Finance

Pensions


I hear the City has sued the residents.  Is this true?

No.  The City has not directly (or even indirectly) sued its constituents.  What the City has done is filed a validation lawsuit regarding the potential issuance of pension obligation bonds.  Under the rules imposed by the State of California, the City is required to file a complaint “in rem.”  This means that it is required by law to be stylized against “all persons interested” in the matter. (See Validation Action Memo below.)


Pension Obligation Bonds

Under the leadership of the City Council, City staff have been exploring the use of Pension Obligation Bonds (POBs) to meet several objectives, including: (1) taking advantage of historically low interest rates to generate cash flow savings to the City; (2) restructuring the City's pension liability payment schedule to provide consistent repayments over time, while reducing the overall repayment period; (3) enhancing budget predictability and long-term fiscal sustainability; (4) leveraging the projected savings to adequately fund various reserves; and (5) setting aside a portion of the future savings into an IRS Section 115 Trust.

The following Q & A provides answers to commonly asked questions about POBs.

What is a POB?

A POB is a taxable bond that the City issues to investors.  The proceeds from the sale of the bond will be sent to CalPERS, the State’s pension system for government employees, to extinguish all or a part of the City's current Unfunded Accrued Liability (UAL).

What is an Unfunded Accrued Liability (UAL)?

The UAL is essentially the City's debt to CalPERS for pension related benefits and is the shortfall between what the City has in pension assets and what it will need in pension assets to fully pay out the benefits that it has promised to retirees.  Currently, the City’s UAL is approximately $120 million.  CalPERS charges the City a 7% interest rate on this debt and enforces a mandatory repayment schedule.  This payment schedule is not flat like a mortgage, but rapidly escalating over the next 10 years before declining to $0 in 2045.

What steps has the City already taken to address the UAL?

The City is aware of its need to address pension liability and has taken many steps in recent years to address pension liability concerns, including, but not limited to:

  • Establishing and funding Section 115 Trusts in May 2016 for both Pension and Other Post-Employment Benefits (OPEB). As of June 30, 2021, pension and OPEB trust balances were $10,638,680 and $1,614,610, respectively.
  • Making the difficult decision in November 2016 to transfer City Fire service operations to San Bernardino County, which was implemented in July 2018. This decision was taken by City Council in part to limit and/or reduce anticipated future pension liabilities.
  • Approving Memorandum of Understandings with all safety labor groups that called for safety employees in 2016 to begin contributing 3% toward the employer portion of the CalPERS normal cost (on top of the entire 9% employee share).
  • Approving Memorandum of Understandings with all non-safety labor groups that called for classic non-safety employees hired after January 1, 2020 to begin contributing 1.4% toward the employer portion of the CalPERS normal cost (on top of the entire 8% employee share).
  • Approving, in March 2020, an additional $1 million dollar payment to CalPERS toward the City's UAL.
  • Reaching an agreement with Govlnvest Inc. (an actuarial technology company) in September 2020 to provide the City with a pension module calculator, assist with the establishment of a pension liability funding plan, and provide internal presentation support services.
  • Issuing an RFQ in October 2020, soliciting municipal advisors to provide informational services to the Finance Committee, City Council, and public pertaining to a pension funding plan and POBs, which culminated in engaging Urban Futures, Inc. in December 2020.
  • Approving, in June 2021, an additional $1 million dollar deposit into the City's pension stabilization trust.
  • Adopting, on June 14, 2021, a General Fund reserve policy and pension funding policies.

Why is the City considering issuing a POB?

The City of Upland is currently paying 7% interest on approximately $120 million in unfunded pension liabilities (detailed definition below) owed to CalPERS.  Given the City's strong credit rating and historically low interest rates, the City can borrow money at rates lower than what CalPERS charges.  The City will use the POB to create a new repayment shape for the debt that is more predictable and conducive to the City's continued fiscal health.  Moreover, there are significant savings projected (over $2M per year on average for the next 20 years) which can be used to bolster the City's reserve levels and reduce the risk that the City will need to cut staff, reduce service levels, or delay critical capital projects that benefit the community.  The following Figure 1 shows the restructuring strategy with the green line representing the estimated new debt payments and the bars representing the current repayment schedule with CalPERS that will be eliminated.

 (Click to enlarge)

Has the consideration of POBs been a public process?

The City has had six public meetings exploring solutions to the UAL, the establishment of a pension management plan, and specifically considering the issuance of POBs.  In addition, legal and financial advisors were selected using a competitive process with the City Treasurer involved in the evaluation process.  These presentations and actions were presented publicly:

  • September 10, 2020 - Pension Obligation Bonds Discussion workshop by Harrell & Company Advisors, LLC with City Council
  • October 28, 2020 - Actuarial Valuation 101 presentation by CalPERS to the Finance Committee
  • January 6, 2021 - Pension Management Plan - Pension Obligation Bonds presentation to the Finance Committee by Urban Futures, Inc. and GovInvest Inc.
  • January 27, 2021 - Pension Management Plan presentation to the Finance Committee by Urban Futures, Inc.
  • March 2, 2021 - Pension Management Plan - POB workshop to City Council by Urban Futures, Inc. and GovInvest Inc.
  • March 22, 2021 - Authorization to proceed with the validation process for POBs
  • April 26, 2021 - Approval of professional services agreement with Urban Futures, Inc. to provide POB municipal advisor services
  • May 10, 2021 - Approval of a professional services agreement with Best Best & Krieger LLP to provide validation and bond counsel legal services for potential POB issuance
  • May 10, 2021 - Approve of a professional services agreement with Stradling Yocca Carlson & Rauth to provide bond disclosure legal services for potential POB issuance
  • June 28, 2021 - Authorization to file validation action related to the issuance of POBs
  • July 28, 2021 - Understanding & Addressing Pension Obligation Bond Risks presentation to the Finance Committee by Urban Futures, Inc.
  • August 9, 2021 - Selection of J.P. Morgan Securities LLC as the manager and Stifel, Nicolaus & Company, Incorporated as the co-manager to serve as underwriters for the potential pension obligation bond issuance

In addition, on February 23, 2021, City Treasurer Bradley independently held a meeting where the public was invited to ask questions regarding the City’s pension obligations and have them answered.

How are the CalPERS UAL payments calculated?

The City’s UAL is calculated by CalPERS and is comprised of a series of amortization bases.  The UAL balance and FY 21/22 payment for the City’s Miscellaneous Plan is shown in Table 1.

The UAL balance and FY 21/22 payment for the City’s Fire Plan is shown in Table 2.

The UAL balance and FY 21/22 payment for the City’s Police Plan is shown in Table 3.

The City’s current UAL is $118.8 million, which is comprised of 31 amortization bases:

  • 25 bases = $42.2 million for the Miscellaneous Plan
  • 3 bases = $27.6 million for the Fire Plan
  • 3 bases = $49.0 million for the Police Plan

The preceding Table 4 summarizes the UAL amortization bases and the required UAL payment for FY 21/22.  The total UAL payment for FY 21/22 is $9,568,560.  (NOTE: This example does not include the Police and Fire PEPRA UAL amounts.)

The UAL payments are comprised of a series of payments with an estimated interest rate of 7.0% that total $220 million over the next 23 years as shown in the following Table 5.

The figure “7%” is mentioned several times regarding the CalPERS charges.  How does this 7% relate to the UAL payment figures that are presented?

CalPERS has a projected investment return of 7.0% annually.  This projected investment rate of return is used to amortize each of the amortization bases shown in Tables 1-3.  In years where CalPERS earns less than the 7% return, additional UAL is added to the City (and all other CalPERS members).  In years where CalPERS earns more than the 7% return, a UAL credit is provided to the City.

Because the savings is based on CalPERS future returns, is the projected savings guaranteed?

No, the savings is not guaranteed.  The rule of thumb is that if CalPERS earns more than the rate paid on the bonds (3.25% to 3.50% estimated right now), the City will be better off.  If CalPERS earns under the rate paid on the bonds, the City would be worse off.  While past performance does not guarantee future results, CalPERS’ historical 30-year returns are 8.0%, 5.5% for the last 20 years, 8.5% for the last 10 years, and 6.3% for the last 5 years.

Are the CalPERS-provided UALs subject to change due to changes in future performance of CalPERS funds, and other factors?

Yes, this is correct.  The UAL is a dynamic and ever-changing amount.  Similar to anyone’s retirement account, it needs to be adjusted (each year) for changes in investment performance, retirement age, and other actuarial assumptions.

How are the POB “debt service” figures arrived at?  How much will be borrowed, at what interest rate, and how much is the total cost?

The City would need to receive about $120 million from the sale of the bonds to pay off the current UAL.  When the costs to issue the bonds are included, the total amount borrowed is estimated to be $121.06 million, which is also known as the “par amount.”  Under current market conditions, POBs are being sold in the bond market with interest rates around 2.8% to 3.0%.  For its analysis, the City is assuming a weighted average interest rate (TIC) of 3.33%.  The 3.33% interest rate utilized provides a “cushion” of about 0.50%.  The market conditions at the time of bond issuance will determine the actual interest rate the City would pay.  The total cost of the POB debt is estimated to be $165.5 million.  The estimated debt service schedule is shown in Table 6.

Using the figures and assumptions provided, the difference between the total UAL payments of $220.8 million (Table 5) and the total cost of the POBs of $165.5 million (Table 6), the estimated savings is $55.3 million.

What has the City done to address reinvestment risk?

The City has taken this risk into careful consideration, both quantifying this risk through stress-testing analysis completed by a 3rd party actuary and working in consultation with its financial advisor.  The stress testing analysis included looking at the impact to the City if CalPERS does not meet its 7.0% annual investment return target.  Moreover, the City has structured the new payments in a way that creates enhanced resiliency for the City to absorb new UAL that might be added on in the future from potential below average investment performance.  Savings realized from the issuance of the POBs will be set aside in various reserves to address future economic uncertainty, emergencies, and to address future pension and OPEB liability increases (per policy noted below).

What is the City's plan for the projected savings?

The City has adopted comprehensive General Fund reserve and pension funding policies.  These policies provide the framework behind how the City will set aside surplus funds and savings from the POBs each year.  In particular, the General Fund reserve policy will prioritize the City's two emergency/economic contingency reserves, and then start to fund pension and OPEB reserves.  These reserves will allow the City to accumulate funds to address future potential pension liability increases as well as pay down the POB debt early to save on interest costs.

Are taxpayers on the hook?

The current CalPERS debt of $120 million is a liability that the City must pay.  The POB replaces that existing liability with a lower cost liability to reduce the burden on the City and taxpayers.

Could the City address this issue through pension reform, not bonds?

No, the current liability cannot be undone through pension reform and the City must make its payments as required by CalPERS.  While the City cannot address the current UAL through pension reform, the City has undertaken reforms that are available, including requiring employees to pay their fair share.  Additionally, new State laws have reduced benefits for new employees (and employer costs).

Could the UAL come back?

Yes, it could.  However, the UAL may come back whether the City issues POBs or not.  The new, flat POB repayment shape shown in Figure 1 provides more capacity /resilience for City to pay for any potential “shocks” while also maintaining services to City residents.

Do POBs “kick the can down the road”?

No.  By issuing POBs, the City is taking immediate, proactive action to address the outstanding UAL debt.  In addition, the City's proposed strategy DOES NOT include an extension of maturity.

Will bond rating agencies view these POB bonds negatively?

No.  The bond rating agencies (Moody's Investors Service, S&P Global, and Fitch Ratings) typically recognize the significant benefits of restructuring the UAL debt and, importantly, they recognize the prudence and thoughtfulness behind the recent General Fund reserve and pension funding policies that were adopted by the City.

Do POBs exchange a “soft” liability for “hard” liability in bonded debt?

The City's liability to CalPERS is already debt on its balance sheet, is legally enforceable, and has a mandatory payment schedule.  Rating agencies treat unfunded pension liabilities as debt in calculating liability and fixed expense ratios.  Furthermore, the Governmental Accounting Standards Board (GASB) requires the debt be included as part of the City’s annual financial statements.

Have POBs contributed to or enabled unsound policy decisions?

This has been true for a handful of cities.  However, more than 30 agencies have used bonds to restructure their UAL over the past two years, totaling about $3 billion in UAL refinanced.  Based on conversations with the City's advisor and other market participants, it is estimated that at least 20 other cities (totaling >$5 billion in UAL) are currently moving forward with or evaluating this strategy.  Other concerns have been raised by the Government Finance Officers Association (GFOA) regarding the issuance of POBs, which are addressed in Figure 2.

Are there alternatives to issuing POBs?

As an alternative to issuing POBs, the City could issue lease revenue bonds or certificates of participation, known as “COPs.”  These types of bonds do not require a judicial validation; however, they would require the City to pledge building/assets as security for the bonds.  Because City assets are pledged, these types of borrowings can be more risky and expensive than POBs.

Why has the City filed a “validation action” in San Bernardino County Superior Court?  What is a validation action?

The California Constitution requires cities to obtain a two-thirds supermajority approval of the electorate before issuing debt obligations payable from General Fund revenues.  However, an exemption exists to finance or refinance “obligations imposed by law,” including the City’s obligation to fund its UAL in compliance with its PERS contract.  To issue debt under this exemption, cities must undertake validation proceedings.

Validation proceedings have long enabled public entities to confirm the legality of various actions, including contractual agreements and the issuance of public debt.  Specifically, section 860 of the California Code of Civil Procedure permits a public agency to validate any matter that the public agency has been authorized to validate pursuant to other laws that provide for such actions, including the authorization to issue bonds.  A public entity may choose to validate an action, including the authority underlying a bond issuance or the procedural elements that comprise the deal, in order to erase any uncertainty.  To do so the public entity files a “validation action” in court, in effect, asking those who would contest their decisions to come forward.

Therefore, the reason for filing the validation action is because the City is considering issuing pension obligation bonds, and in the event that the City issues such bonds, it wants and needs to make sure, as it firmly believes, that the bonds are valid and properly issued so that there is financial certainty for the City, its constituents, and the purchasers of the Bonds.  Importantly, the City must ensure that the Bonds will be valid and binding before the time, effort, and expense are expended to issue Bonds.  Filing a validation action is the best way to get that certainty and financial protection.

Will a public notice be published in the newspaper?

Yes.  Once the validation is filed, California law dictates how notice is to be given to “all persons interested.”  The notice must be published in a newspaper of general circulation in the community for three successive weeks.  Obviously, the City does not dictate the terms of how the newspaper publishes the notice but will make sure that the notice is properly given consistent with the rules.

Has the City already made its decision to issue POBs?

No.  Over the next three to five months, and once the validation process has been completed, additional public meetings will be held to discuss the risks and benefits of issuing POBs.  During these meetings, the City will also consider when and how much to borrow in the form of POBs.

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