How Retirement Costs Impact the City’s Operating Budget

As the City’s unfunded pension and health liabilities increase, current operating budgets must be diverted to meet these obligations. Source: City of San José Federated City Employees’ Retirement System, Comprehensive Annual Financial Report, 2018–2019

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Dear Neighbor,

My last post took a high-level look at how our tax dollars are collected and spent across various levels of government. I appreciate the positive feedback and follow up questions. The top request I received was to dive deeper into the City of San José’s budget and break out costs related to unfunded pension liabilities.

This follow up post will look more closely at how the City’s growing unfunded liabilities impact our current operating budget. Like the last post, my main aim is to provide useful information, but I will offer my perspective where relevant. Thank you to District 10 resident and recent Leland graduate Adrian Rafizadeh for his excellent research support for this post.

While many of you asked specifically about the City’s unfunded pension liabilities, where possible we will include retiree health care costs in our analysis since they are a significant and fast-growing obligation that is similarly underfunded.

For context, the City of San José, like most public sector employers but unlike most private sector employers, offers long-time employees guaranteed retirement benefits (e.g. pension income and health insurance) as part of their compensation package. Essentially, the City pays into retirement funds on behalf of employees during their working years, a retirement board made up of City and public sector union representatives invests and grows those funds, and the fund balance is used to pay for eligible retirees’ current benefits. Pension payments are calculated according to a formula that takes into account years of service and the employee’s salary in their final years of employment.

Unfortunately — as most of you are no doubt aware — the reality of San José’s employee retirement funds (and most public sector pensions around the state and country) is not so straightforward. For a few reasons (which are well-outlined in a 2019 Santa Clara County Civil Grand Jury Report), the cost of retirement benefits contractually committed to current retirees is significantly larger than the pool of funds available, and the gap is growing.

A key reason for this shortfall is that those responsible for overseeing retirement funds — elected officials, ultimately— allowed the funds to set unrealistically high expected rates of return on their investments despite consistently missing those targets. In other words, governments underfunded retirement plans for years based on the assumption that long-term investment returns would eventually cover future obligations. This has proven to be a disastrous assumption over time, as missed targets compound annually and have quickly grown to epic proportions.

Retirement funds’ underperformance relative to their own projections has been a particularly acute problem in San José. In fact, the Grand Jury Report found that returns on San José’s two retirement systems, Federated City Employees Retirement System and Police and Fire Department Retirement Plan, have performed worse over the last decade than 99% and 98% of similar public pension plans, respectively:

Source: 2018–2019 Civil Grand Jury of Santa Clara County

While it seems obvious that retirement fund managers should have adjusted their investment return expectations downward many years ago, it appears that they chose not to out of either misplaced optimism or the reality that doing so would have immediately required much larger annual payments into retirement funds (i.e. to catch up with unfunded future liabilities). Instead, the proverbial can was kicked down the road for future generations of employees and taxpayers to address, which is where we are today.

To be clear, I don’t blame rank and file workers for the situation we’re in. They played by the rules as they existed, often dedicating their entire working lives to the City (much like my father did over nearly three decades with the U.S. Postal Service), and, in the case of first responders, even putting their lives on the line for the community. Sadly, however, current City employees — especially younger workers who struggle to afford our high cost of living — and today’s taxpayers must share the burden of poor fiscal management in the past.

It should also be noted that longer average lifespans and slower rates of population growth have contributed to the mismatch between current obligations and available resources. Still, these trends have been understood for many years and should have elicited an earlier response from our political leaders.

Data from a 2019 report released by the Federated City Employees’ Retirement System shows how the plan’s support ratio (i.e. the number of current employees paying into the fund per retiree receiving benefits) has changed over time. While a healthy and self-sustaining fund should have a support ratio of 2.0, the plan’s support ratio has decreased over the last thirteen years from 1.45 to 0.7.

Source: City of San José Federated City Employees’ Retirement System, Actuarial Valuation Report as of June 30, 2019

Unlike 401k plans that are ubiquitous in the private sector, City employees’ collective labor agreement with the City legally entitles them to predefined retirement benefits irrespective of fund performance, changing demographics or tax revenues. These obligations are legally senior (i.e. must be met first) to city services and other expenses, which means that any portion of the cost of these benefits that the City’s retirement funds can’t meet must be paid out of the general operating budget.

Thus, the City makes extra payments out of the General Fund each year to meet it obligation to retirees. This is not how the retirement funds were intended to work, but it is where we are today. From a taxpayer perspective, this means that the City’s current operating budget delivers less value — e.g. road repairs, park maintenance, library hours, and so forth — than one would expect by simply focusing on top line revenue figures. The General Fund may spend $1.3 billion per year, but residents do not experience $1.3 billion in services and investments.

So, how big is this extra cost?

My previous post mentioned these dynamics, but didn’t outline concrete numbers because the City’s 700-page annual budget document does not explicitly break out unfunded retirement liabilities, which is frustrating. From an outsider’s perspective, it is quite difficult to figure out how these costs are accounted for. I have to thank City staff, however, for being responsive to my questions over the last week and for helping us identify how and where these figures are reported. I appreciate their professionalism and knowledge. In the years ahead I hope to increase the public’s access to this kind of information and make our budget documents more resident-friendly.

The short answer to where in the City budget we can find unfunded retiree pension and health costs are is that they are mainly embedded within current employee compensation costs (i.e. what the budget categorizes as “Personal Services”), which make up 63% of General Fund expenditures:

Source: San José’s Retirement Solutions Working Group

Therefore, the cost of meeting unfunded liabilities that have accrued over time — and continue to grow —effectively increases the City’s current cost of labor. A current employee who earns $60,000 per year in base salary will in reality cost the City over $100,000 per year in total costs, once health and pension contributions are factored in. It is not the case that this individual employee’s health and pension costs are this high; instead, part of the cost assigned to this employee includes their share of the unfunded health and pension benefits for past employees.

According to a report published by San José’s Retirement Solutions Working Group, the unfunded portion of these costs amounts to $256.7 million in the current fiscal year across the city (including General and Special Funds, which are defined in my last post). Given that the General Fund’s share of retirement costs is approximately 78% of the City’s total, this implies that roughly $200 million in annual General Fund spending, or 15%, is currently devoted to backfilling unfunded liabilities accrued over past years.

In all, General Fund contributions to retirement funds for current and future beneficiaries equal roughly 28% of total spending. This is the sum of “normal” retirement payments and those made to address unfunded liabilities. This number has grown significantly over the last fifteen years, driven by increases in unfunded liabilities:

Source: San José’s Retirement Solutions Working Group

As liabilities increase, the ratio of retirement funds’ obligations that are covered by fund assets is dropping, which drives up the General Fund’s cost burden. The figure below illustrates this trend in the case of pension liabilities for the Federated City Employees Retirement System, specifically, but the graph looks roughly the same for Police and Fire pension liabilities.

Source: City of San José Federated City Employees’ Retirement System, Comprehensive Annual Financial Report, 2018–2019

Unlike with pension costs, both retirement systems’ unfunded health liabilities are moving in a better direction, but they are starting from a very low base. The Federated System, for example, has increased its funded ratio from a mere 10.7% in 2009 to a still very concerning 42.6% in 2018.

Source: City of San José Federated City Employees’ Retirement System, Comprehensive Annual Financial Report, 2018–2019

San Joséans have taken action at the ballot box in recent years to mitigate the impact of unfunded liabilities on operating budgets. Measure F, which represented a compromise between fiscal reformers and public sector unions after an earlier measure was mired in legal battles, passed with over 61% of the vote in 2016. It established a new tier of employee benefits for incoming City employees, which implements more sustainable retirement benefits, and required higher pay-in rates. Relatedly, the City has adjusted its expected annualized rate of return down to a more realistic 5.25%.

These reforms were certainly a big step in the right direction, but they don’t prevent our operating budget from bearing a significant burden for years to come. One City Hall staff member we spoke with noted that projected retirement costs as a percentage of the budget should be near their all-time peak (at about 28% of General Fund expenditures). They further noted, however, that this projection is based on expected tax revenues, stock market performance and other actuarial assumptions that may prove incorrect.

The truth is that no one knows for certain how much more the burden will grow or for how many years it will remain at such a high level. What is certain is that, just as it took decades to accrue these massive unfunded liabilities, it will decades to pay them down. Without relitigating decades of bad decisions and old political battles, I do think it’s critical that we track these numbers closely and ensure that we are indeed on a long-term path to eliminating our unfunded liabilities, as Measure F intended. I’ll continue to do my best to keep you informed about these budget trends.

At the moment, I’m especially worried about the combination of growing liabilities and reduced tax revenue due to COVID’s impact on the economy. We should expect the City’s budget to be extremely tight over the next few years given that it is being squeezed on both the revenue and cost side. We will need to have a conversation as a city about our priorities; namely, how we want to balance spending and make trade-offs across local services, such as public safety, parks, libraries, and roads. We will need to push even harder to use our tax dollars efficiently and get as much value out of them as possible.

In future posts, I hope to explore additional solutions that complement Measure F, ranging from strategies for growing the City’s tax base through promoting local economic growth to improving fiscal management. On the latter point, the Civil Grand Jury Report recommended a number of straightforward ideas, such as merging the City’s two retirement boards to reduce overhead costs, and more controversial concepts, such as offering retirees the option of an upfront buyout of their automatic 3% COLA (“cost of living adjustment”). We also need to hold our fund managers accountable for better performance. If our performance consistently ranks near the bottom of all comparable funds, we need new managers, new investment strategies or both. There’s plenty more to consider on this front and I very much welcome your ideas.

Thank you again for engaging with me on these important topics. Your feedback and questions have helped guide my research and make these posts well worth the effort.

Sincerely,

Matt

Councilmember-elect, San José District 10; matt@mahanforsanjose.com, 408–891–9708

Matt is Councilmember-elect for San José District 10, which includes Almaden Valley and Blossom Valley. Matt takes office in January 2021 and uses this blog to share what he’s learning about a variety of local issues and his take on those issues. Matt and his wife, Silvia, are proud to be raising their two young children, Nina and Luke, in District 10. You can subscribe to Matt’s updates here: https://forms.gle/ycvcf3fbKSFU2JfA6

Councilmember, San Jose District 10. Formerly Brigade CEO & Co-founder Brigade, SVLG and Joint Venture Silicon Valley Boards, and SJ Clean Energy Commission