Royal Oak to Consider Tackling Legacy Costs with Bond
(Crystal A. Proxmire, Sept 19, 2015)
Like most cities, Royal Oak bears the cost of funding pensions and benefits for employees. In fact, 26 percent of the personnel budget is spent on employees who no longer work for the city.
Nothing can be done about the obligation itself, but City Manager Donald Johnson does have a plan to reduce costs and save the city what he believes will be approximately $67 million over the next 33 years.
Officials will consider a plan on Monday to take advantage of historically low interest rates and approve a bond to cover the costs. An immediate savings of up to $3.5 million could be immediately realized, according to a recommendation by Johnson. The details of the plan are outlined in the recommendation, which explains the costs and benefits, as well as provides context of the City’s finances.
“When I first interviewed with the City of Royal Oak, ten years ago, at the end of the discussion I asked the commissioners “What do you really want from your next finance director?”
Commissioner Terry Drinkwine didn’t hesitate. He immediately boomed “$6.4 million.”
The city’s 2005-06 budget called for using all fund balance in the general fund and taking money from other funds. It also projected a $6.4 million operating deficit for the following fiscal year (2006-07). Even city commissioners publicly suggested that Royal Oak needed an “Emergency Financial Manager” (The pre-curser to today’s “Emergency Manager”). I may have been the only one who refused to use the word “crises” to describe our situation.
None of us had any indication at the time that things would get far worse before things got better. We were still years away from the real estate crash of 2008 which would reduce our taxable value and property tax revenue by 10.6% percent.
We have come a long way. We made major cuts, some would say draconian cuts, in staffing. We have improved efficiency and effectiveness of city programs and services and we stopped providing some services. We made and continue to make a great effort to make sure fee supported activities cover their full cost. We are diligent about charging other funds their share of costs so the general fund no longer subsidizes other funds. In 2012 the citizens of Royal Oak stepped up and authorized a 3.975 millage for public safety. In 2014, the citizens again authorized a special 2.5 mill tax to repair and replace roads.
The one thing we haven’t done yet is resolve our legacy cost problem. The term “legacy costs” refers to the costs of employees after they leave active service. Specifically, it is the cost of providing pensions and other post-employment benefits, often referred to as OPEB. “Other post-employment benefits” is really just a long winded way of saying retiree health care. Royal Oak is currently fully funding both pensions and OPEB at the “actuarially required contribution” (ARC) level. That is the amount an independent certified actuary has determined is needed to set aside in order meet our current and future pension and OPEB obligations. We have not always done that. OPEB was historically funded on a pay as you go basis until 2008 when the city first created an OPEB trust and began properly funding this liability. In 2010 real estate crash caught up to us and halted our ability to fully fund the OPEB ARC and we reverted to pay as you go until the 2014-15 fiscal year.
Properly funding these liabilities does put a major strain on the city’s budget. Approximately 26% of our personnel budget goes to pay for employees who no longer work here. Looked at another way, nearly 100% of the general operating levy is used to support legacy costs.
The city began taking steps to bring this under control in 2005 when retiree health care and defined benefit pensions were eliminated for all new employees in the AFSCME bargaining unit.
By 2009 retiree health care had been eliminated for new employees in all bargaining units and all non-union positions. By 1/1/08 only employees in police and fire unions still received defined benefit pensions. Just last week the commission approved a change that will consolidate most retiree health care plans, provide better coverage, and reduce our cost by about 6%.
Today, I’m asking the commission to consider a long term solution to the problem.
An amendment to Michigan Public Act 34 of 2001 allows municipalities to issue bonds to cover all or part of the unfunded liability of closed pension and OPEB plans. A preliminary analysis (attached) provided by our financial advisor suggests bonding the full unfunded liability could save the city over $67 million over the next 22 years and immediately reduce our cost for pension and OPEB by as much as $3.5 million per year.
This is possible only because borrowing costs are extremely low today by historical standards. It assumes we will be able to earn far more on our investments than our interest will cost, even though that interest will not be tax exempt to the purchasers of these bonds. I think this is a good assumption but there are no guarantees this will be the case. Those investments are primarily in equities (stocks) and the market can go down as well as up. Because of that, some expect long term rates to follow. This window of opportunity will close. Historically low interest rates are the key to this working.
If we are to proceed, the first question should be “how much do we bond.” Some municipalities have chosen to bond less than the maximum allowed but let’s start with determining that maximum. The law allows a municipality to bond for the full UAAL of closed plans subject to legal debt limits. “Closed” means no new employees are able to enter the plan. Royal Oak has fully closed its retiree health care and partially closed its pension plans. We still have new police and fire union members entering a defined benefit pension plan so our police and fire pension plan is not closed and is therefore not eligible under this act.
As of our latest actuarial valuations, the city’s OPEB unfunded actuarial accrued liability (UAAL) was $120,309,611 and the pension UAAL was $73,030,356. However, most of the pension UAAL is for police and fire employees whose plan is not closed. Only $23,812,491 of pension UAAL is related to general employees whose plan is closed. That means a total maximum of $144,122,102 of UAAL plus bond issuance costs may be bonded under this act. Please note these figures are based on actuarial valuations for the year ending June 30, 2014. Updated actuarial valuations are required to be performed within 150 days of a bond issuance so these numbers will change. In addition to changes that are the result of time, the new actuarial valuations will incorporate the plan change approved by the commission last week.
Total issuance costs for services such as bond counsel, financial advisor and rating agency etc. is estimated at approximately $400,000. This will be less if we decide to go with a single bond rating instead of two. The city charter provides a debt limit is 5% of state equalized value, which when adjusted for existing debt would allow for approximately $92 million of additional debt to be incurred.
However, Mr. John Axe, our bond consul and author of the amendment that allowed for bonding legacy costs, has opined that the authority to issue this type of debt is derived from state law and is subject only to the state restriction on debt which is 10% of state equalized value. Further, Mr Axe’s opinion states that debt issued under the act is not counted against the charter limit at all, thus not impacting the ability to issue future debt. It does count against the state limit and does impact future debt capacity when judged against the state limit. This means we could issue bonds for the full UAAL and still have adequate debt capacity.
Our state debt limit currently provides capacity to issue $208,319,472. If we issued the full $144,522,102 (UAAL plus issuance cost), we would retain $63,797,370 of additional state debt capacity. Charter debt capacity would remain at $91,820,733 so the state rule would become the limiting factor on future debt.
Our total debt at present is $57,679,363 and $33,001,356 of that is not subject to the debt limit. Attached in the “bond scenario analyses” is a snapshot of the details of a $145 million issuance using a current interest rate plus 50 basis points in the event the market moves by the time we are ready to issue.
Also enclosed is the analyses should the city bond only $24 million for general employees’ pension UAAL or only bond $121 million OPEB UAAL. Using the enclosed $145 million scenario, an annual debt payment of approximately $10.7 million would be required and over the life of the debt the city will pay a total of approximately $244.6 million ($99.5 million in interest).
Should the city commission wish to proceed, the director of finance and I recommend that Tom Michaud, the retirement system attorney, help the city establish a 115 trust for the proceeds of the OPEB issuance. Also, we recommend that an ordinance assign responsibility for investing the proceeds of the OPEB trust to the retirement board but require that it be maintained as a separate trust.
The following is a summary of the bonding process in chronological order:
City commission approves: a resolution authorizing insertion of a notice of intent to bond into the newspaper, a bond resolution and continuing disclosure resolution. (Sept. 2015)
Notice of intent is published in the newspaper. (Sept. 2015)
Pension and/or OPEB data is prepared and sent to the actuary. (Sept. 2015)
City administration prepares meets with ratings agency(s) requesting rating on the bond(s). (November 2015)
Actuarial report(s) are received from actuary, showing the updated UAAL. UAAL must be determined within 150 days prior to expected issuance. (November 2015)
City commission approves a resolution approving a bonding plan; includes a notto- exceed amount. (November 2015)
City receives bond rating from rating agency(s). (November 2015)
Forty-five day referendum period expires. (December 2015 – January 2016)
City administration files comprehensive packet for approval with the Michigan Department of Treasury. (January 2016)
City receives approval from the Michigan Department of Treasury. (February 2016)
Publish notice of sale and circulate official statements. (March 2016)
Bond sale and award is conducted. (March 2016)
There are several documents submitted as attachments to this commission letter. These are:
- The “Notice of Intent” resolution. Approving this resolution is the first step in the bonding process. It results in a notice being published in a local newspaper announcing the city’s intention to issue bonds.
- Pension Debt Service Estimate and Savings Analysis Spreadsheet
- OPEB Deb Service Estimate and Savings Analysis Spreadsheet
- Bond Amortization Schedules Prepared by Financial Advisor
- Report from Bond Consul
- Revised Municipal Finance Act (Act 34 of 2001)
Should the city commission wish to proceed, the attached “Resolution Authorizing the insertion of notice of intent of the City of Royal Oak to issue pension and retiree health care obligation bonds, series 2016” should be adopted. The following resolution is also requested to be adopted. Be It Resolved, the city commission hereby authorizes the administration to obtain the necessary updates to our pension and OPEB actuarial valuations required to bond pension and OPEB unfunded liabilities.”
The bond issue is on the agenda for Monday, Sept. 21. For full documents and more info go to http://romi.gov/sites/default/files/meetings/City%20Commission/2015/Funding%20Legacy%20Costs.pdf.