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EXPLAINER: Why the county is looking to ride low interest rates to big savings on refinancing pension debt

Santa Cruz County’s annual debt payments to state benefits agency CalPERS could reach $66.4 million by the end of this decade. To lessen the burden, county officials are looking to refinance some of it by borrowing about $121 million, a move they say could yield close to $70 million in much-needed long-term savings.

Faced with a mountain of debt totaling nearly $700 million owed to California’s underfunded pension system for public employees, Santa Cruz County is considering an option similar to refinancing a mortgage — taking out tens of millions in low-interest loans officials say could help save close to $70 million in the long run.

Historically low interest rates could prove a boon to the county which, like local governments across the state, has been grappling with ballooning payments to CalPERS, the state agency that manages and invests benefits for most public employees.

Those debt service costs have skyrocketed since the fund took a seismic hit during the Great Recession in 2008. Santa Cruz County’s costs are expected to reach $66.4 million annually by the end of this decade, officials say — a big bite out of a county budget that would total $881 million next fiscal year.

That’s why the county is now looking toward so-called pension obligation bonds to essentially refinance its debt to CalPERS. The bonds — which are expected to total somewhere around $121 million and would not need voter approval — would stabilize Santa Cruz County’s future debt payments and potentially cut its interest rate by more than half, officials say.

The biggest risk in taking out the bonds is if CalPERS lowers the interest rate it charges the county below what county officials expect to lock in as the bond’s interest rate. But that happening is “pretty unlikely,” they say.

The risk of not taking out loans now, county officials argue, is far greater. They say the bonds will generate “substantial savings” for taxpayers.

‘The risk of inaction’

The move could free up millions. The first full year of savings in 2022-23 is projected to be about $2 million.

“If we do see the upside, we are looking at some very significant savings,” Supervisor Manu Koenig said during a discussion of the item last week. “I mean, over $2 million a year. That’s a huge amount. That’s close to all the money we have for local road resurfacing in the county. And so we can definitely potentially use that money to make some much-needed investments in the community.”

The board of supervisors earlier this month gave the green light to county staff to further explore the option of issuing bonds, asking them to report back in August with a more concrete figure on borrowing.

“It does appear that we’re looking at some very serious costs if we do nothing that will really hinder our ability to make essential investments in the future,” Koenig said. “The risk of inaction seems higher than taking this action today.”

Supervisor Manu Koenig
“The risk of inaction seems higher than taking this action today,” Supervisor Manu Koenig said of the prospect of borrowing to refinance some of the county’s debt burden.
(Kevin Painchaud / Lookout Santa Cruz)

He added that low interest rates provide an opportunity for the county to borrow money now.

“As Supervisor (Greg) Caput said, this is very much like refinancing a house,” Koenig said. “We’re seeing huge amounts of refinancing today to take advantage of these low-interest rates and I think it makes perfect sense that the county would essentially do the same thing with our unfunded liabilities.”

By the numbers

Because officials are working on making adjustments involving the county’s largest miscellaneous pension plan (essentially separating animal shelter employees and some court personnel to put them into their own pension plans), staff members are focusing on issuing bonds this fall for the county’s two “safety” plans, which cover 1,163 current and former employees, including deputies, probation staff and district attorney investigators.

Overall, as of the most recent CalPERS report, Santa Cruz County had 2,416 active county staff enrolled in CalPERS pension plans. But the total pool is even bigger: 3,269 are retired and at some point in their career worked for the county, and 2,045 left the county at some point in their career but are not yet retired.

Borrowing the $121 million is estimated to provide $69.9 million in savings over the life of the bonds, county officials say, and would increase the funding levels for those plans from 70% to 90%, getting closer to a funding sweet spot. By the time the county makes its last payment on the bonds in 2047, it will have paid $167.3 million between principal and interest, per projections.

Overall, the county owes CalPERS $688 million in total liabilities — in other words, the money needed to fully fund all of the county’s pensions into the future. But while debt payments to CalPERS are projected to increase over the coming years, county staff say that there is no risk to pension obligations the county has to its current or former employees, in part, because those are legally protected by the state supreme court, which means the county can’t just decide not to pay them, and because the plans are funded at a high enough level locally.

According to recent CalPERS data, the average annual pension for its retirees is $38,184; new retirees average $42,744 a year.

CalPERS & how thousands of Santa Cruzans are affected

As the largest pension fund in the nation, serving about 2 million current and retired government employees, CalPERS has a funding gap of about $158 billion between its estimated obligations to retirees and active members and the current value of its assets; this gap is known as UAL, or unfunded accrued liability. The system is currently about 70% funded and as of March had a $445 billion investment portfolio.

Similar to how 401(k)s and retirement programs in the private sector work, public employees pay into the system via a portion of their paycheck and their employers — cities and counties — make contributions on their behalf.

But when CalPERS falls short of its investment targets — its assumed rate of return or discount rate — local governments are left to make up the difference in what county official Marcus Pimentel calls “backfilling.” Pimentel is the county’s assistant director of health but due to his extensive finance background has been working on pension obligation bonds.

Over the past decade, Santa Cruz County’s UAL debt service costs have continued to rise, totaling $23.7 million in 2017-18 and $39.1 million in 2020-21, according to the county. For next fiscal year, which starts July 1, the county is projecting $45.9 million in total debt payments, and by 2030-31 those are expected to reach $66.4 million.

“We’re backfilling for investment losses of the Great Recession and we’re backfilling for — in the last 10 years CalPERS, on average, has underperformed as compared to the stock market,” Pimentel told Lookout in an interview.

“What we hope to achieve is stabilize our cash flows looking outward,” he said. “So instead of seeing this big climb to the top of the mountain, we reduce that peak. … It’s as simple as this: We can borrow money at 3% instead of paying CalPERS the same debt at 7%.”

And aside from a predictable, stable cash flow, allowing the county to model out its future payments, the savings the bonds could generate could also be used to pay down future CalPERS debt, which is some of the highest-interest debt the county has to grapple with year over year.

CalPERS says the economic downturn and volatility in the market are the main drivers for its unfunded liability growth, and that it has worked in recent years to blunt the impact of future financial crises. Officials for the agency say they recognize the increased costs local governments have to deal with but also point to the advances made over the years to try to narrow the funding gap.

CalPERS spokesperson Amy Morgan said in an email to Lookout that over the past few years the agency has made “strong progress” to put the CalPERS fund on more solid ground by streamlining its investment program and reducing the discount rate, among other things.

It’s all “aimed at fully funding the system by reducing risks and lessening the impact of a future financial crisis,” she wrote, adding that the local governments determine the benefits and pay, and CalPERS administers the pension system.