City of Los Angeles’ CAO Miguel Santana Unpacks Fiscal and Budget Challenges

Miguel, last year your office released a report on the City of LA’s fiscal condition, “City at a Crossroads.” It trumpeted fiscal progress. Has anything improved in the year since that report was released?

Miguel Santana: Since then, we’ve issued a subsequent report titled, “Staying the Course,” that was released in March and essentially talks about the progress that we’ve made but still identifies the challenges that lie ahead. It urges the LA City Council to continue the path toward strengthening the fiscal health of the city, and we’re proud of the work that we’ve done. But we still have work to do.

Miguel, your latest CAO report, “Staying the Course,” confirms there is still work to be done—city expenditures continue to exceed revenues, and a structural imbalance is noted as “significant.” Moreover, in the LA 2020 “Time for Truth” report, a panel co-chaired by Austin Beutner and Mickey Kantor and commissioned by LA City Council President Wesson asserts the budget fixes to date and declarations of having “balanced the budget” are simply sophistry.

As the economy improves, we’re seeing revenues grow. We only had one year when revenues declined, and that was immediately after the recession. Since then, revenues have been crawling back up. Our revenues today currently exceed where they were prior to the recession. The unfortunate part is that our expenditures are growing at a faster rate.

Those costs are being driven by our compensation, pensions, healthcare, and workers’ comp. This year, for example, the budget released by the mayor basically maintains the services that we provided last year, and yet there are millions of dollars of new revenue. Every dollar of new revenue we see is basically being taken to address the shortfall that is created by expenditures exceeding our revenue projections. 

At some point, expenditures exceeding revenues portend fiscal danger. Do they not?

We titled the report “Staying the Course” because we recommend that if we continue to try to control costs in the same way that we have, and then we actually forecast that in three years if we maintain those costs and allow the natural growth of revenue to occur, then we actually get out of deficit mode. By keeping those costs even and not growing the size of the workforce—meaning not providing salary increases that we can’t afford— and by continuing to contain our healthcare costs, and ultimately maintaining the pension reform that has been adopted, then we can get out of deficit mode.

The negotiated “successes,” even if they survive legal challenge by unions, are going to have very little impact in the near future on the city’s budget deficit. Many ask, therefore,  if there is the political will on the part of the mayor and the council, as has been the case with Governor Brown, to truly cut costs and painfully address the City’s structural deficit.

Actually, the mayor and the council have demonstrated the political will—the city just a year ago had a rainy-day fund of $500,000, and in just one year that rainy day fund has risen to $70 million. Just a few years ago, our reserve fund, which is our savings account, was below what our own fiscal policy calls for—which is at least 5 percent of the general fund. We are now exceeding the policy—the reserve fund is about 5.5 percent as proposed in the mayor’s budget.

   We’ve made progress in putting money aside, and we’ve been effective at doing that by taking one-time revenue and using it for one-time purposes. This is in contrast to what was done in the past—when one-time revenue was used to build the size of city government. But then, once that one-time revenue was gone, we were forced to maintain that same level of service without the funding to support it. The challenges we now face are really beyond our control—particularly around pensions. 

When you say “beyond our control,” could you elaborate?

I think the city took on the pension challenges before the state and other jurisdictions did. First we adopted a new pension tier for our sworn personnel a few years ago. That’s generating savings. Current employees went from paying nothing toward retiree healthcare and getting that benefit for free—not only for themselves, but also for their spouse or partner—to paying 4 percent of their salary for that same benefit. So 4 percent of my paycheck goes to pay for healthcare that I’ll get once I retire. Before, it came free.

The City Council adopted a new pension tier for civilians, despite the opposition of labor, to ensure that any new hires are on a much more sustainable pension tier. State law and federal law are still unclear as to whether or not government can actually change the formulas for pensions for current employees. We designed our pension system around where we believe the law is clearer. When the city makes a commitment to an employee when they start off, we’re making a commitment to that person not just on the first day of the job, not just in the middle of their career, but until the day they die. The benefits that they signed up for the day they started, they’re entitled to receive when they retire. We have to make sure those benefits are sustainable.

Changes beyond that are tied up in federal and state law, which is being challenged in various forms throughout the country. Ultimately, the health of the pension funds themselves are tied to the strength of the economy, which we don’t control. That’s obviously not just the LA economy, but the national, global economy. The city’s been very aggressive in doing what it can. A lot of the variables associated with our pension systems are really beyond the city’s own ability to change at this point. 

Miguel, would you share with our readers what percent of the current, proposed, and future budgets are and must be dedicated to pension contributions? 

The budget proposed by the mayor for fiscal year 2014-15 is over $8 billion, and the pension costs for next year are expected to exceed $1 billion, so that gives you a sense of the ratio. $1 billion out the total $8 billion in the budget will go to pension costs for civilian and sworn employees. This excludes our proprietary departments, including Water and Power, Harbor, and Airports.

Assuming that we don’t grow the size of the workforce, that we don’t give raises over the next three years, and assuming that there are no major changes to the pension systems on the rate of return assumptions, then they’re expected to grow by year 2016-17 to about $1.125 billion. Based on our current assumptions, we actually see our pension costs starting to go down in fiscal years ‘17-‘18 and ‘18-‘19. We reach a peak in a couple years. These are again illustrations that are done by actuaries that have a number of assumptions in it—basically the assumptions are the status quo that gets put in place.

There are a number of factors that could also change this scenario. If the city were to start growing the size of the work force, if the unions are successful in overturning the new pension tier that was adopted, which they’re currently challenging, if the city gives raises, if the pension system reduces the rate of return assumptions—those factors will obviously change the forecasts.

Currently, as a result of the difficult changes that the city has adopted over the last few years, we’re starting to see the light at the end of the tunnel.

About a year ago, TPR interviewed former City of LA CAO Keith Comrie, who served 20 years in that role. He noted for the record that the Riordan administration adopted the Deferred Retirement Optional Program—DROP—that he asserted was a significant contributor to LA’s current structural deficit. Could you comment on the status of that program and if anything has been done to mitigate it’s impacts? 

When the program was adopted, it established that every five years there would be a review of the program. It’s now been 10 years—there was a review done five years ago and we’re currently doing a review now. The question is, “Is the program cost-neutral?” The way DROP works is that once a police or firefighter is retirement-eligible, he or she could continue staying in the city workforce, and the pension allowance that they would have received had they retired is deposited into an interest-bearing account. They are able to work five additional years, while receiving their salary and benefits, but they can’t touch their pension allowance during that time. Once they retire, they receive not only the future pension that they’re entitled to receive, but they also receive the total funds deposited during those five years that they would have received. The amount they get includes a five-and-a-half percent guaranteed interest.

At the time it was adopted, it was done because the city was having difficulty recruiting police officers, and there was a concern that the size of the police force was declining. They were trying to incentivize police officers to stay in the system and not retire or go on to another system. We recently just had an actuarial analysis done, and it basically determines that if you continue to forecast it in the future, DROP can be cost neutral. However, if you look at the experience that has occurred so far, it currently isn’t cost neutral.

We’re currently looking at what it would take to make it cost neutral, based on the actual experience of the program, as Mr. Comrie had noted. Then we will begin the process of discussing that with the unions. It does require a discussion with them, like most things that are labor related, and we will begin that process soon. 

Referencing your comments about current obligations to past employees and programs like DROP, how are such obligations impacting current budgetary allocations for other high priority services? For example: planning and community plans, the size of the police and fire departments, and street and road repair schedules? In other words: How are past obligations and future obligations crowding the other budget priorities and obligations? 

I think that’s the real tension that’s occurring. It was a very difficult decision and action that the council took when they moved forward to adopt a new pension tier for civilians, even with the opposition of labor. They did it for two reasons. The first reason is based on the idea that if you’re going to continue making a promise to our workforce that they’ll have a pension when they retire, you have to ensure that the pension they’re signing up for is sustainable. Like I said before, there’s difficulty in what we could do for those currently working for us, but we can certainly change the system for those we haven’t made a promise to.

A new pension tier was established that’s less generous—people have to work longer and pay more to receive benefits. Retirement went from age 55 to age 65. We guarantee for current employees a two party retiree healthcare benefit. Under the new pension tier, the benefit is only for one individual—for the employee. Future employees will have to start paying half of the unfunded liability that accumulates over the years. Right now, the city takes on 100 percent of that liability.

That was an important decision in part because more and more of the budget was going toward pensions, which we’re obligated to meet, thus providing less revenue for services that improve the quality of life in Los Angeles.

The second reason is that it’s important that the pensions be there for those employees who rely on their pension systems. Nobody should want a sustainable pension system more than those employees who are relying on that system to exist when they retire. We are surprised at labor’s challenge of the new pension system, because it’s only hurting those current employees who are relying on the pension system to exist at the time that they need it. It was for those two reasons that the council and mayor ultimately adopted the new pension tier.

If it gets overturned—right now, it’s in the process of working its way through our employee relations system and then probably ultimately the courts—then it makes it more difficult for the city to maintain services in the community. Second, it becomes difficult to guarantee the kind of benefit that people signed up for when they started working here.

The council is helping on this issue by suggesting a bond measure for streets and roads, something most citizens of LA think is part of the taxes they already pay—so there would be more revenue rather than cuts. You’re not a policy maker, but is that an incorrect perception? 

My office recommends the initiative for our roads because our roads are in need of repair. The city on its own, based on its current revenue sources, simply does not have the ability to make the kind of improvements necessary to address all of the failed streets. We spend a lot of money on our streets to simply maintain them at the current level today. I think most Angelenos would conclude that the current condition is not something to be proud of. That scenario is not likely to change. If we are interested in improving all of our failed streets, we actually need a new revenue source.

This proposal would be a new revenue source dedicated exclusively to maintain our streets and our sidewalks. The sidewalks are not in much better shape than our streets are. We have an option as a city to continue on the same path and do patchwork fixes on our streets with our current revenue sources, which will still be a challenge. We do it not just with the general fund, but we rely heavily on federal funding, which is on the decline.

The question is, what other options do we have? We proposed this because, frankly, we don’t see any other option if we want to address the real problem. 

But Miguel, you’re not connecting the dots—or maybe it’s being incorrectly suggested that they connect—between the impacts of growing employee pensions and other obligations and the squeeze on the general fund. Is there not a nexus here that is requiring new revenue sources, and is this proposal just the beginning of new bond issues like that?

The city is limited on what it can do on its current pension liabilities by state law. Because your pension is your vested right, even if employees agree to pay more for their pensions or change the benefit itself, state law protects that pension to what it was when they signed up for it. What we can do, we’ve been doing.

We adopted a new tier, and we’re not growing the size of the workforce—for four consecutive years, we kept the workforce at the same level that it’s been. We reduced it originally by 15 percent during the height of the recession, and we’ve kept it there even as other governments begin to grow due to the improvements in the economy. We were contractually obligated to give raises. We stopped doing that for any new bargaining units. With new bargaining units, we require that they start making contributions toward their healthcare premium, so the city has been trying to control these costs to the extent that it’s possible.

If we started seeing the size of the workforce grow, if we started making changes to our pensions, making them more generous, if we started providing raises that we couldn’t afford, then I would agree with that premise that the city was moving forward in a way that’s exacerbating the problem.

But we’ve been doing all of these things, and yet it’s still not enough based on the way revenue is structured today. So in order to do the kind of major repair to our streets and sidewalks, a new revenue source is necessary. 

Because the cost of borrowing is a factor in any of these bond measures, how are the rating agencies now currently rating LA? What’s the nature of your discussions with them going forward?

Actually, on the proposal for our streets, we’re not recommending borrowing. We’re recommending you pay as you go. We’re recommending a sales tax directly earmarked for our roads and our sidewalks and that we only roll out a program that we can afford each year. The proposal that I made to the council does not require any bonding or borrowing because the cost of issuance is high. We felt it was important that every penny goes directly for the program and not to pay interest.

With regard to our bond rating—we were downgraded twice in the height of the recession, in part because we had to rely on our reserve funds to basically end the year in the black. That was unfortunately my first year here, when it was the darkest days of the economy. The City of LA, like many other cities, simply focused on surviving that year, and we ended up dipping into our savings account to end the year in the black. That resulted in being downgraded twice.

Our bond rating now is still solid. We haven’t experienced any downgrades since. The rating agencies have actually acknowledged in their last reports the progress that the city has made, but they do raise concerns—the same ones that we share—about certain liabilities that we have. They recognize that the city has made a major effort to control pensions, or at least minimize their growth. But other liabilities remain, including lawsuits as well as our police overtime.

Again, I’m interested in all the issues you addressed in your “Staying the Course” report. The mayor and council have negotiated with business interests to try to reduce the business tax over a set of years. There’s been discussion that there’s not enough money for the community plans, although there is a 3 percent tax on every real estate transaction, and given the growth of real estate, one wonders why there isn’t enough money for community plans. Talk about the nexus between the budget and its implications for our expenditures and our revenues. 

The business tax is one of the few that we receive 100 percent of. The property tax, sales tax, hotel occupancy tax—those are all taxes that we share with other entities. Any reduction that we experience in the business tax, we experience 100 percent of that reduction. It’s been debated whether the business tax, as it’s currently structured, is a hindrance to economic growth in the city, and I’ve heard both sides of it. The position of this office is less around that, but more around how any reduction is treated.

We have recommended that if they’re going to reduce the business tax, we need be honest about the reduction to revenue. We can’t pretend that there is somehow going to be magical revenue generated in other areas. The trickle down economics theory doesn’t work in this case. Even if it should increase the property tax, sales tax, or hotel occupancy tax, we don’t get 100 percent of those revenue sources, so the federal government, state government, and other governments will benefit from that, including the county and the city—however, usually we get the smallest percentage.

The proposal that has been negotiated and is currently a directive in the budget is a $45 million reduction over three years, starting in fiscal year 15-16. That means that we’ll have a reduction in that revenue source. I appreciate the fact that if it gets adopted, it’s predictable. We can actually plan for that reduction, and we could incorporate that into our forecast—as long as we’re honest that there’s not going to be necessarily any new revenue generated from it.

I worry when there’s speculation that somehow this reduction is going to generate new revenue on top of that, and people start wanting to spend that new revenue that’s not even here. Fortunately, the way the discussion is going, it’s done in a manageable way. But it is a large source of revenue for us. The business tax is almost the same size as the entire budget for the fire department. 

I wonder if you could respond to the plan for implementation of the LA 2020 Commission and its assertions about the budget and its dire straits. Your response would be well received by our readers.

The 2020 Commission was able to identify some major issues. I think they realized this is not an easy thing to fix—it’s a very complicated series of issues to deal with. They raise issues pertaining to the living wage and trying to address the disparity that exists not just in Los Angeles, but across the state and country. They provide a discussion about how to improve transparency and bring in more voices to understand the city’s finances. There’s certainly a lot there to talk about, and I’m sure that their report will be pursued in a variety of ways.

Each one of their recommendations will carry a life of its own. Some of them will perhaps even become ballot measures. Some of them may not go very far. They certainly gave enough there to have a variety of different approaches to what is a very complicated problem.