Pension liability is the largest debt for the City.  In the most recent credit rating analysis conducted by Standard & Poor’s (S&P) in September 2021, the City received an upgrade of two notches, primarily due to the City's “very strong” (the highest qualitative category set by S&P) financial management, liquidity, budgetary flexibility and debt and contingent liabilities.  However, in the same credit report, S&P cited the City’s large pension liability as an area of concern and a constraint on further credit upgrade.  Staff has been working diligently to address this issue, through the recent establishment of a comprehensive Pension Funding Policy, the creation and consistent contribution towards an Internal Revenue Code Section 115 Trust plan, and the implementation of other related financial policies.  Additionally, various options were discussed and evaluated during the past several years, including additional direct contributions to CalPERS, increase contributions to the 115 Trust, or the combination.  The City has also researched pension reforms that are available, including requiring employees to contribute additional funds.  However, current liability cannot be undone through any pension reform and the City must make its payments as prescribed by CalPERS.  The most viable alternative would be the use of Pension Obligation Bonds (POBs). 

City staff, in conjunction with the City’s financial advisor, Fieldman, Rolapp & Associates, and underwriter, Stifel Public Finance, has been exploring the POB option to meet several objectives, including:

•  Generate cash flow savings to the City through the current historically low borrowing interest rates;
•  Create a payment schedule for the City’s unfunded pension liabilities to possibly shorten the term of the debt and realize sizable cost savings;
•  Enhance budget predictability and long-term fiscal sustainability; and
•  Leverage projected cost savings to fund various projects and reserves.

The City is currently paying 6.8% interest on over $329.3 million owed to CalPERS for unfunded pension liability, or Unfunded Accrued Liability (UAL).  A UAL is the shortfall between what the City has in assets vs. what it will need to fully pay the benefits that it has committed to its employees and retirees. The UAL is essentially the City’s debt owed to CalPERS, and CalPERS charges the City a 6.8% interest rate on this debt with a mandatory payment schedule.  The amount of annual payment has increased over 300% during the past ten years, and is anticipated to further escalate till 2030 before it starts to gradually decline, until the debt is eventually paid off in 2044.  The table and chart below reflect the UAL from the most recent CalPERS actuarial valuation as of June 30, 2020.

Given the City’s extremely strong credit rating of AA+, and historically low current market interest rates, the City can borrow at a rate of approximately 3.25%, which is significantly lower than the 6.8% CalPERS currently charges.  Furthermore, the City has various options to structure the POB, to either create immediate and on-going cash flow savings, shorten the life of the debt, or both, to achieve sizable cost savings. 

A POB is a taxable bond that the City issues to investors.  The proceeds from the POB will be sent to CalPERS to extinguish all or part of the City’s current UAL.

Two commonly used POB financing structures evaluated by staff and the consulting team are the “Modified Level” approach, and “Accelerated” approach.  Under the Modified Level approach, annual debt service payment is leveled for the initial 19 years, then declines.  This approach matches the projected UAL payments that will be directly made to CalPERS, with most cost savings realized in the initial 15 years.  Net Present Value savings are anticipated to be $102.6 million over the life of the POB, which is equivalent to 31.1% of the original UAL.

The chart below illustrates the proposed POB debt service payment under the Modified Level approach, the gap between the UAL Payment line and the Debt Service bars represents cost savings.

Modified Level Approach

Under the “Accelerated” approach, debt service payment will be kept at the current level consistent with CalPERS projected annual UAL payment.  Since there is minimum cash flow savings in the initial years, and with the projected lower POB interest rates, it is anticipated that the existing UAL will be paid in full within 13 years, which is 10 years shorter than the original repayment schedule.  This approach also will realize the most cost savings over the life of the debt, which is estimated to be $121.7 million, or 37.3% of the original UAL.

The chart below illustrates the proposed POB debt service payment under the Accelerated approach.

Accelerated Approach

A study session was held on February 28, 2022. Concepts of POB were introduced and the benefits and risk factors associated with POB were fully disclosed and discussed with the City Council and the public at this study session.  The risk factors include:

1. Market Risk

If CalPERS’ average investment return is less than the interest rate of the POB, the issuance of the POB would not result in savings to the City.  Although CalPERS’ earnings have varied significantly and there have been years where the system lost money, the average return has been 8.5% for the 10-year period, 6.9% for the 20-year period, and 8.4% for the 30-year period.

2. Super-Funded Plan

If CalPERS over-performs, the City could over-fund its retirement plan.  However, plan assets stay within the City’s plans.

3. Debt is Locked in for 10 Year

Once POB is issued, it is locked in for 10 years.  After 10 years, if feasible, the bonds can be refinanced or paid down.

4. Squandered Savings

Savings realized from the issuance of POB to pay off the UAL could be taken and used on projects/services that do not enhance the City’s financial position.  However, the City has adopted comprehensive Reserves and Pension Funding policies.  These policies provide the framework behind how the City sets aside surplus funds and savings, and limits the City’s ability to increase pension benefit for existing and future City employees.

Another consideration that was discussed during the February 28, 2022 study session was the potential reoccurrence of the UAL.  UAL may reoccur whether the City issues the POB or not.  This is due to the inherent structure of the pension system.  The POB only pays off the existing UAL, not future UALs.

Finally, the issuance of a POB will effectively address S&P’s comment in regards to the City’s large pension liability.  The rating agencies have generally viewed pension bonds as neutral to positive and an enhancement to long-term affordability.  With the City’s comprehensive financial policy framework, the issuance of a POB will most likely be viewed as credit positive in future ratings.

The recommended actions will authorize staff and consultants to initiate the proceedings to issue a POB.  Staff will bring the item back to the City Council once the initial proceedings are completed for the authorization of the bond issuance.  All cost of issuance will be paid from the bond proceeds, no additional appropriation is necessary.

If City Council approves the issuance of the POB, based on the current market condition, it is estimated that refunding the City’s existing CalPERS UAL with a POB will generate net present value savings between $102.6 million and $121.7 million depending on the structure of the POB, over the life of the debt.  Cost of issuance has been taken into consideration when estimating projected cost savings.

It is recommended that the City Council:

• Adopt a resolution authorizing the City to issue the City of Garden Grove Pension Obligation Bonds, the judicial validation proceedings relating to the issuance of such bonds, and any additional actions related thereto (Attachment 1);

•  Approve the form and authorize the execution of a trust agreement by and between the City of Garden Grove and U.S. Bank Trust Company, as trustee (Attachment 2); and

•  Approve the form and authorize the execution of a Bond Purchase Agreement with Stifel, Nicolaus & Company, as underwriter (Attachment 3).