By Jeff Chang
Municipal and special district employers, particularly their elected council and board members, continue to express concerns over the size of their agencies’ CalPERS “liabilities” and what can be done to mitigate them. Although there are several strategies to address pension liabilities, the proper approach or strategy may depend on whether you are more concerned with overall unfunded accrued liability (UAL) or whether your agency can afford its increasing, minimum required employer contribution (Required Contribution).
In very simple terms, UAL is the amortized dollar amount needed to fund already earned or accrued benefits. In some respects, it is like an unpaid mortgage that is accruing interest at the rate of 7%. The “normal cost” that must be paid is the annual cost of the incremental benefit that active participants are earning for the upcoming fiscal year. The Required Contribution is the sum of the employer’s normal cost rate (expressed as a percentage of payroll) plus the employer’s UAL contribution amounts (billed monthly in dollars).
Many have seen the 2018 report prepared for the League of California Cities that concluded that “city pension costs will dramatically increase to unsustainable levels” – in many cases, increasing by more than 50% between FY 2018-19 and FY 2024-25. Because this report focused primarily on CalPERS affordability, it generated a lot of interest in the use of so-called section 115 trusts, as a way to set aside extra monies to pay for anticipated (larger) Required Contributions. The problem with trying to set aside monies to help pay future bills is that the “time-investment” value of a 115 trust diminishes as the time-investment horizon shrinks. In other words, the economic value of setting aside and investing monies in pension-type portfolios is dramatically different when your investment horizon (when you’ll need the money) is 20 or more years in the future rather than just a few years from now. Unfortunately, many agencies are trying to use 115 trusts to deal with near-term increases in their Required Contributions. If you’ll need some or all of the money within a few years, for budget stabilization or leveling-out cash flows, it might not make sense to invest the money in anything risky (or involving significant set-up costs). If your investment horizon is really short (e.g., less than 5 years), you should carefully analyze the cost-benefit of using a 115 trust for such a short term.
Alternatively, a number of agencies and their boards (particularly special districts with strong revenue streams) are less concerned with paying their Required Contributions than they are with the overall size of their UAL. Because your UAL is “discounted” using the current CalPERS rate (7%), each dollar of UAL that you prepay, like your mortgage, potentially saves you 7% of interest per year. The mere act of paying the UAL portion of your annual Required Contribution at the beginning of each fiscal year as a lump sum (instead of monthly) will save your agency 3.5% in interest for the year on that amount. Prepaying even larger amounts of UAL can dramatically reduce the size of your overall liability over time.
Because of all of the assumptions and variables that go into projecting and analyzing CalPERS liabilities and their mitigation, we often suggest that public agencies that are serious about adopting the right mitigation strategy start by working with an experience consulting actuary to better understand the exact nature of their liabilities and cost – and the various options for impacting overall liabilities and increasing costs.
Jeff Chang is a partner at Best Best & Krieger LLP. He has four decades of experience skillfully evaluating benefit and retirement plan compliance to achieve maximum outcomes for public agency clients throughout California. He can be reached at email@example.com or (916) 329-3685.