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 March 31, 2021, pension and OPEB trust balances were $7,622,044 and $1,332,348, 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.
- Holding the following public meetings exploring the City's UAL, the establishment of a pension management plan, and specifically considering the issuance of POBs:
- POB discussion workshop by Harrell & Company Advisors, LLC with City Council on September 10, 2020;
- Actuarial Valuation 101 presentation by CalPERS to the Finance Committee on October 28, 2020;
- Pension management plan / POB presentation to the Finance Committee by Urban Futures, Inc. and Govlnvest Inc. on January 6, 2021; and
- Pension management plan presentation to the Finance Committee by Urban Futures, Inc. on January 27, 2021.
- Approving, in June 2021, an additional $1 million dollar deposit into the City's pension stabilization trust.
- Adopting, in June 2021, General Fund reserve 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.
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 could 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.
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