Consistent with the City's adopted Goals and Objectives, the City Council has previously directed staff to closely monitor revenues, expenditures, and fiscal issues in order to ensure the City’s long-term fiscal stability. An objective that has been consistently included in the Goals and Objectives over the years is to “identify and evaluate options to reduce the City’s growing unfunded pension liability.” To that end, the City Council has already adopted a number of specific strategies to reduce the City’s current and future employee pension costs, including the creation of lower cost pension tiers for new employees, negotiating increased contributions from employees toward their and the City’s pension costs, and depositing funds, when available, in the City's Section 115 pension trust account to create an additional funding source for future pension obligations.
In continuation of these efforts, the City engaged Fieldman, Rolapp & Associates (Fieldman) in February 2021 to act as the City’s municipal advisor and evaluate options for additional study of the City’s California Public Employees’ Retirement System (“CalPERS”) unfunded actuarial liability (UAL). Because the City lacks the financial resources to fully fund the City’s UAL from available reserves, Fieldman developed a financing option for consideration that was presented to the City Council at a public study session on April 8, 2021. At that time, the City’s total UAL was estimated at $91.7 million, and based on taxable municipal bond rates at that time, City staff and its financing team believed the City could fund part or all of its UAL through the issuance of Pension Obligation Bonds (POBs), which would generate a substantial savings on both an annual and long-term basis.
On July 19, 2021, the City Council approved the issuance of POBs in order to initiate a judicial validation process; however, that action by the City Council did not approve the final documents necessary for an actual public debt issuance. Since that time, staff has continued working with Fieldman to further examine bond market conditions and analyze appropriate funding levels and structures of a proposed bond issuance, as well as prepare a formal pension funding policy for City Council consideration.
On November 4, 2021, staff received notice from its Bond Counsel (Quint & Thimmig, LLP), that the judicial validation process had been approved by the court. As a result, staff now recommends the approval of a Preliminary Official Statement, a Bond Purchase Agreement, and a Continuing Disclosure Certificate to finalize the requirements for a public sale of taxable City of La Habra Pension Obligation Bonds, Series 2021 to refinance the City’s UAL and help manage the City’s pension obligations.
Pension Obligation Bonds are a financing tool that provides public agencies with the ability to “refinance” some or all of their UAL. Depending on market conditions at the time of sale, this financing tool allows an agency to exchange higher cost variable rate debt in the form of a pension UAL with lower cost fixed rate debt over a similar term. While the sale of POBs can refund the entire UAL at the time of sale, they do not affect the City’s annual “normal cost” pension payments to CalPERS, which will continue to be budgeted each year by the City. The Fiscal Year 2021-2022 budget for this "normal cost" payment across all City funds is approximately $2.7 million.
The overall strategy of POBs is to achieve interest rate savings between the 7% currently being charged by CalPERS on the City’s UAL balance and the interest rate at which the bonds are sold on the open market. If approved, the POB issuance will refinance the City’s UAL obligation, providing a “lump sum” payment for part or all of the UAL, which will then be remitted directly to CalPERS, thereby reducing or eliminating the City’s UAL obligation as of the date of the bond sale, and replacing the UAL obligation to CalPERS with a new debt obligation to bond investors. Instead of paying CalPERS 7% interest on the City's UAL obligation, POBs are currently being sold to investors at or below 4%, in some cases less than 3% depending on market conditions on the day the bonds are sold.
It is important to note that the UAL and related required annual payments to CalPERS are not fixed amounts and can (and likely will) change over time. For example, each year CalPERS adds new UAL “bases” to account for actuarial gains and losses. The UAL and related agency payments will:
1. Increase if CalPERS performs worse than the actuarial assumptions or if they change assumptions, such as reducing the discount rate; or
2. Decrease if CalPERS performs better than actuarial assumptions and investment returns exceed the current discount rate.
Actuarial assumptions also include a number of other dynamic factors, such as the investment rate of return/discount rate on funds invested by CalPERS, salary increases, retirement ages and rates, mortality of retirees, and other considerations. Consistent with its normal operational practices, CalPERS will be reviewing its economic and demographic assumptions at the end of this month and the City’s current UAL may be further adjusted.
During Fiscal Year 2020-2021, CalPERS achieved a very strong and non-typical investment return of 21.3%, which will result in a significant positive impact (credit) to the UAL amortization bases across each of the City’s pension plans. The investment gains for the City’s pension assets are estimated to total $32.2 million and will be reflected in the CalPERS annual valuation reports dated July 2022.
Offsetting a portion of these gains; however, will be an expected reduction in the CalPERS actuarial discount rate from 7.0% to 6.8%, which will add negative UAL bases, totaling approximately $9.2 million in costs to the City's plans. Table A below provides a summary of the City’s estimated UAL payoff projected on December 15, 2021, which is the estimated closing date of the POBs, if approved by City Council.
|Table A: City of La Habra Estimated CalPERS UAL Projected on December 15, 2021
||UAL Balance Prior to
FY 2020-21 Investment Gains
|UAL FY 2020-21 Investment Gains
||UAL Balance Change Due
to Expected PERS Change
from 7% to 6.8%
Balance on 12/15/2021
Source: Email from CalPERS actuary regarding City’s UAL dated October 20, 2021
Pension Obligation Bond Financial Analysis
Various POB refinancing scenarios have been analyzed by staff and were presented during the City Council meeting that occurred July 19, 2021. Of these, City staff discussed two scenarios that examined a POB strategy that would achieve UAL funding levels at either 85% or 100%, as well as the risks and benefits of either scenario. After considering the City’s current lower UAL liability and current bond market conditions, staff recommends refinancing 100% of the City’s current estimated UAL. This option increases the chance of realizing the City’s goals of long term pension fund stabilization through the issuance of POBs. Staff also discussed several debt structuring options which included a proportional payment, level payment, and a hybrid payment approach. After considering various options, staff recommends a level bond payment structure. With this particular option, the annual POB debt service payments would be structured in equal annual payments over a 20-year term, creating a more predictable payment schedule compared to the City’s current estimated UAL amortization. A graphical representation of the level debt structuring is shown below.
The data for the level payment structure assumes a $70.605 million UAL payoff to CalPERS, a CalPERS discount rate of 6.80%, a “AA” credit rating from Standard & Poor’s, a 10-year optional call, and current market rates (which includes an assumed increase in current rates of 30 basis points to account for potential volatility up to the date the bonds are sold).
The table below summarizes the key metrics for the level debt service 100% funded scenario.
|100% Funded Scenario Metrics
|Bond Issuance Amount
|CalPERS Funded Ratio
||2041 (20 years)
|Maximum Annual Debt Service
|Average Annual Debt Service
|All-in True Interest Cost
|Present Value Savings
The documents attached to this staff report, along with a brief description of each, are as follows:
Preliminary Official Statement
The Preliminary Official Statement is the “offering” (i.e. marketing) statement used by the underwriter to inform investors about the terms of the POBs and contains all relevant information for investors to decide whether to purchase the POBs.
Bond Purchase Agreement
This Bond Purchase Agreement is between the City and the underwriter (BofA Securities) whereby the underwriter purchases the POBs from the City for resale to investors.
Continuing Disclosure Certificate
This document requires the City to submit annual disclosure reports and notices of certain listed events to the marketplace as long as the POBs are outstanding. Urban Futures Inc., as dissemination agent, assists the City with this responsibility.
The Preliminary Official Statement has been reviewed by City staff and its finance team for transmittal to the City Council for review. The distribution of the Preliminary Official Statement by the City is subject to federal securities laws, including the Securities Act of 1933 and the Securities Exchange Act of 1934. These laws require the Preliminary Official Statement to include all facts that would be material to an investor in the POBs. Material information is information that there is a substantial likelihood it would have actual significance in the deliberations of the reasonable investor when deciding whether to buy or sell the POBs. If the members of the City Council conclude that the Preliminary Official Statement includes all facts that would be material to an investor in the POBs, it may adopt a resolution that authorizes staff to execute a certificate to the effect that the Preliminary Official Statement has been “deemed final.”
The Securities and Exchange Commission (SEC), the agency with regulatory authority over compliance with federal securities laws, has issued guidance as to the duties of the members of the City Council with respect to its approval of the Preliminary Official Statement. In its “Report of Investigation in the Matter of County of Orange, California as it Relates to the Conduct of the Members of the Board of Supervisors” (Release No. 36761, January 24, 1996), the SEC indicated that, if a member of the governing body has knowledge of any facts or circumstances that an investor would want to know about prior to investing in the POBs, whether relating to their repayment, tax-exempt status, undisclosed conflicts of interest with interested parties, or otherwise, he or she should endeavor to discover whether such facts are adequately disclosed in the Preliminary Official Statement. In the release, the SEC indicated that the steps that a member of the governing body could take include becoming familiar with the Preliminary Official Statement and questioning staff and consultants about the disclosure of such facts.
As discussed during the July 19, 2021, City Council meeting and referenced above, the judicial validation process serves as the legal mechanism for the City to refinance its pension debt by issuing bonds. Under normal circumstances, the validation proceedings take approximately 90 to 120 days. The proceedings typically include the following:
1. The City files a Validation Action with Orange County Superior Court
2. The City receives an Order for Publication of Summons from the Court
3. Legal publication for 21 consecutive days
4. Waiting period for ex parte (a decision by a judge that doesn’t require all parties to the dispute to be present) application to file default judgment
5. Clerk of the Court enters default judgement and schedules a hearing (hearing for default judgement and entry of judgement)
6. Appeal Period (30 days)
The judgement was entered on November 4, 2021, and the 30-day appeal period will end on December 4, 2021. Assuming there are no appeals, the judicial validation process will be complete and the City may issue POBs, if approved by City Council.
In October 2021, the City conducted a competitive underwriter Request for Proposal process and selected Bank of America Securities as the underwriting firm to sell the proposed POBs. The key finance team members include:
- Underwriter: Bank of America Securities, Inc.
- Bond Counsel and Disclosure Counsel: Quint & Thimmig LLP
- Municipal Advisor: Fieldman, Rolapp & Associates, Inc.
- Actuarial Consultant: Bartel and Associates
- Trustee: The Bank of New York
Pension Funding Policy
Issuing POBs to refinance the City’s current UAL is a significant part of a broader strategy to manage the City’s current and future retirement costs. As discussed above, there are many factors that can increase or reduce a City’s UAL and it is likely that over the next 20 years CalPERS will make changes to its actuarial assumptions and/or may realize lower than anticipated returns that could form a new UAL for the City, despite the issuance of these proposed bonds. Additionally, unknown future changes in pension laws in the State of California could impact UALs and the City's pension obligations. In order to prepare for and address these possibilities, staff is proposing the City Council review and adopt a Pension Funding Policy (“Policy”) (Attachment No. 4).
The Policy seeks to achieve the following goals:
- Support the City’s long term financial sustainability;
- Ensure the City has flexibility to respond to changes in future UAL balances, service priorities, revenue levels, and operating expenditures;
- Support the City’s creditworthiness; and,
- Ensure that pension funding decisions are structured to protect the City’s services to the La Habra community.
The purpose of this proposed Policy is to provide guidance on the development of a funding plan for any future UAL that could be calculated annually by CalPERS, or for any unfunded accrued liabilities remaining immediately after the issuance of a POB. The primary goal of this Policy is to establish a separate City controlled pension reserve that can be available to pay down or pay off any new UALs or other pension costs that develop in the future, thus providing the City Council with another tool to closely manage and control the City's pension costs without adversely impacting the City's ability to provide services to the community.
The following are some guidelines provided in the proposed Policy:
- The City will create a payoff plan that will address the remaining UALs (if any) immediately after the issuance of the POBs.
- The City will create a funding plan to address any newly formed UAL on an annual basis.
- The City will budget 50 percent of the estimated annual cash flow savings realized at the time the POBs are sold, and will deposit that amount each year over the term of the bonds into the City’s Section 115 Pension Trust, adjusted annually by CPI.
- To the extent that the City has excess annual reserves, the City shall endeavor to apply a portion of such monies as either Additional Discretionary Payments to CalPERS directly, or deposit those funds in the City's Section 115 Pension Trust.
- The funding Policy should also support the decision-making and budgeting process of the City Council.
The fees for the finance team, including the underwriter, financial advisor, rating agency and bond and disclosure counsel are paid from the proceeds of the POBs. These fees, in total, are estimated at $524,846. With the exception of the rating agency, the financing team will not be paid unless the POBs are approved by Council and successfully sold.
Based on a financing that covers 100% of the City's estimated $70.605 million UAL, the City expects to issue $71.135 million in POBs, which would result in $21.2 million in total cash flow savings (UAL payments) over the next 20 years compared to what would have been paid to CalPERS over that same period of time, based on current actuarial assumptions. The POBs are anticipated to carry an average interest rate of 3.14%, based on current interest rates as of October 27, 2021, compared to the 7.0% interest rate currently being assessed by CalPERS on the City’s UAL. The following table shows the projected annual savings over the life of the current UAL.
||EST. UAL Obligation
||Est POB Debt Service
||Annual Est. Savings
It is important to note these are estimates based on information currently available to staff and are subject to bond market fluctuations and will not be finalized until the POBs are sold, which is expected to occur in December 2021, if approved by Council.
It is also important to note that due to potential changes in future actuarial assumptions or investment performance by CalPERS over the 20-year term of this proposed debt, or potential future changes in pension laws in the State of California, that the actual savings derived by the issuance of the proposed POBs may decrease or increase over time.