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HomeMy WebLinkAbout06/01/2010, C3 - UNDERWRITER SELECTION: ANALYSIS OF PENSION COST REDUCTION OPPORTUNITIES council M�,D� 6-1-10 j agenda Report CITY O F SAN LU IS O B I S P O FROM: Debbie Malicoat, Acting Director of Finance& Information Technology SUBJECT: UNDERWRITER SELECTION: ANALYSIS OF PENSION COST REDUCTION OPPORTUNITIES. RECOMMENDATION Authorize the City Manager to issue a request for proposals for an underwriter to serve as part of a financing team that will analyze cost reduction opportunities via the issuance of pension obligation bonds for the City's Safety Plan "side pool;" and to award the contract to the most qualified firm. DISCUSSION Background In 2003, the California Public Employees Retirement System (CalPERS) required that contracting local agencies with Safety or Miscellaneous Plans with less than 100 active employees become part of a State Pool for that plan. CalPERS' purpose in doing so was to provide improved rate stability for smaller groups by pooling them together, as smaller plans are subject to much greater volatility in actual results compared with actuarial assumptions. Plans with more than 100 active members continue to be actuarially evaluated based on their own experience. While both of the City's plans currently have over 100 active employees (254 in the Miscellaneous Plan and 103 in the Safety Plan), in 2007 the City went below 100 active employees in the Safety Plan. Accordingly, effective in 2008, the City's Safety Plan was pooled with other local agency safety plans in the state with less than 100 active members that provide the same benefits. Once an agency is in the State Pool, it remains in that pool even though (like the City) its active employees in the plan may later rise above this level. (The City's Miscellaneous Plan continues to be evaluated based on its own experience.) When an agency enters the State Pool, its liabilities begin with a "fresh start" within the State Pool; and any unfunded liabilities are placed in a separate "Side Pool" that contains only that agency's unfunded liabilities at the time it entered the State Pool. Its employer contribution rates are then based on the experience of the State Pool plus the amortization of the unfunded liabilities in its separate Side Pool. Potential Cost Savings from Sale of Pension Obligation Bonds for"Side Pool" As discussed in greater detail below, the sale of pension obligation bonds in funding the City's Safety Plan "Side Pool" has the potential to result in significant cost savings of about $220,000 annually. However, before recommending this action to the Council, there are several "due C3- — Underwriter Selection: Analysis of Pension Cost Reduction Opportunities Page 2 diligence" steps that need to be taken first. To perform this analysis, the City staff is in the process of assembling a financing team composed of the City's financial advisor (Fieldman Rolapp), bond counsel (Jones Hall) and an independent actuary that we have used in the past for actuarial analyses (Bartel Associates). Another key member of this team that should be selected at the beginning of this process is the underwriter — the firm that would purchase the bonds if they are issued. To select the underwriter, staff recommends issuing a request for proposals (RFP) for underwriter services. The City will be assisted in this selection process by its financial advisor. There are no costs associated with this action: underwriter compensation, if any, will be from the bond proceeds; and that will only occur after subsequent analysis shows that the issuance of pension obligation bonds is financially advantageous for the City and the Council approves the sale. Compensation upon bond issuance is also the case for the financial advisor and bond counsel. Guaranteed "Side Pool' Investment Yield Offers Opportunity for Long-Term Cost Savings Under CalPERS regulations, the "Side Pool" earns an investment yield of 7.75% regardless of the performance of the CalPERS overall portfolio (higher or lower). This guarantee is unaffected by other changes in actuarial assumptions and offers the opportunity for ongoing, long-term cost savings with virtually no risk if pension obligation bonds can be sold at a lower rate than the guaranteed 7.75% yield on the Side Pool. The City's current Side Pool unfunded liability is $24 million and has 24 years remaining before it is fully amortized. An initial analysis shows that at current market rates, the net interest rate on pension obligation bonds (which would be sold as taxable bonds) would be 6.75%. This 100 basis-point difference between the Ca1PERS yield and interest costs on the bonds would result in General Fund savings of about $220,000 annually, or $5.2 million over the 24-year life of the issue. Recognizing that $220,000 in annual savings 24 years from now does not have the same value as $220,000 in annual savings today, the "present value" (PV) analysis results in $2.5 million in savings, for PV percent savings of 10.6%. This represents significant savings. For context, the City's Budget and Fiscal Policies call for refinancing bonds whenever the PV savings are 5% or more: this is potentially twice that level. The time is now right to consider this option. Given the volatility of the credit markets in the last several years, the timing has not been favorable for the issuance of long-term pension obligation bonds. However, the market for these types of bonds has stabilized and now offers favorable interest rate spreads between the cost of borrowing funds and guaranteed returns on the Side Pool. Why not consider financing all of the City's pension obligations this way? This is an option, but it has risks. The savings from this approach come from the spread between the cost of borrowing funds and CalPERS investment earnings. In the case of the Side Pool, Ca1PERS investment yield is guaranteed at 7.75% per year, regardless of how its investments actually perform. Additionally, the amount of the unfunded liability does not increase: it is fixed at the Underwriter Selection: Analysis of Pension Cost Reduction Opportunities Page 3 amount when the side pool was created. Thus, as long as the bonds are issued at an interest rate that is significantly lower than the Ca1PERS guaranteed yield, there is virtually no risk that the projected savings in the Side Pool will not occur. Importantly, the City will know what that spread is before issuing bonds. The same is not true for the balance of the City's unfunded pension liabilities in both the State Pool for the Safety Plan and in the City's Miscellaneous Plan: the amount of the unfunded liability can grow depending on the actual results of actuarial factors versus assumptions; and Ca1PERS investment yield in these two plans is not guaranteed. As we have experienced, while CalPERS' actuarial assumption is an annual 7.75% return on investments, this can be significantly lower(and in fact reflect significant losses rather than gains). Stated simply, issuing pension obligation bonds for the Side Pool conceptually makes sense in balancing risks versus benefits, and we should move forward with the next steps in finalizing this analysis. However, the factors that make this favorable for the Side Pool are not present at this time for the balance of the City's unfunded pension obligations in the State Pool Safety Plan or the City's Miscellaneous Plan. Underwriter Selection The City's Budget and Fiscal Policies state that: "The City will generally conduct financings on a competitive basis. However, negotiated financings may be used due to market volatility or an unusual or complex financing or security structure." The issuance of pension obligation bonds is one of those cases where a negotiated sale makes the most sense. This allows the City to bring the underwriter on the financing team early in the process in ensuring that the issue is structured in a way that best protects the City while yielding the lowest possible interest cost. Fieldman Rolapp will assist the City in preparing the underwriter RFP and selecting the best qualified firm. Along with Fieldman Rolapp, the City's review team will consist of representatives from Administration, Human Resources and the Finance Division, who will consider the following factors in making their selection recommendation to the City Manager: 1. Understanding of the work required by the City 2. Quality, clarity and responsiveness of the proposal 3. Demonstrated competence and professional qualifications necessary for successfully performing the underwriter services required by the City 4. Recent experience in successfully performing similar services 5. Proposed approach in completing the work 6. References 7. Background and related experience of the specific individuals to be assigned to this project 8. Proposed compensation As reflected above, contract award will not be based solely on price, but on a combination of factors as determined to be in the best interest of the City. After evaluating the proposals and Underwriter Selection: Analysis of Pension Cost Reduction Opportunities Page 4 discussing them further with the finalists or the tentatively selected contractor, the City will reserve. its right to further negotiate the proposed work and/or method and amount of compensation. Next Steps There are two key steps in the process after assembling the financing team: 1. Staff plans to return to the Council on July 20 with a more detailed analysis of the likely savings in issuing pension obligation bonds for the Side Pool and the subsequent procedures required to do so. 2. If the Council decides to go forward on July 20, the financing team will then complete several "due diligence" actions. Following this, the Council would then consider formally approving the legal and financing documents, which staff plans to present to the Council in early November. The bond closing would then be tentatively scheduled for late November or early December, at which time the General Fund would begin to see lower pension costs of about $220,000 on an annual basis. It should be noted that because the refinancing will occur mid-way in the 2010-11 fiscal year, first year savings will be less than this. However, based. on current market conditions, the full annual savings should be available starting with the next two-year Financial Plan in 2011-13. In short, authorizing the selection of an underwriter is an initial step in the process without any commitment on the City's part to issue bonds: this will only occur after the due diligence steps outlined above are completed. CONCURRENCES The Human Resources Department concurs with this recommendation. FISCAL IMPACT As noted above, there are no costs associated with this action: underwriter compensation, if any, will be from the bond proceeds; and that will only occur after subsequent analysis shows that the issuance of pension obligation bonds is financially advantageous for the City and the Council approves the sale. Compensation upon bond issuance is also the case for, the financial advisor , and bond counsel. On the other hand, based on current market conditions, if the City goes forward with issuing pension obligation bonds for the Safety Plan Side Pool, this is likely to generate General Fund savings of about $220,000 annually. Underwriter Selection: Analysis of Pension Cost Reduction Opportunities Page 5 ALTERNATIVES 1. Do not go forward with this analysis. Given the potential for significant savings and that there are no "out of pocket" costs in performing this analysis, this option is not recommended. 2. Do not use a negotiated sale approach. Given the unique and complex nature of pension obligation bonds, this is one of those cases envisioned in the City's Budget and Fiscal Policies where a negotiated sale makes the most sense. However, while the bond sale will be a negotiated process, under the proposed RFP process, the underwriter selection process will be a competitive one. T:\Council Agenda Reports\Finance&IT CAR\Finance\2010\CAR,POB Underwriter,6-1-IO.doc