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Report regarding approval by the City of South San Francisco of a resolution authorizing the issuance of bonds to refund and prepay certain Pension Obligations of the City and authorizing judicial validation proceedings relating to the issuance of such bonds. (Jason Wong, Acting Director of Finance)
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RECOMMENDATION
Recommendation
Staff requests that the City Council of the City of South San Francisco consider this administrative step by adopting a Resolution authorizing the issuance of bonds to refund and prepay certain Pension Obligations of the City; approving the Form and Authorizing the Execution of a Trust Agreement and Bond Purchase Agreement; authorizing Judicial Validation proceedings relating to the Issuance of such Bonds; and approving Additional Actions Related Thereto.
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BACKGROUND/DISCUSSION
Background. The City has two retirement plans (Miscellaneous and Safety) and three benefit tiers for each plan (Classic Tier 1, Classic Tier 2, and PEPRA-Public Employees’ Pension Reform Act, which took effect in January 2013):
1) Miscellaneous
a. Classic Tier 1: 2.7% @ 55
b. Classic Tier 2: 2.0% @ 60
c. PEPRA: 2.0% @ 62
2) Safety
a. Classic Tier 1: 3.0% @ 50
b. Classic Tier 2: 3.0% @ 55
c. PEPRA: 2.7% @ 57
The City is a contracting member of CalPERS and, as such, the City is obligated to make certain payments to CalPERS each year. The City’s annual pension obligations are comprised of two primary components: 1) Normal Costs and 2) Unfunded Accrued Liability (“UAL”) Payments. Normal Costs represent the pension benefits earned by current employees during the fiscal year and are set by CalPERS as a percentage of payroll.
The UAL Payments are the annual dollar amounts needed to fund past service credit earned for (active or retired) members, as of the current valuation date. The UAL is equal to the difference between the present value of benefits earned to date, less the current market value of the assets. As of the most recent Actuarial Valuation (dated as of June 30, 2020), the City’s UAL was equal to approximately $220 million. CalPERS provides for a fixed dollar repayment of this past due amount over time at an “interest rate” equal to CalPERS’ investment target, or Discount Rate (which is currently 6.8%). As of the June 30, 2020 Valuation Date, the City’s UAL Payment for Fiscal Year 2022-23 is projected to be $18.3 million and will continue to increase until Fiscal Year 2030-31 when it peaks at $24.7 million.
The UAL is a dynamic liability, and the City should anticipate that its UAL will fluctuate as a result of everchanging variables. Each year, CalPERS adjusts the UAL to account for investment performance, changes in assumptions or methodology, demographic changes, and payroll/salary adjustments. Given that these annual adjustments can be significant, CalPERS establishes a long-term fixed dollar repayment schedule for each new adjustment. In the case where CalPERS’ return exceeds the investment target or Discount Rate, CalPERS provides a “credit” (reflected by negative numbers) against the existing payment schedule.
For Fiscal Year 2020-21, CalPERS reported a 21.3% investment return (well above its 7.0% target or Discount Rate for such fiscal year), which will provide a significant credit to the City’s UAL Payment schedule (a portion of which will be offset by the lowering of the Discount Rate from 7.0% to 6.8%). It is estimated that the City’s UAL will be approximately $174 million, as of June 30, 2021, after factoring in the net credit. While this is good news, the City’s UAL remains an important issue to address. Even with the projected net credit, the City’s retirement funds are estimated to be only 72% funded. Moreover, CalPERS’ Fiscal Year 2021-22 year-to-date investment return is below its target/Discount Rate, and the City should expect that a new adjustment will be reflected in its Actuarial Valuation as of June 30, 2022.
City Council Study Session. On October 26, 2021, the Finance Department staff and UFI (the City’s municipal advisor for pension obligation funding strategies), gave a presentation to the City Council that included the following agenda topics:
• Background - Staff provided an overview of the credit concerns related to the City’s pension liability, past efforts by the City to address pension, and staff recommendation to develop a formal written policy to address pension.
• Understanding City’s Pension Liability - Staff and UFI reviewed the composition of the City’s pension fund, the City’s UAL as of its June 30, 2020 Actuarial Report, its funded ratio for the Miscellaneous and Safety Plans compared to peers, UAL amortization bases and payment schedule, and anticipated CalPERS adjustments for June 30, 2021.
• Pension Obligation Funding Strategies - UFI reviewed various pension obligation funding strategies, implementation of these strategies based on cost of capital, applying the City’s $5.5 million pension reserve towards paying down a portion of the City’s UAL, and Section 115 Trusts.
• Pension Obligation Bonds (“POBs”) - UFI reviewed the economics of POBs, recent POB issuance trends, POBs 1.0 versus POBs 2.0, a hypothetical POB scenario for the City, and a selected case study demonstrating how various factors influence the outcome of POBs.
• Conclusion and Q&A - Staff provided concluding remarks and potential next steps for the City Council to consider, including offering follow-up with the City Council on the topics of the Study Session. Staff also recommended returning to the City Council at a future date for formal direction and authorization to undertake judicial validation proceedings, which is the next step in making POBs available as a “tool in the toolbox” but does not commit the City to the sale of POBs.
At the conclusion of the Study Session, the City Council expressed interest in staff following up on the topics of the Study Session and directed staff to return to the City Council at a future date for consideration of authorizing judicial validation proceedings for the issuance of POBs.
Judicial Validation Proceedings. Under the California Constitution, a city may not incur debt for any purpose that exceeds the income and revenue for any particular year without voter approval (the “Constitutional Debt Limit”) unless such debt qualifies for an exception under California law. There are three exceptions to the Constitutional Debt Limit, including an exception for obligations imposed by law. Under this exception, cities are not required to obtain voter approval to finance obligations that they are legally required to pay. POBs payable from the general fund of a city rely on this exception. Before a city can access the public capital markets to sell POBs in reliance of this exception, a city must approve the issuance of POBs and undertake a judicial validation to obtain a court judgment. By undertaking the judicial validation process, a city may obtain a court judgment that a city’s pension costs are obligations that the city is legally required to pay and that the issuance of POBs refinances that obligation imposed by law.
The judicial validation proceedings require a sequential process that can take 90 to 180 days:
1. City Council passes a resolution authorizing the sale of pension obligation bonds
2. File Validation Action with Superior Court of San Mateo County
3. Receive Order for Publication of Summons from the Court
4. Publish notice in local publication of general circulation once a week for three consecutive weeks
5. Waiting period to file petition - minimum of 10 days
6. Clerk enters hearing for a default judgement and schedules a hearing
7. Hearing for default judgement
8. 30-day Appeal Period
Adoption of Resolution. Today’s recommended action allows the City to take the next step in making POBs available as a “tool in the toolbox” without committing the City to the sale of POBs. The resolution accomplishes the following:
1) Appoints The Bank of New York Mellon Trust Company, N.A., as the trustee and approves the substantially final form of Trust Agreement that describes the material provisions and parameters of each series of POBs and authorizes certain officers (“Authorized Officers”) to make changes as deemed required and to execute and deliver the Trust Agreement;
2) Authorizes the issuance of Taxable Pension Obligation Bonds (the “Bonds”), subject to the terms and conditions set forth in the Trust Agreement, provided that: 1) the principal amount of the Bonds does not exceed the lesser of $221.5 million or the sum of the City’s remaining UAL plus the annual required pension costs due and payable to CalPERS within 18 months of the issuance of the Bonds (the “Current Obligation”) plus costs of issuance of the POBs; 2) the issuance of the Bonds results in net present value savings to the City as determined by Authorized Officers; 3) the Bonds do not mature later than the last date through which CalPERS has determined for the amortization of the City’s UAL; and 4) the Underwriter’s discount for the purchase of the Bonds will not exceed 0.50% of the principal amount of the Bonds;
3) Authorizes the issuance of one or more series of additional POBs in the future, provided that: 1) the principal amount of each series of POBs does not exceed the City’s remaining UAL plus the Current Obligation plus costs of issuance of the POBs; 2) the issuance of each series of POBs results in net present value savings to the City as determined by Authorized Officers; and 3) each series of POBs does not mature later than the last date through which CalPERS has determined for the amortization of the City’s UAL.
4) Authorizes Authorized Officers to select one or more Underwriters and approves the substantially final form of the Bond Purchase Agreement specifying the terms and conditions upon which each series of POBs would be sold to the Underwriter(s);
5) Authorizes Authorized Officers to negotiate and execute bond insurance and a debt service reserve fund insurance policy for the Bonds, if economical, and any other documents necessary to issue the Bonds;
6) Authorizes the City Attorney and Stradling Yocca Carlson & Rauth (Bond Counsel) to prepare and file all proceedings required for judicial validation of the POBs;
7) Directs staff to work with the financing team to prepare the remaining required financing documents (i.e., Preliminary Official Statement, Continuing Disclosure Agreement, documents required by CalPERS) and bring such documents to the City Council for final approval before the sale of POBs.
If the City Council adopts the resolution, the City Attorney and Bond Counsel plans to file the validation action with the Superior Court of San Mateo County on or about March 10th. As mentioned previously, judicial validation proceedings can take anywhere from 90 to 180 days. In the meantime, staff will work with Bond Counsel and UFI (on a contingent basis) to select Underwriter(s) and prepare remaining financing documents to bring back to the City Council for approval at a future date, should it be deemed prudent to move forward with the issuance of the Bonds.
Ongoing Planning and Analysis. With pension costs being one of the largest cost drivers in public agencies today, staff recognizes that any one strategy would not comprehensively address these costs. During the judicial validation process, staff will work with UFI to conduct one-on-one meetings with council members to do a deep dive of pension related issues. Staff and UFI will present a Pension Obligation Funding Plan/Policy for City Council consideration that involves multiple strategies for continued management of the City’s pension costs. In order to further evaluate the issuance of POBs as one of these strategies, staff and UFI will present various POB structuring options, risk analysis, and market updates to the City Council.
FISCAL IMPACT
Staff estimates a cost of approximately $25,000 to draft documents for the validation process and filing fees. In accordance with California Government Code Section 5852.1, good faith estimates for the Bonds are provided as Exhibit A to the attached resolution.
RELATIONSHIP TO STRATEGIC PLAN
Adoption of this resolution will authorize the issuance of the Bonds (subject to the City Council’s future approval of the additional financing documents described above) and the judicial validation proceedings for the issuance of POBs to refund and prepay certain Pension Obligations of the City. This action is the next step in making POBs available as a “tool in the toolbox” to help address the City’s pension obligations. The approval would meet the City’s Strategic Plan Priority Area 3 - Financial Stability.
CONCLUSION
Despite positive actions taken by the City to address and manage its pension obligations, and despite the expectation of a significant net credit to the City’s UAL as of June 30, 2021, the City’s retirement plans are estimated to be only 72% funded. Developing a plan to address pension costs is critical to maintaining the City’s financial stability into the future. POBs may or may not be utilized as one of the strategies for addressing the City’s UAL. Authorizing judicial validation proceedings for their issuance is the next step in making POBs available as a strategy but does not commit the City to the sale of POBs. Therefore, staff recommends that the City Council approve the resolution that will authorize the issuance of the Bonds (subject to the City Council’s future approval of the additional financing documents described above) and the judicial validation proceedings for the issuance of POBs.
ATTACHMENTS
1. Trust Agreement
2. Bond Purchase Agreement