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Report regarding a Single-Employer Section 115 Pension Prefunding Trust (Christie Donnelly, Director of Finance)
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RECOMMENDATION
Recommendation
It is recommended that 1) the City Council direct staff to proceed with development of a single-employer Internal Revenue Code Section 115 pension prefunding trust for the purpose of setting aside reserves for future pension obligations; 2) Direct staff to evaluate an initial pension reserve funding level with the preliminary target of $24 million, with the final recommended amount to be informed by analysis from finance staff, with input from a municipal advisor, and 3) Direct staff to return to the City Council for approval of the final trust documents, governance and investment structure, service providers, recommended initial funding amount, treatment of the City's existing Pension Stabilization Reserve, and any required budget appropriation.
No funds would be transferred into a trust as a result of the recommended action at this meeting.
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BACKGROUND/DISCUSSION
The City’s FY 2026-27 budget utilizes $5.5M of general fund reserve to offset an operational deficit. Recent developments indicate that this deficit, without consideration of the state’s uncertain Property in-lieu of Vehicle License Fees (VLF) backfill, will in fact be closer to $12.5M. To address these ongoing budget pressures without having to impact ongoing services, staff continue to identify strategies that leverage the City’s current reserve position in order to strengthen long-term financial stability rather than allowing ongoing operating deficits to gradually erode those resources. One of these tools is the establishment of a Section 115 Pension Trust.
The City participates in the California Public Employees' Retirement System (CalPERS) through two pension plans: a Safety Plan for sworn police and fire employees and a Miscellaneous Plan for most other City employees. The City's annual employer pension obligation has two components: a normal cost which pays toward the pension benefit being earned by staff today; and the Unfunded Accrued Liabilities (UAL) payments which address the remaining unfunded costs associated with benefits previously earned by current and retired staff. The combined FY 2026-27 budget for CalPERS normal and UAL costs, for both safety and miscellaneous plans, is $35.2M. Based on the current actuarial valuations, those two components together are projected at $36.6 million for FY 2027-28.
CalPERS’s investment performance is an important contributor to the outlook of its plans. Recent experience with CalPERS’ investment strategy demonstrates that its investment performance causes marked swings in pension liabilities, both in positive and in negative directions. Several strong years can improve the City's pension position substantially; similarly, one poor investment year can create new actuarial losses that will increase required payments in later years. For this reason, staff believe the city faces a unique opportunity to preserve a portion of its current General Fund balance to help protect future City budgets and by extension, future City services, for if/when pension investment returns decline.
Purpose of a Pension Prefunding Reserve
A Section 115 pension prefunding trust allows a public agency to set aside assets today to pay future employer pension contributions, providing a financial shock absorber that could be used over time to reduce volatility in pension costs and protect City services during periods when required pension contributions increase. Without a pension reserve, increased contribution requirements would compete directly with public safety, infrastructure, parks & recreation, library, and other City services that utilize General Fund resources.
On important distinction it that while a Section 115 Pension trust gives the City another tool for managing its UAL, this strategy does not remove pension obligations or the fluctuations in the amounts of the obligation.
Flexibility of Section 115 Trust Assets
With a Section 115 trust, a barrier around the assigned resources is created: the funds remain available to the City for pension costs and are dedicated to that purpose. In addition, a Section 115 trust can be structured to permit a broader, longer-term investment mix which could allow for increased investment returns. This is unlike the City’s regular investment portfolio, which is limited by California Government Code Section 53601 to specified types of investments and related maturity, credit-quality, and concentration limits. The appropriate investment objectives, risk tolerance, and asset allocation would be established as part of the trust and investment policy ultimately presented to the City Council.
Another important feature of a Section 115 pension trust is that its assets can be used for both employer normal cost contributions and UAL payments, which are expected to equal over $35M per year for the city for at least the next nine years. Funds transferred to the trust remain dedicated to pension purposes and cannot simply be redirected to an unrelated City expenditure. However, a future City Council could, consistent with the trust documents, elect to use trust assets to pay pension costs that otherwise would have been paid from the operating budget.
Accordingly, although a Section 115 trust intentionally restricts the use of its assets to pension purposes, it does not eliminate future budget options. If financial conditions changed significantly, a future Council could use pension trust assets to satisfy some or all of pension obligations that otherwise would need to be supported by the City's operating budget, thereby preserving operating resources for other City priorities. This provides an important balance between fiscal discipline today and flexibility for future Councils.
Single-Employer Trust Recommendation
After consideration of three general approaches to maintaining a pension stabilization reserve, staff recommend a single-employer Section 115 trust. Unlike the city-held non-trust reserve it has now, and unlike multi-employer Section 115 trusts, a single employer Section 115 trust would:
• Be established specifically for the City;
• Provide greater ability to tailor governance and investment policy;
• Ensure the ability to select investment and other professional advisors;
• Facilitate greater local control over the long-term structure;
• Allow its asset balance to be reported as a pension asset to offset UAL on financial statements; and
• Be viewed favorably by credit rating agencies.
While a multi-employer trust offers simplicity and speed, the choices for investments, advisors, and service providers are pre-packaged and thereby largely non-negotiable within the existing trust. For a reserve of the potential size being considered by the City, however, staff believes there is value in establishing a trust specifically for South San Francisco. A single-employer structure would allow the City to develop governance provisions and an investment strategy around its own financial objectives, select its advisors and service providers, and maintain greater control over how the trust operates over the long term.
Existing City Reserves and Preliminary Capacity Analysis
The City entered FY 2026-27 with healthy reserves, which provides an opportunity to hedge against long-term financial risks (such as pension liabilities) before they become immediate budget problems. As presented during the FY 2026-27 budget process, projected General Fund reserves and available unassigned fund balance were expected to total approximately $86.3 million at the end of FY 2026-27. This total included:
- $34.3 million General Fund Policy Reserve (20% general fund revenues);
- $5.3 million Infrastructure Reserve;
- $6.2 million City-owned Pension Stabilization Reserve; and
- $40.5 million remaining available unassigned General Fund balance.
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- While relatively strong, the City's reserve position must be considered in the context of other financial uncertainties. In addition, as part of the Long-Term Fiscal Sustainability Plan, upcoming analysis may identify needs for additional infrastructure reserves, equipment replacement reserves or other long-term purposes. Knowing that there are other anticipated pressures that may also require use of general fund reserves, the full $86.3 million unassigned general fund balance should not be considered for a Pension Trust. Instead, staff’s preliminary calculations indicate that resources of up to $24 million ought to be considered for a pension trust. The exact amount should be determined through a deliberate analysis of competing long-term needs. To that end, staff intend to leverage the expertise of a municipal advisor specializing in pension reserves to assist with analyzing the recently released actuarial valuations and recommend an appropriate reserve target before returning to Council for final action.
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- The final reserve recommendation will consider, among other factors:
- anticipated future UAL payments;
- anticipated employer normal costs;
- the amount necessary to provide meaningful pension-cost smoothing;
- the City's existing Pension Stabilization Reserve;
- General Fund reserve requirements;
- VLF revenue uncertainty and potential loss of future backfill;
- future infrastructure funding requirements;
- equipment replacement needs;
- other long-term liabilities and reserve requirements; and
- an appropriate methodology for making future contributions to the trust.
FISCAL IMPACT
There is no immediate fiscal impact or transfer of funds associated with the recommended Council direction. The costs associated with hiring consulting services would be covered by the Finance department within its current FY 2026-27 available budget.
The proposed trust would represent a change in where pension reserves are held and how they are governed. Although trust assets would be dedicated to pension purposes, they would remain available to pay both future UAL payments and employer normal costs. Accordingly, assets placed into the trust would continue to provide meaningful financial flexibility by allowing future pension obligations to be paid from the trust rather than entirely from operating revenues when circumstances warrant.
RELATIONSHIP TO CITY COUNCIL PRIORITIES ACTION PLAN
This effort supports the major focus area of Modern and Sustainable Organization and specifically the Key Strategy to ensure financial sustainability.
CONCLUSION
The City's pension outlook has fluctuated significantly over the several years, demonstrating that pension experience moves in cycles. Strong investment years can improve liabilities and future contributions, while poor investment years can move those same numbers in the opposite direction. Establishing a dedicated pension reserve during a period of favorable experience allows the City to preserve a portion of today's stronger position for the years when conditions may be less favorable.
A Section 115 trust effectively creates a pension-only reserve. It provides greater discipline than holding the same amount as a general City reserve, while retaining meaningful future flexibility because the assets can be used to pay both UAL and normal pension costs that otherwise would be supported by the City's operating budget.
Of the alternatives considered, staff believe a single-employer Section 115 trust provides the best balance of fiscal discipline, investment flexibility, and local control for the City. Staff therefore recommend that the City Council provide direction to proceed with development of a single-employer trust and return at a future meeting with the proposed trust structure and legal documents, recommended governance, investment framework, professional service costs and recommended providers of the trust, reserve-sizing analysis, initial funding recommendation, and proposed long-term funding strategy for final Council consideration.
Attachments:
1. PowerPoint Presentations