moderately Conservative (30% Equities) 32%
Moderate (50% Equities) 24%
Balanced (60% Equities) 29%
Capital Appreciation (75% Equities) 5%
6. What is our current annual payment and what percentage will our contribution to the fund be of that number?
The City’s Fiscal Year 2016-2017 contribution is estimated to be $6.2 million. The City Council has directed that $500,000 per year be deposited in the fund. That equates to 8% of FY 16-17 contributions. If City Council approves the staff recommendation to include the $780,000 from the Marriott sale, the total contribution of $1.28 million equates to 20.6%.
7. Are there additional policies needed for the City in association with this fund? What existing state laws are there and do we need to be augmenting them?
Please see #3 above. Existing state laws do provide additional flexibility with respect to plan investments compared to the City’s current investment guidelines. The City (Finance Subcommittee) would work with the investment advisors to develop an Investment Guideline Document (IGD) with respect to assets held in the trust.
8. Timeline for developing those financial policies, if necessary.
If City Council accepts the staff recommendation to utilize the Finance Subcommittee to develop policies (including the Investment Guidelines Document), staff anticipates that policies would be prepared within 30-45 days.
9. Are there any reference guides from John Bartel on these issues?
According to Mr. Bartel, there are no reference guides on this topic at this time. However, Bartel and Associates commonly recommend the establishment of a pension stabilization fund as a more meaningful actions a jurisdiction can take to smooth future rate increases.
10. Will this limit our risk more or less than PERS? Compare the two risks.
This will reduce our exposure to the risks associated with CalPERS’ aggressive style of investments, which are currently geared to attain 7.5% returns. CalPERS uses a diversified portfolio that has many different asset classes. For example, pension funds are invested in real estate, equities (stocks), bonds, and corporate debt. Investments in a City controlled trust can potentially be invested more conservatively than CalPERS, which can reduce the overall investment risk to the City. Please see Attachment #2 which includes investment options.
11. Compare and contrast this fund with what was done before
Generally speaking, the City has made only the required contributions as calculated by CalPERS each year. With the exception of a one-time payment to CalPERS in the 1990s used to pay down unfunded liabilities, and the issuance of pension obligation bonds in 2008 to payoff liability side funds in the safety pools, no additional payments have been made. However, please note that all regular, required payments to CalPERS include a component to pay down unfunded pension liabilities.
In FY 2003-2004, in the face of rising pension costs, the City established a Pension Stabilization reserve within the General Fund. This reserve was funded with one time moneys totaling $2,024,505 realized from a utility cost allocation study. Pension contribution increases totaling $2.2 million were expected in FY 2003-2004 and FY 2004-2005. The reserve was ultimately used in FY 2005-2006 ($680K), with the balance ($1.3 million) utilized in FY 2006-2007.
This new pension stabilization fund will act in much the same way the 2003-2004 reserve was intended, except that the City will have the ability to reduce pension costs through higher investment earnings potential than can currently be achieved with general City investments. Funds may be drawn to stabilize annual pension payments so that substantial increases can be eased into operational expenditure budgets and reduce immediate impacts on service levels.
12. How does this limit our risk with the volatility of PERS?
See #10 above.
13. Compare the annual payments and financial commitments of this fund vs. CalPERS
There are no financial commitments or annual minimum payments required for the trust fund. It can be determined on an ad-hoc basis by the City Council, or through a policy approved by the City Council. Conversely, CalPERS requires certain minimum payments each year to fund the normal cost of pensions as well as unfunded liabilities. The Pension Stabilization program’s major requirement is that the funds may be used only for pension costs, and that reimbursements cannot exceed more than one year’s worth of actual pension costs, which currently exceeds $6 million. For example, if the City did contribute $1.28 million to the fund, the City would have immediate access to request a distribution of that original contribution since it is well below the City’s current annual pension costs.
14. How does it compare to the cushion that is already included by Finance in the annual budgets?
Aside from any budgeted General Fund surplus amount (such as the $416,425 in FY 2016-2017) there is no budgeted cushion per se. Salaries and benefits are generally budgeted with a vacancy factor (4% in FY 2016-2017) in recognition of the fact that all positions are not filled 100% of the year. This factor applies to CalPERS contributions, which are budgeted at 96% of estimated cost.
Budget aside, the City typically generates year-end General Fund surpluses (e.g., revenues in excess of expenditures) which may be directed to the fund either through policies or on an ad-hoc basis by the City Council.
15. What other jurisdictions have similar pension liabilities? How are they addressing them? Which ones are using PARS?
Attachment #3 includes unfunded liabilities as a percentage of payroll for comparator agencies (these were provided by Bartel Associates earlier this year). Attachment #4 lists PARS’ clients utilizing the Pension Stabilization Reserve Fund program. PARS has 18 cities and 23 public agencies in the state of California using the pension fund method. Other agencies may be addressing unfunded liabilities by issuing pension obligation bonds (interest arbitrage between CalPERS and borrowing rate), borrowing from other agency funds that may have sufficient working capital, reducing the amortization period with CalPERS (reduces interest expense but increases payment amounts), or using one time money to reduce unfunded liabilities with CalPERS.
16. Can the funds be used for OPEB liabilities as well?
No. While one trust fund may be established for both OPEB and pension stabilization purposes, funding must be used for the purpose intended at the time of deposit.
17. What will the process be for accessing the pension stabilization funds?
A written request to the trust administrator will be submitted with direction on whether the requested funds are to be refunded to the City after incurring the expense, or paid directly to CalPERS to satisfy the required contribution or payment.
18. What impact on the existing funds and process will the new Pension Stabilization program fund have?
The pension stabilization funds will reduce reliance on on-going resources through increased earnings potential above that level achievable with the City’s general investments.
CONCLUSION:
In an effort to proactively address the City’s unfunded pension liabilities, as well as projected contribution rate increases, the City Council directed staff to establish an irrevocable Pension Rate Stabilization Trust Fund, and seed it with $500,000 in FY 2016-2017 budgeted funds. Staff recommends that proceeds from the Marriott Hotel sale totaling $780,000 also be deposited in the fund as an appropriate use of one time moneys, bringing the total deposit to $1.28 million.
In order to complete the process, staff recommends that the City Council: a) adopt Resolution No. 16-0053 establishing a Pension Rate Stabilization Trust Fund Administered by Public Agency Retirement Services (PARS) ; b) Appoint the City Manager as the City’s Plan Administrator; c) Authorize the City Manager to negotiate and execute the final documents of the Trust; d) appropriate $780,000 from unreserved General Fund moneys and authorize the transfer of those funds to the Pension Rate Stabilization Trust Fund; e) authorize the transfer of $500,000 in budgeted General Funds to the Pension Rate Stabilization Trust Fund, and f) assign responsibility and authority to the Finance Subcommittee to develop an investment policy and direct investments in the fund.
PUBLIC OUTREACH/INTEREST:
None.
ENVIRONMENTAL REVIEW
Not Applicable
LEGAL REVIEW
The City Attorney’s office has reviewed the trust documents and has generally approved as to form. Minor modifications recommended will be addressed with PARS through the City Manager’s requested authority prior to execution if City Council approves the trust.
Attachments:
1. Resolution No. 16-0053
2. High Mark Investment Options
3. Unfunded Liabilities of Comparator Agencies
4. PARS Client List for Pension Stabilization Program