San Jose Pension Cost Pressures and Options

A Report to the Carla and David Crane Foundation

Don Boyd*, Gang Chen**, and Yimeng Yin***

The State and Local Government Finance Project
Center for Policy Research, Rockefeller College, University at Albany

*Co-Director (dboyd@albany.edu)
** Co-Director and Associate Professor (gchen3@albany.edu)
*** Economic Researcher and Modeler (yyin@albany.edu)

Summary

At the request of the Carla and David Crane Foundation, we examined a wide range of potential changes to pension benefit policies for members of the San Jose pension plans. We were asked to examine options that would achieve substantial savings for the city without attempting to evaluate whether they might be subject to successful legal challenge. The policies examined below are not proposals from the authors, but rather options designed to meet these goals. We modeled these changes for the Police and Fire Department Retirement Plan and the Federated City Employees Retirement System. We found that:

• If lower benefit provisions similar to those in effect before 1999 are applied to future service of all current workers and new workers, assuming plan return assumptions are met every year, the change would:

  • Reduce annual required employer contributions by approximately 14.8 percent ($61.9 million) in 2021 and 16.7 percent ($69.6 million) by 2030.

  • Reduce unfunded liability by 20.4 percent in 2021 and 28.5 percent by 2030.

  • For an illustrative mid-career active police and fire member aged 35 in 2021, reduce annual retirement benefits by 19.6 percent at the retirement age of 55 and by 33.1 percent at the age of 80.

  • For an illustrative mid-career active Federated member aged 35 in 2021, reduce annual retirement benefits by 3 percent at the retirement age of 60 and by 16.2 percent at the age of 80.

• If aggressive cost-sharing policies are adopted, including suspending a fixed annual three percent increase (“Suspension”) until the plan is fully funded, and extending the Tier 2 contribution-sharing policy to Tier 1 members, assuming plan return assumptions are met every year, the change would:

  • Reduce annual required employer contributions by approximately 8.6 percent ($35.9 million) in 2021 and 39.3 percent ($163.9 million) by 2030.

  • Reduce unfunded liability by 5.1 percent in 2021 and 76.3 percent by 2030.

  • For an illustrative new retiree aged 55 (police and fire) or 60 (Federated) in 2021, reduce the annual pension benefit at age 80 by about 21 percent (police and fire and Federated). The initial retirement benefit would not be affected.

  • The retirement benefit of an illustrative mid-career active member aged 35 in 2021 would not be affected if he or she retires at age 55 in 2040 (police and fire) or at age 60 in 2045 (Federated) because the Suspension would have already ended before he or she retires. However, this member would pay 73 percent (police and fire) or 46 percent (Federated) more in employee contributions over his or her career due to the contribution-sharing policy.

• The city bears unusually high costs for police and fire disability retirement pensions compared to other governments, possibly because the procedures governing these pensions authorize them more readily than in other cities. If the disability retirement rates for the police and fire plan are reduced to rates similar to CalPERS, annual employer costs could be reduced by about 1.8 percent ($7 million) annually.

• The three policies above combined would lead to substantial cost reduction, lowering annual required employer contributions by approximately 23.4 percent ($97.8 million) in 2021 and 45.6 percent ($190.2 million) by 2030.

The table below summarizes the impact of the alternative policy options on the contributions and unfunded actuarial accrued liability (UAAL) of the two San Jose pension plans combined.

Introduction

The city of San Jose has faced significant problems with retirement costs for well over a decade. These problems have led to sharp increases in contributions, deep pension underfunding, and significant cuts in services. These problems have been highlighted in multiple reports including:

• Report in 2011 on shrinking services due to rising retirement costs. [1]

• Civil Grand Jury report in 2012 [2]

• Civil Grand Jury report in 2019 [3]

• The recently issued April 2, 2021, Retirement Stakeholder Solutions Working Group report. [4]

The stakeholder solutions report ruled out or deemed unlikely most options that could have a significant impact on San Jose unfunded liabilities and costs. Among other things, the report ruled out analyzing the following potentially big-ticket items that would affect existing plan members:

• Reduction in retirement benefits beyond those adopted in Measure B (2012) and Measure F (2016).

• “Auto-Triggers” such as Cost of Living Adjustments or Guaranteed Increases that are contingent on plan funded status, for the same reason.

They also ruled out securitizing public assets.

The stakeholder solutions report analyzed six remaining potential policy changes, with comments on feasibility, cost, risk, difficulty, and impact on unfunded liability. The only item on the list that could provide significant new funds to reduce unfunded liability was new dedicated taxes. However, the working group concluded that new taxes were highly unlikely to garner the needed 2/3 voter majority and didn’t examine them in depth. The group examined a few small items such as reducing investment fees, changing investment allocation, and lump-sum buyouts, but concluded that these items likely would not have a major impact on the UAAL.

The only remaining option that might reduce the UAAL significantly is the issuance of pension obligation bonds (POB), although it would not reduce pension obligations or overall debt but rather exchange UAAL for bonded debt. Such an approach does not raise new funds to pay for benefits nor does it reduce liabilities. It aims to achieve financial savings by earning more on the proceeds of the bonds than their issuance cost. In addition, some POBs aim to push some costs to the future by stretching out costs over time. Because POBs do nothing to affect pension costs, we do not analyze them in our report and rather focus on benefit changes.

Retirement costs in the context of the San Jose budget

San Jose has been grappling with the costs of funding retirement benefits for its workforce for two decades. These costs have risen from about six percent of city general fund expenditures in 2001 to approximately 28 percent of expenditures in 2022 (See the figure below). City contributions for retirement benefits have stabilized in recent years but at a high level, accounting for more than one-quarter of all dollars spent each year. Under the current assumption that retirement investments will earn 6.625 percent annually, contributions are likely to remain 28-29 percent of the general fund budget for the next 5 years. Actuarial projections beyond this period suggest pension costs will remain stable. We discuss the reasons for pension cost increases in the next section.

Approximately 69 percent of the city’s annual pension contributions pay for benefits attributable to service performed in years past – i.e., for unfunded liabilities. Only 31 percent of the annual cost is to pay for benefits earned in a given new year.

City pension plan members are qualified for benefits under two tiers, depending on when they are hired. Members hired before September 30, 2012 (Federated plan), August 4, 2013 (Police), and January 2, 2015 (Fire) are covered by Tier 1 benefits; members hired after those dates are qualified for Tier 2 benefits, which are lower. Currently, approximately 75 percent of the cost of new benefits earned in a given year is attributable to Tier 1. Although Tier 2 has been in effect for 7 years, new service rendered under Tier 2 accounts for only 6 percent of the city’s annual pension costs (see Table 1).

As older workers retire and new workers are enrolled in Tier 2, it will account for an increasing share of pension costs over time, but only very slowly. By 2025-26, new service under Tier 2 is projected to account for 9.7 percent of pension contributions. Past liabilities and new service under Tier 1 will account for the other 90.3 percent of pension expenditures. Thus, the cost of decisions made long ago will fall only very slowly: contributions for unfunded liabilities and for new service under Tier 1 are projected to fall from 23.7 percent of general fund expenditures in 2022 to 23.1 percent in 2025-26.

If policymakers wish to reduce the cost of benefits in a way that is meaningful for the budget, it will not be practical to do so without affecting Tier 1 benefits.

What caused pension costs to rise and how the city responded

From FY 2010 to FY 2019, the Federated plan’s funded ratio (actuarial basis) dropped from 69 percent to 53 percent, and the Police and Fire plan’s funded ratio (actuarial basis) dropped from 79.8 percent to 74.3 percent. From FY 2010 to FY 2019 the Federated plan’s unfunded liabilities (UAALs) increased from 259.6 percent to 629 percent of payroll, and the Police and Fire plan’s UAALs increased from 260.4 percent to 543 percent of payroll (Figure 2).

Most of the city’s pension costs and UAALs are attributable to Tier 1. Currently, Tier 1 members pay 27.3 percent of the normal cost, while the city pays the rest of the normal cost and the amortization cost of UAALs. With Tier 2, both the normal cost and amortization cost of UAAL are evenly split between the city and the members. The city has always fully paid the required contributions for both pension funds. The figure below shows the city and members’ contributions rates, as a percent of payroll, for Tier 1 and Tier 2 for both funds from FY 2011 to FY 2019.

The high costs and low funding of the city pension funds have several causes.

First, in earlier years, San Jose pension funds increased pension benefits. Some benefit enhancements were retroactively applied over the entire careers of members active at that time. Currently in Tier 1, members are eligible to receive normal pension benefits as early as age 50 in the Police and Fire plan and age 55 in the Federated plan. The benefit factor for Tier 1 in both plans is between about 2.5 and 4 percent and an annual increase is guaranteed at 3 percent. The benefit calculation is based on the final 12 months compensation. Since the funds’ establishment, member benefits have substantially increased over time. In the first decade of 2000s, the Police and Fire plan increased its maximum benefits three times in 2000 (police and fire), 2006 (police) and 2008 (fire) and changed COLAs from CPI-linked to fixed 3 percent in 2002. The Federated plan changed COLAs from CPI-linked to fixed 3 percent in 2006.

Second, investment returns were not as high as the plans assumed. Before 2011, the plans assumed a rate of return of approximately 8 percent. The plans lowered the assumed rate over subsequent years to 6.625 percent. Over the last 20 years, total fund net investment performance was 5.09 percent for the Federated plan and 5.51 percent for Police and Fire, well below the returns assumed.

As a result of the shortfall between assumed and actual returns, the two plans’ funded ratios dropped to 74.3 percent (police and fire) and 53 percent (Federated), as shown in Figure 2 The legacy UAALs from tier 1 are amortized over a closed 30-year period starting June 2009. Tier 2 was created to lower the benefits, but the amortization costs to pay off UAALs are still growing.

Third, although the city has always fully paid required contributions, overall contributions to the pension funds have been insufficient. This is further due to investment return assumptions that proved too optimistic, which were 8 percent before 2011 and then steadily dropped to the current assumption of 6.625 percent but the average rate of return was lower than the assumed rates, creating unfunded liabilities. In addition, when return assumptions were met, the city used excess returns to justify supplemental benefits to retirees.

The city adopted pension reforms in 2012 and 2016. The 2012 Measure B (“Sustainable Retirement Benefits and Compensation Act”) reduced pension benefits by increasing existing members’ contributions, temporarily suspending guaranteed increases during emergencies, establishing cost and benefit limitations for new employees, and requiring voter approval for future benefit increases. Measure B received voter approval by a margin of 69 percent to 31 percent but was challenged in court and eventually partially overturned in 2015 by a Superior Court. The city declined to appeal that decision.

Measure B was replaced by the 2016 Measure F (“Alternative Pension Reform Act”), a compromise version of Measure B. Measure F set pension benefits to the “levels similar to other Bay Area agencies.” New employees in Tier 2 share the normal cost and amortization cost of UAALs evenly (50/50) with the city. The annual increase for Tier 2 is set to be the lesser of the CPI index or between 2.0 and 1.25 percent. Voter approval is still required for future benefit enhancements. The pension funds are also barred from giving supplemental payments to retirees or lowering employee contributions even if the funds received higher-than-expected investment returns.

The role of disability costs in San Jose fire and police plans

Disability costs are often high in police and fire plans because of the hazards of the occupations. However, these costs are extraordinarily high in San Jose. A 2011 report by the city auditor found that:

In San José, 2 out of 3 Fire personnel, and more than 1 out of 3 Police personnel are retiring on service-connected disability, compared to 1 out of 16 non-sworn (Federated) personnel. These sworn disability retirement rates are higher in San José than elsewhere. [5]

The audit concluded that San Jose’s higher rates of disability retirement were not due to more hazardous working conditions than elsewhere and noted that there are substantial incentives for disability retirement, including partial federal and state income tax exemption for disability retirement pensions. The audit argued that San Jose’s disability pension review process is not sufficiently independent and that a more-independent process might lead to more appropriate disability retirement rates. Based on the findings of the auditor’s report, since 2015 the city has been seeking to establish an independent panel of medical experts to evaluate disability retirement applications. [6] As of the 2020 actuarial valuation, the disability retirement rates remain high.

Table 2 shows the total normal cost for police and fire plans in 2020, broken down between service retirements, disability retirements, and all other costs. Disability pension normal costs totaled $31.2 million and amounted to more than 37 percent of total normal cost. The city bears approximately 70 percent of normal cost for fire and 67 percent for police.

Table 3 shows the normal cost as a percentage of payroll for fire and police plans under Tier 1 and Tier 2. While the normal cost for service retirements was lowered significantly between Tier 1 and Tier 2, the normal cost for disability pensions was little changed and now is greater than the service retirement costs for both fire and police plans.

The difference between San Jose disability retirement rates and rates for other California plans found by the city auditor in 2011 remains large (Table 4):

How we model public pension costs and risks

We examined the San Jose retirement systems and potential impacts of selected policy options using a pension policy simulation model that incorporates the most important features of the San Jose Retirement systems and allows us to examine alternative benefit and contribution policies, and alternative investment-return scenarios. Details of our model may be found in papers listed here.

The initial year of our analysis is 2021, the most-recent year for which data were available at the time of the analysis. We show the immediate impact of the policy changes in 2021 and projected future impact.

We examined alternative policies under current investment return assumptions. We also examined the policies under an asset shock scenario in which the portfolio falls initially by 24 percent, before gradually recovering; these results are not presented in this report but are available upon request. The tables below present results under current investment return assumptions.

Policies we modeled

We modeled the San Jose Police and Fire Department Retirement Plan and the San Jose Federated City Employees Retirement System under the current baseline policy and three alternatives:

1. Pre-1999 policy: This policy is based largely on benefit provisions that were in effect before 1999, after which benefits were increased sharply. This is useful to model because it is a real-world policy based on what was once considered appropriate in San Jose. We modeled this policy so that it only applies to new service rendered after it goes into effect. Benefits earned under the prior policy would remain.

   For the police and fire plan, the key provisions of this policy are:

   1. The benefit factor for each new year of service is 2.5 percent, rather than the

      baseline benefit factor that ranges from 2.5 percent to 4 percent for Tier 1 and

      from 2.4 percent to 3.4 percent for Tier 2.

   2. The maximum benefit is 75 percent of final average service, rather than the

      baseline maximum of 90 percent (if already-accrued benefits exceed 75 percent,

      the additional benefit would not be lost); and

   3. A COLA capped at 2.25 percent rather than the guaranteed 3 percent for Tier 1;

      the COLA for Tier 2 would convert to an actual COLA and remain capped at 2 percent. [7]

   For the Federated plan, the key provisions of this policy are:

   1. Service retirement benefits are calculated based on the highest 3 years of salary, rather than the highest one year of salary in the baseline.

   2. A COLA capped at 2.25 percent rather than the guaranteed 3 percent for Tier 1; the COLA for Tier 2 would convert to an actual COLA and remain capped at 2 percent. [8]

      We assume reduction in future benefits would be reflected immediately in accrued liability and normal cost.

2. Cost-sharing: This policy has two key cost- and risk-sharing provisions, similar to what other states have considered:

   1. The guaranteed annual increase for both Tier 1 and Tier 2 would be suspended until the plan reaches full funding after which it returns to the baseline level, and

   2. The current Tier 2 contribution-sharing policy would be extended to Tier 1. Under this policy, employee contributions are 50 percent of the actuarially determined contribution (ADC). There is a contribution floor of 50 percent of normal cost, and the increase in any single year is capped 1/3 of a percent of payroll.

3. Lower disability retirement rates. To examine the impact of high police and fire disability retirement rates on plan costs, we also modeled the San Jose Police and Fire Department Retirement Plan (the Federated plan is not included in this analysis) under a scenario with lower service-related disability retirement rates. This presumes that the city might implement a tighter review process or make other institutional changes to bring disability retirement rates more in line with other plans, as was suggested in the 2011 City Auditor report. Under this assumption, we model the impact of service-related disability retirement rates that are substantially lower than those in the baseline. Our model fully reflects these lower rates in its actuarial assumptions. The disability retirement rates in this scenario are constructed based on the assumptions used by CalPERS as follows:

   • Firefighters: the average of service-related disability rates for state peace officers and firefighters (POFF) and the rates for public agency firefighters.

   • Police: the average of service-related disability rates for state peace officers and firefighters (POFF) and the rates for public agency police officers.

     The CalPERS-based disability retirement rates are about 60 percent lower than the rates used by the San Jose police and fire plan.

4. Pre-1999 policy, cost-sharing policy, and lower disability retirement rates combined. This policy includes all policy and assumption changes described in the three policies above.

We assume all policies go fully into effect in the first year. The benefit factor reduction affects future service of current workers and all service of new hires but does not affect past service. Suspension affects all current retirees, all current workers, and all new hires.

Results

We briefly summarize key results below. More detailed results are available on request.

Impacts on contributions and UAAL

We provide two tables below. Table 5 shows key results for the baseline policy and alternative policies in millions of dollars. Table 6 has the same format but shows changes from the baseline in percentage terms. The tables below show that:

• The pre-1999 benefit policy and the cost-sharing policy achieve significant reductions in the UAAL and employer contributions relative to the baseline after 10 years. [9]

• Employee contributions would be significantly greater under the cost-sharing policy, due to the shared actuarially determined contributions.

• Reducing disability retirement rates for police and fire members would only result in moderate savings. An important reason for this is that the service-related disability retirement benefit and the regular service retirement benefit have similar costs at ages when disability retirement is most likely to occur. [10] Some members who might otherwise retire with a disability pension may instead retire with a regular service retirement of similar value. The estimates in this report do not consider higher federal and state income tax revenue resulting from reduced disability retirements.

• The combination of the pre-1999 benefit policy, the cost-sharing policy, and reducing disability retirement rates further reduces the UAAL and employer contributions. The total reduction is less than the sum of impacts from the three policies.

Impacts on benefits and contributions of representative plan members

We examined the impacts of the alternative policies on representative plan members (for member characteristics, see the appendix). [11]

Conclusions

Costs of the San Jose pension funds have risen dramatically over the last 20 years, placing stress on the city budget and its ability to fund services. In this report, we examined a wide range of potential changes to pension benefit policies for members of the San Jose pension plans, without regard to legal or political feasibility.

If the city were to adopt cost-sharing policies similar to those adopted by several other governments, under current plan assumptions employer contributions could be reduced by more than 8 percent initially, and by almost 40 percent after 10 years, for an initial reduction of more than $35 million and a reduction after 10 years of more than $160 million.

If the city were able to revert to benefits similar to those in place before 1999, initial employer contributions could be reduced by about 15 percent annually, for annual reductions in cost of $65-70 million.

The city bears unusually high costs for police and fire disability retirement pensions compared to other governments, possibly because the procedures governing them authorize these pensions more readily than in other cities. If the city were able to reduce disability retirement rates for police and fire members to rates similar to other governments, annual employer costs could be reduced by about $7 million annually.

Combinations of the three policies would reduce employer costs by somewhat more.

Appendix: Representative plan members

We assume all members above entered the plan at age 25, police and fire members retire at age 55 with 30 years of service and Federated members retire at age 60 with 35 years of service.

Below we first show the annual benefit for these members at age 80, in 2021 dollars, under the baseline and three alternative benefit policies, then we show the career employee contribution as a percentage of career salary under these policies.

Endnotes

1 Joe Nation, “Shrinking Services: Public Pension Costs and Their Impacts on San Jose” (Stanford Institute for Economic Policy Research, December 14, 2011), https://www.sanjoseca.gov/home/showpublisheddocument?id=63249.

2 2011-2012 Santa Clara County Civil Grand Jury, “2011-2012 Santa Clara County Civil Grand Jury Report: An Analysis of Pension and Other Post Employment Benefits,” May 17, 2012, https://www.scscourt.org/court_divisions/civil/cgj/2012/Pension.pdf.

3 2018-2019 Civil Grand Jury of Santa Clara County, “2018-2019 Santa Clara County Civil Grand Jury Report: San José – Unfunded Pension Liabilities: A Growing Concern” (2018-2019 Civil Grand Jury of Santa Clara County, June 19, 2019), https://www.scscourt.org/court_divisions/civil/cgj/2019/San%20Jos%C3%A9%20- %20Unfunded%20Pension%20Liabilities.pdf.

4 Retirement Stakeholder Solutions Working Group, “Retirement Stakeholder Solutions Working Group Final Report,” April 2, 2021.

5 Sharon W Erickson, “Disability Retirement: A Program in Need of Reform” (Office of the City Auditor, San Jose, April 2011).

6 For the relevant municipal code language, see: https://library.municode.com/ca/san_jose/codes/code_of_ordinances?nodeId=TIT3PE_IIREPL_CH3.3619 61POFIDEREPL_PT1GEPRDE_3.36.020.16INMEPA.

7 For modeling purposes we use the plans’ constant annual inflation assumption of 2.25 percent. As a result, the actual COLAs in the model are at the capped level (2.25% for Tier 1 and percent for Tier 2), and the results underestimate the savings from this policy slightly.

8 See endnote 7.

9 In fact, under the cost-sharing policy, the police and fire plan would become overfunded (when liabilities are valued at a 6.625 percent earnings assumption). This is mainly because of the employee contribution floor of 50% of the normal cost applied to Tier 1.

10 The San Jose Police and Fire plan provides a minimum service-related disability retirement benefit equal to 50 percent of plan members’ final average salary regardless of years of service. For members who have more than 20 years of service, the pre-tax service-related disability retirement benefit is the same as the unreduced service retirement benefit. Therefore, the costs for service-related disability retirement and service retirement are the same for members who are eligible for unreduced service retirement. Because the San Jose police and fire plan members generally become eligible for unreduced service retirement benefits at ages from 50 to 60, which are also the ages when disability retirement rates rise sharply, a substantial portion of disability retirements occurs when plan members are also eligible for unreduced service retirement, making the plan costs not sensitive to changes in disability retirement rates. Tier 1 members become eligible for unreduced service retirement benefit at (1) age 55 with 20 years of service, or (2) age 50 with 25 years of service, or (3) age 70, or (4) 30 years of service. Tier 2 members become eligible for unreduced service retirement benefit at age 57 with 5 years of service.

11 The benefit formulas for Tier 1 police and fire members are slightly different if they have more than 20 years of service. A weighted average formula is used for the representative police and fire members in the model.