PHOENIX – Some local governments in California, faced with increasing pension funding requirements, may turn to tax increases.

The cities of El Segundo and Arcadia both told the California Public Employees' Retirement System's November board meeting that they are looking at raising taxes to deal with their pension liabilities, which are expected to increase in part because CalPERS is dialing back its assumed return on its investments under a plan adopted in late 2016.

The California Public Employees' Retirement System headquarters in Sacramento.
Local government officials say the contributions required by the California Public Employees' Retirement System are stretching their budgets to the limits.

The hand-wringing in the two Los Angeles County cities comes as public pension funds around the country reduce their expected investment return rates, which, in the absence of benefit changes, has the effect of increasing the amount public employers are expected to pay into the systems. Credit analysts said they would not be surprised to see other cities at least contemplating tax increases.

El Segundo’s pension contribution for this year is $11 million, which is 16% of the general fund. It is expected to increase in five years to $18 million, representing 25% of the general fund, said Suzanne Fuentes, mayor of the city of 16,800.

“Pensions have been a concern for the entire four years I have been in office,” Fuentes said.

The City Council is contemplating a proposal to impose a 0.75% city sales tax to bolster its finances with the looming growth in the pension burden.

The city is looking at a $400,000 budget deficit by next year and the pension burden could mean a reduction in parks and recreation services, library closures or layoffs, Fuentes said. The city has established a pension trust fund, advanced payments of pension debt, frozen pay raises for some employee groups for the last five years, and is deferring $2.3 million per year in facility repairs and maintenance.

San Jose, which has its own pension systems, raised an estimated $52 million a year in new sales and business tax revenues that voters approved in November 2016, and Mayor Sam Liccardo subsequently admitted that a small portion of that would be used to help offset San Jose’s pension liability. San Jose is among the handful of larger cities to enact major pension reforms, having passed reductions in retirement benefits via the voters in 2012. The city said it is seeking “new revenues” to offset its spiking pension costs.

“Like many California cities, we continue to face challenges with growing pension costs borne from decisions decades ago,” city spokesman David Low said. “However, we’ve taken a slightly different path: enacting meaningful pension reform to slow the growth in our retirement costs, and then seeking new revenues to restore services.

El Segundo, Calif. Mayor Suzanne Fuentes
"Pensions have been a concern for the entire four years I have been in office," said El Segundo, Calif., Mayor Suzanne Fuentes.

“It’s a bit too early to tell if the Council will place a revenue measure on the ballot in 2018,” Low said. “Different folks have floated the possibility of pursuing a tax measure, but that call won’t be made until March at the earliest; and also worth noting that none of the potential tax measure possibilities floated to date were connected to servicing retirement costs.”

The CalPERS board voted on Monday not to adopt any further reductions in its assumed rate of return, a victory for El Segundo and other governments that would be forced to contribute more money to keep CalPERS funded under a lower assumed rate. Credit analysts said that while many California cities are facing increasing pressure from their pension costs, most of them are not in grave danger of fiscal insolvency.

In contrast to states like Illinois and New Jersey, CalPERS has strong powers to compel governments to make their actuarially required payments; its primary Public Employees' Retirement Fund was 68% funded as of June 30.

It is the prospect of making these required payments that is straining local governments.

Moody’s analyst Eric Hoffmann said he has not seen a groundswell of sentiment toward raising taxes to service pension liabilities, but that Moody’s would expect cities to talk about it.

“There are pressures across the board,” he said, particularly for medium-sized cities away from the coast where revenue growth has generally been a bit slower in recent years. Hoffmann said that many California cities have increased sales taxes in the past year, but have never tried to sell them to the public as necessary due to pension costs. Hoffmann said one of the most common types of taxes being discussed in California is marijuana sales tax, which could potentially give cities more discretionary funds to deal with whatever pressures they have, including retirement.

“Presumably you could use that tax to pay pension cost increases,” Hoffmann said.

According to the League of California Cities, CalPERS employer contribution payments have soared since 2008, causing a crowd-out of essential public services, hiring freezes, layoffs and other strains on local budgets.

"Cities want greater flexibility, including the ability to modify benefits prospectively, according to the league, which reported sending more than 50 city leaders to the CalPERS November board meeting.

"They all communicated one uniform message," according to the league: "The 'employer just paying more' option is no longer viable."

“It goes without saying that whenever a city or county identifies a dedicated revenue source, we view that as a positive credit factor,” said S&P Global Ratings analyst Benjamin Geare.

“We also have been and are keeping an eye on issuers relative to rising pension costs,” Geare said. “It is something we have a regular conversation with issuers about throughout California. We look at the costs for different jurisdictions and whether it would result in a reduction of services. We also look at whether they are increasing revenues or seeking reform to lower the burden or slow the rate of growth.”

“It’s nuanced,” he continued, “because each local government situation is going to be different. It depends on which plan they have, whether it’s a multi-payer cost sharing or one single-agent plan.”

Geare said that if S&P were concerned about cities being in the situation that Stockton and San Bernardino were when they filed bankruptcy, it would be reflected in ratings reports.

El Segundo's calculations are complicated by its effort to maneuver around county sales tax proposals. If it doesn’t impose a city sales tax now, it might not have the option in the future.

The overall sales tax in Los Angeles County is capped at 10.25%; the rate in El Segundo now, without a city sales tax, is 9.5%. Fuentes said city officials want to get the sales tax before the county takes it.

“It’s like earthquakes in California,” Fuentes said. “It’s not a matter of if, it’s just a matter of when the county will put the next tax item on the ballot. And it will pass, because every county tax ballot issue gets passed.”

Voters approved a quarter-cent county sales tax increase in March to help homeless people and a half-cent county sales tax in 2016 to fund transportation projects,. The original El Segundo proposal would ask city voters in April to approve a 3/4-cent sales tax generating $9 million a year that would not take effect until the county approved a new sales tax. If the county measure is rejected, the city tax would be suspended.

The council is also considering a city tax that would be triggered when the county places a measure on the ballot or on a date several years after the April vote, whichever comes first.

California’s cities are hardly alone: a Dec. 14 Moody’s report showed that for the 50 largest local governments, adjusted net pension liabilities reached aggregate $456 billion in fiscal 2016, up from $390 billion the prior year. As a percentage of operating revenues, Chicago was at the top with unfunded pension liabilities at 703%, followed by Dallas at 609%, Houston at 606%, Phoenix at 494%, and Los Angeles at 432%.

Unfunded pension liabilities will spike an additional 33% for most local governments in fiscal year 2017 due to lagged recognition of weak investment returns in the prior year, Moody’s said, and are expected to post moderate declines in fiscal 2018.

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Kyle Glazier

Kyle Glazier

Kyle Glazier is a reporter covering market trends, infrastructure, and the Far West region for The Bond Buyer.