How 5 O.C. cities are working to pull down the rising cost of a pension ‘mess’

Local cities are set to dedicate millions of dollars more per year on top of already-determined payments to try to bring down unfunded employee pension liabilities that are running up to seven times higher than a decade ago.

With California’s pension crisis clearly defined, cities are beginning to budget for even larger payments to the state retirement system to keep ahead of interest.

Newport Beach has committed to paying roughly $9 million more a year through 2038, and it’s exploring setting aside money in a trust. Without taking action, the city’s projected unfunded pension liability for the new fiscal year starting July 1 would balloon to $353 million, compared with $46 million 10 years ago.

Costa Mesa will add $500,000 a year, Fountain Valley and Huntington Beach about $1 million each. Costa Mesa’s unfunded liability is projected at $246 million for fiscal 2017-18, up from an estimated $46 million 10 years ago. In Huntington Beach, the latest number is $363 million; a decade ago, it was $79 million.

“Why are we in this mess? Well, everybody’s in this mess,” said Huntington Beach Assistant City Manager Ken Domer.

The reason depends on whom you ask.

“The bottom line is that public employees didn’t cause this problem — it was caused by Wall Street bankers who got greedy and we ended up in a recession and the stock market crashed,” said Costa Mesa Mayor Katrina Foley.

According to the California Public Employees’ Retirement System, or CalPERS, about 62% of its income is the result of earnings from investing employer and employee contributions in stocks, bonds and real estate.

“Many city leaders throw their hands up and say that any meaningful action must come from the state,” said Newport Beach Councilman Will O’Neill. “I agree that the state must take meaningful action. But cities that do not take meaningful action themselves risk deficits and bankruptcy.”

Some state remedies are already in place — for example, the Public Employers Pension Reform Act of 2013, which essentially lowered new hires’ future retirement benefits by capping how much of their compensation can be factored into calculating their pensions.

Costa Mesa Councilman Jim Righeimer, who spearheaded the city’s 2011 outsourcing effort to reduce pension commitments, apportions the blame for its unfunded liability as such: “75% the people that get the money — the employees — and 25% the people that want to be elected and don’t want to upset that apple cart.”

“Nobody can believe the numbers when they start to dig into it,” he said. “They don’t realize how ridiculous it is. There is no mathematical way, period, to pay an employee 90% of their pay for the rest of their life when they’re 50 years old.”

Righeimer was referring to what is known as the “3% at 50” benefit formula, in which some public safety employees, including in Costa Mesa, can retire as early as age 50 with a pension rate set at 3% of their final year’s salary multiplied by how many years they were on the job.

Cities’ financial experts identified these factors in how the pension balloon swelled:

More-generous benefits: In 1999, the state Legislature passed a law giving public employees robust, retroactive retirement benefits. This resulted in the “3% at 50” formula.

“Agency after agency accepted the new benefits as if they were free,” said Newport Beach Finance Director Dan Matusiewicz. “They competed with each other, contending the benefits were necessary to attract and retain employees.”

As a result, liabilities likely grow at a faster rate than revenue growth, he said. The 2013 reforms “will soften this ascent, but we all know this will take decades to have a meaningful impact.”

Pensions are “grandfathered” for employees who benefited from the earlier law.

Lower returns: A gradual lowering of the rate of investment return from 7.5% to 7% per year.

For Huntington Beach, that means the city will have to pay an additional $23 million over the next few years toward pensions to make up the difference. City Manager Fred Wilson described it as a “pretty heavy hit.”

Recessions: The financial crisis of 2008 caused crippling investment losses.

“For many, it took the investment losses in 2008 to reveal how susceptible agencies are to the market-value losses on assets to fully understand how vulnerable their agencies are to the (accrued liability) associated with their promised benefits,” Matusiewicz said.

Here are local cities’ strategies for paying down their unfunded pension liabilities:

NEWPORT BEACH

The plan: Add about $9 million a year to the existing pay-down schedule and explore setting aside money in a special trust.

Mayor Kevin Muldoon sees his city as a trendsetter.

Newport has agreed to direct $9.1 million more per year for the next 20 years to its minimum annual payments in an effort to shrink its liability. Muldoon expects other California cities to step up their payments as well.

“It’s not a pleasant issue to have,” he said at a meeting this month where the City Council voted to accept the new fiscal year’s budget with the addition. “Newport Beach is setting a trend to aggressively pay down our unfunded pension liability and pick up the slack left by Sacramento.”

With a $25-million compulsory payment defined by the state, $16.2 million in normal annual costs and the $9.1-million boost, the city’s net pension cost in 2017-18 will be $40.3 million after deducting $10 million contributed by employees.

The voluntary boost is expected to save about $15 million in interest over the 20 years.

The $9.1-million addition will be challenging but no real sacrifice, City Manager Dave Kiff said. The city has healthy property, sales and bed taxes, plus about $48 million gathering interest in its rainy-day reserve. It will split the added millions over 12 monthly installments, allowing the city to pull back if the market goes sideways.

“It is a very good strategy in (that) it strikes balance between providing a valuable service to both current and future residents,” Matusiewicz said.

Councilman O’Neill, who also is on the city Finance Committee, said this isn’t like prepaying a mortgage. Pensions are more like a “devil’s mortgage” because cities’ liabilities are growing without meaningful stability, he said.

The Finance Committee, which discusses pensions at every semi-weekly meeting, likely will address socking away money in a dedicated trust fund.

Kiff said Newport is cautiously optimistic about its plan.

“There’s always caution in what will happen in the economy,” he said.

COSTA MESA

The plan: Budget $500,000 per year for additional payments to CalPERS and annually prepay CalPERS for employee bargaining groups and use the savings from a prepay discount — more than $250,000 per year — to make additional payments. The city also has formed a Finance and Pension Advisory Committee to look at options for future reductions in pension cost and liability.

In 2011, Costa Mesa was ground zero in the battle over public employee pensions. The City Council drew national attention for a controversial decision to issue layoff notices to more than 200 employees and outsource many services.

The motivation, officials said, was to get a handle on Costa Mesa’s ballooning pension obligations. Critics, though, blasted the move as a reckless political stunt.

Though the council eventually abandoned the bulk of its outsourcing plan and settled a lawsuit with the Costa Mesa City Employees Assn., the philosophical battle over public pensions in the city has never entirely gone away.

The unfunded liability itself also hasn’t disappeared. In the next fiscal year, it’s expected to be roughly $246.2 million, according to interim Finance Director Stephen Dunivent.

By comparison, the city’s adopted budget for next fiscal year is $163.2 million.

There are multiple tiers for both safety and non-safety employees in Costa Mesa, determined by an employee’s hire date.

Among Orange County cities, Costa Mesa’s employees pay some of the highest contributions toward their pension costs, according to city officials.

For instance, under a new contract the council approved in April 2016, the city’s rank-and-file police officers are required to contribute 14% of their pay to their pensions.

Members of the non-public safety Costa Mesa City Employees Assn., who have paid as much as 17.04% of their salaries toward their pensions, will contribute at least 12% throughout the life of a new contract the council OKd in March.

Both groups also brokered raises as part of their contracts.

Negotiations are continuing with the Costa Mesa Firefighters Assn.

Costa Mesa employees are already “paying more than their fair share” toward pensions, Mayor Foley said, and other options need to be looked at in Sacramento — such as implementing a new retirement cap or having the state make additional payments to CalPERS.

“It is my firm opinion that the state Legislature and the governor have got to solve this problem, because the cities cannot do it,” she said. “We cannot balance these requirements and these obligations on the backs of the employees.”

In Councilman Righeimer’s mind, though, any solution needs to include now-retired employees taking a cut on their pension benefits.

“I will debate anybody who says there is some simple way to fix it short of the employees who get the money taking less,” he said. “Until you do that, you can’t fix it.”

HUNTINGTON BEACH

The plan: Pay an extra $1 million a year beyond the required minimum, with additional contributions from a pension rate stabilization trust.

Wilson, the city manager, believes unfunded pension liabilities are the greatest budget issue the city will face over the next five to seven years.

The city currently is on the hook for 1,440 retirees and will have to cover 958 active employees. The city’s unfunded liabilities also are affected by 437 transferred and 295 terminated employees, according to city documents.

But under Wilson’s command the city has come up with a two-pronged plan to prepay the city’s liabilities.

The first part requires the city to devote an extra $1 million to pensions each year. The plan was initiated in 2014 and Wilson said it should save taxpayers $54 million in the long term.

Additionally, the city created a pension rate stabilization plan last year that the City Council funded with a $2.5-million contribution. Wilson said the budget feature is essentially a trust that money can be allocated to, earmarking it to pay down pension liabilities.

Councilman Erik Peterson believes changes made about a decade ago to the equation the city uses to calculate pension values is part of the problem. The equation includes the year of retirement when the pension would become available and the percentage of yearly compensation aggregated through a career.

In 2008, the council increased the formula from 2% at age 55 to 2.5% at 55 for non-public safety employees. For public safety personnel, it was increased to 3% at 50, a figure mirrored by other Orange County cities.

This is “a huge problem,” Peterson said.

He praised the city for its efforts to combat the pension issue with prepayment but added that it’s like “going down a hole that doesn’t have a bottom.”

He and other council members said the state may ultimately have to deal with it.

The council recently voted to support state pension reform legislation proposed by state Sen. John Moorlach (R-Costa Mesa).

Moorlach has proposed three bills and three amendments to the state Constitution. One of the constitutional amendments would “prohibit public employers from increasing retirement benefits for their employees without two-thirds voter approval.”

Another would give “the Legislature and public pension systems the ability to adjust public employees’ retirement benefit formulas on a prospective basis without impacting any benefits earned.”

FOUNTAIN VALLEY

The plan: Add about $1 million a year to the pay-down schedule.

A local sales tax increase approved by Fountain Valley voters last year will help pay down the city’s unfunded pension liabilities.

Revenue from the Measure HH 1% sales tax, which the city started collecting in April, will go toward “essential city services” including roads, parks and public safety. That includes pensions for all city employees.

A portion of sales tax revenue will be set aside in a trust just for pensions and doled out at a rate of a little more than $1 million a year over 10 years on top of regular annual payments to help shrink the $65-million unfunded liability the city expects to have next year, said city Finance Director David Cain.

Fountain Valley residents will not see a cut in local services as the city directs more money toward pensions, officials say.

“Part of what we recognized as we moved into the (Measure) HH as a potential solution for the community is without doing something we were going to impact (services),” Cain said.

Over the past five years, Fountain Valley also has instituted a tiered benefit system for new hires and paid off the liability in its “side fund,” the amount of unfunded liability it had when it was in a pooled plan.

Fountain Valley was one of the first cities in Orange County to bring on employees with lower retirement benefits when it started the two-tiered system in 2012, Cain said.

LAGUNA BEACH

The plan: Commit 4% of revenue greater than budget estimates to help offset increasing pension costs in the next five years.

Laguna Beach officials have made paying down the city’s unfunded pension liability a priority. The city had 362 retirees as of fiscal 2014-15. Its projected unfunded pension liability for 2017-18 is $53 million.

In 2010, the City Council approved borrowing surplus money from Laguna’s own funds, such as its parking fund and street lighting fund, to pay off $10 million in a side fund earmarked for police, fire and marine safety plans. Three years later, it approved higher employee contributions for pensions, ranging from 8% to 12% of salary.

The city expects those strategies to save $25 million in the next 30 years and significantly reduce Laguna’s unfunded liability, according to a letter from City Manager John Pietig to the City Council.

But in a foreboding development for Laguna and other California cities, CalPERS late last year said it would lower its expected investment return rate from 7.5% to 7%.

Increases to Laguna’s overall pension costs, including unfunded liabilities, will be phased in over five years, with the city’s required minimum contribution jumping from $9.1 million in 2016-17 to $11.8 million by 2021-22, according to city statistics.

At a city budget workshop last month, the council agreed to commit 4% of revenue greater than budget estimates to pay all or a portion of that increase in the next five years in hopes of not reaching into reserves or reducing services, city Finance Director Gavin Curran said. The city will evaluate the plan every six months.

“We do everything we can do to address the situation,” Councilman Robert Zur Schmiede said. “With the reserves we have, we’re in a better position than most cities.”

An unfunded liability does not mean failure to fund the plan, said Councilman Steve Dicterow, a lawyer who at one point focused exclusively on pension planning.

“A new liability gets created every year, even if you paid down to zero,” Dicterow said.

He said the only thing cities have control over is salaries they pay employees. But he did not suggest Laguna start cutting pay.

“We are not going to reduce people’s salaries because the pension costs are too large,” Dicterow said. “We’re in a competitive environment with other cities.”

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