Pension cost optimization strategies for California’s cities, water and wastewater agencies, and fire departments
UAL is one of the costliest and least understood financial challenges for California’s local governments. It can be an intimidating topic – and in the world of finance, things that we don’t understand or ignore usually end up costing us more than necessary.
The interest on the UAL accrues at 6.8% per year, a rate that is probably higher than on any other debt you have. If you feel that things could be done better, you are not alone.
Ridgeline has helped dozens of public agencies save millions of dollars on their UAL payments. We have identified twelve different tools that may help you reduce your pension costs. Our process includes:
We can help you save money on your UAL payments.
Pension Liability Assessment and Management Policy
We start with a thorough assessment of your agency’s CalPERS obligations and explain how CalPERS’ actuarial policies impact your pension plan funded levels, UAL, and related costs. We then cover different UAL optimization strategies and identify the ones that work best for your situation. Finally, we help you develop a pension liability management policy to set the course for sustainable UAL cost management.
UAL Optimization Strategies
Your agency's financial, operational, and political context determine the specific set of UAL optimization strategies that are right for you. We help you evaluate them through the lens of reserve levels, cash flow balancing, workforce management, capital improvements funding, debt issuance, and refinancing of existing obligations.
Pension Obligation Bonds
While debt should not be the first tool to reach for, many agencies have successfully used pension obligation bonds to achieve UAL cost smoothing and cash flow savings. As a municipal advisor, we help you determine if a pension liability refunding makes sense for your agency.
Ongoing Pension Liability Management
There is no one-time UAL fix. We help you navigate the annual CalPERS actuarial reports and implement the cost saving strategies laid out in your pension liability management policy. While you can’t prevent future UAL increases, you can prepare for them!
Q: Where can I learn more about my agency’s CalPERS’ pension plans?
A: Your primary source of information is the annual actuarial report available on your MyCalPERS portal. The report is updated annually in July and covers pension plan data through the end of the prior fiscal year. It includes information on the agency’s past and future pension payments, accrued pension liabilities, market value of assets, unfunded accrued liabilities and their amortization schedules, etc.
Q: What payments do we have to make to CalPERS?
A: Each agency must pay the minimum required contributions, which include the Normal Cost and the Unfunded Accrued Liability (UAL) payments. The Normal Cost is the annual cost of pension benefits earned by active employees during the fiscal year. It is shared by the employer and the employees and calculated as a percentage of salaries. The payments are made monthly and fluctuate with payroll. The UAL Payments are the repayment of previously accrued UAL amortized over 20-30 years. You have a choice between monthly and annual UAL payments. Making the annual payment prior to July 31 saves you 3.2%. The payments are billed as a fixed dollar amount. Even if your agency laid off all employees, you would still have to make the UAL payments.
Q: What is UAL?
The Unfunded Accrued Liability (UAL) is the difference between the accrued pension liability (the amount that your agency needs to have in its pension plan to meet all pension obligations earned to-date) and the market value of assets (the amount your agency actually has in its pension plan). In other words, it is the shortfall between what your agency should have and what it actually has in its pension plan.
Q: How is my UAL calculated?
UAL changes every year with CalPERS’ investment performance, pension plan experiences, and revisions to pension formula assumptions. It consists of multiple layers (called “bases”), each with its own repayment schedule. The bases are either positive (increasing your UAL balance) or negative (decreasing your UAL balance). Different base types have varying amortization rules, with payments extending up to 30 years. Newly added bases have a negative amortization period for the first several years, when the required minimum payments do not cover the interest cost. This leads to the base balance increase and interest charged on top of interest.
Q: Why is my UAL so high?
Your agency is not alone in facing a large and growing UAL – most other municipalities are right there with you. Here are some of the reasons for UAL increases:
Inadequate investment performance. When CalPERS investment returns fall short of the formula expectations (the discount rate), the UAL grows. However, if investment performance is better than expected, the UAL is reduced.
Assumption changes. Actuarial assumption changes by CalPERS, such as life expectancy, salary increases, retirement age, etc., have a direct impact on the UAL. It is unusual to see an assumption change that results in a UAL decrease.
Discount rate reduction. The discount rate is the minimum average rate of investment return that CalPERS must earn for the pension plan to be sufficiently funded to meet earned retirement benefits, holding all other assumptions unchanged. When the discount rate is reduced, which has been the trend for the last two decades, it results in future expected investment earnings to be lower, and that shortfall requires an increase of pension contributions by the agencies and their employees. CalPERS has been gradually decreasing the discount rate from 8.75% in 1995 down to 6.8% in 2021. There are further automatic discount rate reduction provisions built into CalPERS' policies. Every time the discount rate is lowered, you must make up the loss of expected investment income through higher contributions.
Actual plan experience adjustments. Every year CalPERS reconciles the actual plan experience with actuarial assumptions. Retirement age, mortality rates, COLA, inflation, salary increases, etc., to the extent that they differ from the assumptions, can lead to UAL changes.
Q: What does UAL cost my agency?
A: UAL resembles a loan. CalPERS requires you to pay 6.8% interest on the outstanding UAL balance. For new UAL bases, the interest payments over the repayment term exceed the amount of the UAL increase by more than 20%. UAL is usually your agency’s most expensive debt. New UAL bases have several years of negative amortization, with interest charges exceeding the minimum required payments.
Q: Will my pension costs go up?
A: Most agencies see their pension costs growing every year, particularly the UAL component. A typical CalPERS member agency saw its Classic plan UAL payments increase approximately 1.5x (150%) to 2.25x (225%) from 2017 to 2023 fiscal year. As of the 2022 valuation report date, the UAL payments are typically scheduled to continue increasing through 2032. Each agency’s situation is different and needs to be reviewed individually. The Normal Cost rate also tends to increase every year.
Q: How is negative amortization impacting my UAL costs?
A: When a new UAL base is added, it immediately starts accruing interest at 6.8%. For the first two years, CalPERS does not require any payments on that base and adds the interest to the base balance. This creates a snowball effect, with interest charged on top of interest. The required minimum payments start in year three. Some bases have a 5-year payment ramp up, with payments increasing over five years. With the ramp-up, your payments begin to cover the annual interest cost only in year six, but by that time your original UAL base balance has grown by 23%.
Q: How can we better manage pension costs and can Ridgeline help?
A: The Normal Cost can only be managed through labor practices, but there are many ways to optimize UAL costs. In our experience, most agencies can find strategies to improve their pension payments situation – whether through lowering the overall interest costs or through modifying the annual payment requirements (and sometimes both). We have identified twelve such strategies. Not all of them are a fit for you, but some likely are. Figuring out the right mix of tools is a part of our comprehensive pension liability assessment. In addition to addressing your current UAL costs, it is important to implement policies and practices that help minimize future UAL increases.
