Spend money to save money: How four cities are managing their pension obligations

California’s unfunded pension woes could become worse in the next few years. Last year, the California Public Employees’ Retirement System (CalPERS) suffered a 6.1% investment loss in the fiscal year ending on June 30, the first such loss since 2008. Cities will not feel these impacts immediately, but they will almost certainly be felt in the next few years. 

Thanks in part to the painful lessons of the 2008 recession, cities have more tools that can help them prepare. Education efforts have also increased employers’ awareness about their ability to make additional discretionary payments and the advantages of doing so. Western City spoke with city officials from Lodi, Roseville, Scotts Valley, and Upland to learn how cities can better prepare.

Although the historic bull market and near-zero interest rates are gone for the foreseeable future, there is still an opportunity to prepare for an uncertain future. “You need to make hay when the sun is shining,” Lodi City Manager Steve Schwabauer said. “And the sun was shining for the last eight years. And unfortunately, it’s probably not right now. So, make hay in the next two to three years if you can. If you have excess reserves, I would definitely invest them in cutting down my pension bill."

Invest now for the rainy days ahead 

Making additional, one-time pension payments has some obvious benefits. They result in lower interest rates, less risk, a reduction in net pension liability, and most importantly, more money for critical services. Cities can make these payments monthly, quarterly, or even on an ad hoc basis depending on their fiscal health. These payments, while potentially painful in the short term, pay off in the long term. Roseville will save $800,000 per year for 20 years as a result of two additional, $6 million payments.

How those payments are funded depends on the city.

The city of Lodi has several additional payment strategies in place, most notably a pension stabilization policy. Any budget reserves over and above 16% must be invested in the city’s pension obligations. The city pays its entire unfunded accrued liability — the difference between the estimated costs of future benefits and how much is set aside to pay them — at once. CalPERS provides a discount for early payments, which the city forgoes, resulting in even more long-term savings. The city also maintains a diverse investment portfolio to provide liquidity in the event of an unexpectedly large pension payment.

As a result of these policies, the city has invested an extra $2-3 million in its pension obligations per year since 2017. Before these payments, Lodi was one of the worst-funded cities in California. Today, it is firmly in the middle.

“It takes a tremendous amount of fiscal discipline from a city to pursue this type of policy,” Schwabauer said. “There are a lot of calls on spending money. And a lot of them are very appropriate.”

For Lodi, this discipline paid off. The city anticipated its pension costs would go up by as much as $14 million. Instead, it went up by $8 million.

Spending money to save money

Pension stabilization policies are a great way to lower pension obligations, but this raises an obvious question: How? For many cities, this often means investing in a Section 115 Pension Trust Fund. Named after a section of the federal Internal Revenue Code, Section 115 trusts do not have a direct impact on a city’s reported pension liability or the size of its required annual contribution. More importantly, Section 115 Trusts can serve as a reserve to mitigate risk during economic downturns.

Preemptive, strategic thinking like this is critical, especially when market conditions — and the discount rate — fluctuate. “It’s really very difficult for cities to budget or predict when CalPERS … is constantly changing even what our liability number is,” said Scotts Valley City Manager Mali LaGoe, who is currently pursuing a Section 115 Trust.

LaGoe emphasized that managing pension investments through Section 115 Trusts is an important way to maintain local control. “Our liability was $16 million and all of a sudden it was $24 million,” she said. “If you have a strategy for a $16 million liability and then all of a sudden it goes up by 50% … [that makes it] very difficult for cities to plan. That’s where the 115 Trust shows that we are exercising some discipline, putting some money aside, earning interest on that money, but we’re also not just giving it to CalPERS.”

Section 115 Trusts can be particularly potent when combined with a disciplined pension funding policy. The city of Upland’s pension policy calls for several intentional contributions to its Section 115 Trust. Fifty percent of its budgetary cash savings made from additional discretionary payments to CalPERS are directed to its Section 115 Trust. The city also remits 40% of any year-end operating surplus to its Pension Stabilization Reserve.