Many California cities and counties are living interesting times, experiencing rising revenue together with skyrocketing pension bills. Although required pension contributions usually rise in response to bear markets, today they are escalating just as stock indexes reach new highs. The reason is that CalPERS and other systems are taking advantage of today’s relatively benign investment environment to reduce discount rates on future pension liabilities. Lowering the discount rate increases the recognized amount of Total Pension Liabilities (TPL) and thus the amount required each year to pay for benefits earned as well as to pay down Unfunded Actuarially Accrued Liabilities (UAAL).
California municipal revenues are rising especially in affluent parts of the state near the coast. As a result, many cities and counties are finding themselves with spare cash – an unusual circumstance in our often fiscally-challenged state. According to state controller data, aggregate city revenues rose 4.5% to $78 billion in fiscal year 2016. Total county revenues climbed 4% to $69 billion. For both cities and counties, total revenues comfortably exceeded total expenditures.
Some local governments are using the cash windfall to pay down unfunded liabilities. For example, Irvine, a city in Orange County with especially strong finances, has been sending CalPERS $5 million each year over and above its Actuarially Determined Contribution (ADC).
Unfortunately, the results of Irvine’s aggressive payment strategy have been disappointing. According to a recent analysis by California Policy Center’s Ed Ring, Irvine’s unfunded pension liabilities climbed from $91 million in 2013 (when it began making the extra payments) to over $156 million in 2016. Irvine’s excess payments were swamped by the effects of CalPERS assumption changes and weak portfolio performance during that period.
The city should see some improvement in its UAAL when the June 30, 2017 numbers come out, because CalPERS returned 11.1% in the most recent fiscal year. But, going forward, CalPERS may give Irvine and other California public agencies a bumpy ride.
Currently, two-thirds of CalPERS’s portfolio is invested in equities and real estate – and these two asset classes are very vulnerable to an economic downturn. With the last recession eight years behind us and the Dow Jones Industrial Average nearly four times higher than its 2009 low, the risk of a bear market is increasing. When the downturn arrives, funded ratios will fall and unfunded liabilities will climb. While a bear market does not affect the amount retirees are owed, it reduces the assets on hand to pay for them.
Cities and counties that prefer to avoid the risk of spiking UAAL and pension debt payments always have the option of retaining spare money in their general fund and sending it to CalPERS only when required. Unfortunately, state law mandates that general fund balances be placed primarily in short term, fixed income securities, which, in today’s environment, yield next to nothing.
For California municipalities that want to squirrel away resources to cover future expected UAAL payments, a better alternative would be to invest spare cash in a diversified portfolio that includes longer term assets with a modest level of risk. A portfolio containing a large proportion of long term bonds and a smaller allocation of stocks promises less volatility than CalPERS without totally sacrificing upside potential.
Cities and counties can invest in such goldilocks portfolios (not too risky and not too cautious, but just right), by creating an IRS Section 115 Irrevocable Pension Trust. Once deposited in a 115 Trust, the funds must ultimately be devoted to pension contributions. But the local employer can retain the money for several years before contributing it to CalPERS (or another system). In the interim, the agency can invest funds in the trust more flexibly.
For example, Newport Beach-based Public Agency Retirement Services (PARS) has been promoting 115 Trusts heavily after obtaining an IRS Private Letter Ruling that confirms the lawfulness of these vehicles. PARS is a private company that offers a variety of retirement-oriented financial products to local governments. An early adopter of the PARS 115 Trust, Riverside County, recently reported a total balance of $9 million in the vehicle, evenly split between stocks and bonds. Although I would recommend a less aggressive allocation, Riverside’s asset split is considerably more conservative than that provided by CalPERS.
Like any tool, many of PARS’ offerings can be misused. Reason and other pension reformers have expressed concerns about PARS in the past because some of its programs have not been fiscally responsible. For example, PARS sold the City of Redding – in Northern California – a pension enhancement plan in 2004. The plan enabled the outgoing City Manager to pad his annual pension by $50,000 per year while saddling Redding with $31 million in additional unfunded pension liabilities.
But not all of the PARS products are intrinsically bad – as demonstrated by the interest in its 115 trusts displayed by more financially sophisticated local agencies.
Another worry about PARS and other financial service firms is the fees they charge or pass through. PARS offers actively managed mutual funds from HighMark Capital Management (HCM). This fund family can charge up to 0.58% annually in fees, which can take a large bite out of returns.
But Riverside County is not using this option. Most of the money is invested in passively managed Exchange Traded Funds from Vanguard and IShares which have relatively modest management fees: as low as 0.18%. The fund management charges are in addition to a 0.25% administrative fee levied by PARS. As Riverside County’s balance increases, it will enter lower fee tiers, which bottom out at 0.10% for amounts over $50 million.
According to PARS, more than twenty local agencies have signed up for its 115 trust; several more, including my home town of Walnut Creek, are kicking the tires. Pension trusts appear to be a good option for cities and counties with extra cash that are worried about escalating contributions. But investments should be chosen carefully, both to minimize costs and contain risks.
Ultimately, making extra employer contributions is just one option California local governments have to restrain the escalation of their pension costs. Among the other options are adjusting employee contributions, offering more modest defined benefits and/or defined contributions to new hires and contracting out or privatizing services or infrastructure assets when legally permissible. As the next downturn gets closer, California municipalities should pursue one or more of these approaches.