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Item 5.1 - Public Employees' Retirement System (PERS) Actuarial AnalysisCity of Poway (FD COUNCIL AGENDA REPORT DATE: September 18, 2018 TO: Honorable Mayor and Members of the City Council FROM: Tina White, City Manager CONTACT: Wendy Kaserman, Assistant City Manager Wv\ (858) 668-4502 or wkaserman(cDpoway.org Donna Goldsmith, Director of Finance (858) 668-4411 or daoldsmithPpoway.org APPROVED a APPROVED AS AMENDED ❑ (SEE MINUTES) DENIED ❑ REMOVED ❑ CONTINUED RESOLUTION NO. Jodene Dunphy, Director Human Resources/Risk Management IF (858) 668-4413 or idunphvCcDpoway.orp U" SUBJECT: Public Employees' Retirement System (PERS) Actuarial Analysis Summary: Employee salaries and benefits comprise approximately 36% of the City's operating budget in Fiscal Year (FY) 2018-19. A major component of the employer -paid benefit costs are pension costs paid to the California Public Employees' Retirement System (CaIPERS). These costs are a percentage of pay, not a flat amount, and total approximately $4.6 million for FY 2018-19. In addition to the City's payment, employees will contribute an estimated additional $1.3 million through their contributions. Poway, like other cities, counties, and districts throughout California, continues to see substantial increases in employer -paid contributions to CaIPERS. While the City can control growth in employee salaries, the City has very little control over CalPERS increases to the employer -paid contributions. As will be described later in this report and during the City Council presentation on this item, the City withdrawing from CaIPERS to implement an alternative retirement plan, such as a 401 K, is cost prohibitive. The operating budget's ability to absorb projected future increases to the employer -paid contributions is very concerning to city management. Particularly because, as noted in the last two budget reports, overall expenses (not just pension costs) are growing at a faster pace than revenues. To better understand the cost drivers behind the increasing CalPERS employer rates and present the City Council with options to mitigate some of the impacts of rising pension costs, the City Council appropriated $14,250 in March for a consultant to perform an independent actuarial evaluation. The City selected Bartel Associates to perform the analysis as they specialize in providing public sector clients with actuarial consulting services such as CalPERS valuations. Bartel has completed its actuarial evaluation for the City of Poway and has provided options for consideration. Recommended Action: It is recommended the City Council receive the report and provide direction to staff to: 1) Pursue establishing an Internal Revenue Code Section 115 trust; and 2) Return with a recommendation with the FY 2017-18 year-end close report to use a portion of any year-end surplus to make an initial deposit into a Section 115 trust, as well as make an additional contribution to CalPERS to pay down a portion of the City's unfunded liability using the shortest amortization period. 1 of 7 September 18, 2018, Item #5.1 Public Employees' Retirement System Actuarial Analysis September 18, 2018 Page 2 Background: The City of Poway, since incorporation, has contracted with the California Public Employees' Retirement System (CaIPERS) to provide defined -benefit retirement pension plans for the City's Fire -Safety group and Miscellaneous (Non -Safety, Management/Confidential) group of employees. In 2001, when pension plans were extremely well funded statewide, and CaIPERS was achieving high rates of return on its investments, Assembly Bill 616 was signed into law allowing CaIPERS member agencies to provide employees with enhanced retirement formulas. In San Diego County alone, every City that contracts with CaIPERS approved one of the new enhanced retirement formulas for their employees. To remain competitive with the other cities at that time, Poway approved a 3% at 50 formula for Fire -Safety employees, and a supplemental retirement benefit for Miscellaneous employees, with significant eligibility requirements focused on longevity through the Public Agency Retirement Services (PARS) program. Currently, the PARS benefit is a closed plan that only applies to 70 remaining Poway employees hired between certain dates. Even though it is a closed plan (meaning no new enrollees), the Plan must continue to pay benefits to retirees receiving the benefit and it must have enough assets to also pay benefits to the 70 existing members when they retire. Employees hired after January 9, 2012 are not eligible for the PARS benefit because of pension reform. In FY 2018-19, there are 213 full- time positions budgeted, so less than one-third of the City's full-time employees are eligible for the PARS benefit. While PARS and CaIPERS are defined -benefit plans, there are very distinct differences between the PARS plan and the CaIPERS plans. As a closed plan, PARS will not see the steep increases in contributions that are projected for CaIPERS. Additionally, the City controls how PARS funds are invested. The PARS plan is well funded due to several City Council actions. When the City Council adopted the 45% General Fund Reserve policy in 2015, there were surplus reserve funds available and the City Council chose to use $2.8 million toward paying down the PARS unfunded liability. An additional $500,000 from the Fiscal Year 2016-17 year-end surplus was used to further pay down the PARS unfunded liability. Due to the projected fiscal impact of changing rates with CaIPERS and the fact that the City makes employer contributions for all full- time (and a limited number of benefitted part-time) employees to CaIPERS, the focus of the Bartel analysis was the CaIPERS plans. Histo The impact of the Great Recession on CaIPERS funds was significant. CaIPERS lost more than 27% or $67 billion in value. As a result, employer rates for all CaIPERS agencies began increasing significantly. Employer rates had to make up for the losses since there was still an obligation to pay retiree benefits as well as the costs of the unfunded liability of future benefits to be paid to CaIPERS participants. Cities began the process of negotiating lower CaIPERS retirement formulas with employee bargaining groups to work toward ensuring future sustainability of retirement benefits. Poway employees and the City Council recognized the importance of financial sustainability and agreed to a second tier of benefits that included a lower retirement formula for employees hired after January 9, 2012. Less than one year later, the State of California passed the Public Employees' Pension Reform Act, known as PEPRA, which mandated lower retirement formulas for all CaIPERS member agencies for employees entering CaIPERS on or after January 1, 2013. This established a third tier of retirement benefits with an even lower CaIPERS retirement formula for City of Poway employees. An additional provision of PEPRA caps pensionable salary for employees that fall within this third tier. The maximum pensionable salary is based on social security caps and the maximum for 2018 for Tier 3 employees is $145,666. 2 of 7 September 18, 2018, Item #5.1 Public Employees' Retirement System Actuarial Analysis September 18, 2018 Page 3 The current City of Poway retirement tiers for the Fire -Safety employee group and the Miscellaneous employee group (Non-Safety/Teamsters, Management/Confidential employees) are outlined in the table below. City of Poway CalPERS Retirement Formulas .up Plan E 7Iet3 oi'� 1I1C3 Miscellaneous 2% at 55 FAE1 ** 2% at 60 (FAE3)*** 2% at 62 FAE3 Fire -Safety 3% at 50 (FAE3) 3% at 55 (FAE3) 2.7% at 57 (FAE3) * Tier 2 emplovees must be emplovees who are not new to working for a CalPERS agencv or an agency with a reciprocity agreement with CalPERS and who have not had a break in service for more than 6 months prior to being hired by Poway. ** FAE1 means the single highest year of earnings (typically final) is used to calculate the employee's salary used in the benefit formula. *** FAE3 means the highest three years (typically final three) of average earnings is used to calculate the salary used in the benefit formula. While this table can be complicated to follow, key takeaways are higher retirement eligibility ages for Tier 2 and Tier 3, and a lower percentage of salary for Fire -Safety Tier 3 employees. Additionally, using the final three years average of earnings for benefit calculation is presumed to be a lower benefit than using an employee's highest single year of earnings. However, it should be noted that for Tier 3 employees, the highest three years may not be applicable if their average earnings exceed the cap on pensionable salary under PEPRA. Below is an illustration of how the retirement benefit would be calculated for a "Classic" Miscellaneous employee. Formula: 2%@55 ❑ Hire age 30, retire at 55 = 25 years of service ❑ 2.0% x 25 years =50% of highest single -year pay for life. Included below is snapshot of the organization as of June 30, 2018 showing how many employees the City has in the three tiers for the Miscellaneous and the Fire -Safety group. 'Group Plan Tler 1 Tier : Tier 3 "Claslc" , "Classic" "Pe Miscellaneous 81 14 82 Fire -Safety Group 32 2 19 Funding of CalPERS pensions relies on three sources: employee contributions (fixed by statute based on formula), employer contributions, and investment returns. During labor negotiations in 2017, employees of the Poway Firefighters Association and Teamsters union agreed to contribute an additional 1 % towards PERS costs beyond the required employee contribution. Currently, all employees of the City of Poway considered "classic" CalPERS employees in Tier 1 and Tier 2, including employees in the Management/Confidential group, are contributing an additional 1% of 3 of 7 September 18, 2018, Item #5.1 Public Employees' Retirement System Actuarial Analysis September 18, 2018 Page 4 their salaries beyond the required employee rate depending on their CaIPERS group plan and tier. In other words, employees are contributing 1 % toward the employer cost, in addition to the 7% (Miscellaneous) or 9% (Safety) employee contribution. Employees in Tier 3 who are considered PEPRA employees are contributing what is required statutorily by PEPRA. Discussion: Each year CalPERS provides an actuarial valuation of the Fire -Safety Group plans and the Miscellaneous Group plans to determine contribution rates for the following year. The valuations include Tier 3 (PEPRA) for the following fiscal year. The employee contribution rate for Tier 1 and Tier 2 employees is statutorily dictated unless a higher rate is negotiated between the City and employee bargaining units, as is the case in Poway. There are also provisions in statute allowing higher employee contribution rates to be imposed upon employees, but this is only after a lengthy impasse process and there are caps on the amounts that can be imposed. There are two components to the CalPERS rates: Normal Cost and Unfunded Liability. Employees contribute to the Normal Cost which is the value of benefits in the current year. The City also contributes to the Normal Cost, as well as paying the full Unfunded Liability. Unfunded liability is the difference between what the City and employees have already contributed, and the benefits owed to retirees. Unfunded liability is the component that creates rate volatility for employers and, by statute, unfunded liability is solely attributed to the employer rate. The total combined Employer Contribution Rate for FY 2018-19 for the Miscellaneous Group is 24.3%. The total combined Employer Contribution Rate for FY 2018-19 for the Fire -Safety Group is 34.2%. There are many variables that contribute to how these numbers will grow in the future, but the presentation will illustrate that the Miscellaneous group rates are projected to peak around 35% by FY 2024-25 and peak around 54% for the Fire -Safety group in FY 2028-29. Rates are not projected to return to current levels until the late 2030s and early 2040s when the workforce will be solely comprised of PEPRA employees. The rising costs in Unfunded Liability present the biggest challenge for Poway going forward. While state statute includes provisions for imposing additional Normal Cost contributions on employees following a negotiations process, it does not include provisions for imposing any portion of the Unfunded Liability costs on employees. The CalPERS rates have been significantly impacted in recent years by the Great Recession, followed by CalPERS Board decisions to: 1) Lower the discount rate (assumed rate of return on investments), 2) Change demographic assumptions such as mortality rates, and 3) Implement other changes such as a rate volatility smoothing approach (an attempt to smooth the impact of higher rates on member agencies by gradually implementing changes. However, the longer it takes to get the rates to where they need to be, the more the costs of unfunded liability continue to grow). The above decisions, combined with investment losses during the Great Recession, have caused the normal cost and unfunded liabilities to increase, which in turn drives the City's required annual contributions higher. 4 of 7 September 18, 2018, Item #5.1 Public Employees' Retirement System Actuarial Analysis September 18, 2018 Page 5 The City's annual contribution for all funds toward the CalPERS unfunded liability is approximately $2.7 million for FY 18-19, which is included in the $4.6 million budgeted for PERS expenditures this fiscal year. Based on the CalPERS Actuarial Valuation as of June 30, 2016 (the most recent valuation), the City's Miscellaneous Plans have a combined Unfunded Accrued Liability of more than $31 million and the City's Safety Plans have a combined Unfunded Accrued Liability of nearly $15 million. Until recently, the City's only option for reducing the Unfunded Liability was to commit additional funds to CalPERS, beyond the required annual contribution. However, a recent ruling received from the IRS established that public agencies or municipalities could create a separate trust to "pre -fund" CalPERS unfunded liability and/or to be used as a rate stabilization fund to mitigate the impacts of future increases in rates. Another option considered by some cities has been to leave the CalPERS system. To do so would require the City to pay, in full and up front, CaIPERS for the City's entire existing pension liability. It should be noted that even trying to negotiate with employee bargaining groups for alternative pension plans for new hires, such as a defined contribution (vs. a defined benefit) plan or a 401K type plan would be considered leaving the CaIPERS system and could not be done without buying out of CalPERS as described above. Options for Mitigating the Impacts of Future Rate Increases As described throughout this report, the City has little control of the projected increases in employer contribution rates for CalPERS, so a core component of the Bartel analysis was to present options for mitigating the impact of future increases on the operating budget. There are two primary options described below; the third option of leaving CalPERS is included but as previously stated and illustrated below, it is cost prohibitive. Should Council wish to pursue either Option 1 or Option 2 or a combination of both, the City Council could direct staff to identify potential funding with the FY 2017-18 year-end close report that is scheduled to be presented to the City Council in October. Option 1: Commit Additional Funds to CaIPERS The City Council could appropriate and commit to CaIPERS an amount over and above the annual required contribution. Several factors must be considered with this option. First, before an additional contribution is made, the City must identify what is the intended goal regarding future CaIPERS payments. The City's Unfunded Liability is comprised of various components that have amortization periods ranging from seven to thirty years. If the City's objective is to reduce the required annual contribution as much as possible, the City would select a short amortization base/period to which to apply the additional contribution. This would result in the largest reduction in annual CalPERS contributions for a short period of time (estimated seven years), with CalPERS payments returning to original required contributions after the effect of the additional payment has been realized. Should the City's objective be to save more interest over time, the City would select a longer amortization base/period to apply the additional contribution. Although the City would save more on accrued interest, there would be less savings on the annual contribution and in turn less savings to the annual operating budget. Although there is not a lot of flexibility regarding how these additional contributions/funds are invested, the investment rate of return achieved by the CalPERS system over the long-term may be higher than may be realized through the Section 115 trust described below. Conversely, these additional funds would also be subject to the same market volatility risk as all CaIPERS 5 of 7 September 18, 2018, Item #5.1 Public Employees' Retirement System Actuarial Analysis September 18, 2018 Page 6 investments. Many CalPERS member agencies are also wary of providing additional funds to CaIPERS. Option 2: Establish a Section 115 Trust An Internal Revenue Code Section 115 trust is a vehicle for segregating City funds from general assets for funding essential governmental functions. For example, a 115 trust can be used to set aside monies to meet future pension contributions or liabilities. Funds placed in a 115 trust are irrevocably committed for the essential government function(s) specified in the applicable trust agreement (e.g., pension obligations). Monies held in such trusts can be invested in accordance with the rules governing such special purpose accounts. For example, 115 trust funds dedicated to satisfying pension obligations can be invested in the same manner as funds in a typical pension fund rather than being limited to those investments allowed for the City's General Fund. Thus, agencies can potentially earn a higher rate of return on monies set aside for future pension obligations. A 115 trust could be used as a rate stabilization fund. If funds are contributed to the 115 trust and interest is allowed to accumulate, the City could draw on those funds as rates increase and insulate the operating budget from the full impact of the increases. Alternatively, funds in a 115 trust could be applied to pay down specific portions of an agency's CalPERS liabilities. It is also an option to use 115 trust funds to pay down the agency's unfunded liability. While the funds are irrevocably committed, should there be a point in the future where the City cannot afford to make some or all of the annual required payment to CaIPERS, funds from the 115 trust could be used toward making the required payment. Establishing a 115 trust would provide the City with an alternative to sending funds directly to CalPERS and would provide greater City control over assets and portfolio management. Additionally, establishment of a trust would allow the City to set aside funds today towards future CalPERS costs. There is no fiscal impact associated with establishing a 115 trust beyond the setup fees. The City would have the flexibility to add funds to the trust as funds are available. Option 3: Leave the CaIPERS System As mentioned above, should the City want to sever its relationship with CalPERS and leave the pension system, the total cost to do so is estimated to be nearly $170 million for all plans, assuming a 3% rate of return or, more than $200 million, assuming a 1.75% rate of return. Additionally, it is anticipated that an alternative form of retirement benefits, as well as funding, would need to be identified for new employees. However, before any consideration could be given to this option, as a vested benefit, this option would be subject to labor negotiations, in addition to substantial legal review. Environmental Review: This item is not subject to CEQA review. Fiscal Impact: None. Public Notification: None. 6 of 7 September 18, 2018, Item #5.1 Public Employees' Retirement System Actuarial Analysis September 18, 2018 Page 7 Attachments: None. Reviewed/Approved By: Reviewed By: Approv By: Wenc( Kaserman Alan Fenstermacher Tina M. White Assistant City Manager City Attorney City Manager 7 of 7 September 18, 2018, Item #5.1