With the adoption of City of Garden Grove Fiscal Year 2019-21 biennial budget on June 25, 2019, the City Council asked staff to formulate a policy to effectively address the City’s unfunded pension liability for the purpose of strengthening the City’s financial sustainability.

The City of Garden Grove’s pensions are pre-funded, as opposed to pay-as-you-go retirement systems like Social Security.  In pre-funded systems, the employer and employee make contributions into a pension trust each year, over the course of an employee’s working life.  The money in the trust are invested and earnings together with contributions accumulate in the trust account.

The City contracts with the California Public Employee Retirement System (CalPERS) as an investment and administrative agent for the City’s pension plans.  In the most recent Annual Review of Funding Levels and Risks published by CalPERS in November 2018, the average funded status of public agency miscellaneous and safety plans based on June 30, 2017 funding valuations were 72.7% and 69.4% respectively.  However, the funded status of the City’s miscellaneous and safety plans for the same period were 70.1% and 65.0% respectively, considerably lower than the state average.  This is concerning as the unfunded pension liability has a direct and significant impact on the City’s CalPERS contribution rate.  In other words, the greater the City’s unfunded pension liability, the higher the City’s required contribution rate and related payment obligation.

In 2018, the League of California Cities issued its findings from a recent Retirement System Sustainability Study (the 2018 League Study).  The first finding stated “rising pension costs will require cities over the next seven years to nearly double the percentage of their General Fund dollars they pay to CalPERS.”  For Garden Grove, we have budgeted $22.4 million for CalPERS contribution for FY2019-20 in the General Fund.

The City is determined to proactively address the unfunded pension liability before the growing costs further threaten the City’s fiscal sustainability.  The initial step is to develop a pension funding policy.  The Government Finance Officers Association (GFOA) recommends government employers that provide defined benefit pensions create a funding policy that establishes the government’s commitment to fund benefit obligations based on regular actuarial valuations, and through a systematic and disciplined manner to accumulate resources for future payments, thereby avoiding the transfer of costs into the future.

The intent of the City of Garden Grove Pension Funding Policy (the Policy) is to establish a formal methodology for financing the current and future pension liabilities.  The purpose of the methodology is to ensure that current assets plus future contributions from both employees and employer, as well as investment earnings will be sufficient to finance all defined pension obligations provided in the City’s plan documents.  The Policy is intended to reflect a reasonable and fiscally conservative approach with intergenerational equity.

Following the best practices for sustaining defined benefit pension plans, the Policy requires paying down unfunded liability or stabilizing future contribution rates, considering full pension costs when making hiring decisions, applying Actuarially Determined Contribution (ADC) as the basis for annual contribution, contributing 100% of the ADC, and prohibiting any pension benefit increases until funded status reaches 100%.

The 2018 League Study provided six options for California cities to address the growing unfunded pension liability, including:

1.    Pay down unfunded liability by shortening amortization period or contributing additional funds above the ADC. 

Staff observation:

Under this option, the City would contribute funds directly to CalPERS.  All additional contributions would be subject to the same investment strategies applicable to existing plan assets. Therefore, funds contributed to CalPERS could not be applied to future ADC’s.

2.  Consider local ballot measures to enhance revenues. 

Staff observation:

Voter approved the passage of Measure O in November 2018.

3.  Create a Pension Rate Stabilization Program by establishing an IRC Section 115 Trust Fund.

Staff observation:

IRC Section 115 Trusts are irrevocable trust accounts that can be used by local governments to fund pension contributions and liabilities.  Recent statistics show that over 150 cities and counties use IRC Section 115 Trust as a rate stabilization vehicle.

Trustee of the IRC Section 115 Trust is not CalPERS, the investment of trust assets are not subject to CalPERS investment policies and thus diversifies the investment.  The funds in the trust can only be used for pension related costs. The City would retain full control over the funds, subject to investment options offered by trustee.  Funds could be used to offset spikes in employer contributions, making this a desirable option for the City.

4.  Change service delivery methods and levels of certain public services.

Staff observation:

The City has contracted certain services and reduced the levels of some services in past years to battle a structural deficit.  This approach would contradict the City Council’s goal to maintain and enhance our service levels on critical services such as public safety.

5.  Use procedures and transparent bargaining to increase employee pension contributions. 

Staff observation:

The City has negotiated with certain bargaining groups and increased employee contributions in the past.

6.  Issue Pension Obligation Bonds (POB).

Staff observation:

This approach is not recommended as it only delays and compounds the financial impact of unfunded pension liability.  Financial experts including the GFOA strongly discourage local agencies from issuing POB’s.

The proposed Policy does not preclude any of the six options discussed above.  However, in comparing all six options, Option 3, creating a pension rate stabilization program by establishing an IRC Section 115 Trust Fund is more desirable, as it commits the City to allocate additional funding to reduce its pension liability, yet provides flexibility for smoothing out the required employer contribution when significant rate increase occurs.  This option also allows diversification on investment thus reduces the risk due to market fluctuation.  In order to implement the pension rate stabilization program through IRC Section 115 Trust, direction is needed on plan funding.

Effective Fiscal Year 2019-20, the City started pre-paying its annual Unfunded Actuarial Liability (UAL).  This is an option provided by CalPERS. By prepaying the UAL, cash flow savings can be realized.  Based on the June 30, 2017 CalPERS actuarial valuation, cash flow savings for the Miscellaneous Plan is $256,092, and $417,067 for the City’s Safety Plan, with a total of $673,159 for Fiscal Year 2019-20.  Staff is recommending investing these funds into the respective plans through IRC Section 115 Trust.  Staff also recommends the City commit a certain percentage of the General Fund surplus each year to be invested in pension pay down or rate stabilization.  Staff will bring a General Fund Reserve Policy to the City Council for consideration in December 2019, the reserve policy will discuss the possible additional contribution towards unfunded pension liability from the General Fund’s operating surplus.

There is no cost to approve the proposed City of Garden Grove Pension Funding Policy.  However, a total of $673,159 is requested to be redirected for the implementation of the proposed Policy.  These funds are currently appropriated as personnel costs in the Fiscal Year 2019-20 Adopted Budget.  By prepaying the CalPERS UAL, the City will realize a cash flow savings of $673,159 based on CalPERS valuation report.  Minimum costs associated with the IRC Section 115 trust plan administration will be absorbed by investment earnings generated by the assets within the trust accounts.

It is recommended that the City Council:

• Adopt the attached resolution establishing the City of Garden Grove Pension Funding Policy;

•  Authorize the City Manager or his designee to execute any necessary agreements to implement the Policy by establishing an IRC Section 115 Trust (Option 3); and

•  Approve an appropriation of $673,159 from the cash flow savings resulting from the prepayment of the Fiscal Year 2019-20 UAL to be invested in the IRC Section 115 Trust accounts.